BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
6 Blank
UNIT 1 INTRODUCTION TO
ECONOMICS AND ECONOMY
Structure

1.0 Objectives

1.1 Introduction

1.2 Concept of Scarcity

1.3 Meaning of Production

1.4 Central Problems of an Economy

1.4.1 What to Produce?
1.4.2 How to Produce?
1.4.3 For Whom to Produce?
1.4.4 The Problem of Growth
1.4.5 Choice between Public and Private Goods
1.4.6 The Problem of ‘Merit Goods’ Production

1.5 Production Possibility Curve

1.6 Allocation of Resources: Solution of Central Problems

1.6.1 Resource Allocation in a Mixed Economy

1.7 Economic Methodology and Economic Laws

1.7.1 Inductive and Deductive Reasoning
1.7.2 Equilibrium

1.8 Positive versus Normative Economics

1.9 Microeconomics and Macroeconomics

1.10 Stocks and Flows

1.11 Statics and Dynamics

1.12 Let Us Sum Up

1.13 References

1.14 Answers or Hints to Check Your Progress Exercises

1.15 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College (University of Delhi), Delhi.
7
Introduction
1.0 OBJECTIVES
After studying this unit, you will be able to:

 explain the problem of scarcity of resources for satisfying ever-increasing

wants of society;
 state the meaning and nature of an economy;
 describe the concept of economic entities;
 discuss the concept of production possibility curve;
 state the issues relating to allocation of resources between investment and
consumption, and between private and public goods;

 explain the methods of resource allocation in a market economy in a

socialist economy and in a mixed economy;
 clearly describe the basic concepts and methodology of Economics;
 state the nature of economic laws; and
 explain some of the analytical concepts associated with economic
reasoning.

1.1 INTRODUCTION
Let us begin with defining the discipline of Economics.
Definition of Economics
Economics has been variously defined. As summarised by Samuelson, some of
the definitions seek to explain that economics:

 analyses how a society’s institutions and technology affect prices and the
allocation of resources among different uses.

 explores the behaviour of the financial markets, including interest rates

and stock prices.

 examines the distribution of income and suggests ways that the poor can
be helped without harming the performance of the economy.

 studies the business cycle and examines how monetary policy can be
used to moderate the swings in unemployment and inflation.

 studies the patterns of trade among nations and analyses the impact of
trade barriers.

 looks at growth in developing countries and proposes ways to encourage

the efficient use of resources.

 asks how government policies can be used to pursue important goals such
as rapid economic growth, efficient use of resources, full employment,
price stability, and a fair distribution of income.

8
A common theme running through all these definitions is that scarcity is a fact Introduction to
of life and that an efficient use of these scarce resources is to be found. That is Economics and
how we define economics as a science that deals with scarcity. Economy

It explains the behaviour of different economic units, households, firms,

government and the economy as a whole, when they are faced with scarcity.

1.2 CONCEPT OF SCARCITY

“Scarcity” lies at the root of all economic activities. The concept of scarcity
finds an expression in two basic facts of economic life:
A. Unlimited wants or ends, and
B. Scarce resources or means.
A. Unlimited wants or ends
Every person has some wants. Different persons have generally different
wants, and wants of even the same person keep changing with the passage of
time, change of place and status.
Human wants are unlimited and keep on increasing. Different wants differ
in their intensity. Subject to the availability of resources, higher order wants
need be satisfied first and if the resources are still available these may be used
to satisfy lower order wants.
B. Scarce resources or means
Satisfaction of wants requires resources (or the means to satisfy wants).
Availability of resources is limited in relation to requirements.
However, scarce means have alternative uses.
The resources therefore need be allocated among different uses in a systematic
coordinated manner. Every individual and economy has to devise a mechanism
for this.
Different societies try to solve these issues in different ways and in the process
each society creates a set-up called ‘an economy’. The term ‘economy’ or
‘economic system’ is a comprehensive one. It covers the entire set of
institutions and arrangements, (including rules and regulations which facilitate
their interactions) for resolving the basic and permanent problem of an
imbalance between means and wants.
The human society has evolved several sets of such institutional arrangements
each is termed an economic system and they have their own distinguishing
features and nomenclatures. These systems try to adopt their own means and
methodologies for solving the basic problems.
For example, take the case of a capitalist economy. In this case the means of
production are owned and inherited by individuals, and various economic
decisions are guided by prices of goods and services in the market. The income
of an individual is determined by means of production supplied by him to the
market and the price which they are paid for their service. On the other hand, in
a strict socialist economy all the means of production are owned by the state.
The state takes all the decisions regarding the use of available resources.
9
Introduction However, whatever its nature, every economy has to solve the basic problem of
scarcity of means in relation to the ever-increasing and varied wants. The
means and wants can be combined in alternative ways. The problem of scarcity
exists in every society, irrespective of the levels of its development. Hence it
has to address itself to two issues:
1) increasing the availability of means of satisfaction, and
2) laying down the priorities of the wants to be satisfied.
Check Your Progress 1
1) State two important characteristics of wants which make them unlimited
in number.
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2) What is an economy?
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3) Pick up the correct option among the following:
Which of the following can be called scarce:
a) Stock of rotten vegetables
b) Useless plants in a jungle
c) Number of flowers in a nursery
d) Water in a dirty pit.

1.3 MEANING OF PRODUCTION

The term ‘Production’ implies the transformation of various inputs into
output thereby increasing the want-satisfying capacity of the inputs. The
process of production transforms the things occurring in nature into goods and
services which are capable of satisfying human wants. The things which are so
transformed are called inputs while output is nothing but the transformed form
of inputs, that is, the goods and services. This involves some human effort,
both physical and intellectual. The transformation may be physical (a different
appearance which enhances want satisfying capacity), spatial (relocate or
transfer the things from one place to another to make them available to the end
users) or inter-temporal (saving/preserving things which arise/grow/made
today for use at a later date-storage and warehousing). A particular
transformation is production if the want-satisfying capacity of the output (also
called ‘product’) is more than that of inputs used. To put it differently
production is nothing but the creation of utility.

10
 Introduction to
1.4 CENTRAL PROBLEMS OF AN ECONOMY Economics and
Economy
Because of the scarcity of resources every economy is faced with certain basic
or fundamental problems which it must try to solve within its socio-economic
framework. These central problems are:

1.4.1 What to Produce?

An economy does not have enough resources to produce everything required
by it. So, it must be selective and decide what to produce and what not to
produce. When some goods are not produced, some wants of the society
remain unsatisfied. The decisions regarding the wants to be satisfied and the
goods and services to be produced are interrelated and are taken in a
coordinated manner. This is called allocation of productive resources. If some
factors of production are employed in the production of product X, to that
extent, these will no longer be available for production of product Y. The
problems can be illustrated by Production Possibility Curve which we will
introduce shortly.

1.4.2 How to Produce?

This is a problem which covers the details of the allocation of productive
resources in the production of various goods and services. More precisely, we
can say that when an economy decides to produce X , it has also to work out
exactly how much of labour, capital, land, etc., would go into its production.
The exact proportion of factor-inputs used in the production of goods needs to
be decided, irrespective of the size and nature of an economy. This is called the
technique of production of that item. For example, we may think of goods
which are produced by using more of labour than capital. In such cases labour
intensive techniques of production are said to be in use. On the other hand, if
more of capital goes into the production of an item, then we say that it is being
produced by a capital-intensive technique.
When an individual producer is to decide about the technique of producing any
particular product, he considers the prices and productivities of alternative
inputs, say labour and capital, since frequently their relative usage can be
varied. He tries to use those inputs in such a combination which costs him the
least and will yields him the maximum output.
His decision is based on consideration of following two factors:
i) the relative price of labour and capital, and
ii) the relative efficiency of the two inputs

1.4.3 For Whom to Produce?

A society comprises a large number of individuals and households. All the
output of consumption goods and services is ultimately meant for their use.
Therefore, all goods and services produced are to be distributed amongst the
individuals and households. The share of each individual and household has to
be determined and also the quantities of specific goods and services which
comprise that share.
We can see that it is possible to propose different principles whereby this
distribution may be carried out. In an economic system organised on market
11
Introduction principles, the income shares of individual members of the society are
determined in the following manner:
In a market economy, productive resources are privately owned. They are sold,
bought and hired like any other goods or services. The price of a productive
resource is determined by the market forces of demand and supply. Whenever
it is to be employed by a producer, he has to pay its market price to its owner.
It is for the owner to supply it to the market or withhold it. The income of each
individual under these conditions, is determined by the amounts of different
productive resources owned and supplied by him to the market and their
respective price.

1.4.4 The Problem of Growth

Every economy seeks to increase its stock of capital to increase its production
capacity and thereby generate more income. The generated income in an
economy has two alternative uses, viz. consumption expenditure (C) and
saving (S). Thus, Y = C + S. Saving is source of finance for investment in an
economy. Investment adds to the capital stock of an economy. And therefore,
there is a need to reduce the share of consumption expenditure (and thereby
increase investment); this helps in capital formation.

1.4.5 Choice between Public and Private Goods

1) Private Goods: There are certain goods (the term goods here includes
services also) whose availability can be restricted to selected individuals
only. For example, a product may be priced in the market and only those
who pay its price may be allowed to have it. This characteristic of a
product by which some people can be prevented from its use is referred
to as the ‘principle of exclusion’. Accordingly, those persons who
cannot pay for it or who are not ready to pay, are not allowed to use it.
The use of the goods is thus divisible between different persons. Any
goods which can be priced and whose use can be restricted to selected
persons is termed as private goods.
2) Public Goods: When it is not possible to restrict the availability of a
product to selected individuals, they are termed as public goods or social
goods. Such goods cannot be so priced as to deprive some persons from
using it. That way, it is indivisible. Defence service is a typical example
of a public service. When a country is protected against foreign
aggression, every citizen is protected.
With its limited resources, an economy cannot have enough of both public and
private goods. It must try to achieve an optimum combination of both.

1.4.6 The Problem of ‘Merit Goods’ Production

Those goods whose consumption is considered highly desirable for the
members of the society are termed as merit goods. The important feature of
the merit goods is that their consumption benefits both the user and non-users.
For example, if a person is educated and healthy, it not only helps him but also
the society as a whole. Health and education, therefore, are called a merit
product/service and it is desirable that every member of the society gets
education. Consumption of merit goods benefits the society as a whole and
raises the level of its efficiency and well-being. Therefore, every society has to
12 decide the extent it can and should produce and consume merit goods.
Check Your Progress 2 Introduction to
Economics and
1) State the central problems of an economy? Economy
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2) What is capital formation?
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3) What is a technique of production?
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4) What are merit goods?
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5) Differentiate between public and private goods.
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1.5 PRODUCTION POSSIBILITY CURVE

The economy has to choose between alternative combinations of various goods
and services. This problem of choice can be illustrated by a simple graph
known as Production Possibility Curve or a Product Transformation
Curve. A typical Production Possibility Curve (PPC) is drawn on the
following assumptions:
i) The country has to choose between alternative combinations of only two
goods, say. LED (L) and computer monitor (M).
ii) All productive resources of the country are taken as given and so is the
state of technology, no changes are made in them.
iii) All productive resources of the economy are fully employed. There is no
wastage or under utilisation.
iv) The productive resources are suitable for the production of both goods
(L) and (M). They can, therefore, be shifted from the production of one to
the other goods. However, such a shift would reduce the production of
the first good and increase that of the other.
v) No factor of production is considered to be specific in the production of
one good alone and inappropriate for the production of the other.
vi) We consider the productive efficiency of the productive resources only in
physical terms, i.e., the units of LED (L) and Computer Monitor which
they can produce. 13
Introduction Based upon these assumptions, we can illustrate the set of production
possibilities available to a country by a hypothetical example. Look at Table
1.1. The figures in the table show that all the productive resources of the
country put together can produce a maximum of either 30 L or 30 M or some
other combinations thereof. The production possibilities illustrated in Table 1.1
are also represented in Fig. 1.1 in the form of a production possibility curve
(PPC).
Quantity of M is measured along X-axis and the numbers of L are measured
along Y-axis. The respective pairs of the quantities of L and M are plotted and
joined with each other to yield a curve which is called the Production
Possibility Curve. Thus, the PPC represents all the possible combinations of L
and M which can be produced by using all the productive resources of the
economy, efficiently. In that sense, each point on the curve represents the
maximum possible output and, for that reason, it is also termed as the
production frontier of the economy.
Table 1.1: Production Possibilities Available to a Country

Combination LED Computer Loss of M for Loss of L for

(Numbers) Monitor each each
(L) (M) Additional Additional
L Produced M Produced
(Tones) (Numbers)
1 30 0 2.8
2 25 14 1.2 0.357
3 20 20 0.8 0.833
4 15 24 0.6 1.250
5 10 27 0.4 1.667
6 5 29 0.2 2.500
7 0 30 5.000

Fig. 1.1

14
The economy can produce any combination of L and M represented by a point Introduction to
either on the PPC or in the shaded area of the diagram. Production Economics and
combinations represented by the shaded area imply that the economy can Economy
produce either L or M or both. For example, combinations represented by
points A, B and C are feasible, as these lie either on the PPC or in the shaded
area. But the combination represented by A is feasible but not efficient.
Combination represented by points B and C are both feasible and efficient. If it
produces at Point A it is not utilising some of its productive resources and let
them go waste. Thus consider point A which represents a combination of 10
tonnes of M and 14 L. The PPC, however, shows that with this much of M, the
economy can produce 27 L (as shown by point C on PPC). Alternatively, with
14 L, the quantity of M can be increased to 25 tonnes (see point B).
Any point beyond the PPC, which is in the non-shaded area of the diagram,
shows a combination of L and M which the economy cannot produce. For
example, point D represents a combination of 30 M and 20 L. However, when
30 M is produced, no resources are left for the production of L. On the other
hand, if 20 L are produced, then the quantity of M has to be reduced to 20.
Characteristics of PPC
A typical PP curve has two characteristics:
1) Downward sloping from left to right
It implies that in order to produce more units of one good, some units of the
other good must be sacrificed (because of limited resources).
2) Concave to the origin
A concave downward sloping curve has an increasing slope. The slope is the
same as MRT. So, concavity implies increasing MRT, an assumption on which
the PP curve is based.
Can PP curve be a straight line?
Yes, if we assume that MRT is constant, i.e. slope is
constant. When the slope is constant the curve must
be a straight line. But when is MRT constant? It is
constant if we assume that all the resources are
equally efficient in production of all goods.
Note that a typical PP curve is taken to be a concave
curve because it is based on a more realistic
assumption that all resources are not equally efficient
in production of all goods. (Fig. 1.2)

Fig. 1.2

Does production take place only on the PP curve?

Yes and no, both. Yes, if the given resources are fully and efficiently utilised.
No, if the resources are under-utilised or inefficiently utilised or both. Refer to
the Fig. 1.3.
On point F, and for that matter on any point on the PP curve AB, the resources
are fully and efficiently employed. On point U, below the curve or any other
15
Introduction point but below the PP curve, the resources are either under-utilised or
inefficiently utilised or both. Any point below the PP curve thus highlights the
problem of unemployment and inefficiency in the economy.

Fig. 1.3

Can the PP curve shift?

Yes, if resources increase. More labour, more capital goods, better technology,
all means more production of both the goods. A PP curve is based on the
assumption that resources remain unchanged. If resources increase, the
assumption breaks down, and the existing PP curve is no longer valid. With
increased resources, there is new PP curve to the right of the existing PP curve.

Fig. 1.4 Fig. 1.5

It can also shift to the left, if the resources decrease. It is a rare possibility but
sometimes it may happen due to fall in population, and due to destruction of
capital stock caused by large scale natural calamities, war, etc.

16
 Introduction to
1.6 ALLOCATION OF RESOURCES: SOLUTION Economics and
OF CENTRAL PROBLEMS Economy

Theoretically, there are two types of economic systems, viz.. Capitalistic

economy and socialistic economy. In practice, all the countries have adopted a
system which is broadly identified as mixed economy.
The problem of resources allocation may be tackled in several ways and each
economy tries to solve it in line with its own chosen objectives.

1.6.1 Resource Allocation in a Mixed Economy

A mixed economy is one in which some decisions are left to the market forces
while others are taken under direct government regulation or even ownership.
Some selected areas of economic activities are reserved for the government
sector. The government acquires the necessary productive resources for these
activities and employ them in conformity with its priorities. The production
pattern of the public sector, the prices of items produced by the public sector
and other measures are used to regulate the allocation of resources in private
sector as well. These other measures include price controls, licensing, taxation,
subsidies and others. Additionally, various labour welfare measures are
implemented and enforced by the government. Similar steps are taken to
encourage the use of productive resources for encouraging the development of
backward areas of the country for removing specific shortages, and for
bringing about a balanced development of the economy as a whole.

1.7 ECONOMIC METHODOLOGY AND

ECONOMIC LAWS
Economic methodology investigates the nature of economics as a science. It
investigates the nature of assumptions, types of reasoning and forms of
explanations used in economic science. Various practices such as
classification, description, explanation, measurement, prediction, prescription
and testing are associated with economic methodology. Economic
methodology examines the basis and groups for the explanations. Economists
give answer why questions about the economy. For example, economists use
the shifting of demand and supply curves to answer the question of why prices
change.
Economics being a social science, economic laws are, therefore, a part of social
laws. In the words of Alfred Marshall, we should separate that part of
behaviour of members of the society where the main motive happens to be an
economic one, where the main motive can be expressed in terms of money
price. The corresponding activities are then economic activities. However, such
a dividing line between economic laws and other social laws is not always
clear. Very often an activity happens to be motivated by a combination of both
economic and non-economic considerations. As a result, it is often quite
difficult to formulate pure economic laws which have full validity also.

1.7.1 Inductive and Deductive Reasoning

Economists have followed two traditions in formulating economic laws.
According to one tradition, the causes (also called conditions or assumptions)
17
Introduction are specified and different economic units are expected to behave in a ‘rational’
manner. The outcome in this case is predictable, provided the assumptions
made are satisfied. The assumptions themselves may be totally unrealistic or
may be very close to reality but they are stated in a precise manner. In any
case, this type of reasoning is called deductive reasoning. In this method, the
generalisation or law is stated and the individual activities are expected to
conform to it. A typical example of deductive reasoning is the law of demand
which states that, other things being equal, the quantity of a product demanded
varies inversely with its price. When price falls, demand expands and when
price rises, demand contracts.
As against this deductive reasoning, some thinkers try to discover economic
laws the other way round. Instead of laying down causes or conditions on a
hypothetical basis, they collect the actual information regarding the behaviour
of economic units under different conditions. In other words, empirical
information is collected and generalisations regarding the behaviour of
economic units under different conditions are worked out. This is called the
method of inductive reasoning. A well-known example of the use of this
method is the Engel’s Law. Through a study of family budgets, Engel
concluded that as the income of a family increases, the proportion of its
expenditure on necessities decreases while that on comforts and luxuries goes
up. Most business firms prefer this line of approach.
In economics, both inductive and deductive methods of reasoning are used to
supplement our understanding of an economy and its working.

1.7.2 Equilibrium
The concept of equilibrium is an important tool of analysis in economics. It is
very frequently used and one should become familiar with it. Usually, an
economic variable (such as the price of a commodity) is subject to various
forces trying to pull it in different directions. When these forces are in balance,
the value of variable stops changing and it is said to be in equilibrium.
Concept of Equilibrium
Equilibrium means a state of rest, the attainment of a position from which there
is no incentive nor opportunity to move.

 A consumer is in equilibrium when his expenditure on different goods

and services yield maximum satisfaction. No move on his part can
increase his satisfaction but, rather, will decrease it.

 A business firm is in equilibrium when its resource purchases and its

output are such that it maximises its profits, if profit maximisation is its
objective, any change on its part will cause profits to decrease.

 A resource owner is in equilibrium when the resources which he owns are

placed in their highest paying employments and the income of the
resource owners is maximised. Any transfer of resource units from one
employment to another will cause his income to decrease.

 An economy is in equilibrium at the level of income (and employment)

where aggregate demand equals aggregate supply.
Equilibrium concepts are important, not because equilibrium is ever in fact
18 attained but because they show us the directions in which economic changes
proceed. Economic units in disequilibrium usually move toward equilibrium Introduction to
positions. Economics and
Economy
Equilibrium can be analysed in two forms:
1) Partial: In partial equilibrium analysis we concentrate on a single
market in isolation from the rest of the economy.
2) General: In general equilibrium analysis, we analyse simultaneously all
the markets in the economy on the basic premise that everything depends
on everything else.

1.8 POSITIVE VERSUS NORMATIVE

ECONOMICS
The term positive economics is concerned with only formulating economic
laws and describing reality. The economic laws may be derived from
theoretical assumptions or from recorded facts. Either way, they only tell us
what exists. They do not pass any judgement as to whether the findings of
economic analysis are desirable or need a modification.
As against this, normative economics realises the fact that an economy is
never perfect. The outcome of its working can always be improved upon. It
is quite normal to find an economy faced with many problems requiring
immediate attention. Such problems can be related to price changes,
employment, scarcity of certain inputs, inequalities of Income and wealth, and
so on. In normative economics, the knowledge gained is put to use for
improving the working of the economy. Targets of improvement are laid down
and policy measures are formulated by which the targets are to be achieved.
Thus, normative economics is concerned with what ought to be.

A positive statement:

“An increase in price of petrol leads to a fall in its quantity demanded.”

A normative statement:

Government should take steps to cut the consumption of Petrol.

More generally, normative statement uses the verb “should”.

1.9 MICROECONOMICS AND

MACROECONOMICS
The terms microeconomics and macroeconomics are used in connection with
the level of aggregation, that is the extent to which economic units and
variables are covered in economic analysis. At one end, the analysis may cover
the behaviour and responses of a single economic unit and at the other extreme
it may cover the entire economy. These two terms (micro and macro) are
derived from Greece words mikros and makros which mean small and large
respectively.

19
Introduction Microeconomics deals with the behaviour of individual elements in an
economy such as the determination of the price of a single product or the
behaviour of a single consumer or business firm.
As against this, macroeconomics covers large aggregates or collection of
economic units which may extend to the entire economy. In the words of
Kenneth Boulding, macroeconomics covers the great aggregates and
averages of the economic system rather than individual items. Here we
study collections of variables and economic units (i.e., macro variables) such
as national income, employment, level of prices in general, intersectoral flows
of goods and services, total savings and investment, and the like. While the
study of an individual firm or an industry lies within the scope of
microeconomics, an entire sector falls within the scope of macroeconomics.
To use a metaphor, macroeconomics studies elephant as one object;
microeconomics (like five blind men in a flok tale) studies individual parts of a
whole body. Each study leads to different results. Or, to use another metaphor,
one enjoys the macro-view of a cricket test match while one enjoys a ball-by-
ball description when sitting in before a TV.

1.10 STOCKS AND FLOWS

Economic variables are of two kinds: 1) stocks and 2) flows. A stock variable
is the one which can be measured only with reference to a point of time
and not over a period of time. As against this, a flow variable is the one
which can be measured only with reference to a period of time and not a
point of time. We come across numerous economic variables which belong to
one category or the other. Take the examples of the supply of money and
magnitude of wealth. They have reference to point of time. They are, therefore,
‘stock’ concepts. Correspondingly, examples of flow variables are production,
saving, expenditure, income, sales, purchases, etc. All these variables can be
measured only over a period of time. A factory can produce so much during,
say, a month and not at a given moment of time. A person does not have an
income at a point of time. But he has it only for a period of time. A flow
concept can assume some value only with the passage of time, not otherwise.
One should observe that stock and flow variables are often used together in
economic analysis.

1.11 STATICS AND DYNAMICS

Economic analysis can be conducted either by using a static framework or a
dynamic setting. Static and dynamic modes of analysis can be differentiated in
more than one ways. According to one definition, in a static model (theory)
the variables (cause effect) are not dated. The demand-supply model of market
behaviour is a static model. The model that demand depends on own price,
supply depends on own price, with an equilibrium condition that demand must
equal supply, time does not enter into the picture at all and the variables are all
undated. According to this definition, a dynamic model would be one where
the relevant variables are dated. If the demand-supply model is restructured as
follows, then the model would become dynamic according to this criterion.
Dt = f(Pt)
St = g(Pt)
20 Dt = St
where‘t’ is the relevant time unit. Introduction to
Economics and
However, according to some economists, even if the variables are dated the Economy
model does not become dynamic. A dynamic model according to this
definition would be one where the variables must be dated and a time lag must
exist in their relationships. According to this criterion the following would be
a dynamic model.
Dt = f(Pt)
St = g(Pt-1)
Dt = St
There is no lag in the demand relationship. Demand in period ‘t’ depends on
own price of the same period. However, in the supply relationship a gestation
lag exists which makes the model dynamic. Supply in period ‘t’ depends on
price prevailing in the previous period (t–1). The price level in previous period
(t–1) would have induced the producers to increase or decrease the supply, full
impact of such decisions are visible in time period ‘t’ only. For market to
attain equilibrium, demand in period ‘t’ must equal supply in period ‘t’.
Check Your Progress 3
1) State whether the following statements are True or False:
i) Positive economics is concerned with what ought to be.
ii) Normative economics requires a system of value judgement for
recommending policy steps.
iii) Every economist prescribes the same remedies for a particular
economic problem.
iv) Positive economies always depict reality.
v) We can always extend the conclusions of microeconomics to the
field of macroeconomics.
vi) Demand and supply are both stock variables.
vii) In comparative statics, a comparison of two equilibrium positions is
made.
2) Match the item in Column A with those in Column B.
Column A Column B
i) Study of individual firm and industry a) Barter
ii) A variable which can be measured at a point b) Macroeconomics
of time
iii) Study of an entire sector of an economy c) Marginal utility
iv) A variable which can be measured over a d) Ceteris paribus
period of time
v) Want satisfying capacity of a good e) Flow variable
vi) Satisfaction yielded from consuming one f) Microeconomics
additional unit
vii) Other things being equal g) Utility
viii) Exchange of apples with eggs h) Stock variable 21
Introduction 3) Which of the following will be the new production possibility frontier, if
new technology is developed that enables higher productivity in
agricultural (A) only? Industrial output (I) is not impacted.

Fig. 1.6

1.12 LET US SUM UP

Economics explains the behaviour of different economic units like consumer,
producer, households, firms, governments and the economy as a whole when
they are faced with the problem of scarcity. Scarcity is observed in terms of
unlimited wants in relation to available scarce resources. Scarcity gives birth
to three central problems: What to produce, how to produce and for whom to
produce. The other problems aligned with these three problems are the
problems growth, choice between public and private goods and the problem of
merit goods production. The central problem of an individual as well as for the
society is therefore the allocation of scarce means among competing ends. A
production possibility curve shows, given scarcity of resources and given
technology, the maximum output produced of one good, given the output of
other good. It shows how one good can be transformed into another good not
physically but via the transfer or shifting of the resources from one line of use
to another.
Economic methodology investigates the nature of economics as a science.
Economic laws enable us to provide explanation of an event or phenomena in
terms of cause and effect relationship. Two types of logics are followed in
formulation of economic laws – induction and deduction.
Equilibrium is an important tool of analysis in economics. When the different
forces pulling a variable in different directions are in balance, its value stops
changing and is said to be in equilibrium.
The term positive economics denotes that part of economic analysis which just
describes reality (or theoretical reasoning) without stating the desirability or
otherwise of the findings. Normative economics, on the other hand, is
concerned with what ought to be. It views reality in the light of chosen goals of
society and suggests ways and means of achieving them.
Microeconomics studies the economic activities and responses of individual
economic units and their small groups. Macroeconomics covers large
collections of economic units, their aggregates and averages and macro-
variables like national income, employment, and so on.

22
Economic variables can further be classified into stocks and flows. A stock Introduction to
variable is the one which can be measured only with reference to a point of Economics and
time. A flow variable, on the other hand, is measurable only over a period of Economy
time.
Static economic or comparative statics is a technique of analysis in which the
parameters of the economy are taken to be given. The assumption of ceteris
paribus is made and the initial and final equilibrium positions arc compared. In
dynamic-economics or dynamic analysis, parameters of the economy are
allowed to change.

1.13 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi,
2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

1.14 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Unlimited, ever increasing
2) Economy refers to the setup created for meeting the basic and permanent
problem of an imbalance between means and wants.
3) c)
Check Your Progress 2
1) The central problems of an economy are (i) what to produce, (ii) how to
produce, (iii) for whom to produce, (iv) the problems of growth, (v)
choice between public and private goods (vi) the problem of merit goods
production.
2) Addition in its stock of capital is capital formation.
3) Technique of production refers to exact proportion of factor inputs used
in the production of goods.
4) The goods whose consumption benefits both user and non-users are merit
goods.
5) Private goods are the goods whose availability is restricted to selected
individuals whereas in case of public goods nobody is excluded in the
availability of such goods.

23
Introduction Check Your Progress 3

1) i) False ii) True iii) False iv) False – It will depict reality only if its
assumptions are realistic. Otherwise it would have only correct reasoning
without applicable conclusions. v) False vi) False vii) True
2) i) f ii) h iii) b iv) e v) g vi) c vii) d viii) a
3) b

1.15 TERMINAL QUESTIONS

1) What is an economic system? Explain the central problems of an
economy.
2) What are the main characteristics of human wants?
3) Scarcity lies at the root of every economy. Explain.
4) What do you understand by factors of production? Briefly explain each of
the four main factors.
5) Write short notes on the following:
a) Public goods and private goods
b) Merit goods
c) Human wants
6) Explain how the solutions to the fundamental problems of an economy
are interlinked with each other.
7) Explain the concept of a production possibility curve. Enumerate its
assumptions. Illustrate it with the help of an example.
8) Briefly explain how resource allocation takes place in the following
systems:
a) Market economy
b) Socialist economy
c) Mixed economy
9) Giving reasons state which of the following statements are true or false:
i) All human wants cannot be satisfied. It is a universal truth. Why to
make a serious effort to satisfy them?
ii) Only a resource rich economy like Dubai is not faced with the
problem of choice.
iii) The difference between labour force and work force of an economy
indicates the size of unemployed persons.
iv) National Library at Kolkata is a right example of a public good.
v) MTNL/BSNL produce a private good.

24
10) Distinguish between positive and normative economics. Which one Introduction to
should be preferred and why? Economics and
Economy
11) Write short notes on the following :
a) Concept of Equilibrium
b) Limitations of Economic Laws
c) Ceteris Paribus
d) Tracing the Path of Change
12) Distinguish between :
a) Microeconomics and Macroeconomics
b) Static Economics and Dynamic Economics
13) State the reasons on account of which almost every modern economy is a
dynamic one.
14) In what forms opportunity costs manifest themselves for the consumer,
the producer, the investor, and a factor of production?

25
 UNIT 2 DEMAND AND SUPPLY
ANALYSIS
Structure
2.0 Objectives
2.1 Introduction
2.2 The Nature of Demand
2.3 Determinants of Demand
2.3.1 Determinants of Demand by a Consumer
2.3.2 Determinants of Market Demand

2.4 The Law of Demand

2.4.1 The Demand Schedule
2.4.2 The Demand Curve
2.4.3 Why does a Demand Curve Slope Downwards?

2.5 Change in Quantity Demanded versus Change in Demand

2.6 The Concept of Supply
2.6.1 Determinants of Supply

2.7 The Law of Supply

2.7.1 The Supply Schedule
2.7.2 The Supply Curve
2.7.3 Exceptions to the Law of Supply

2.8 Changes in Supply versus Changes in Quantity Supplied

2.8.1 Changes in Quantity Supplied
2.8.2 Change in Supply
2.8.3 Why the Supply Curve Shifts?

2.9 The Idea of Elasticity

2.9.1 Elasticity of Demand
2.9.2 Elasticity of Supply

2.10 Measurement of Price Elasticity of Demand

2.11 Determinants of Price Elasticity of Demand
2.12 Determinants of Elasticity of Supply
2.13 Let Us Sum Up
2.14 References
2.15 Answers or Hints to Check Your Progress Exercises
2.16 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College
26 (University of Delhi), Delhi.
 Demand and
2.0 OBJECTIVES Supply Analysis
After studying this unit, you will be able to:
 distinguish between want and demand;
 explain the law of demand with the help of a demand schedule and a
demand curve;
 identify the movement along a demand curve and a shift of the demand
curve;
 state the concept of supply and its determinants;
 discuss the concept of elasticity of demand and supply and various
methods of their measurement; and
 explain the importance and determinants of elasticity of demand and
supply.

2.1 INTRODUCTION
Satisfaction of human needs is the basic end and goal of all production
activities in an economy. As we have learnt in Unit 1, human wants are
unlimited and recurring in nature, whereas means available to satisfy them are
limited. Therefore, a rational consumer has to make an optimal use of available
resources. The demand and supply analysis provides a framework within which
these decisions have to be made. Hence, in this unit we shall discuss the
various issues related to the theory of demand and supply analysis.

2.2 THE NATURE OF DEMAND

At first, let us understand the meaning of the terms like desire, want, and
demand. Desire is just a wish on the part of the consumer to possess a
commodity. If the desire to possess a commodity is backed by the purchasing
power and the consumer is also willing to buy that commodity, it becomes
want. The demand, on the other hand is the wish of the consumer to get a
definite quantity of a commodity at a given price in the market backed by a
sufficient purchasing power. There are three important points to remember
about the quantity demanded:
First, the quantity demanded is the quantity desired to be purchased. It is the
desired purchase. The quantity actually bought is referred to as actual purchase.
Secondly, quantity demanded is always considered as a flow measured over a
period of time, like if the quantity demanded of oranges is 10, it must be per
day or per week, etc.
Thirdly, the quantity demanded will have an economic meaning only at a
given price. For example, the demand for oranges equal to 10 units per week at
a price of Rs. 100 per dozen is a full and meaningful statement, as used in
micro-economic theory.

2.3 DETERMINANTS OF DEMAND

The demand of a product is determined by a number of factors. Let us discuss
them in detail.

27
Introduction 2.3.1 Determinants of Demand by a Consumer
The demand for commodity or the quantity demanded of a commodity on the
part of the consumer is dependent on a number of factors. These are mentioned
as follows:
i) Price of the commodity in question
ii) Prices of other related commodities
iii) Income of the consumers, and
iv) Taste of the consumers.
Demand function refers to the rule that shows how the quantity demanded
depends upon above factors. A demand function can be shown as:
Dx = f (Px, Py,Pz, M, T)
where, Dx is quantity demanded of X commodity, Px is the price of X
commodity, Py is the price of substitute commodity, Pz is price of a complement
good, M stands for income, T is the taste of the consumer.
If all the factors influencing the demand for a commodity X vary
simultaneously, the picture would be highly complicated. Therefore, normally
we allow only one of the factors to change, assuming that all other factors
remain unchanged (‘ceteris paribus’ other things remaining equal).
Demand Relationship: Relationship of quantity demanded of a commodity to
its various determinants can be stated as follows:
1) Price of the commodity: Normally, higher the price of the commodity,
the lower the demand of the commodity. This is the law of demand.
2) Size of the consumer’s income: When the increase in income leads to an
increase in the quantity demanded, the commodity is called a ‘normal
good’. If an increase in income leads to a fall in the quantity demanded,
we call that commodity an ‘inferior good’.
3) Prices of other commodities: A consumer’s demand for a commodity
may also be influenced by the prices of some other commodities. Some
are complementary goods, which are consumed along with the
commodity in question while others may be used in place of this
commodity. This category is called substitutes.
Demand bears inverse relationship with prices of complements and
direct relationship with prices of substitutes.
Tea and coffee are substitutes and a car and petrol are example of a pair
of complementary goods.
4) Tastes of consumer: If a consumer has developed a taste for a particular
commodity, he/she will demand more of that commodity. Similarly, if a
consumer has changed his taste against a particular commodity, less of it
will be demanded at any particular price. This development of tastes may
be related to seasons of the year as well. In summer months, you may
consume more cold drinks and ice creams, whereas in winters, the
preference may shift towards hot or warm drinks like tea and coffee etc.

28
2.3.2 Determinants of Market Demand Demand and
Supply Analysis
The factors determining the demand for a commodity in a market are the same
as those which determine the demand for the commodity on the part of a
consumer. Besides that two additional factors are also to be included. These
two factors are:
1) Size of the population: All other factors remaining unchanged, the
greater is the size of the population, more of a commodity will be
demanded.
2) Income distribution: People in different income groups show marked
differences in their preferences. So if larger share out of national income
goes to the rich, demand for the luxury goods may rise and a rise in
income share of the poor will increase demand for the wage goods.
A correct specification of the demand equation is a must for the estimated
function to predict demand accurately.
Check Your Progress 1
1) Distinguish between want and demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What are the determinants of demand of a commodity by an individual
consumer?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Explain the factors influencing the market demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................

2.4 THE LAW OF DEMAND

The inverse ralationship between the quantity of a commodity and its price,
given all other factors that influence the demand is called ‘law of demand’. It
gives us a demand curve that slopes downwards to the right. We can explain
this idea with help of a demand schedule, a table that records quantities
demanded at different prices. This schedule, on being recorded on a two
dimensional axes system, gives us a demand curve.

2.4.1 The Demand Schedule

Let us use imaginary figures to show the application of the law of demand.
Table 2.1 given below, showing the application of the law of demand, is called
the ‘Demand Schedule’.
29
Introduction Table 2.1 : The Demand Schedule of a Consumer for Apples

Quantity Demanded of
Price of Apple per Kg. Apples
(in Rs.)
(in Kg. per week)
100 15
200 12
300 8
400 3

Four combinations of price and quantity demanded are shown in the Table 2.1.
We can easily infer that as price of an apple rises quantity demanded by the
consumer is falling.
2.4.2 The Demand Curve
The demand curve graphically shows the relationship between the quantity of a
good that consumers are willing to buy and the price of the good. Let us
understand the demand curve with the help of the Fig. 2.1. In this figure, on the
Y-axis, price of an apple in rupees in measured and on the X-axis the quantity
demanded of apples per week is measured. The first combination of Table 2.1
is shown by point a where at Rs. 100 per kg 15 units of apples are demanded.
Similarly points b, c, d represent combinations of Rs. 200 price – 12 quantity
demanded, Rs. 300 price – 8 quantity demanded and Rs. 400 price – 3 quantity
demanded, respectively. The joining together of points a, b, c, and d give us the
demand curve, DD.

Fig. 2.1

The most important feature of a demand curve is that it slopes downward from
left to right. In Fig. 2.1 the demand curve is a straight line. But it can also be in
the form of a curve as shown in Fig. 2.2.
Whether a demand curve is a straight line or a curve depends on how much
quantity demanded rises with the fall of its price or how much quantity
demanded falls with the rise in the price of the commodity. Whether we take
Fig. 2.1 or 2.2, in both the cases the law of demand is applicable.
30
 Demand and
Supply Analysis

Fig. 2.2

If we record demand schedules of two or more consumers of a commodity on

the same axes, we can get a number of demand curves. Horizontal summation
of those curves gives us the market demand curve. We are illustrating a two
consumer market demand curve for ice cream with help of the following
schedule and diagram:
Table 2.2

Price (Rs) Quantity Demanded by Market

Demand
Household A Household
B
3 4 + 5 =9
4 3 + 4 =7
5 2 + 3 =5
6 1 + 2 =3

Market demand curve is a horizontal summation of individual demand curves,

as illustrated below.

Fig. 2.3

31
Introduction 2.4.3 Why does a Demand Curve Slope Downwards?
Law of demand states that there is an inverse relationship between the price of
a commodity and its quantity demanded.
1) Substitution Effect
Substitution effect results from a change in the relative price of a commodity.
Suppose a Pepsi Can and a Coke Can both are priced at Rs. 90 and Rs. 20 each.
If the price of Coke is raised to Rs. 25, and the price of Pepsi is not changed,
Pepsi will become relatively cheaper to Coke, i.e. although the absolute price
of Pepsi has not changed, the relative price of Pepsi has gone down. The
change in the relative price of commodity causes substitution effect.
Similarly, if price of mango falls, the rest of the fruits will appear costlier, in
comparison with mango.
So in both the cases above, the quantity demanded of relatively costlier items
will register a decline.
2) Income Effect
This is the effect of a change in total purchasing power of the money income of
the consumer. As price of mango falls the purchasing power of the given
money income rises, or his real income rises. Thus, he can buy more of the
mangoes with the same money income. His demand for any other commodities
may also rise. This is called the ‘income effect’. A commodity with positive
income effect is called a ‘normal good’. It shows a positive or direct
relationship between the income and the quantity demanded.
When rise in income leads to a fall in the quantity demanded, we have a case of
negative income effect. Such goods are called the ‘inferior goods’.
3) Price Effect
Price Effect is the sum total of the substitution effect and income effect, i.e.
PE = SE + IE
Where PE = Price Effect.
SE = Substitution Effect
IE = Income Effect
It is important to note that substitution effect and income effect operate
simultaneously with the change in the price of the commodity. ‘Substitution
effect’, and ‘income effect’ taken together give ‘price effect.’ We can identify
three cases.
1) Substitution effect always operates in a manner such that as price falls,
quantity demanded of this commodity increases. If along with
substitution effect, we take income effect and if that happens to be
positive (a case of normal commodity) the law of demand will
necessarily apply.
2) Given substitution effect, if income effect is negative (a case of an
‘inferior commodity’) the law of demand can still apply provided the
substitution effect outweighs or is more powerful than the negative
income effect, and

32
3) Given substitution effect, if income effect is negative and it outweighs or Demand and
is more powerful than the substitution effect, the law of demand will not Supply Analysis
hold good.
GIFFEN GOOD
A case where negative income effect outweighs substitution effect is possible
when we have ‘Giffen good’ named after the Robert Giffen who first talked of
such paradox. Here a fall in the price of a commodity does not lead to a rise in
its demand, it may result in a fall in demand for this commodity.

2.5 CHANGE IN QUANTITY DEMANDED Vs.

CHANGE IN DEMAND
When the demand for a commodity changes because of the change in its price,
it is called ‘change in quantity demanded’. On the other hand, when the change
in demand is due to the factors other than its price cause a change it is called
‘change in demand’.
Expansion and Contraction in Demand
The change in quantity demanded of a commodity is called the expansion in
demand if a fall in the price causes the quantity demanded to rises. Conversely,
if with a rise in the price of a commodity, its quantity demand falls, we call it
contraction in demand. These can be represented in the form of a movement on
a demand curve, as shown in Fig. 2.4.

Fig. 2.4

DD is the demand curve. At point ‘a’ on the demand curve we find that at price
OPa, OQa of a commodity is demanded. As price falls to OPc, demand becomes
OQc. This movement from point a to point c on the demand curve DD is
referred to as ‘extension in demand’. Similarly when price of a commodity
rises to OPb, demand falls to OQb. Thus, the movement from a to b on the
demand curve DD is known as ‘contraction in demand’.
Change in Demand
Change in demand takes place when the whole demand scenario undergoes a
change. This change occurs due to a change in any determinant of demand
33
Introduction other than the price of that commodity.
Change in demand may take two forms:
i) Increase in demand, and (ii) Decrease in demand
Increase in demand takes place when;
a) at a given price, higher quantity is demanded, or
b) at a higher price, the same quantity is demanded
Decrease in demand takes place when:
a) at a given price, lower quantity is demanded, or
b) at a lower price, the same quantity is demanded
Graphically, increase in demand results in rightward shift of the whole demand
curve. Likewise, decrease in demand results in leftward shift of the demand
curve. This is shown in the Fig. 2.5.

Fig. 2.5

At price Pa, at point ‘a’ on DD, quantity demanded is OQa. At the same price,
quantity demanded rises to OQb at point b on the demand curve D'D'. This is
called ‘increase in demand’. Similarly, at price OPa the quantity demanded
comes down to OQc on point ‘c’ of demand curve D"D". This change in
quantity demanded is ‘decrease in demand’. The shift of the demand curve to
the right shows ‘increase in demand’ and a movement of the demand curve to
the left of the initial demand curve is a ‘decrease in demand’.
Many factors can shift a demand curve. Some of them are:
1) A rise in income of the consumer can enables him to demand more of a
commodity at a given price and a fall in income will generally force him
to curtail his demand.
2) A rightward shift in the demand curve can also take place because of
increase in price of a substitute. Similarly, a leftward shift in the demand
curve can be because of decrease in price of a substitute.
3) If the consumer develops a taste for a commodity, he may demand more
of it even if the price remains unchanged, shifting the demand curve to
the right. On the other hand, a leftward shift in the demand curve can
34 indicate that our consumer has started disliking the commodity.
Check Your Progress 2 Demand and
Supply Analysis
1) Given the demand function
q = 90 – 3P
i) at what price, no one will be willing to buy any commodity?
....................................................................................................................
....................................................................................................................
ii) what will be the quantity demanded, if the commodity is given free.
....................................................................................................................
....................................................................................................................
2) State the law of demand. Does it apply to all the goods?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) What is substitution effect?
....................................................................................................................
....................................................................................................................
....................................................................................................................
4) Substitution effect + Income effect = Price effect. Is it always true?
....................................................................................................................
....................................................................................................................
....................................................................................................................
5) Does a change in taste leads to a movement along the demand curve?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.6 THE CONCEPT OF SUPPLY

Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time. Just like demand, the word supply also has
some distinguishing features which are given below.
1) The supply of a commodity indicates the offered quantities. In fact,
current supply can be different from current production, the difference is
accounted for by the changes in the inventories or the stocks.
2) Like the demand, the supply is also with reference to the price at which
that quantity is supplied. If the price is not mentioned, our statement
would not carry any economic meaning.
35
Introduction 3) The supply is a flow. It has a time unit attached therewith. The supply has
to be per day/week or month.
Formally, supply of a commodity refers to the quantity that a producer is
willing to sell at different prices.

2.6.1 Determinants of Supply

Some of the important determinants of supply are as follows:
1) Price of the commodity supplied: The price is most immediate
determinant of supply. A person or firm will make quick check whether
the costs will be covered by the price. As the price goes up, a firm/person
will be willing to sell larger quantity.
2) The prices of factors of production or cost of production: These affect
the cost of production and possible profits of the firm. A rise in the prices
of factors of production discourages the production and supply of the
commodity.
3) Prices of other goods: As the prices of other commodities rise, they
become more attractive to produce for a profit maximising firm. Hence
supply of commodity whose price is unchanged will decline.
4) The state of technology: The improvement in the knowledge about the
means and the methods of production lead to lower costs of production
and helps increasing output.
5) Goals of the producer: The objective with which the producer
undertakes production also influences his production and supply
decisions.
A simultaneous change in all the determinants makes analysis difficult.
Therefore, we talk of a change in only one of the factors, others remaining
unchanged to work out effect of that factor on the quantity of the commodity
supplied by a firm.

2.7 THE LAW OF SUPPLY

A producer aims to maximise profits, the difference between total revenue and
total cost. Total revenue is the price of the product multiplied by its quantity
sold. Total cost is the cost of production.
Profit = TR – TC
TR = Total Revenue (q.p)
TC = Total Cost (q.AC)
where AC is average cost.
A higher price would mean more profits. The producer will supply more at a
higher price. Similarly, a producer will supply smaller quantity at a lower
price. This is a direct relationship between the price and the quantity supplied
of a commodity and is called the ‘Law of Supply’.
Here the change in price is the cause and change in supply is the effect. Thus,
the supply function is:
36
 S = f (P) Demand and
Supply Analysis
The supply of a commodity is a function of its price, the price of all other
commodities, the prices of factors of production, technology, the objectives of
producers and other factors remaining unchanged. So:
Qs = f(P1, P2, P3... Pn, F1… Fa, T, G, ….)
Where Qs stands for the quantity of the commodity supplied;
P1 is the price of that commodity, P2, P3...Pa are the prices of other
commodities;
F1 …… Fn are the prices of all factors of production;
T is the state of technology;
G is the goal of the producer.

2.7.1 The Supply Schedule

A supply schedule shows quantities of a commodity that a seller is willing to
supply, per unit of time, at each price, assuming other factors remaining
constant. A supply schedule of a product based on imaginary data is given in
Table 2.3 illustrating the relationship between price and quantity supplied as
given by the law of supply.
Table 2.3: Supply Schedule of a Pen Producer

Price (in Rs) per Pen Quantity Supplied (in

thousand)
per Month
2 25

3 40

4 50

5 60

6 70

The schedule presented in Table 2.3 shows that at Rs. 2 per pen, the producer
is willing to supply 25 thousand pens per month. At a higher price of Rs. 3 per
pen, he is willing to supply 40 thousand pens per month and so on. This
schedule depicts direct relationship between price per pen and quantity
supplied of pens per month.

2.7.2 The Supply Curve

Look at Fig. 2.6 where the data from Table 2.3 has been plotted. Here price is
plotted on the Y-axis and quantity supplied on X-axis.

37
Introduction

Fig. 2.6 : Supply Curve

Fig. 2.6 shows that point labelled a, for example, gives the same information
that is given on the first row of the table; when the price of pens is Rs. 2 per
pen, 25,000 pens per month are offered for sale. Similarly, points b, c, d, and e
on the graph correspond to row 3rd, 4th, 5th and 6th of Table 2.3 respectively.
The supply curve S is a smooth curve drawn through the five points a, b, c, d
and e. This curve shows the quantity of pens offered for sale at each price.
The supply curve (just like a demand curve) can be linear straight line, or in the
shape of an upward slopping curve convex downwards.
The upward slope of the supply curve indicates that higher the price, the
greater the quantity will be supplied. If the supply curve is extended to the Y-
axis, it may or may not pass through O. If it passes through O, it shows that the
quantity supplied is zero when the price is zero. If it does not pass through
zero, it shows that until the price rises up to a certain point, the quantity
supplied will remain zero. Re. 1 can be such a price. The producer will not
offer any quantity for sale if price is Re. 1 or less. The upward sloping supply
curve is just a diagrammatic representation of the law of supply.

2.7.3 Exceptions to the Law of Supply

Generally speaking, the law of supply indicates a direct relation between the
price and the quantity supplied. But there can be some exceptions to the law of
supply such as:
Non-maximisation of profits: In some cases the enterprise may not be
pursuing the goal of maximisation of profits. In that case, the quantity supplied
may increase even when price does not rise. For example, if the firm wants to
maximise sales, it may sell larger quantities even when the price remains
unchanged.
A multiproduct firm may aim at maximising total profits, rather than profit
from each of the line of production. So, the law of supply may not apply for
each product.
Factors other than price not remaining constant: We may notice that factors
other than the price of the product may not remain constant. For example, the
quantity supplied of a commodity may fall at a given price if prices of other
commodities show a tendency to rise. The change in technology can also bring
about a change in the quantity supplied of a commodity even if the price of that
38 commodity does not undergo a change.
Check Your Progress 3 Demand and
Supply Analysis
1) Producers supply more at a higher price. Why?
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Why does a supply curve usually slope upwards to the right?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.8 CHANGES IN SUPPLY VERSUS CHANGES IN

QUANTITY SUPPLIED
2.8.1 Changes in Quantity Supplied
Just as we saw for the demand, there can be changes in the quantity offered for
sale due to changes in the price of the commodity only, all other factors
remaining constant. This is termed as change in quantity supplied. The change
in quantity supplied can be of two types,
1) When the price of a commodity falls and its quantity supplied falls. It is
termed as ‘contraction of supply’.
2) When the price of a commodity rises and its quantity supplied rises,
provided the law of supply applies, it is termed as “extension of supply”.
The contraction, and ‘extension’ of supply has been shown in Fig. 2.7 below.

Fig. 2.7 : Supply Curve

Start with point b on the supply curve at which price per pen is Rs. 3 and
quantity supplied is 30,000 pens. As price per pen falls to Rs. 2, the quantity
supplied falls to 20,000. This is contraction of supply. When price of pen rises
to Rs. 4, the quantity supplied rises to 40,000. This is extension of supply.
39
Introduction On the graph it is the movement from b to a on the supply curve which
represents ‘contraction of supply’. Similarly, the movement from b to c on the
curve represents ‘extension of supply’.
2.8.2 Change in Supply
If supply of a commodity undergoes a change because of changes in factors
other than the price of the commodity, we call this change in supply. It is
usually shown by a shift in the position of the supply curve.
Change in supply can be of two types:
A decrease in supply: When the quantity of a commodity supplied declines, at
the same price it is referred to as a ‘decrease in supply’. It implies a leftward
shift of the supply curve.
An increase in supply: When the quantity of a commodity supplied increases,
at the same price, it is known as an increase in supply. This is shown by a
rightward shift in the supply curve.

Fig. 2.8: Shifts in Supply Curve

In short, a rise in supply implies a rightward shift of the supply curve showing
that producers are willing to supply more at each price. A fall in supply, on the
other hand, implies a leftward shift of the supply curve indicating that
producers are willing to supply less at each price.

2.8.3 Why the Supply Curve Shifts?

The reasons for the change in supply (both increase and decrease in supply)
are:
1) Change in the prices of other commodities: A decrease in the prices of
other commodities increases the supply of the commodity in question at
each price because relative profits from supplying other products fall. An
increase in the prices of other commodities decreases the supply of the
commodity in question at each price.
2) Change in the prices of factors of production: An increase in the prices
of factors of production used in producing the commodity tends to reduce
the supply of the commodity as the cost of production rises but the price
is given. Conversely, a decrease in the price of factors of production used
40
 in making a commodity leads to an increase in supply, at each price. Demand and
Supply Analysis
3) Change in technology: An improvement in technology normally leads to
a fall in cost of production and given the price of the product, a producer
tends to produce more of that commodity, at each price. Conversely, loss
in technical knowledge (the chances of which are meager) leads to a fall
in supply.
4) Change or expectation of change in other factors: Sometimes, supply
of a commodity may change because of the change in or expectation of a
change in government policies, taxes or rate of interest, fear of war,
inequalities of income and wealth which influence the demand pattern.
This will affect supply through expectations of the producer about the
profits.
Check Your Progress 4
1) How do you interpret a right shift of a supply curve?
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Effects of factors other than the own price are shown by a shift of entire
supply curve. Why?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) Distinguish between an ‘increase’ in supply and an ‘extension’ of supply.
....................................................................................................................
....................................................................................................................
....................................................................................................................
4) How does a contraction of supply differ from a decrease in supply?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.9 THE IDEA OF ELASTICITY

In Sections 2.4 to 2.8, we have studied impact of changes in determinant
variables on the demand and supply. We examined, in particular, impact of
own price, prices of related goods and income of the consumer on demand for
a commodity. Likewise, we tried to explore impact of a change in own price,
prices of factors of production etc. on the supply of a commodity. The above
analysis underlined only one aspect: a change in a determinant leads to a
change in the determined variable. We still do not know how strong the impact
is. We still cannot say that how much change in, say, demand for oranges (or in
41
Introduction supply of) will be if their price increased by 10 per cent. This situation makes it
difficult to talk about the possible effects of the policy changes. In fact, an
assessment of relative strength of the impacts of different determinants is also
not possible. To this end, we use ‘the idea of elasticity’.
The elasticity of a variable X with respect to some other variable Y shows
responsiveness or sensitivity of X to changes in Y. the elasticity of X with
respect to Y is defined as the ratio of per cent change in X to per cent change in
Y. Symbolically:
Per cent change in X
E =
Per cent change in Y
We can also write it as:
∆X
E = X
∆Y
Y
So the elasticity of demand for (or supply of ) oranges with respect to a change
in their price will be:
∆Q
Q
E , =
∆P
P
Where Q represents quantity of oranges and P represents their price.
If we show two commodities by symbols X and Y, their respective quantities
and prices by Qx & Qy and Px & Py we can write down the expression for the
cross elasticity of demand for X with respect to a change in the price of
commodity Y:
∆Q
Q
E , =
∆P
P

Similarly, We can write expression for income elasticity of demand:

∆Q
Q
E , =
∆M
M
Where M shows the income of the consumer.

2.9.1 Elasticity of Demand

We can use different diagrams to depict the demand curves and their
elasticities.
The demand curve with Zero elasticity is depicted in Fig. 2.9. Here a change in
price has no impact on the quantity demanded. Such a commodity is,
sometimes, called an absolute necessity.

42
 Demand and
Supply Analysis

Fig. 2.9: Demand curve with zero elasticity

The Fig. 2.10 shows a demand curve which is infinitely elastic. In such a
situation, a very small fall in price can lead to an extremely large increase in
quantity demanded.

Fig. 2.10 : Infinite Elasticity of Demand

For a straight line demand curve falling to the right, elasticity of demand at
any point on the curve is given by the ratio of the lower segment to the upper
segment. Fig. 2.11, the elasticity will be:
E = (-) BE/EA

Fig. 2.11 43
Introduction A Proof: Initial price was OH and quantity demanded was OM. The price rises
to OA. At this price, the consumer does not demand any quantity of the good.
So, new demand is zero. Using this information in the formula for elasticity we
get:
E = (Change in quantity/ original quantity)/( change in price/ original price)
= (OM/OM ) / {( OA – OH) / OH} = 1/ (HA/OH) = OH/HA.
Now consider right angled triangle AOB. Line HE is parallel to base OB.
Therefore it divides perpendicular and the hypotenuse in equal proportions.
Therefore:
OH/HA = BE /EA
That means elasticity at point E on the demand curve AB equals ratio of lower
segment BE to the upper segment EA.
We can depict a special type of demand curve which has elasticity equal to
unity at every point. Such a demand function is shown using a rectangular
hyperbola, a curve which shows constant area under the curve at every point on
the curve. The Fig. 2.12 is such a demand curve.

Fig. 2.12: Demand curve with unitary elasticity

We can, likewise, show supply curves with zero, unitary, infinite and variable
elasticity.

2.9.2 Elasticity of Supply

A supply curve with zero elasticity is a vertical straight line, just like the
perfectly inelastic demand curve.
A straight line supply curve passing through the origin will have unitary
elasticity throughout.
A straight line supply curve running parallel to the quantity axis will have
infinite elasticity. This too is similar to the case of demand curve.
A straight line supply curve that intersects price axis will have elasticity greater
than one at all points in the 1st quadrant.
A straight line demand curve that intersects quantity axis in 1st quadrant has
elasticity less than one.
44
We can make a general observation about the supply curves involving the Demand and
above characteristics. For a straight line supply function shown in Fig. 2.13, Supply Analysis
elasticity of supply at a point E can be determined in this manner: drop a
perpendicular EM from E to the quantity axis. Extend the supply line to meet
the quantity axis in point K. Then:

Fig. 2.13: Elasticity of supply at point E

Es = KM/OM
If supply line passes through origin, point K will coincide with O. Therefore,
the ratio KM/OM will be equal to unity (KM = OM). If the supply line
intersects quantity axis in the 1st quadrant, elasticity will be less than one as
KM < OM. In the Fig. 2.13, the supply line cuts quantity axis in 2nd quadrant.
Therefore, KM> OM. Hence elasticity is greater than one.

2.10 MEASUREMENT OF PRICE ELASTICITY OF

DEMAND
There are a number of methods to measure price elasticity of demand. Some of
the important methods are as follows:
1) Point Method: Also known as the percentage method (as discussed
above), the main point to remember about this method is that it is
employed only when the changes in price and quantity demanded are
very small.
2) Total Expenditure Method: This total outlay method to measure price
elasticity of demand is used whenever the changes in price and demand
are not small. But it only helps us to distinguish three situations (i)
whether the price elasticity of demand is one or unity, (ii) whether the
price elasticity of demand is more than one, and (iii) whether the price
elasticity of demand is less than one. Here the elasticity is measured by
ratio P1Q1/P0Q0.
E = (P1Q1 ) / ( P0Q0 )
Where initial and after change price and quantity are indicated by subscript 0
and 1 respectively
3) Geometrical Method: According to this method, elasticity of demand is
different at different points on a given demand curve, and is measured as
follows on any point of a straight line curve.
Lower segment of the demand curve
E =
Upper segment of the demand curve

45
Introduction
2.11 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND
The price elasticity of demand for a commodity depends on these important
factors:
1) Nature of the Commodity: The commodities are divided into three
categories (i) necessities, (ii) comforts, and (iii) luxuries. Price elasticity
of demand will be less for the necessities. We know a rise in the price of
salt will not be able to force people to reduce their consumption. As
luxuries are purchased by people with high income their demand also
does not change much with change in price.
2) Number of Substitutes: If a good’s substitutes are easily available, price
elasticity of demand will be high.
3) Number of uses of a commodity: The greater the number of possible
uses of a commodity, the greater its price elasticity of demand will be.
4) Price level of a commodity: The level of price will also have an impact
on price elasticity of demand. A commodity priced high will have higher
elasticity of demand and a low priced commodity will have lower
elasticity (This idea becomes clearer when you revisit Fig. 3.12).
Importance of Elasticity of Demand
The price elasticity of demand is very important in a number of policy
decisions regarding individual commodity markets. Some of the important
fields where price elasticity of demand is important are:
1) Price fixation by a monopolist: The monopolist is always interested in
charging a higher price. If he comes to know that the price elasticity for a
commodity is low, he would fix up a higher price for that commodity. He
would not be able to charge a very high price for a commodity whose
price elasticity of demand is relatively higher.
2) Price support programme of the government: A good harvest, because
of better monsoon can lead to a big fall in agricultural prices as elasticity
of demand is rather low. To protect the farmer’s interests, the government
announces a price support programme and the price of the commodity is
not allowed to fall below a particular level. Obviously, this creates a
situation of excess supply and the government has to lift the excess
supply from the market.
Similarly, a poor harvest can raise the price. Here to protect the interest of the
consumer, the government can announce a ‘price ceiling’ and releases stock
from its own warehouses or imports to meet the excess demand in the market.
Check Your Progress 5
1) Income elasticity is positive for normal goods only. Explain.
....................................................................................................................
....................................................................................................................
....................................................................................................................

46 ....................................................................................................................
2) Do you agree with the statement that ‘The sign of coefficient of cross Demand and
elasticity depends on whether the commodity is a complement or a Supply Analysis
substitute’. Give reasons.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.12 DETERMINANTS OF ELASTICITY OF

SUPPLY
Elasticity of supply depends on a number of factors and all these factors are to
be taken together before one can comment on the elasticity of supply of a
commodity. Some of the important determinants of elasticity of supply are
given as follows:
1) Behaviour of costs as output varies: As output of a commodity rises
total cost do rise, normally, at a falling rate in the beginning, then at a
constant rate and finally at a rising rate. If cost of production rises rapidly
as output rises, then a rise in price will not induce a big rise in supplies.
2) Nature of the commodity: Perishable products cannot be stored for long
and thus, their supply does not respond very much to the price changes.
Durable products can be stored and their supply responds to the price
changes.
3) Time: In the short-run, supply of a commodity is less elastic, but in the
long run, the size of the plant can be changed supply responds to the price
changes. Hence, supply can be more elastic.
4) Price expectations: If the producers expect that prices in the future will
be maintained above particular level, they may produce more. If they
expect prices to rise in the future, they may hold more stocks and may
supply lesser quantities in the market. Supply in such a case will be
inelastic. If the prices are expected to fall in the future, supply will be
more elastic.

2.13 LET US SUM UP

The demand refers to the wish on the part of the consumer to buy a commodity
in the market at a given price backed by the sufficient purchasing power. The
price of the commodity in question, prices of other related commodities,
income and taste of the consumers determine the demand for consumer.
Supply refers to the quantity a firm is willing to sell at a given price in every
time period. In addition to the own price, supply of a commodity depends on
prices of related goods and the factors of production as well. State of
technology is another important determinant of supply.
Elasticity is the responsiveness of quantity demanded (supplied) to given
changes in own price or prices of other related goods. In case of demand, it can
be with respect to income as well. Elasticity can be measured by way of point 47
Introduction method, outlay method or geometrical method. Nature of the commodity,
number of substitutes, number of uses of a commodity and price level of the
commodity are among important determinants of price elasticity. Elasticities of
demand and supply play an important role in price fixation by a monopolist,
price support programme of the government and in determination of incidence
of indirect tax.

2.14 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi,
2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

2.15 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 2.2
2) See Sub-section 2.3.1
3) Size of the population, Income distribution.
Check Your Progress 2
1) i) Rs. 30
ii) q = 90
2) See Section 2.4
3) See Section 2.4
4) Yes
5) No
Check Your Progress 3
1) See Section 2.6
2) See Sub-section 2.7.2
Check Your Progress 4
1) See Sub-section 2.8.2
2) See Sub-section 2.8.3
3) See Section 2.8
4) See Sub-section 2.8.1 & 2.8.2

48
Check Your Progress 5 Demand and
Supply Analysis
1) See Section 2.9
2) See Section 2.9

2.16 TERMINAL QUESTIONS

1) Explain the main determinants of demand for a commodity in the market.
2) Explain the law of demand with the help of a demand schedule and a
demand curve.
3) Explain the exceptions to the Law of demand using the distinction
between substitution and income effects.
4) Distinguish between an inferior good and a Giffen good.
5) What uses can be made by the government of the law of demand in
deciding about the price policy and tax cum subsidy policy.
6) What is law of supply? Explain with help of a suitable example.
7) Explain the circumstances where the law of supply may not hold.

49
 UNIT 3 DEMAND AND SUPPLY IN
PRACTICE
Structure
3.0 Objectives
3.1 Introduction
3.2 Determination of Equilibrium
3.3 Effects of Shift in Demand and Supply on Equilibrium
3.3.1 Determination of Equilibrium: A Mathematical Presentation
3.3.2 Uniqueness of Equilibrium and Multiple Equilibria

3.4 Applications
3.4.1 Rationing and the Allocation of Scarce Goods
3.4.2 Price Support Measures
3.4.3 Minimum Wage Legislation
3.4.4 Arbitrage
3.4.5 Sharing of Tax Burden

3.5 Let Us Sum UP

3.6 References
3.7 Answers or Hints to Check Your Progress Exercises
3.8 Terminal Questions

3.0 OBJECTIVES
After going through this unit, you will be able to :
 appreciate how market price and quantity are determined;

 evaluate the impact of price controls, minimum wages, price support and
arbitrage on price and quantity;

 determine how the taxes and subsidies affect consumers and producers;
and
 appreciate the usefulness of economic theory in our day to day life.

3.1 INTRODUCTION
Demand and supply curves are used to describe the market mechanisms. These
two market forces by way of equilibrium determine both the market price of a
good and the total quantity produced/supplied. The level of price and the
quantity depend on the particular characteristics of Demand and Supply.
Variations in price and quantity over time depend on the ways in which supply
and demand respond to other economic variables.
In this unit we will try to acquaint you with the usefulness of this analysis.
*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College
50 (University of Delhi), Delhi.
 Demand and Supply
3.2 DETERMINATION OF EQUILIBRIUM in Practice
Equilibrium price is defined as the price at which the quantity demanded and
quantity supplied are equal. Quantity demanded is an inverse function of price,
while quantity supplied is a direct function of price. The two functions can be
stated as follows:

q = 10 − 1P
and
q = 1P
Equilibrium price is the one at which the quantity demanded equals quantity
supplied, i.e.,

q =q
or
10 − 1P = 1P
∴ P=5
Equilibrium price is Rs. 5. At this price q = q and q = 5 units. Thus, 5 units
would be sold and purchased in the market at price Rs. 5.
Similarly, if we graphically represent these two functions as in Fig. 3.1, we
find that the downward sloping demand curve intersects the upward sloping
supply curve at E, forming what is known as the Marshallian cross.

Fig. 3.1

In the equilibrium, OQ1 quantity is sold and purchased at OP1 price.

If, for any reason, the market price were to be less than the equilibrium price,
say at OP1, quantity demanded will be more than the quantity supplied,
resulting in excess demand in the market, TW in Fig. 3.2. This will push the
market price upwards, till the market price equals the equilibrium price.
Similarly, if the market price is more than the equilibrium price, the resultant
excess supply, RS, will push the price downwards to OP2. In short, we reach
the following conclusions:
 All demand curves have negative slopes throughout their entire range.
51
Introduction  All supply curves have positive slopes throughout their entire range.
 Prices change if and only if, there is excess demand or excess supply.
 Prices rise, if there is excess demand and fall if there is excess supply.
In short, market price has a tendency to be equal to the equilibrium price. This
is called stable equilibrium.

Fig. 3.2

The essential condition for stable equilibrium is that the demand curve should
have a negative slope and the supply curve a positive slope. Otherwise, it will
not be a stable equilibrium, this would be what can be called unstable
equilibrium.
Let us illustrate the situation of unstable equilibrium with the help of Fig. 3.3.

Fig. 3.3

We have plotted a negatively sloped demand curve and a negatively sloped

supply curve. Equilibrium is determined at point E. If the market price were to
fall to Op1 quantity supplied > quantity demanded, and therefore the market
52 price should fall further (rather than rise).
Similarly, if market price were to be Op3, quantity supplied < quantity Demand and Supply
demanded, and hence the price should still rise further (rather than fall to back in Practice
to equilibrium).
Thus, in this situation there is unstable equilibrium. The condition for stable
equilibrium is that above the equilibrium point surplus must exist (Qs > Qd) and
below the equilibrium point shortage must exist (Qd, > Qs). In case this
condition is not fulfilled, we get unstable equilibrium.
Can there be a stable equilibrium when supply curve is downward
sloping?
Yes, there can be a stable equilibrium even if supply curve is downward
sloping. This is illustrated with the help of Fig. 3.4. At price Op2, which is
more than the equilibrium price Op1 there exists surplus to the extent of SR,
which creates competition among sellers, as such price falls to Op1.

Fig. 3.4

At price Op3, which is less than equilibrium price Op1 there exists shortage to
the tune of WT, which creates competition among buyers, this causes the price
to increase to Op1 Thus, we get stable equilibrium.
This is also known as the Walrasian Equilibrium. The Walrasian stability
condition can be stated as follows:
Above the equilibrium price, the supply curve must be to the right of the
demand curve; and below the equilibrium price, the supply curve must be to
the left of the demand curve.
It would be seen that whereas the Marshallian adjustment process works
through a change in quantities, the Walrasian adjustment process works
through a change in price.

3.3 EFFECTS OF SHIFT IN DEMAND AND

SUPPLY ON EQUILIBRIUM
In the method of comparative statics we start from a position of equilibrium
and then introduce the change to be studied. The new equilibrium position is
determined and compared with the original one. The differences between the
53
Introduction two positions of equilibrium must result from the change that was introduced,
by keeping everything else as constant.
1) Shift in Demand Curve
A shift in demand curve (the supply curve remaining unchanged) will affect
the equilibrium price and equilibrium quantity, as shown in Fig. 3.5.

Fig. 3.5

An increase in demand would result in:

 an increase in the equilibrium price
 an increase in the equilibrium quantity.
Conversely, a decrease in demand would result in:
 a decrease in the equilibrium price
 a decrease in the equilibrium quantity.
2) Shift in Supply Curve
A shift in supply curve (the demand curve remaining unchanged) will also
affect both, the equilibrium price and equilibrium quantity, as shown in
Fig. 3.6.

Fig. 3.6
54
An increase in supply would result in: Demand and Supply
in Practice
 a fall in the equilibrium price
 an increase in the equilibrium quantity.
A decrease in supply would result in:
 a rise in the equilibrium price
 a fall in the equilibrium quantity.
3) Simultaneous Shift
We may also examine if both demand and supply curves shift simultaneously.
The combined result would be determined as we have analysed above.
The net result would depend upon the relative change in demand and supply.
The various results can be briefly summarised as follows:
When one of the demand or supply curves shifts, the effect on both the price
(P) and quantity (Q) can be determined:
 An increase in demand (a shift rightward in the demand curve) raises P
and increases Q.

 A decrease in demand (a shift leftward in the demand curve) lowers P

and decreases Q.

 An increase in supply (a shift rightward in the supply curve) lowers P and

increases Q.

When both the demand and supply curves shift the effect on the price or the
quantity can be determined but without information about the relativity of the
shifts, the effect on the other variable is ambiguous.
 If both the demand and supply curves increase (shift rightward), the
quantity increases but the price may rise, fall or remain the same.

 If the demand decreases (shifts leftward) and the supply increases (shifts
rightward) the price falls but the quantity may increase, decrease, or not
change.

3.3.1 Determination of Equilibrium: A Mathematical

Presentation
We begin with a simple numerical example:
qd = 100 – 2p (1)
qs = 3p (2)
qd = q s (3)
We solve the system by substituting (1) and (2) into (3):
100 – 2p = 3p = 100 = 3P + 2P
55
Introduction or 5p = 100
or p = 20
by putting P value in equation (1) we get,
qd = 100 – 2(20)
qd = 60
and qs = qd = 60
If we let the demand curve shift to the right so that 60 more units are bought at
each price, (I) becomes
qd = 160 – 2p (1')
Substituting (1') and (2) into (3) yields p = 32 and qd = qs = 96.
In this manner we could solve the equations every time.
Algebra allows us, however, to find the solution to any linear demand supply
system. To do this, we substitute letters, called parameters, for the numbers in
the above system:
qd = a + bp, a> 0, b < 0 (4)
qs = c + dp, c < a, d > 0 (5)
qd = q s (6)
The restrictions on the parameters ensure that a positive amount is demanded at
a zero price (a > 0), that the demand curve has a negative slope (b < 0), and the
supply curve has a positive slope (d > 0). The restriction on c is a little more
complex. If c is less than zero a positive price is required to call forth any
supply. If c exceeds zero, some amount is supplied at a zero price. In that case,
we need less to be supplied than demanded at a zero price (a >c) if we are to
get a positive equilibrium price. If c > a, supply exceeds demand at a zero price
and the linear model solves for a negative price.
To avoid this, we need the added condition that p = 0 whenever c > a.
Once again, we solve by substituting the equations (4) and (5) into (6). This
gives
a + bp = c + dp
Simple manipulation produces

p= (7)

Now, whenever we encounter a numerical example, we can substitute the

numbers directly into (7) and obtain the answer.

3.3.2 Uniqueness of Equilibrium and Multiple Equilibria

So far, we have examined the situations in which a unique equilibrium is
established, i.e., a single price (or single quantity) corresponding to a single
quantity (or single price).
56
We can also conceive of a situation in which there is no such unique price or Demand and Supply
unique quantity. This is illustrated with the help of Fig. 3.7 and Fig. 3.8. in Practice

Fig. 3.7 Fig. 3.8

In Fig. 3.7, both the demand curve and the supply curve have horizontal
segments.
As a result of this, though the equilibrium price is uniquely determined, there is
no unique quantity. It lies in the range TW.
In Fig. 3.8 similarly, both the demand curve and the supply curve have vertical
segments. Though a unique quantity is determined, there is no unique price.
The equilibrium price lies in the range TW.
This is also known as multiple equilibria.
Check Your Progress 1

1) Given the following demand and supply functions, find the equilibrium
price and quantity in the market

qs = – 5 + 3P, qd = 10 – 2P

2) From the following equation find the equilibrium price and output qd =
6 – P, qs = 3P – 2

3) State whether following statements are true or false:

i) All demand curves have positive slopes
ii) Prices change if and only if there is excess demand or excess supply
iii) Prices fall if there is excess demand
iv) The Walrasian equilibrium adjustment process works through
change in quantity
v) The quantity increases in case of both demand and supply curve
shift rightwards.

4) There are 1000 identical individuals in the market for commodity X

given the individual demand function qd = 12 – 2P and 100 identical
producers of commodity given the individual producer supply
function qs = 20P. Find the equilibrium price and quantity.
57
Introduction
3.4 APPLICATIONS
3.4.1 Rationing and the Allocation of Scarce Goods
Rationing implies fixation of price controls. Price control means that a ceiling
has been imposed on the prices of such commodities as are covered under the
price-control measures. Fixation of ceiling on prices means that the free
operation of the forces of demand and supply is not being permitted.
Let us see what will happen in such a situation. This can be illustrated with the
help of Fig. 3.9. DD and SS are the original demand and supply curves
respectively for a commodity. R is the equilibrium point, corresponding to
which OQ quantity is being demanded and supplied at the price OP per unit.
Suppose the Government decides to interfere with the free operation of the
market forces, i.e., it decides to impose price controls. Price controls, as
already stated, take the form of ceiling on prices. Ceiling could be fixed at a
price (a) higher than the equilibrium price, say at OK, (b) equal to the
equilibrium price, i.e., OP, and (c) less than the equilibrium price, say at OH.

Fig. 3.9

 Ceiling price more than the equilibrium price will have no effect on the
market. At a higher price say OK, OT quantity of the commodity will be
demanded. The suppliers, on the other hand, would be waiting in their
wings to supply more than the quantity being presently demanded. There
will be a tendency for the price to fall down to the equilibrium level.

 If ceiling price equals the equilibrium price, OP, it will leave the market
unaffected.

 If ceiling price is less than the equilibrium price, it will create conditions
which need our further attention. Suppose, in Fig. 3.9, the Government
imposes ceiling at OH per unit. The equilibrium price, OP, would no
longer be legally obtainable. Prices must be reduced from OP to OH. At
the lower price, OH, quantity demanded will expand to HN or OW. But
at this reduced price, suppliers will be ready to supply only HL or OT
quantity of goods. As a result, a shortage of this commodity (equal to
quantity demanded minus quantity supplied) will emerge. This shortage
58 is being represented by the line segment LN.
We reach the following conclusion about the effect of price control in free Demand and Supply
market: The setting of minimum prices will either have no effect (maximum in Practice
price set at or below the equilibrium) or it will cause a shortage of the
commodity and reduce both the price and the quantity actually bought and sold
below their equilibrium values.
Consequences of Price Controls (ceiling below the equilibrium price).
Imposition of ceiling below the equilibrium price will have the following major
implications:
1) Shortages: The quantity actually sold and bought in the market will
shrink. As a result, a large chunk of consumer’s demand will go
unsatisfied. The situation, as it arises, has been explained in Fig. 3.9.
2) Problem of allocation of limited supplies among large number of
consumers: As already observed, shortage of a commodity means that all
those consumers who demand the commodity at the ruling price cannot
be satisfied. In other words, a large number of potential consumers of the
commodity will be denied its use.
Here question arises how to allocate the limited supplies among large numbers
of consumers?
One general way is that it is left at the retail shops to arrange for the
distribution of the scarce product. For example, in our country, we have often
witnessed such products as kerosene, edible oils, sugar, onions, etc., going
scarce in the market. More generally, the consumer is left at the mercy of the
local retailer, who more often than not chooses I: serve his regular customers in
preference to others.
Among all others, the scarce product may be distributed on the basis of first-
come-first-served. The latter situation often develops in the formation of long
unmanageable queues at the retail centres, so that the persons lining up at the
tail of the queue have only a little chance of getting the desired good. To avoid
these problems which may often arise from the free marketing of the scarce
product, Governments generally couple price controls with distribution
controls. The most effective form of distribution control is rationing.
Rationing implies that a ceiling is imposed on the quantity which can be
bought and consumed by a consumer. A consumer with less utility may choose
not to purchase the rationed product. But those consumers for whom the
rationed product has fairly large marginal utility are assured of some quantity
at least, which possibly might not have been available to them in free
marketing conditions. Rationing thus will increase the aggregate utility derived
by the community from the consumption of the commodity. In such a situation,
in all probabilities, rationing will replace first-come-first-served method of
distribution.
We reach the conclusion:
Where there is a feeling against allocation on the basis of first-come-first-
served and seller’s preferences, effective price ceiling will give rise to strong
pressure for a central (administered) system of rationing.

59
Introduction 3) Black Marketing: It is a direct consequence of price controls. Black
marketing implies a situation in which the controlled commodity is sold
unlawfully, below the desk, at a price higher than the lawfully enforced
ceiling price.
This situation arises largely because of the fact that (i) the number of potential
consumers of the commodity is more than what can be served by the available
supplies of the commodity, and, (ii) there are consumers who are willing to pay
more than the ceiling price. This latter phenomenon is more important in
creating black market and sustaining it.
In Fig. 3.9, OH is the ceiling price. At this price only OT quantity is being
supplied and therefore actually bought in the market. We can see from DD
curve in Fig. 3.9 that OT quantity would be demanded even at the price TZ or
OK, which is substantially higher than the ceiling and the equilibrium price.
Those buyers, who are willing to pay more than the ceiling price, will prefer to
indulge in underhand transactions rather than go without the commodity since
none of the free market methods of distribution can assure these consumers
that the desired supplies would be coming.
Thus, we reach the interesting conclusion:
Black marketing in a commodity whose price has been controlled by the
authorities will invariably arise since there are consumers who are willing to
pay more than the controlled price.
3.4.2 Price Support Measures
Price support means a floor has been fixed on the prices of such commodities
as are covered under the price-support measures.
Producers of these commodities need not sell at prices lower than the floor
prices (i.e., the minimum prices) fixed by the Government. Fixation of floor on
prices means that the free operation of the forces of demand and supply is
being interfered with. Let us see what will happen in such a situation.
In Fig. 3.10; R is the equilibrium point determined by the intersection of
demand and supply curves, OQ quantity is being supplied and demanded at OP
price. Suppose, the Government decides to impose price supports. Price
supports mean that the Government imposes a floor on prices. Floors could be
fixed at a price (a) lower than the equilibrium price, say at OH; (b) equal to the
equilibrium price, OP; and (c) more than the equilibrium price, say at OK.

Fig. 3.10
60
Floor Price Lower than the Equilibrium Price: If floor price is less than the Demand and Supply
equilibrium, it will have no effect on the market. At a lower price, say OH, HZ in Practice
quantity will be supplied. The consumers, on the other hand, would be willing
to pay a higher price. The price will move upwards towards the equilibrium
level.
Floor Price Equal to the Equilibrium Price: If floor price equals the
equilibrium price, OP, it will leave the market unaffected.
Floor Price Higher than the Equilibrium Price: If floor price is more than the
equilibrium price, it will need our further attention. Suppose, in Fig. 3.10, the
Government imposes the price floor at OK per unit. The equilibrium price OP
would no longer be legally obtainable. Price must be raised to OK. At the
higher price, OK, quantity demanded will contract to KL. But at this price
suppliers will be ready to supply KN quantity. As a result, a surplus will
emerge; surplus is shown by the line segment LN.
We reach the following conclusion about the effect of price support in a free
market:
The setting of minimum prices will either have no effect (minimum price set
below the equilibrium) or it will cause surplus of the commodity to develop
with the actual price being above its equilibrium level but the actual quantity
bought and sold being below its equilibrium level.
Consequences of Price Support (Floor above equilibrium price): Imposition of
floor prices above equilibrium price will have the following major
implications:
1) Surpluses: The quantity actually bought and supplied will shrink as a
direct consequence of price support. As a result, large chunk of
producer’s stocks will remain unutilised. The situation, as it arises, has
been explained in Fig. 3.10 where the surplus has been shown equal to
LN.
2) Buffer Stocks: In order to maintain the support price, the Government
would have to design some such programme as to enable producers to
dispose of their surplus stocks. One such programme can take the form of
buffer stocks. The Government purchases the surplus stocks available
with the producers, these stocks are released if and when the production
of the supported commodity suffers. The buffer stock operations benefit
the producers as a group. But who bears this cost? First, consumer who
has to pay higher prices for the product. Second, the people in general
who have to pay taxes to support this programme.
3) Subsidies: To offset the loss to the consumers, the Government may
undertake to subsidise the product. By subsidy we mean that the
Government purchases the product at the support price and sells the
product to consumers below its cost of procurement. The difference
between cost and price is borne by the Government.
Before we leave this discussion of price floors and ceilings, the reader should
note that such terms as surplus and shortage are defined with reference to a
specific price.

61
Introduction 3.4.3 Minimum Wage Legislation
Minimum wage legislation is similar to fixing of floor prices. Governments, at
times, are known to have interfered in the factor markets also. Legislation may
be enacted whereby in the market, employers may be prohibited from paying
less than the minimum wage fixed by the Government. The effect of fixing the
minimum wage would be the same as that of fixing the minimum price of a
commodity. Let us illustrate this effect diagrammatically, as in Fig. 3.11.

Fig. 3.11

In Fig. 3.11, OQ quantity of labour is being demanded and supplied at the

equilibrium wage rate OP. If the wage rate is fixed at OZ by Government
legislation, or by trade union agreement, the following consequences will
follow:
1) Where the law or the agreement is effective, it will raise the wages of that
labour which remains in employment, from OP to OZ.
2) Minimum wage will lower the actual amount of employment; at the new
minimum wage rate only ZT or OW labour would be demanded, whereas
at the equilibrium wage OQ labour was being supplied and demanded.
Employment will fall by WQ.
3) Minimum wage will create a surplus of labour which would like to work,
but cannot find a job. The surplus labour would equal TJ.
4) Some of the unemployed workers may be tempted or forced to offer
themselves for work at the wage rate below the floor rate. Some sort of
clandestine transaction in the labour market will begin to take place.

3.4.4 Arbitrage
Arbitrage is an operation involving simultaneous purchase and sale of a
commodity in two or more markets between which there are price differentials
or discrepancies. The arbitrageur aims to profit from the price difference; the
effect of his action is to lessen or eliminate it.
Suppose fresh mushrooms are being sold in New Delhi and Noida.
Geographically separate markets are illustrated in Fig. 3.12.
62
 Demand and Supply
in Practice

Fig. 3.12

New Delhi (ND) and Noida (NA) are separate markets with separate demand
curves. The vertical supply curve in each city represents the quantity of
mushrooms now available in each place. The equilibrium price in New Delhi is
labelled PND and in Noida, PNA.
If the equilibrium price in New Delhi is much less than that in Noida, a trucker
might buy a load in New Delhi and sell them in Noida. As long as the price
differential is greater than the cost of transporting the mushrooms, it will pay
truckers to buy and sell in this way. As mushrooms are bought in New Delhi
for sale in Noida, the price in New Delhi will increase, while that in Noida will
fall. Thus the transport of mushrooms from New Delhi to Noida tends to
narrow the price gap between the two cities. This process is called arbitrage.
Arbitrage will stop when the price differential becomes equal to or less than the
cost of transportation between the two points. If transportation costs are small
relative to the price of the good, the price differentials between cities will
remain small.
Arbitrage narrows the dispersion of prices. If commodities are easily
transported, geographic variations in price are small. If a commodity is easily
stored, seasonal variations in price are insignificant. When markets are well-
organised, with information about prices in different places and times readily
available, arbitrage works easily. Any dealer can act as an arbitrageur by
deciding when and where to buy. If, however, information about prices in
different times and places is expensive to get, the dispersion of prices will then
be greater.
Case Study
A few years ago The New York Times carried a dramatic front page picture of
the President of Kenya setting fire to a large pile of elephant tusks that had
been confiscated from poachers. The accompanying statement explained that
the burning was intended as a symbolic act to persuade the world to halt the
ivory trade. One may well doubt whether the burning really touched the hearts
of criminal poachers. However, one economic effect was clear. By reducing the
supply of ivory in the world markets, the burning of tusks forced up the price
of ivory which raised the illicit rewards reaped by those who slaughter
elephants. They could only encourage more poaching – precisely the opposite
of what the Kenyan government sought to accomplish!

63
Introduction 3.4.5 Sharing of Tax Burden
Who bears the tax burden under following situations:
a) When demand is perfectly elastic and supply is of normal shape.
b) When demand is perfectly inelastic and supply is of normal shape.
c) When supply is perfectly elastic and demand is of normal shape.
d) When supply is perfectly inelastic and demand is of normal shape.
a) When demand is perfectly elastic, the whole tax burden is borne by the
producer himself as is illustrated in the Fig. 3.13. Before imposition of
tax, equilibrium point is E which gives equilibrium price as OP. After the
imposition of per unit tax, the equilibrium point shifts to giving
equilibrium price as OP which is same as before the imposition of tax.
Hence the whole tax burden is borne by the producer.

Fig. 3.13

b) When demand is perfectly inelastic, the whole tax burden is borne by the
consumer because in this case the price rises by the full amount of tax as
shown in the Fig. 3.14. The equilibrium point before imposition of tax is
E which gives the equilibrium price as OP. After the imposition of tax per
unit, the equilibrium point shifts to E1 which gives equilibrium price as
OP1 Thus, price rises by the full amount of tax.

64 Fig. 3.14
c) When supply is perfectly elastic, the whole tax burden is borne by the Demand and Supply
consumer as illustrated in the Fig. 3.15. Before imposition of tax, the in Practice
equilibrium point is E giving equilibrium price as OP. After the
imposition of tax, the equilibrium point shifts to E1 showing equilibrium
price as OP1. Thus the whole tax burden is borne by the consumer.

Fig. 3.15

d) When supply is perfectly inelastic, the whole tax burden is borne by the
seller as the pre-tax equilibrium position and post-tax equilibrium
remains unchanged, as shown in Fig. 6.16. Since supply is perfectly
inelastic, with the imposition of tax the supply curve remains unchanged
as such equilibrium price remains unchanged. So the tax burden falls on
producer.

Fig. 3.16
65
Introduction  Show that as the demand curve becomes steep (arid hence inelastic) as
greater amount of the tax is passed on to the consumer.

We take three different demand curves with different elasticities as shown in

Fig. 3.17.

Fig. 3.17

All the three curves are drawn through the point E in order to facilitate
comparison. Let the imposition of tax shift the supply curve to S1S1. The post-
tax equilibrium position is shown by three points, A, B or C depending upon
whether the relevant demand curve is D1D1, D2D2 or D3D3 respectively. The
length of vertical line segment from points A, B or C to the line PE shows the
amount of increase in the consumer price that will occur, given the respective
demand curves. Examining the relationship between the amount of the price
increase and the slope of the demand curve, we note that as the demand curve
becomes steep (and hence elastic) a greater amount of the tax is passed onward
to the consumer.
Check Your Progress 2
1) The price of a personal computer has continued to fall in the face of
increasing demand. Explain.
2) New cars are normal goods. Suppose that the economy enters a period of
strong economic expansion so that people’s incomes increase
substantially. Determine what happens to the equilibrium price and
quantity of new cars.
3) State whether following statements are true or false:
i) If ceiling price equals the equilibrium price, it will affect the
market.
ii) The minimum wage Act lowers the actual employment of workers.
iii) Arbitrage widens the dispersion of prices.
iv) When the demand is perfectly elastic, the whole burden is born by
66 the consumer.
4) Suppose that the policy makers decide that the price of a pizza is too high Demand and Supply
and that not enough people can afford to buy pizza. As a result, they in Practice
impose a price ceiling on pizza that is below the current equilibrium
price. Are consumers able to buy more pizza: before the price ceiling or
after?
5) Suppose that demand for a good is subject to unpredictable fluctuations.
Explain how speculators help reduce the price variability of the good.

3.5 LET US SUM UP

Basics of demand and supply enables us to appreciate the relevance of
economics in day to day life. Market price is determined at a point where
quantity demanded is equal to quantity supplied. The characteristics of demand
and supply may differ from one situation to another and from one market to
another. These market forces influence the prices and quantity over a period of
time. Marshalian equilibrium is attained through the process of change in
quantity whereas Walrasian adjustment process works through a change in
price.
Imposition of ceiling below the equilibrium price have implications of shortage
of supply, black marketing and hence the need for central administered system
of rationing. The imposition of floor prices may cause the surpluses of the
commodity, hence need for buffer stocks and selling of the product to the
consumers at subsidised prices.
The impact of minimum wage legislative is similar to fixing of floor prices.
The Arbitrage narrows the dispersion of prices.

3.6 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi, 2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

3.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) P = 3, qd = 4
2) p = 2, q = 4
3) (i) False (ii) True (iii) False (iv) false (v) True
4) P = 3, q = 6000

67
Introduction Check Your Progress 2
1) Personal computers have fallen in price although the demand for them
has increased because the supply has increased more rapidly.
2) Because new cars are a normal good, an increase in income increases the
demand for them. Hence the demand curve shifts rightward. As a result,
the equilibrium price rises and the equilibrium quantity also rises.
3) (i) False (ii) True (iii) False (iv) False
4) As a result of a price ceiling, the sellers would offer less quantity for sale
in the market. The consumers would end up consuming less of the pizzas.
There would be a large unmet demand.
5) Speculators buy the product to exploit any potential profit opportunities.
In particular, speculator- aim to sell the good from their inventories if the
current price is higher than the expected future price and they strive to
buy the good to be added to their inventories if the current price is below
the expected future price.
The first profit opportunity – selling when the current price is higher than the
expected future price – reduces the current price. The second profit opportunity
– buying when the current price is lower than the expected future price – raises
the current price.
Selling, if the price is higher than, or buying, if the price is lower than the
expected future price, means that the price will not deviate much from the
expected future price.
Thus, speculators help reduce price fluctuations and make the price less
variable.

3.8 TERMINAL QUESTIONS

1) Given the following supply and demand equations
Qu – 100 – 5P
Qs – 10 + 5P
a) Determine the equilibrium price and quantity.
b) If the government sets a minimum price of Rs. 10 per unit, how
many units would be supplied and how many would be demanded?
c) If the government sets a maximum price of Rs. 5 per unit, how
many units would be supplied and how many would be demanded?
d) If demand increases to
Qd1 = 200 – 5P
determine the new equilibrium price and quantity.
2) Discuss the likely effects of the following:
a) Rent ceilings on the market for apartments.

68
 b) Floors under wheat prices on the market for wheat. Demand and Supply
in Practice
Use supply-demand diagrams to show what may happen in each case.
3) The demand and supply curves for T-shirts in the tourist town,
Bengaluru, are given by the following equations:
Qd = 24,000 – 500 P
Qs = 6,000 + 1,000 P
a) Find the equilibrium price and quantity algebraically.
b) If tourists decide they do not really like T-shirts that much,
which of the following might be then demand curve?
Qd = 21,000 – 500 P
Qd = 27,000 – 500 P
Find the equilibrium price and quantity after the shift of the demand
curve.
c) If, instead, two more new stores that sell T-shirts open up in town,
which of the following might be the new supply curve?
Qs = 3,000 + 1,000 P
Q = 9,000 + 1,000 P
Find the equilibrium price and quantity after the shift of the supply curve.
4) Under which condition will a shift in the demand curve result mainly in a
change in quantity? In price?
5) Under which condition will a shift in the supply curve result mainly in a
change in price? In quantity?
6) Suppose the market demand for pizza is given by Qd = 300 – 20 P and the
market supply for pizza is given by Qs = 20 P – 100, where P = price (per
pizza).
a) Graph the supply and demand schedules for pizza using Rs. 5
through Rs. 15 as the value of P.
b) In equilibrium, how many pizzas would be sold and at what price?
c) What would happen if suppliers set the price of pizza at Rs 15?
Explain the market adjustment process.
d) Suppose the price of hamburgers, a substitute for pizza, doubles.
This leads to a doubling of the demand for pizza (at each price
consumers demand twice as much pizza as before). Write the
equation for the new market demand for pizza.
e) Find the new equilibrium price and quantity of pizza.

69
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
 BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
 Demand and Supply
in Practice

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

71
Introduction
BLOCK 2 THEORY OF CONSUMER BEHAVIOUR
Microeconomics essentially describes how prices are determined. In a market
economy prices are determined by the interaction of consumers, firms and
workers. Demand is made by the consumers. Hence this block explains the
principles underlying consumer behaviour. The block comprises of two units.
Unit 4 explains Consumer behaviour under cardinal approach wherein utility is
measured in quantitative scale. Law of diminishing marginal utility, consumer
equilibrium with the help of equi-marginal utility, derivation of demand curve,
consumer surplus and critical evaluation of the cardinal utility analyses
constitute the core contents of this unit. Unit 5 discusses the consumer
behaviour under Ordinal approach where utility is perceived in terms of
preferences and ranking. Properties of indifference curves, consumer
equilibrium through indifference curve analysis, law of diminishing marginal
rate of substitution, separation of price effect into income effect and
substitution effect, derivation of demand curve from indifference curve etc.
have been covered in this unit.

72
UNIT 4 CONSUMER BEHAVIOUR:
CARDINAL APPROACH
Structure
4.0 Objectives
4.1 Introduction
4.2 Concept of Utility
4.2.1 What is Utility?
4.2.2 Relationship between Want, Utility, Consumption and Satisfaction
4.2.3 Measurement of Utility

4.3 Some Basic Assumptions about Preferences

4.3.1 Assumptions about Consumer Preferences

4.4 Cardinal Utility Analysis

4.5 Law of Diminishing Marginal Utility
4.5.1 Exceptions to the Law/Limitations of the Law
4.5.2 Criticism of the Law

4.6 Consumer Equilibrium through Utility Analysis

4.6.1 Determination of Consumer Equilibrium

4.7 Derivation of Demand Curve with the Help of Law of Diminishing

Marginal Utility
4.8 Consumer Surplus
4.9 Critical Evaluation of Cardinal Utility Analysis
4.10 Let Us Sum Up
4.11 References
4.12 Answers or Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After completion of this unit, you will be able to:
 explain the concept of utility;
 analyse and use cardinal utility approach for measurement of utility;
 explain Law of Diminishing Marginal utility;
 describe consumer equilibrium with the help of law of equi-marginal
utility;
 distinguish between cardinal and ordinal utility approaches; and
 list the assumptions of consumer preferences.

*Dr. Vijeta Banwari, Assistant Professor in Economics, Maharaja Surajmal Institute, New Delhi. 73
Theory of
Consumer
4.1 INTRODUCTION
Behaviour
In previous units, we have understood the concept of demand and supply, their
determinants, and elasticity of demand and supply etc. We have also applied
the concepts of demand and supply in practice i.e. equilibrium, determination
of price and quantity, rationing and allocation of scarce goods, minimum wage
legislation and arbitrage etc. In this and subsequent unit, we shall examine the
theory of consumer behaviour. Consumer behaviour has always been a subject
of curiosity and research. Researchers have been trying to understand and
predict consumer behaviour ever since the commencement of trade. However,
relevance of this subject has increased over the time. With global markets and
more informed customers today, success of business is entirely dependent on
its understanding of consumer behaviour. Traditional businesses are getting
obsolete every day and new businesses based on needs of consumers (or
utility) are evolving. Increased internet penetration has changed the concept of
market. Businesses are increasingly talking about value creation rather than
mere product creation.
The concept of value creation is based on the concept of utility. Consumer
values a product only if it has ‘utility’ for him. Thus, the concept of utility has
become extremely relevant today. It is guiding marketing team across the globe
in designing business and marketing the company in a way that is likely to
attract the maximum number of customers and maximise sales revenues.
Let us begin to state the concept of utility and how has it evolved.

4.2 CONCEPT OF UTILITY

Utility is the basis of consumer demand. The consumers demand a commodity
because they desire or expect to derive utility from that commodity. As
discussed above, the concept of market, interaction between consumer and
producer has evolved in present times. Today, a consumer is more informed
about the choices available to him and someone somewhere is trying to
produce a good/service in order to provide utility to the customer. New
businesses, like an app to book a cab, maid, grocery, medicine, beauty service
etc. which have evolved in present time are successful because they provide
high utility to their customers.

4.2.1 What is Utility?

Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure
or well-being experienced by the consumer from the consumption or
possession of the commodity or availing of a service. In this sense, it is a
subjective or relative concept i.e. level of utility derived from a product differs
from person to person. For example, meat has no utility for vegetarians.
Utility of a product can be ‘absolute’ in the sense that the want satisfying
power is ingrained or embeded in it. For example, pen has its own utility
whether a person can write or not. However, utility is considered as
‘subjective’ in consumer analysis because a consumer will demand a good only
if that good holds utility for her. Utility not only varies from person to person
but also from time to time, at different level of consumption and at different
moods of a consumer. The most basic example to understand this concept is
food. If a person is not hungry, even her favourite food will not have any utility
74 for her at that point of time.
Based on this understanding, marketing concepts have also evolved over the Consumer Behaviour :
time. Advertisers target now consumers on the basis of their past purchases, Cardinal Approach
interests, likes/dislikes, sites they visit. Customers are often offered customised
coupons for the product/service that might hold ‘utility’ for them.

4.2.2 Relationship between Want, Utility, Consumption and

Satisfaction
Want of the consumer is the basis of understanding her behaviour. A consumer
selects a commodity based on its want satisfying power. Consumption of the
commodity leads to satisfaction of wants. Thus want, utility, consumption and
satisfaction are related in following manner:
Want Selection of Consumption of Getting utility in the sense
commodity the commodity of satisfaction of the want

Following points can be noted about utility:

a) Utility is a want satisfying power of a commodity
b) Utility varies from person to person
c) It varies from time to time, at different level of consumption and at
different moods of a consumer.
There are three concepts related to utility:
1) Initial Utility- The utility derived from the first unit of a commodity is
called initial utility. For example: utility obtained from consumption of
first roti is called initial utility.
2) Total Utility- The utility derived by a person from the total number of
units of a commodity consumed by her is called total utility.
i.e. TUn= U1+ U2=U3=….Un
3) Marginal Utility- It means addition made to total utility by consuming
an additional unit.
It can be measured with the help of following formula:
MUn= TUn –TUn-1
Where: MUn = Marginal utility of nth unit
TUn = Total utility of n units
TUn-1 = Total utility of n – 1 units or one unit less than the total no. of
units
Let us understand the concept with the help of Table 4.1 and Fig. 4.1.

75
Theory of Table 4.1: Relationship between Total utility (TU) and Marginal utility
Consumer (MU)
Behaviour
Units of a Good Total Utility Marginal Utility
Consumed (TU) (MU)
1 6 6
2 10 4
3 12 2
4 12 0
5 10 -2
6 6 -4

14 12 12
12
Marginal utility and Total Utility

10 10
10
8 6 6
6
4
2
0
-2 0 1 2 3 4 5 6 7
-4
-6
Units of commodity

Marginal utility (MU) Total utility (TU)

Fig. 4.1: Relationship between Total utility (TU) and Marginal utility (MU)

In Fig. 4.1, units of commodity are measured along x axis and utility is
measured along y axis. Upto 3rd unit the total utility is increasing but marginal
utility is diminishing but is positive. When a consumer consumes 4th roti, the
total utility is maximum and the marginal utility is zero. Consumer is getting
maximum satisfaction at this point. If a consumer consumes more than 4 units,
total utility will diminish and the marginal utility will be negative. This is also
called Law of diminishing Marginal Utility, which is discussed in detail in
Section 4.4.

4.2.3 Measurement of Utility

The concept of measurement of utility has evolved over the time. The classical
economists viz Jeremy Bentham, Menger, Walras etc. and neoclassical
economists like Marshall believed that utility is cardinally or quantitatively
measurable like height, weight etc. The belief resulted in Cardinal Utility
Approach. The exponents of cardinal utility analysis regard utility to be a
cardinal concept. According to them, a person can express utility or satisfaction
he derives from the goods in the quantitative cardinal terms. Jeremy Bentham
(1748–1832), the founder of Utilitarian school of ethics coined a psychological
unit of measurement called ‘utils’. Thus, a person can say that he derives utility
equal to 10 utils from the consumption of a unit of good A, and 20 utils from
the consumption of a unit of good B. Moreover, the cardinal measurement of
utility implies that a person can compare utilities derived from goods in respect
76
of size, that is, how much one level of utility is greater than another. Consumer Behaviour :
According to Marshall, marginal utility is actually measurable in terms of Cardinal Approach
money and money is the measuring rod of utility. This approach will be
discussed in detail in Section 4.4. The modern economists like J.R Hicks, Allen
are of view that utility is not quantitatively measurable but can be compared or
ranked. This is known as Ordinal concept of utility. Modern Economists hold
that utility being a psychological phenomenon, cannot be measured
quantitatively, theoretically and conceptually. However, a person can
introspectively express whether a good or service provides more, less or equal
satisfaction when compared to one another. In this way, the measurement of
utility is ordinal, i.e. qualitative, based on the ranking of preferences for
commodities. For example, Suppose a person prefers tea to coffee and coffee
to milk. Hence, he or she can tell subjectively, his/her preferences, i.e. tea >
coffee > milk. Ordinal Utility approach of measurement of utility is discussed
in detail in the next unit.
Check Your Progress 1
1) Explain the relationship between total utility and marginal utility.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Calculate Marginal utility in following table:

Ice Creams Consumed Total Utility Marginal Utility

1 20
2 36
3 46
4 50
5 50
6 44

4.3 SOME BASIC ASSUMPTIONS ABOUT

PREFERENCES
One of the basic questions addressed in microeconomics is how a consumer
with limited income takes decision about which good/service to buy. As
discussed above, consumer behaviour has gained great relevance today and
companies are spending huge amount to understand consumer preferences.
Success of business has always been dependent on its understanding of
consumer behaviour. But now since the world is more connected than ever
through internet, consumers have large number of options. It has become
imperative for companies to analyse consumer choices, preferences and design
their goods/services accordingly.
Economists have identified three basic steps to understand consumer
behaviour:

77
Theory of 1) Consumer Preferences: First step is to identify consumer preferences.
Consumer This can be done graphically or algebraically also. Behaviour is based on
Behaviour preferences i.e. likes, dislikes of the consumers. Thus, it is important to
identify ‘what gives value to the consumer’. We live in an information
age and today. Companies follow their customers online, keep a track of
sites they visit, products they buy etc. in order to identify their
preferences. Social networking sites have become popular data source to
identify preferences.
2) Budget Constraints: This is next important aspect. Prices of goods and
paying capacity of consumer has strong influence on his behaviour.
Through online tracking, companies today are not only able to identify
consumer preferences alone, but also their paying capacity and budget
constraints. Additional discounts, cash back schemes, EMI options etc.
are offered to the customer these days in order to ease their budget
constraint.
3) Consumer choices: Final step to understand consumer behaviour is
consumer choices. Given preferences and limited income, consumer
chooses the combination of goods which maximise their satisfaction.
With markets becoming global, consumers have large number of choices
available these days. But final demand for a good will be dependent on
combination of factors: their preferences, value offered by the product
and budget constraint.
4.3.1 Assumptions about Consumer Preferences
As discussed above, the theory of consumer behaviour is based on consumer
preferences. For better understanding of consumer behaviour with the help of
consumer preferences, economists usually make following assumptions about
consumer preferences:
a) Completeness: Preferences are assumed to be complete i.e. any two
different bundles of goods can be compared. A consumer either prefers
one basket over other or is indifferent between two baskets.
Mathematically, (a1, a2) ≥ (b1, b2) or
(a1, a2) ≤ (b1, b2) or
Both
b) Transitivity: Transitivity means that if a consumer prefers X over Y and
Y over Z then the consumer also prefers X over Z. Transitivity is a
necessary assumption to ensure consumer consistency.
c) More is always preferred over less: Consumer is rational and knows
that greater utility can be derived by consuming more quantity of a
commodity. Thus, he always prefers more quantity over less.
Check Your Progress 2
1) What are the basic assumptions about consumer preferences?
.....................................................................................................................
.....................................................................................................................

78 .....................................................................................................................
2) How does consumer preferences affect consumer behaviour? Consumer Behaviour :
Cardinal Approach
.....................................................................................................................
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.....................................................................................................................

4.4 CARDINAL UTILITY ANALYSIS

Cardinal utility Analysis was mainly given by neoclassical economists like
Jevons, Dupuit, Menger, Walras and Pigou etc. The exponents of this approach
regards utility as cardinal concept. In other words, they hold that utility is a
measurable and quantifiable entity. For example, According to cardinal utility
approach, if a person is drinking a glass of water, it will be possible for him to
assign some numerical value say 10 utils or 20 utils to the utility derived from
it.
This approach is based on following assumptions:
1) The cardinal measurement of utility- Utility of any commodity can be
measured in units called ‘utils’.
2) Utilities are additive i.e. total utility can be calculated by measuring
utility derived from all the units of a commodity consumed.
3) Utility is independent i.e. not related to the amounts of other commodities
purchased by the consumer. Further, it is also assumed that it is not
affected by utilities of other individuals.
4) Marginal utility of money remains constant: When a person purchases
more of a good, the amount of money diminishes and marginal utility of
remaining money may increase. But in this approach, marginal utility of
money is treated constant. This assumption is important as cardinalists
have used money as a measure of utility and it is necessary to keep the
measuring rod of utility as fixed.

4.5 LAW OF DIMINISHING MARGINAL UTILITY

Law of Diminishing Marginal Utility is one of the most fundamental law of
utility analysis. It explains the relationship between utility and quantity of a
commodity. This law states that after sufficient quantity of a commodity is
consumed, the utility derived from each successive unit decreases,
consumption of all other commodities remaining same. Let us take an example
to illustrate this law. For example, If a person is hungry, the first roti he
consumes will have high utility for him as it will give him high level of
satisfaction. As he keeps on consuming more and more roties, utility derived
from each successive unit will go on decreasing. After a point of time, when
person is satisfied, he will not be able to eat more. The utility will drop to zero
here. If the consumption of roti is continued further, a person would get
negative utility or disutility. This can be illustrated with the help of following
table:

79
Theory of Table 4.2: Diminishing Marginal Utility
Consumer
Behaviour
No. of Roti Marginal Utility (MU)
1 10
2 8
3 5
4 3
5 0
6 -2

Fig. 4.2: Diminishing Marginal Utility

It can be noted from the above table and diagram, that the utility of first roti is
very high i.e. 10 utils. The utilities of 2nd, 3rd, 4th roti falls to 8, 5 and 3 utils
respectively. 5th roti gives zero utility, after which each successive roties starts
giving negative utility.

4.5.1 Exceptions to the Law/ Limitations of the Law

The law of Diminishing Marginal utility does not apply in following cases:
1) Small initial unit: The law is not applicable when the initial units of
commodity are of very small size. For example, drinking water with a
spoon. In such cases, initially utility derived from additional units will go
on increasing and the law may not operate for sometime. It is only after a
stage in consumption is reached that marginal utility begins to diminish.
2) Rare and curious things like rare paintings, gold and diamond
jewellery: The law does not apply in such cases because collection of
more and more units usually give more satisfaction to the
collector/consumer.

4.5.2 Criticism of the Law

Law of Diminishing Marginal utility has been criticised by modern economists
on following grounds:
1) Measurement of utility is not possible: The major criticism of this
80 approach is that it is not possible to measure utility in cardinal numbers.
 Utility is a psychological phenomenon and thus it is not possible to Consumer Behaviour :
measure it in quantifiable terms. In real life, we can only describe utility Cardinal Approach
of a product in words.
2) Marginal utility of money does not remain constant: Cardinal
economists believe that marginal utility of money remains constant
throughout. However, when a person uses money, stock of money
reduces leading to increase in utility of remaining stock.
3) Utility is not always independent: Sometimes utility of one commodity
is affected by other commodities. Many times, consumer prefers to
consume series of related goods. For example, A consumer may prefer to
consume biscuits or pakoda along with tea.
4) Unrealistic assumptions: The law is based on various unrealistic
assumptions. It assumes no change in fashion, taste, income, preferences
of a customer. But in real life, environment is extremely dynamic and so
are taste, fashion etc. With new products having advanced features being
launched so frequently, taste and preferences of customers are also
changing frequently. Thus, this law may not operate in present dynamic
times, at least not in the same form it was believed to operate, say one
century ago.
Check Your Progress 3
1) Why does marginal utility diminished?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) What does happen to marginal utility at a point when total utility is
maximum?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.6 CONSUMER EQUILIBRIUM THROUGH

UTILITY ANALYSIS
Consumer Equilibrium is a situation wherein a consumer gets maximum
satisfaction out of his limited income and has no tendency to change his
existing expenditure pattern. A consumer is considered to be extremely
satisfied when he allocates his income in such a way that the last rupee spent
on each commodity yields the same level of utility. The concept of consumer
equilibrium can be examined under one-commodity model and multi-
commodity model.
Consumer equilibrium through utility analysis is based on following set of
assumptions:

81
Theory of 1) Consumer is rational: This is one of the basic assumption of the law.
Consumer Consumer is rational i.e. he measures, compares and chooses the best
Behaviour option in order to maximise his utility.
2) Cardinal measurement of utility: Utility can be measured in
quantifiable terms.
3) Marginal utility of money is constant: It is assumed that utility is
measured in terms of money and utility of money does not change.
4) Fixed income and prices: It is assumed that income of the consumer and
prices of goods remain constant.
5) Constant tastes and preferences: It is assumed that taste and
preferences of the consumer remain same.

4.6.1 Determination of Consumer Equilibrium

As discussed above, Consumer equilibrium can be examined under two cases:
1) Consumer equilibrium-One commodity case
Suppose a consumer with fixed income consumes a single commodity x. He
will continue his consumption till a point where marginal utility that he
derived from consumption of a unit of commodity is greater than marginal
utility of money spent on purchasing that unit. If the marginal utility of
commodity x (MUx) is greater than the marginal utility of money (MUm), then
a consumer will exchange his money for a commodity. Consumer will keep
on consuming and spending his money so long as (MUx)>Px(MUm) where Px
is the Price of commodity x and MUm is 1(constant), Thus a utility
maximising consumer will be in equilibrium where
MUx=Px

Fig. 4.3: Consumer equilibrium in case of single commodity

Let us understand the concept with the help of an example. Suppose, the
consumer wants to buy a good x costing Rs. 10 per unit. Marginal utility
derived from each successive unit (in utils is determined and is given in Table
4.3 (It is assumed that 1 util = Re. 1, i.e. MUm = Re. 1).

82
 Table 4.3: Consumer Equilibrium in case of Single Commodity Consumer Behaviour :
Cardinal Approach
Unit of Price of Marginal Difference Remarks
‘x’ ‘x’ Utility (MU) between
MU and
(Px) in Utils Px
1 10 18 8 Since MUx>Px
Consumer will
2 10 16 6 increase
3 10 12 2 consumption

4 10 10 0 Consumer
equilibrium
MUx=Px
5 10 8 -2 Since MUx<Px
Consumer will
6 10 0 -10 not buy any
7 10 -2 -12 more units

2) Consumer equilibrium in Multi-commodity case:

Consumer equilibrium in single commodity is unrealistic model in the sense
that in real life, consumer consumes a large number of commodities. This
model deals with the equilibrium in case of many commodities. This model
works under the assumption of limited income of the consumer and
diminishing marginal utility of commodities. Thus, utility maximising
consumer will first spend money on commodity which yield highest utility,
then the second highest and so on. Finally, a consumer will reach equilibrium
when the last rupee he spent on different commodities will yield equal level of
utility.
This case of multi-commodities is known as Law of Equi-Marginal Utility, a
consumer having choices of multiple goods distribute their limited income in
such a way that the last rupee spent on each commodity yields equal marginal
utility. Suppose a customer consumes only two goods x (with price Px) and y
(with price Py). Thus he will try to maximise his utility by equating his
marginal utility and prices.
MUx=Px (MUm)
MUy=Py (MUm)
Given these conditions, a consumer will be in equilibrium when:
MUx/ Px (MUm) = MUy/ Py (MUm)
Or
MUx/ Px = MUy/Py (because MU of each unit of money is assumed to be
constant at 1)
Two commodity case can be generalised for multi-commodity case. Suppose a
customer consumes various goods, he will be in equilibrium when:
MUx/ Px = MUy/ Py= MUc/ Pc= ……MUz/ Pz 83
Theory of Diagrammatically, equilibrium is achieved at a point when MUx/Px= MUy/Py
Consumer
Behaviour

Fig. 4.4: Consumer equilibrium in multi commodity case

Let us understand the law with the help of an example: Suppose, total money
income of a consumer is 5 which he wants to spend on two goods ‘x’ and ‘y’.
Both these commodities are priced at Re. 1 per unit. Table 4.4 presents
marginal utility which consumer derives from various units of the two
commodities.
Table 4.4: Consumer Equilibrium in case of multi-commodity
Unit MU Derived from Good X MU Derived from Good Y
(in Utils) (in Utils)
1 12 9
2 10 8
3 8 6
4 6 4
5 4 2

It can be noted from Table 4.4 that the consumer will spend first and second
rupee on commodity ‘x’, which will provide him utility of 12 and 10 utils
respectively. The third rupee will be spent on commodity ‘y’ to get utility of 9
utils. Fourth and fifth rupee will be spent on X and Y respectively. To reach the
equilibrium, consumer should purchase that combination of both the goods,
when:
a) MU of last rupee spent on each commodity is same; and

84
b) MU falls as consumption increases.
It happens when consumer buys 3 units of ‘x’ and 2 units of ‘y’ because: Consumer Behaviour :
Cardinal Approach
a) MU from last rupee (i.e. 5th rupee) spent on commodity y gives the same
satisfaction of 8 utils as given by last rupee (i.e. 4th rupee) spent on
commodity x; and
b) MU of each commodity falls as consumption increases.
The total satisfaction of 47 utils will be obtained when consumer buys 3 units
of ‘x’ and 2 units of ‘y’. It reflects the state of consumer’s equilibrium. If the
consumer spends his income in any other order, total satisfaction will be less
than 47 utils.
Check Your Progress 4
1) Given the price of good, how will a consumer decide as to how much
quantity of the good to buy? Use utility analysis.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) A consumer consumes only two goods – x and y. State and explain the
conditions of consumer equilibrium using utility analysis.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.7 DERIVATION OF DEMAND CURVE WITH

THE HELP OF LAW OF DIMINISHING
MARGINAL UTILITY
We have learned in Unit 2 that the demand curve or law of demand shows the
relationship between price of a good and its quantity demanded. Marshall
derived the demand curves for goods from their utility functions.
Marshall assumed the utility functions of different goods to be independent of
each other. In other words, Marshallian technique of deriving demand curves
for goods from their utility functions rests on the hypothesis of additive utility
functions.
Dr. Alfred Marshall derived the demand curve with the help of law of
diminishing marginal utility. The law of diminishing marginal utility states that
as the consumer purchases more and more units of a commodity, utility that he
derives from successive units goes on decreasing.
A rational consumer, while purchasing a commodity compares the price of the
commodity which he has to pay with the utility he receives from it. So long as
the marginal utility of a commodity is higher than its price (MUx >Px), the
consumer would demand more and more units of it till its marginal utility is
equal to its price MUx = Px or the equilibrium condition is established.

85
Theory of In other words, as the consumer consumes more and more units of a
Consumer commodity, its marginal utility goes on diminishing. So it is only at a
Behaviour diminishing price at which the consumer would like to demand more and more
units of a commodity. Derivation of demand curve with the help of law of
diminishing marginal utility is presented in Fig. 4.5.

Fig. 4.5: Derivation of demand curve with the help of law of diminishing marginal utility
In Fig. 4.5, the MUx is negatively slopped. It shows that as the consumer
acquires larger quantities of good X, its marginal utility diminishes.
Consequently at diminishing price, the quantity demanded of the good X
increases as is shown in the second Fig. of 4.5.
At X1, quantity of the marginal utility of a good is MU1. This is equal to P1 by
definition. Thus, consumer demands OX1 quantity of the commodity at
P1 price. In the same way X2 quantity of the good is equal to P2. Here at
P2 price, the consumer will buy OX2 quantity of commodity. At X3 quantity the
marginal utility is MU3, which is equal to P3. At P3, the consumer will buy
OX3 quantity and so on.
It can be concluded that as the purchase of the units of commodity X are
increased, its marginal utility diminishes. So at diminishing price, the quantity
demanded of good X increases. The rational supports the notion of down
slopping demand curve that when price falls, other things remaining the same,
the quantity demanded of a good increases and vice versa.

4.8 CONSUMER SURPLUS

The concept of consumer surplus was first formulated by Dupuit in 1844 to
measure social benefits of public goods such as canals, bridges, national
highways. Marshall further refined and played a significant role in providing it
a theoretical structure in his book ‘Principles of Economics’ published in 1890.
Marshall’s concept of consumer’s surplus was based on the cardinal
measurability and interpersonal comparisons of utility. According to him,
consumer’s surplus is the difference between what ‘one is willing to pay’ and
‘what one actually pays’ to acquire a particular good. Concept of consumer’s
surplus is a very important concept in economic theory, especially in theory of
demand and welfare economics. It is also very useful in formulation of
economic policies such as taxation by the Government.
The quintessence of the concept of consumer’s surplus is that people generally
86 get more utility from the consumption of goods than the price they actually pay
for them. This extra satisfaction, which the consumers obtain, from buying a Consumer Behaviour :
good has been called consumer’s surplus. Cardinal Approach

The concept of consumer’s surplus is derived from the law of diminishing

marginal utility. As we purchase more units of a good, its marginal utility goes
on diminishing. It is because of the diminishing marginal utility that
consumer’s willingness to pay for additional units of a commodity declines as
he has more units of the commodity.
The measurement of consumer surplus from a commodity from the demand or
marginal utility curve is illustrated in Fig. 4.6. In the figure, quantity of a
commodity is measured along the X-axis, the marginal utility (or willingness to
pay for the commodity) and the price of the commodity are measured on the Y-
axis.
DD' is the demand or marginal utility curve which is sloping downward,
indicating that as the consumer buys more units of the commodity, marginal
utility derived from the additional units of the commodity falls.
If OP is the price that prevails in the market, then the consumer will be in
equilibrium when he buys OM units of the commodity, since at OM units,
marginal utility from a unit of the commodity is equal to the given price OP.
The Mth unit of the commodity does not yield any consumer’s surplus to the
consumer since this is the last unit purchased and for this price paid is equal to
the marginal utility which indicates the price that he is prepared to pay rather
than go without it. But for the units before Mth unit, marginal utility is greater
than the price and therefore, these units yield consumer’s surplus to the
consumer. The total utility of a certain quantity of a commodity to a consumer
can be known by summing up the marginal utilities of the various units
purchased.

Fig. 4.6: Consumer Surplus

In Fig. 4.6, the total utility derived by the consumer from OM units of the
commodity will be equal to the area under the demand or marginal utility curve
up to point M. That is, the total utility of OM units in Fig. 4.6 is equal to
ODSM.
In other words, for OM units of the good the consumer will be prepared to pay
the sum equal to Rs. ODSM. But given the price equal to OP, the consumer
will actually pay the sum equal to Rs. OPSM for OM units of the good. It is
thus clear that the consumer derives extra utility equal to ODSM minus OPSM 87
Theory of = DPS, which has been shaded in Fig. 4.6. If market price of the commodity
Consumer rises above OP, the consumer will buy fewer units of the commodity than OM.
Behaviour As a result, consumer’s surplus obtained by him from his purchase will
decline. On the other hand, if price falls below OP, the consumer will be in
equilibrium when he is purchasing more units of the commodity than OM. As a
result of this, the consumer’s surplus will increase. Thus, given the marginal
utility curve of the consumer, the higher the price, the smaller the consumer’s
surplus and the lower the price, the greater the consumer’s surplus.

4.9 CRITICAL EVALUATION OF CARDINAL

UTILITY ANALYSIS
Cardinal utility analysis of demand has been criticised by modern economists
on following grounds:
1) Cardinal measurability of utility is impractical:
Cardinal utility analysis of demand is based on the assumption that utility can
be measured in absolute, objective and quantitative terms. But in actual
practice utility cannot be measured in such quantitative or cardinal terms. Since
utility is a psychological phenomenon and subjective feeling, it cannot be
measured in quantitative terms. In reality, consumers are only able to compare
the satisfactions derived from various goods or various combinations of the
goods. In other words, in the real life consumer can state only whether a good
or a combination of goods gives him more or less, or equal satisfaction as
compared to another. Thus, economists like J.R. Hicks are of the opinion that
the assumption of cardinal measurability of utility is unrealistic and therefore it
should be given up.
2) Wrong assumption of independent utilities:
Cardinal Utility analysis also assumes that utilities derived from various goods
are independent. This means that the utility which a consumer derives from a
good is the function of the quantity of that good only. In other words, the
assumption of independent utilities implies that the utility which a consumer
obtains from a good does not depend upon the quantity consumed of other
goods. On this assumption, the total utility which a person gets from the whole
collection of goods purchased by him can be calculated as sum of the separate
utilities of various goods. In other words, utility functions are additive. But in
the real life this is not so. In actual life the utility or satisfaction derived from a
good depends upon the availability of some other goods which may be either
substitutes for or complementary with each other. For example, the utility
derived from a pen depends upon whether ink is available or not. Similarly,
utility of tea may increase if accompanied by biscuits. It is, thus, clear that the
utilities derived from various goods are interdependent, that is, they depend
upon each other.
3) Assumption of constant marginal utility of money is not true:
An important assumption of cardinal utility analysis is that when a consumer
spends varying amount on a good or various goods or when the price of a good
changes, marginal utility of money remains constant. But in actual practice,
this is not correct. As a consumer spends his money income on the goods,
money income left with him declines.
88
With the decline in money available to the consumer, the marginal utility of Consumer Behaviour :
remaining money rises. Further, when price of a commodity changes, the real Cardinal Approach
income of the consumer also changes. With this change in real income,
marginal utility of money will change and this would have an effect on the
demand for the good in question, even though the total money income
available with the consumer remains the same.
Cardinal utility analysis ignores the changes in real income and its effect on
demand for goods following the change in price of a good. Further, it is
because of the constant marginal utility of money and therefore the neglect of
the income effect by Marshall that he could not explain Giffen Paradox.
Marginal utility of money also varies from a poor man to a rich one. For
example, a person having just Rs. 80/- with him will place much higher
valuation as each of these 10 rupees. But, someone who has thousands of
rupees with him may not place that much value on a Rs. 10 note.
4) Cardinal utility analysis does not split up the Price effect into
Substitution and Income effects:
Another shortcoming of the cardinal utility analysis is that it does not
distinguish between the income effect and the substitution effect of the price
change. Marshall and other exponents of cardinal utility analysis ignored
income effect of the price change by assuming the constancy of marginal
utility of money.
In real life, when the price of a good falls, the consumer becomes better off
than before, that is, a fall in price of a good brings about an increase in the real
income of the consumer. With this income he would be in a position to
purchase more of this good as well as other goods. This is the income effect of
the fall in price on the quantity demanded of a good. Besides, when the price of
a good falls, it becomes relatively cheaper than other goods and as a result the
consumer is induced to substitute that good for others. This results is increase
in quantity demanded of that good. This is the substitution effect of the price
change on the quantity demanded of the good. Thus total effect of price can be
decomposed into substitution effect and income effect.
5) Marshall could not explain Giffen Paradox:
By not visualising the price effect as a combination of substitution and income
effects and ignoring the income effect of the price change, Marshall could not
explain the Giffen Paradox. He treated it merely as an exception to his law of
demand. In contrast to it, indifference curve analysis has been able to explain
satisfactorily the Giffen good case.
According to indifference curve analysis, in case of a Giffen Paradox or the
Giffen good, negative income effect of the price change is more powerful than
substitution effect so that when the price of a Giffen good falls, the negative
income effect outweighs the substitution effect with the result that quantity
demanded of it falls.
Check Your Progress 5
1) If price of good is Rs. 10 and marginal utility of a consumer is Rs. 12,
how much will be the consumer surplus? Use utility analysis.
.....................................................................................................................
89
Theory of .....................................................................................................................
Consumer
Behaviour .....................................................................................................................
2) Critically examine Cardinal utility approach.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.10 LET US SUM UP

Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure
or well-being experienced by the consumer from the consumption or
possession of the commodity or a service. In this sense, it is a subjective or
relative concept i.e. level of utility derived from a product differs from person
to person. We also examined the relationship between want, utility,
consumption and satisfaction i.e. how want leads to selection of commodity
having utility which in turn leads to consumption and finally satisfaction of
want. We further analysed the relationship between Marginal utility and Total
utility and the law of diminishing marginal utility. We also explained consumer
equilibrium using utility approach in case of single commodity and multiple
commodity. We also discussed the basic assumptions of consumer preferences.

4.11 REFERENCES
1) Dwivedi, D.N.(2008). Managerial Economics, 7th edition, Vikas
Publishing House.
2) Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th
edition, 2010.
3) Hal R. Varian, Intermediate Microeconomics, a Modern Approach, 8th
edition, W.W. Norton and Company/Affiliated East-West Press (India),
2010.
4) Kumar, Raj and Gupta, Kuldip (2011). Modern Micro Economics: Analysis
and Applications, UDH Publishing House.
5) Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill
education.
6) Salvatore, D. (8th rd. 2014) Managerial Economics in a Global economy,
Oxford University Press.
7) http://www.learncbse.in/important-questions-for-class-12-economics-
consumers-equilibrium-through-utility-approach/
8) https://www.meritnation.com/ask-answer/question/explain-the-conditions-
of-consumer-s-equilibrium-in-case-of/theory-of-consumer-behaviour/
2323428
9) http://economicsconcepts.com/derivation of the demand curve.htm
10) http://www.vourarticlelibrary.com/economics/consumer-surplus-meaning-
measurement-critical-evaluation-uses-and-application/36842
90
 Consumer Behaviour :
4.12 ANSWERS OR HINTS TO CHECK YOUR Cardinal Approach
PROGRESS EXERCISES
Check Your Progress 1
1) Study Section 4.2 and answer
2) 1. 20 2. 16 3. 10 4. 4 5. 0 6. -6
Check Your Progress 2
1) Completeness, Transitivity and more is preferred to less.
2) Consumer preference are the first step for determining consumer
behaviour. Consumer behaves according to his preferences and budget
constraint.
Check Your Progress 3
1) Study Section 4.5 and answer
Marginal utility is zero when total utility is maximum
Check Your Progress 4
1) A consumer buys a quantity of commodity when Marginal utility is equal
to price of that good.
2) Study Sub-section 4.6.1 and answer
Check Your Progress 5
1) Consumer Equilibrium is the difference between what customer is willing
to pay and what he actually pays. So consumer surplus is Rs. 2
2) Study Section 4.9 and answer

91
 UNIT 5 CONSUMER BEHAVIOUR:
ORDINAL APPROACH
Structure
5.0 Objectives
5.1 Introduction
5.2 Ordinal Utility Approach
5.3 Indifference Curve Analysis
5.3.1 Indifference Schedule
5.3.2 Indifference Curve
5.3.3 Indifference Map
5.3.4 Law of Diminishing Marginal Rate of Substitution
5.3.5 Properties of Indifference Curve

5.4 Some Exceptional Shapes of Indifference Curve

5.5 Budget Line
5.6 Shift in Budget Line
5.7 Consumer Equilibrium through Indifference Curve Analysis
5.8 Some Exceptional Shapes of Indifference Curve and Corner Equilibrium
5.9 Price Effect as Combination of Income Effect and Substitution Effect
5.9.1 Income Effect
5.9.2 Substitution Effect
5.9.3 Price Effect

5.10 Measuring Income and Substitution Effects of Price Change

5.11 Derivation of Demand Curve from Indifference Curves
5.12 Let Us Sum Up
5.13 References
5.14 Answers or Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After completion of this unit, you will be able to:
 state ordinal utility approach for measurement of utility;
 use Indifference curve analysis to explain consumer behaviour;
 identify shape of Indifference curve in case of perfect substitutes and
complementary goods;
 explain the concept of Budget line;

*Dr. Vijeta Banwari, Assistant Professor in Economics, Maharaja Surajmal Institute, New Delhi.
92
 identify the factors causing shift in Budget line; Consumer Behaviour :
Ordinal Approach
 describe consumer equilibrium through Indifference curve approach;

 decompose price effect into income effect and substitution effect using
Hicksian and Slutsky approach; and
 derive demand curve from Price Consumption curve (PCC).

5.1 INTRODUCTION
In Unit 4, we have learnt the concept of cardinal and ordinal utility in order to
understand the concept of consumer preferences. We also examined consumer
equilibrium through cardinal utility analysis. As discussed in previous unit,
study of consumer behaviour has been a focus point for researchers as well as
business houses. Consumer behaviour directly affects the sales and thus profits
of the companies. In order to understand consumer’s buying pattern, it is also
important to understand how consumer equilibrium is attained. A rational
consumer wants to maximise his satisfaction derived from consumption of
various goods but is subject to his budget constraint. In this unit, we will
examine the concept of consumer equilibrium using ordinal utility approach.

5.2 ORDINAL UTILITY APPROACH

Cardinal Utility approach was criticised for being restrictive in nature. English
economist Edgeworth criticised cardinal approach for its Unrealistic
assumptions. He was of opinion that measurement of utility in quantitative
scale is neither possible nor necessary. This idea gave birth to ordinal
approach. Edgeworth also believed that all consumer behaviour can be
measured in terms of preferences and rankings and can be understood using
Indifference curve approach. Though this approach was originally propounded
by Edgeworth, it became popular because of Vilfred Pareto (1906), Slutsky
(1915) and finally because of RGD Allen and J.R Hicks. However, this
approach is also based on some assumptions.
Assumptions of Ordinal Utility Approach

1) Rationality: The basic assumption is that consumer is a rational being,

i.e., he prefers more to less and tries to maximise his satisfaction.

2) Indifference curve analysis assumes that utility is only ordinally

expressible i.e. utility derived from two goods can be compared, as more,
less, or equal, but not how much more or less.

3) Transitivity: Consumer choices are assumed to be transitive. Transitivity

of choices means that if a consumer prefers A to B and B to C, then he
prefers A to C, or if she treats A>B and B>C, then she also treats A>C.

4) Consistency: Consistency of choice means that if a person prefers A over

B in one period, he/she will not prefer B over A in another period.

5) Non satiety: This assumption means that a consumer prefers a larger

quantity of all the goods over smaller quantities of the same.

6) Diminishing Marginal Rate of Substitution (MRS): MRS is that rate at

which a consumer is willing to substitute one commodity (say X) for 93
Theory of another (say Y) while maintaining the same utility or level of satisfaction
Consumer to the consumer. The concept of diminishing MRS will be discussed in
Behaviour greater detail in next section.

5.3 INDIFFERENCE CURVE ANALYSIS

J.R Hicks used the concept of Indifference curve to analyse consumer
behaviour. A consumer facing choice between large number of bundles of two
goods tries to maximise his satisfaction by choosing a combination which gives
him maximum utility. In the course of decision making, consumer finds out
that goods can be substituted for each other and identifies various combinations
of commodities that give him equal level of satisfaction. When all these
combinations are plotted graphically, it produces a curve called Indifference
curve.

5.3.1 Indifference Schedule

An indifference schedule is a table which represents various combinations of
two goods, which yield equal satisfaction to consumer. Since all the
combinations give equal level of satisfaction, consumer is indifferent between
them.
Table 5.1 presents an imaginary indifference schedule representing the various
combinations of two goods X and Y.
Table 5.1: Indifference schedule of two commodities ‘X’ and ‘Y’

Combinations Units of ‘X’ Goods Units of ‘Y’ Satisfaction

(Cup of Tea) Goods (Biscuits)
A 1+ 12 K
B 2+ 8 K
C 3+ 5 K
D 4+ 3 K
E 5+ 2 K

In above table, five different combinations of Tea and Biscuits are depicted.
All these combinations give equal level of satisfaction i.e. K. The consumer is
indifferent whether he buys 1 cup of tea and 12 biscuits or 2 cups of tea and 8
biscuits. Different schedules can be formed showing different levels of
satisfaction.

5.3.2 Indifference Curve

The graphical presentation of Indifference schedule is known as Indifference
curve. The indifference curve is locus of all the combinations of two
commodities which give same level of satisfaction to the consumer.
Fig. 5.1 is graphical representation of Table 5.1. It shows all the combinations
of good X and good Y i.e. A, B, C, D and E which yield equal level of
satisfaction to the consumer. The curve is downward sloping, convex to the
point of origin.

94
 Consumer Behaviour :
Ordinal Approach

Fig. 5.1: Indifference curve

5.3.3 Indifference Map

The combinations of two commodities X and Y given in the Indifference
schedule are not the only possible combinations for these commodities. The
consumer may make any other combinations with less of one or both of the
goods, each yielding the same level of satisfaction but less than the one shown
in schedule. IC curve of this schedule will be above IC1. Similarly, the
consumer may make other combinations with more of one or both of the
goods, each combination yielding the same satisfaction but greater than the
satisfaction indicated.
A diagram showing different indifference curves corresponding to different
indifference schedules of the consumer is indifference map. In other words, a
set or family of indifference curves is an indifference map.

Fig. 5.2: Indifference map

Fig. 5.2 shows four indifference curves: IC1, IC2, IC3 and IC4. All the points on
IC2 will yield higher satisfaction than the points on IC1 and all the points on
IC3 will yield lesser satisfaction than the points on IC4.

95
Theory of 5.3.4 Law of Diminishing Marginal Rate of Substitution
Consumer
Behaviour What is Marginal Rate of Substitution?
Marginal rate of substitution may be defined as the rate at which a consumer
will exchange successive units of a commodity for another. In other words,
Marginal rate of substitution is the rate at which, in order to get the additional
units of a commodity, the consumer is willing to sacrifice or give up to get one
additional unit of another commodity.
The Marginal Rate of Substitution can symbolically be represented as under:
MRSxy= ΔY/ΔX
Where MRSxy= Marginal rate of substitution of X for Y
ΔY= Change in ‘Y’ commodity
ΔX= Change in ‘X’ commodity.
Diminishing Marginal rate of Substitution
One of the basic postulates of ordinal utility theory is that Marginal rate of
substitution (MRSxy or MRSyx) decreases. It means that the quantity of a
commodity that a consumer is willing to sacrifice for an additional unit of
another commodity goes on decreasing. Law of diminishing Marginal rate of
substitution is an extensive form of the law of diminishing Marginal Utility. As
discussed in previous section, Law of diminishing marginal Utility states that
as a consumer increases the consumption of a good, his marginal utility goes
on diminishing. Similarly as consumer gets more and more unit of good X, he
is willing to sacrifice less and less units of good Y for each extra unit of X. The
significance of good X in terms of good Y goes on diminishing with each
addition of good X. The law can be understood with the help of following
Table 5.2.
Table 5.2: Marginal rate of Substitution

Units of ‘X’ Units of ‘Y’ MRS of ‘X’ for

Good Good ‘Y’
1 10 -
2 7 3:1
3 5 2:1
4 4 1:1

To have the second combination and yet to be at the same level of satisfaction,
the consumer is ready to forgo 3 units of Y for obtaining an extra unit of X.
The marginal rate of substitution of X for Y is 3:1. The rate of substitution is
units of Y for which one unit of X is a substitute. As the consumer desires to
have additional unit of X, he is willing to give away less and less units of Y so
that the marginal rate of substitution falls from 3:1 to 1:1 in the fourth
combination.
In Fig. 5.3 given below at point M on the Indifference curve I, the consumer is
willing to give up 3 units of Y to get an additional unit of X. Hence, MRSxy =3.
As he moves along the curve from M to N, MRSxy, = 2. When the consumer
96 moves downwards along the indifference curve, he acquires more of X and less
of Y. The amount of Y he is prepared to give up to get additional units of X Consumer Behaviour :
becomes smaller and smaller. Ordinal Approach

Fig. 5.3: Indifference curve and Marginal rate of Substitution

The marginal rate of substitution of X for Y (MRSxy) is, in fact, the slope of the
curve at a point on the indifference curve, such as points M, N or P in Fig. 5.3.
Thus MRSxy = ∆Y/∆X

5.3.5 Properties of Indifference Curve

1) Indifference curve slopes downwards from left to right: It implies that
Indifference curve has a negative slope. This attribute is based on the
assumption that if a consumer uses more quantity of one good, he has to
reduce the consumption of the other good in order to stay at the same
level of satisfaction.
2) Indifference curves are generally convex to the origin ‘O’: This
property is based on the principle of Diminishing Marginal Rate of
Substitution. It means that as the units of ‘X’ are increased by equal
amounts, the ‘Y’ diminishes by smaller and smaller amounts. This
happens because as a consumer gets more and more units of ‘X’ good, he
is willing to give up less and less units of good Y for each extra unit of X.
3) Indifference curves cannot intersect each other: This is because of the
fact that each indifference curve represents different level of satisfaction.
If two indifference curves intersect, it will lead to self-contradictory
result. In Fig. 5.4, two Indifference curve IC1 and IC2 are shown
intersecting each other at point C. But this is not possible.
Point ‘A’ and point ‘C’ on Indifference curve IC1 represents combination
yielding equal satisfaction. That is satisfaction from A combination = the
satisfaction from C combination, therefore,
i) Pt. A = Pt. C ( Because both lie on same IC curve IC1)
ii) Pt. B = Pt. C ( Because both lie on same IC curve IC2)
Thus Pt. B = Pt. A in terms of satisfaction. But this is impossible because at
combination ‘B’ quantities of both X and Y are more than in combination ‘A’,
hence this is self-contradictory.

97
Theory of
Consumer
Behaviour

Fig. 5.4: Two Indifference curves cannot intersect

Thus, two Indifference curves cannot intersect with each other. The
Indifference curves cannot be tangent to each other.
4) Higher Indifference curve represents higher level of satisfaction: In
Fig. 5.5, the indifference curve IC2 lies above and to the right of the IC1.
Point C on IC2 represents more units of ‘x’ than point A on IC1.
Similarly, Point B on IC2 represents more units of ‘y’ than point A on
IC1. It is thus evident that higher the indifference curve, the higher the
satisfaction it represents because our consumer prefers more of a good to
less of it. Also note that all the points between B and C on IC2 show
larger amounts of both X and Y compared to point A on IC1.

Fig. 5.5: Higher Indifference curve means higher level of satisfaction

5) Indifference curves do not touch either of the axes X or Y . This is

because of the assumption that the consumer purchases combination of
different commodities. In case, an indifference curve touches either axis,
it means the consumer wants only one commodity and his demand for the
98 second commodity is zero. Purchasing one commodity means
 monomania, i.e. consumer’s lack of interest in the other commodity. This Consumer Behaviour :
is against the assumption of Indifference curve which is a two good Ordinal Approach
model.
6) No Indifference curve cuts either of axes: If it were to happen, the
consumer will be consuming negative quantity of that commodity which
makes no sense.

5.4 SOME EXCEPTIONAL SHAPES OF

INDIFFERENCE CURVE
Indifference curve may take a different shape in case of perfect substitutes and
perfect complements. Some exceptional shapes of Indifference curve are
discussed as follows:
Perfect Substitutes
We have examined the concept of perfect substitutes in previous units. Two
goods are perfect substitutes if the utility consumers get from one good is the
same as another.
When two goods are perfect substitutes of each other, their indifference curve
will be a straight diagonal line sloping downwards from left to right. It is
because of the fact that MRS in such cases is constant i.e. 1.
For example: Suppose good A and good B are perfect substitutes, consumer
will be indifferent between them and will be ready to sacrifice equal quantity
of good A to achieve good B. But, even here, the ICs will not cross the axes.

Fig. 5.6: Indifference curve in case of Perfect Substitutes

Perfect Complements
Two goods may be perfect complementary to each other. Just as left and right
shoes, cups and saucers of a tea set etc. In such case, the indifference curve
will be parallel to each other and bent at 90 degree angle or L shaped. Perfect
complementary goods are those goods which are used in fixed ratio i.e. 1:1or
2:2. They cannot be substituted for each other, thus putting MRS as zero. This
99
Theory of case is shown in Fig. 5.7. It is clear that IC1 and IC2 are right angled curves,
Consumer meaning thereby that the consumer buys piece of each right shoe. This will be
Behaviour useless. The consumer will be no better off and he will remain at point ‘A’ on
IC1. In case, he buys 2 pieces of left shoe and only one piece of right shoe, it
will be useless, the consumer will be no better off and he will remain at point C
of IC1. It means that having one more pair of shoe will not add to his
satisfaction. But if he buys one more shoe, his satisfaction will immensely
increase and he will move to point B on higher Indifference curve IC2.

IC3
IC2

IC1

Fig. 5.7: Indifference curve in case of Perfect Complements

Check Your Progress 1
1) Suppose that goods A and B are perfect compliments. Draw a set of
indifference curves for perfect compliments, and explain why the curves
look the way they do. Do the same for perfect substitutes?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain the concept of Marginal Rate of Substitution (MRS). What
happens to MRS when consumer moves downward along the
Indifference curve?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Why is Indifference curve convex to origin?
......................................................................................................................
......................................................................................................................
......................................................................................................................

5.5 BUDGET LINE

As discussed above, a rational consumer always acts according to his budget
constraint and tries to maximise his level of satisfaction. Thus, the knowledge
of the concept of budget line or what is also called budget constraint is
essential for understanding the theory of consumer’s equilibrium.
100
A consumer in his attempt to maximise his satisfaction will try to reach the Consumer Behaviour :
highest possible indifference curve. But in his pursuit of maximising Ordinal Approach
satisfaction by buying more and more goods, he has to consider two
constraints: first, he has to pay the prices for the goods and, secondly, he has a
limited money income to purchase the goods. Thus, how much a person is
capable to buy, depends upon the prices of the goods and the money income
which he has at his disposal.
Price line or budget line represents all possible combinations of two goods that
a consumer can purchase with his given income and the given prices of two
goods. Let us try to understand the concept with the help of an example:
Suppose a consumer has an income of Rs. 100 to spend on Oranges and Apples
which cost Rs. 10 each. He can either spend his limited income only on one
good or both the goods. All the possible alternative combinations of two goods
are presented in Table 5.3.
Table 5.3: Alternative consumption possibilities

Income Apples (Rs. 10/piece) Oranges (Rs. 10/piece)

Rs. 100 10 0
Rs. 100 9 1
Rs. 100 8 2
Rs. 100 7 3
Rs. 100 6 4
Rs. 100 5 5
Rs. 100 4 6
Rs. 100 3 7
Rs. 100 2 8
Rs. 100 1 9
Rs. 100 0 10

It can be observed from the above table that if the consumer spends his total
income of Rs. 100 on Apples, he is able to buy 10 Apples. On the other hand, if
he buys Oranges alone, he can get 10 Oranges by spending his total income.
Further, a consumer can also buy both the goods in different combinations.
The budget line can be written algebraically as follows:
Algebraic Expression for Budget Set: The consumer can buy any bundle (A,
B), such that:
M ≥ (PX * QX) + (PY * QY)
Where PX and PY denote prices of goods X and Y respectively and M stands
for money income
We can rewrite the budget line as: PYQY = M – PXQX

dividing both sides by PY yields: QY = − Q

This is the budget line plotted in Fig. 5.8.

101
Theory of SLOPE OF BUDGET LINE
Consumer
Behaviour As we know that the slope of a curve is calculated as a change in variable on
the Y-axis divided by change in variable on the X-axis, slope of the budget line
in given example will be number of units of Oranges, that the consumer is
willing to sacrifice for an additional unit of Apple.
Slope of Budget Line = Units of Oranges (Y) willing to Sacrifice/ Units of
Apples (X) willing to Gain = ∆Y/∆X
In above example, 1 Apple need to be sacrificed each time to gain 1 Orange.
So, Slope of Budget Line = –1/1 = –1
This slope of budget line is equal to ‘Price Ratio’ of two goods.
Price Ratio = Price of X (PX)/Price of Y (PY) = –PX /PY
Budget line is presented in Fig. 5.8.

Fig. 5.8: Budget Line

5.6 SHIFT IN BUDGET LINE

Budget line is drawn on the basis of assumption of constant prices of the goods
and constant income of the consumer. Thus, if there is any change in either of
the two variables, budget line shifts.
Thus, there are two variables that causes shift in Budget Line:
1) Change in Income of the consumer
2) Change in equal proportion of Prices of both the goods.
Change in Income of the consumer
If income changes while the prices of goods remain the same, Budget line will
shift rightwards or leftwards. Since the prices of two goods are constant, slope
102
of budget line will remain constant. The effect of changes in income on the Consumer Behaviour :
budget line is shown in Fig. 5.9. If consumer’s income increases while prices Ordinal Approach
of both goods X and Y remain unaltered, the price line shifts upward and is
parallel to the original budget line.

Fig. 5.9: Effect of change in Income on Budget Line

This is because with the increased income the consumer is able to purchase
proportionately larger quantity of both goods than before.
On the other hand, if income of the consumer decreases, prices of both goods
X and Y remaining unchanged, the budget line shifts downward but remains
parallel to the original price line. This is because a lower income will leave the
consumer in a position to buy proportionately smaller quantities of both goods.
Changes in Price of either of the two goods:
Budget Line also shifts when there is change in price of either of the two
goods. Increase in price of any commodity reduces the purchasing power of the
consumer, in turn reducing the quantity demanded. Shift of Budget line due to
change in prices of either good x or good y is presented below:
Changes in Budget Line as a Result of Changes in Price of Good X
Suppose, price of good X rises, the price of good Y and income remaining
unaltered. With higher price of good X, the consumer can purchase smaller
quantity of X.
In Fig. 5.10, original price line is AB. With increase in Price of good X, budget
line will shift to AB2 i.e. consumer will be able to buy less quantity of good X,
quantity of good Y remaining same. Similarly when there is fall in price of
good X, keeping prices of good Y constant, budget line shifts from AB to AB1
i.e. consumer will be able to buy more quantity of good X, quantity of good Y
remaining same.

103
Theory of
Consumer
Behaviour

Fig. 5.10: Shift in Budget line due to change in price of good X

Change in Price of good Y
Fig. 5.11 shows the changes in the budget line when price of good Y falls or
rises, with the price of X and income remaining the same. It can be observed
from Fig. 5.11 that the initial budget line is AB. With fall in price of good Y,
other things remaining unchanged, the consumer could buy more of Y with the
given money income and therefore budget line will shift above to EB.
Similarly, with the rise in price of Y, other things being constant, and the
budget line will shift below to DB.

Fig. 5.11: Shift in Budget line due to change in price of good Y

104
Check Your Progress 2 Consumer Behaviour :
Ordinal Approach
1) What is budget line? Calculate slope of Budget line if prices of good X
and good Y are 8 and 10 respectively?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What will happen to budget line if:
Case A: Price of good X increases
......................................................................................................................
......................................................................................................................
Case B: Price of good Y decreases
......................................................................................................................
......................................................................................................................
Case C: Income of consumer increases
......................................................................................................................
......................................................................................................................

5.7 CONSUMER EQUILIBRIUM THROUGH

INDIFFERENCE CURVE ANALYSIS
Assumptions
As discussed above, consumer equilibrium is a point of maximum satisfaction
for the consumer. It is a state of rest for the consumer. Study of Consumer
equilibrium requires some assumptions to be made about the consumer
behaviour. These are:
i) Rationality: The consumer is rational. He wants to obtain maximum
satisfaction given his income and prices.
ii) Consumer has an indifference map, showing his scale of preference for
various combinations of good x and y.
iii) Utility is ordinal: It is assumed that the consumer can rank his preference
according to the satisfaction of each combination of goods.
iv) Consistency of choice: It is also assumed that the consumer is consistent
in the choice of combination of goods.
v) Consumer has a given and fixed amount of money income to spend on
the goods. Thus, consumer has to choose to spend his income on either of
the two goods or a combination thereof.
vi) All the units of the goods are homogeneous.
vii) The goods are divisible i.e. they can be divided into small units.
105
Theory of viii) Total utility: The total utility of the consumer depends on the quantities
Consumer of the good consumed.
Behaviour
Conditions of Consumer’s Equilibrium
There are two fundamental conditions of consumer’s equilibrium through
Indifference curve approach:
1) The price line should be tangent to the Indifference curve. It means that at
the point of equilibrium the slope of the indifference curve and of the
price line should be same. The slope of Indifference curve indicates
MRSxy i.e. –ΔY/ΔX. The slope of the price line indicates the ratio
between price of two goods X and Y i.e. Px/Py.
2) Indifference curve should be convex to the point of origin: Marginal rate
of substitution of X for Y (MRSxy i.e. Δy/Δx) is equal to the slope of the
price line that indicates the ratio between prices of two goods.
Condition 1: MRSXY = Ratio of prices or PX/PY
Let the two goods be X and Y. The first condition for consumer’s equilibrium
is that
MRSxy = Px/Py
 If MRSxy> Px/Py, it means that the consumer is willing to pay more for X
than the price prevailing in the market. As a result, the consumer buys
more of X. As a result, MRS falls till it becomes equal to the ratio of
prices and the equilibrium is established.

 If MRSxy< Px/Py, it means that the consumer is willing to pay less for X
than the price prevailing in the market. It induces the consumer to buys
less of X and more of Y. As a result, MRS rises till it becomes equal to
the ratio of prices and the equilibrium is established.

Condition 2: MRS continuously falls

The second condition for consumer’s equilibrium is that MRS must be
diminishing at the point of equilibrium, i.e. the indifference curve must be
convex to the origin at the point of equilibrium. Unless MRS continuously
falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in
equilibrium.
Let us now understand this with the help of a diagram:
In Fig. 5.12, IC1, IC2 and IC3 are the three indifference curves and MM is the
budget line. With the constraint of budget line, the highest indifference curve,
which a consumer can reach, is IC2. The budget line is tangent to indifference
curve IC2 at point ‘P’. This is the point of consumer equilibrium.

106
 Consumer Behaviour :
Ordinal Approach

Fig. 5.12: Consumer equilibrium through indifference curve

All other points on the budget line to the left or right of point ‘P’ will lie on
lower indifference curves and thus indicate a lower level of satisfaction. As
budget line can be tangent to one and only one indifference curve, consumer
maximises his satisfaction at point P, when both the conditions of consumer’s
equilibrium are satisfied:
i) MRS = Ratio of prices or PX/PY:
At tangency point P, the absolute value of the slope of the indifference curve
(MRS between X and Y) and that of the budget line (price ratio) are same.
Equilibrium cannot be established at any other point such as MRSXY> PX/PY at
all points to the left of point P or MRSXY< PX/PY at all points to the right of
point P. So, equilibrium is established at point P, when MRSXY = PX/PY.
ii) MRS continuously falls:
The second condition is also satisfied at point P as MRS is diminishing at point
P, i.e. IC2 is convex to the origin at point P.

5.8 SOME EXCEPTIONAL SHAPES OF

INDIFFERENCE CURVE AND CORNER
EQUILIBRIUM
As hinted earlier, indifference curve may take different shape in exceptional
cases like perfect complements, perfect substitutes. Also if an assumption of
‘two goods’ is dropped, indifference curve may touch X axis or Y axis also. In
case of an exceptional shape of an indifference curve, equilibrium may be
called as corner solution. This section deals with such cases.
Normally, an equilibrium is achieved at the point of tangency between the
budget line and his indifference curve. At this point, consumer’s preferences
are such that he likes to consume some amount of both the goods. This
equilibrium position at the point of tangency which lies within commodity
space between the two axes is often called interior solution. Interior solution
implies that consumers’ pattern of consumption is diversified and they prefer
basket or bundle of several different goods instead of spending their entire
income on a single commodity.
107
Theory of However, this may not be true in real life scenario and a customer may prefer
Consumer small number of goods and service rather than buying all goods and services
Behaviour available. There may be various reasons for such behaviour – price, taste and
preference etc.
Corner solution when only Commodity Y is purchased
Fig. 5.13 presents a case where indifference map between two goods X and Y
and budget line BL are such that the interior solution is not possible and
consumer in its equilibrium position at point B will not consume any quantity
of commodity X. The reason behind such indifference map is high price of
commodity X. As we already know that the slope of budget line is ratio of
price of two goods, high price of good X makes the budget curve is steeper
than the indifference curves between the two commodities i.e. price or
opportunity cost of commodity X in the market is greater than the marginal rate
of substitution of X for Y which indicates willingness to pay for the
commodity X (Px/Py >MRSxy). The price of good X is so high that the
consumer does not purchase even one unit of the commodity X. Thus the
consumer maximises his satisfaction or is in equilibrium at the corner point B
where he buys only commodity Y. Thus, consumer’s equilibrium in this case is
a corner solution.

Fig. 5.13: Corner solution when only Commodity Y is bought

Corner solution when only Commodity X is purchased
On the other hand, when the indifference map between the two goods is such
that the budget line BL is less steep than the indifference curves between the
two goods so that the MRSxy > Px/Py for all levels of consumption along the
budget line BL. Therefore, he maximises his satisfaction at the corner point L
where he buys only commodity X and none of Y. In this case price of
commodity Y and willingness to pay (i.e. MRS) for it are low that he does not
consider it worthwhile to purchase even one unit of it. Fig. 5.14 presents the
corner solution when only commodity X is purchased.

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 Consumer Behaviour :
Ordinal Approach

Fig. 5.14: Corner solution when only Commodity X is purchased

Corner Equilibrium and Concave Indifference Curves:
The indifference curves are usually convex to the origin. Convexity of
indifference curves is due to the reason that marginal rate of substitution of X
for Y falls as more of X is substituted for Y. However, indifference curves are
concave to the origin in some exceptional cases. Concavity of the indifference
curves implies that the marginal rate of substitution of X for Y increases when
more of X is substituted for Y. Thus, in case of concave indifference curve,
consumer will choose or buy only one good. It implies that the customer
prefers to buy only one good and does not prefer diversification in his buying
pattern.
In case of concave indifference curves, the consumer will not be in equilibrium
at the point of tangency between budget line and indifference curve, that is, in
this case interior solution will not exist. Instead, we would have corner solution
for consumer’s equilibrium. Corner solution in case of concave indifference
curve is presented in Fig. 5.15.

Fig. 5.15: Consumer equilibrium in case of concave indifference curves

It can be observed from Fig. 5.15 that the given budget line BL is tangent to
the indifference curve IC2 at point Q. However, consumer cannot be in
equilibrium at Q since by moving along the given budget line BL he can get on
109
Theory of to higher indifference curves and obtain greater satisfaction than at Q. Thus, by
Consumer moving on higher indifference curve he will reach at extreme point B or point
Behaviour L. In Fig. 5.15, point B is on higher indifference curve. Thus, consumer will be
satisfied at point B where he will buy OB units of commodity Y. It should be
noted that at B the budget line is not tangent to the indifference curve IC5, even
though the consumer is here in equilibrium. It is clear that when a consumer
has concave indifference curves, he will consume only one good.
Corner solution in case of Perfect Substitutes and Perfect Complements:
Another case of corner solution to the consumer’s equilibrium occurs in case of
perfect substitutes. As seen above, indifference curves for perfect substitutes
are linear. In their case tangency or interior solution for consumer’s
equilibrium is not possible since the budget line cannot be tangent to a point of
the straight-line indifference curve of substitutes.
In this case budget line would cut the straight-line indifference curves. Fig.
5.16A presents a case where slope of the budget line BL is greater than the
slope of indifference curves. If the slope of the budget line is greater than the
slope of indifference curves, B would lie on a higher indifference curve than L
and the consumer will buy only Y.

Fig. 5.16 A: Corner equilibrium in case of Perfect Substitutes

Fig. 5.16 B presents a case the slope of the budget line can be less than the
slope of indifference curve. If the slope of the budget line is less than the slope
of indifference curves, L would lie on a higher indifference curve than B and
the consumer will buy only X.

Fig. 5.16 B: Corner equilibrium in case of Perfect Substitutes

Perfect complements
Another exceptional case of perfect complementary goods is presented in Fig.
110 5.17. Indifference curves of perfect complementary goods have a right-angled
shape. In such a case the equilibrium of the consumer will be determined at the Consumer Behaviour :
corner of indifference curve which just touches the budget line. It can be noted Ordinal Approach
from Fig. 5.17 that in case of perfect complements equilibrium point will be
point C and will be consuming OM of X and ON of Y.

Fig. 5.17: Corner solution in case of Perfect Complements

5.9 PRICE EFFECT AS COMBINATION OF

INCOME EFFECT AND SUBSTITUTION
EFFECT
As discussed above, a consumer’s equilibrium position is affected by the
changes in his income, prices of substitute and changes in the price of goods
consumed. These effects are known as:
1) Income effect,
2) Substitution effect, and
3) Price effect

5.9.1 Income Effect

In the analysis of the consumer’s equilibrium it is assumed that the income of
the consumer remains constant, and the prices of the goods X and Y are given.
Thus, given the tastes and preferences of the consumer and the prices of the
two goods, if the income of the consumer changes, the effect it will have on his
purchases is known as the Income effect.
The Income effect may be defined as the effect on the purchases of consumer
caused by the changes in income, if the prices of goods remain constant. If the
income of the consumer increases his budget line will shift upward to the right,
parallel to the original budget line. On the contrary, a fall in his income will
shift the budget line inward to the left. The budget lines are parallel to each
other because relative prices remain unchanged.
Assumptions of Income Effect
1) The prices of both the commodities X and Y remain constant
2) Taste and preferences remain constant
111
Theory of 3) There is no change in fashion and market condition
Consumer
Behaviour Kinds of Income Effect
Income effect may be of three types:
1) Positive Income effect
2) Negative Income effect
3) Zero Income effect
1) Positive Income effect: When an increase in income leads to an increase
in demand for a commodity or for both the commodities the income
effect is positive. In case of Normal goods, income effect is positive and
Income consumption curve slopes upwards to the right.
2) Negative Income effect: Income effect is negative, when with the
increase in his income, the consumer reduces his consumption of the
good. Income effect is negative in case of inferior goods.
3) Zero Income effect: If with the change in income, there is no change in
the quantity purchased of a commodity, than the income effect is said to
be zero. Zero income effect is in case of goods like medicines, necessities
like salt etc.
All the three effects are explained diagrammatically.
In Fig. 5.18, when the budget line is B1, the equilibrium point is X* where it
touches the indifference curve I1. If now the income of the consumer increases,
B1 will move to the right as the budget line B2, I1, and the new equilibrium
point is X1 where it touches the indifference curve I2. As income increases
further, B3 becomes the budget line with X2 as its equilibrium point.
The locus of these equilibrium points X*, X1 and X2 traces out a curve which is
called the income-consumption curve (ICC). The ICC curve shows the income
effect of changes in consumer’s income on the purchases of the two goods,
given their relative prices.
Normally, when the income of the consumer increases, he purchases larger
quantities of two goods. Usually, the income consumption curve slopes
upwards to the right as shown in Fig. 5.18. Here the income effect is also
positive and both X and Y are normal goods.

Fig. 5.18: Income Consumption curve-Normal goods

112
But an Income-consumption curve can have any shape provided it does not Consumer Behaviour :
intersect an Indifference curve more than once. Ordinal Approach

The second type of ICC curve may have a positive slope in the beginning but
become and stay horizontal beyond a certain point when the income of the
consumer continues to increase. In case where X is a superior good and Y is a
necessity, shape of ICC curve will be as shown in Fig. 5.19.
In Fig. 5.19, the ICC curve slopes upwards with the increase in income up to
the equilibrium point R at the budget line P1Q1 on the indifference cure I2.
Beyond this point it becomes horizontal which means that the consumer has
reached the saturation point regarding consumption of good Y. He buys the
same amount of Y (RA) as before despite further increases in his income. It
often happens in the case of a necessity (like salt) whose demand remains the
same even when the income of the consumer continues to increase further.
Here Y is a necessity.

Fig. 5.19: Income Consumption curve (X is a superior good and Y is a necessity)

Further, the demand of inferior goods falls, when the income of the consumer
increases beyond a certain level, and he replaces them by superior substitutes.
For example, he may replace coarse grains by wheat or rice, and coarse cloth
by a fine variety. In Fig. 5.20, good X is inferior and Y is a normal good.
It can be observed from the Fig. 5.20, that up to point R the ICC curve has a
positive slope and beyond that it is negatively inclined. The consumer’s
purchases of X fall with the increase in his income.

Fig. 5.20: Income Consumption curve (Y is normal good and X is inferior)

113
Theory of The different types of income-consumption curves are also shown in Fig. 5.21
Consumer where: (1) ICC1, has a positive slope and relates to normal goods; (2) IСС2 is
Behaviour horizontal from point A, X is a normal good while Y is a necessity of which
the consumer does not want to have more than the usual quantity as his income
increases further: (3) IСС3 is vertical from A, y is a normal good here and X is
satiated necessity; (4) ICC4 is negatively inclined downwards, Y becomes an
inferior good form A onwards and X is a superior good; and (5) ICC5 shows X
as an inferior good.

Fig. 5.21: Possible shapes of Income Consumption curve (ICC)

5.9.2 Substitution Effect

The substitution effect relates to the change in the quantity demanded resulting
from a change in the price of one good it prompts the substitution of relatively
cheaper good for a dearer one, while keeping the price of the other good, real
income and tastes of the consumer as constant. Prof. Hicks has explained the
substitution effect independent of the income effect through compensating
variation in income. “The substitution effect is the increase in the quantity
bought as the price of a commodity falls, after adjusting income so as to keep
the real purchasing power of the consumer the same as before. This adjustment
in income is called compensating variations and is shown graphically by a
parallel shift of the new budget line until it become tangent to the initial
indifference curve.”
Thus, on the basis of the methods of compensating variation, the substitution
effect measures the effect of change in the relative price of a good. The
increase in the real income of the consumer as a result of fall in the price of,
say good X, is so withdrawn that he is neither better off nor worse off than
before.
The substitution effect is explained in Fig. 5.22 where the original budget line
is PQ with equilibrium at point R on the indifference curve I1. At R, the
consumer is buying OB of X and BR of Y. Suppose the price of X falls so that
his new budget line is PQ1. With the fall in the price of X, the real income of
the consumer increases. To make the compensating variation in income or to
keep the consumer’s real income constant, take away the increase in his
income equal to PM of good Y or Q1N of good X so that his budget line
PQ1 shifts to the left as MN and is parallel to it so that new budget line tangent
to I1 at point H.
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 Consumer Behaviour :
Ordinal Approach

Fig. 5.22: Substitution effect (Hicksian Analysis)

As MN is tangent to the original indifference curve I1, at point H, the consumer

buys OD of X and DH of Y. Thus PM of Y or Q1N of X represents the
compensating variation in income, as shown by the line MN being tangent to
the curve I1 at point H. Now the consumer substitutes X for Y and moves from
point R to H or the horizontal distance from В to D. This movement is called
the substitution effect. The substitution affect is always negative because when
the price of a good falls (or rises), more (or less) of it would be purchased, the
real income of the consumer and price of the other good remaining constant. In
other words, the relation between price and quantity demanded being inverse,
the substitution effect is negative.

5.9.3 Price Effect

The price effect indicates the way the consumer’s purchases of good X change,
when its price changes, given his income, tastes and preferences and the price
of good Y. This is shown in Fig. 5.23. Suppose the price of X falls. The budget
line PQ will extend further out to the right as PQ1, showing that the consumer
will buy more X than before as X has become cheaper. The budget line
PQ2 shows a further fall in the price of X. Any rise in the price of X will be
represented by the budget line being drawn inward to the left of the original
budget line towards the origin.
If we regard PQ2, as the original budget line, a two time rise in the price of X
will lead to the shifting of the budget line to PQ1, and PQ2 – PQ. Each of the
budget lines fanning out from P is a tangent to an indifference curve I1, I2, and
I3 at R, S and T respectively. The curve PCC connecting the locus of these
equilibrium points is called the price-consumption curve (PCC). The price-
consumption curve indicates the price effect of a change in the price of X on
the consumer’s purchases of the two goods X and Y, given his income, tastes,
preferences and the price of good Y.

115
Theory of
Consumer
Behaviour

Fig. 5.23: Price effect through Indifference curve analysis

Check Your Progress 3

1) Differentiate between Income effect, price effect and substitution effect.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What will be the shape of Income consumption curve (ICC):
Case A: X is an inferior good, Y is superior good
......................................................................................................................
......................................................................................................................
Case B: Y is an inferior good, X is superior good
......................................................................................................................
......................................................................................................................

5.10 MEASURING INCOME AND SUBSTITUTION

EFFECTS OF PRICE CHANGE
As noted above, the change in consumption basket due to change in the prices
of consumer goods is called price effect. Price effects combines two effects:
Income effect and substitution effect. Income effect is the result of increase in
real income due to decrease in price of a commodity. Substitution effect arises
due to substitution of costly good by cheaper good. This section presents the
decomposition of Income and substitution effect from the price effect. There
are two approaches for the decomposition: a) Hicksian approach, and b)
Slutsky approach.
Hicksian approach uses two methods of splitting the price effect, namely
i) Compensating variation in income

116 ii) Equivalent variation in income.

Slutsky uses cost-difference method to decompose price effect into its two Consumer Behaviour :
component parts. Ordinal Approach

Hicksian or Compensating Variation approach

In this method of decomposition of price effect into income and substitution
effects by compensating variation, income of the consumer is adjusted so as to
offset the change in satisfaction and bring the consumer back to his original
indifference curve, that is, his initial level of satisfaction before the change in
price.
For instance, with the fall in price of a commodity, a consumer moves to a new
equilibrium position at a higher indifference curve i.e. at a higher level of
satisfaction. To offset this increase in satisfaction resulting from a fall in price
of the good, one part of income is taken back to force him to come back at his
original indifference curve. This requires reduction in income (say, through
levying a lump sum tax) to cancel out the gain in satisfaction or welfare on
account of by reduction in price of a good. It is called compensating variation
in income.
The effect is called compensating variation in income because it compensates
(in a negative way) for the gain in satisfaction resulting from a price reduction
of the commodity. Process of decomposition of price effect into substitution
effect and income effect through the method of compensating variation in
income is presented in Fig. 5.24.

Fig. 5.24: Decomposition of price effect into income effect and substitution effect through
Compensating variation in Income

It can be observed from Fig. 5.24, that when price of good X falls, budget line
shifts to PL2 i.e. real income of the consumer i.e. he can buy more of both the
goods with his increased income. With the new budget line PL2, consumer is in
equilibrium at point R on a higher indifference curve IC2 and enjoy increased
satisfaction as a result of fall in price of good X.
Suppose, money income of the consumer is reduced by the compensating
variation in income so that he is forced to come back to the original
indifference curve IC1 he would buy more of X since X has now become
117
Theory of relatively cheaper than before. In Fig. 5.24, with the reduction in income by
Consumer compensating variation, budget line will shift to AB which has been drawn
Behaviour parallel to PL2 so that it just touches the indifference curve IC1 on which he
was before the fall in price of X.
Since the price line AB has got the same slope as PL2, it represents the changed
relative prices with X being relatively cheaper than before. Now, X being
relatively cheaper than before, the consumer, in order to maximise his
satisfaction, in the new price income situation substitutes X for Y.
Thus, when the consumer’s money income is reduced by the compensating
variation in income (which is equal to PA in terms of Y or L2B in terms of X),
the consumer moves along the same indifference curve IC1 and substitutes X
for Y. At price line AB, consumer is in equilibrium at S at indifference curve
IC1 and is buying MK more of X in place of Y. This movement from Q to S on
the same indifference curve IC1 represents the substitution effect since it occurs
due to the change in relative prices alone, real income remaining constant.
If the amount of money income which was taken away from him is now given
back to him, he would move from S at indifference curve IC1 to R on a higher
indifference curve IC2. The movement from S at lower indifference curve to R
on a higher in difference curve is the result of income effect. Thus the
movement from Q to R due to price effect can be regarded as having taken
place into two steps first from Q to S as a result of substitution effect and
second from S to R as a result of income effect. Thus, price effect is the
combined result of a substitution effect and an income effect.
In Fig. 5.24 the various effects on the purchases of good X are:
 Price effect = MN
 Substitution effect = MK
 Income effect = KN
 MN = MK+KN or
Price effect = Substitution effect + Income effect
Slusky’s Cost difference approach
In Slutsky’s approach, when the price of good changes and consumer’s real
income or purchasing power increases, the income of the consumer is changed
by the amount equal to the change in its purchasing power which occurs as a
result of the price change. His purchasing power changes by the amount equal
to the change in the price multiplied by the number of units of the good which
the individual used to buy at the old price.
In other words, in Slutsky’s approach, income is reduced or increased (as the
case may be), by the amount which leaves the consumer to be just able to
purchase the same combination of goods, if he so desires, which he was having
at the old price.
That is, the income is changed by the difference between the cost of the
amount of good X purchased at the old price and the cost of purchasing the
same quantity of X at the new price. Income is then said to be changed by the
cost difference. Thus, in Slutsky substitution effect, income is reduced or
118
increased not by compensating variation as in case of the Hicksian substitution Consumer Behaviour :
effect, but, by the cost difference. Ordinal Approach

Slutsky substitution effect is explained in Fig. 5.25.

Fig. 5.25: Slutsky’s Substitution Effect (For a Fall in Price)

Initially, with a given money income and the given prices of two goods as
represented by the price line PL, the consumer is in equilibrium at point Q on
the indifference curve IC1 where consumer is buying OM units of good X and
ON units of good Y. Suppose that price of X falls, price of Y and money
income of the consumer remaining constant. As a result of this fall in price of
X, the price line will shift to PL' and the real income or the purchasing power
of the consumer will increase.
In order to identify Slutsky’s substitution effect, consumer’s money income
must be reduced by the cost difference or, in other words, by the amount which
will leave him to be just able to purchase the old combination Q, if he so
desires.
For this, a price line GH parallel to PL' has been drawn which passes through
the point Q. It means that income equal to PG in terms of Y or LH in terms of
X has been taken away from the consumer and as a result he can buy the
combination Q, if he so desires, since Q also lies on the price line GH.
Consumer will not now buy the combination Q since X has now become
relatively cheaper and Y has become relatively dearer than before. The change
in relative prices will induce the consumer to rearrange his purchases of X and
Y. He will substitute X for Y. But in this Slutsky substitution effect, he will not
move along the same indifference curve IC1, since the price line GH, on which
the consumer has to remain due to the new price-income circumstances is
nowhere tangent to the indifference curve IC1.
The price line GH is tangent to the indifference curve IC2 at point S. Therefore,
the consumer will now be in equilibrium at a point S on a higher indifference
curve IC2. This movement from Q to S represents Slutsky substitution effect
according to which the consumer moves not on the same indifference curve,
but from one indifference curve to another.
It is important to note that movement from Q to S as a result of Slutsky
substitution effect is due to the change in relative prices alone, since the effect
119
Theory of due to the gain in the purchasing power has been eliminated by making a
Consumer reduction in money income equal to the cost-difference.
Behaviour
At S, the consumer is buying OK of X and OW of Y; MK of X has been
substituted for NW of Y. Therefore, Slutsky substitution effect on X is the
increase in its quantity purchased by MK and Slutsky substitution effect on Y
is the decrease in its quantity purchased by NW.

5.11 DERIVATION OF DEMAND CURVE FROM

INDIFFERENCE CURVES
A demand curve shows quantity of a good purchased or demanded at various
prices, assuming that tastes and preferences of a consumer, his income, and
prices of all related goods remain constant. Demand curve showing
relationship between price and quantity demanded can be derived from price
consumption curve (PCC) of indifference curve analysis.
In Marshallian utility analysis, demand curve was derived on the assumptions
that utility was cardinally measurable and marginal utility of money remained
constant with the change in price of the good. In the indifference curve
analysis, demand curve is derived without making such assumptions.
Let us suppose that a consumer has got income of Rs. 300 to spend on goods.
In Fig. 5.26 money is measured on the Y-axis, while the quantity of the good X
whose demand curve is to be derived is measured on the X-axis. An
indifference map of a consumer is drawn along with the various budget lines
showing different prices of the good X. Budget line PL1 shows that price of the
good X is Rs. 15 per unit.
As price of good X falls from Rs. 15 to Rs. 10, the budget line shifts to PL2.
Budget line PL2 shows that price of good X is Rs. 10. With a further fall in
price to Rs. 7.5 the budget line takes the position PL3. Thus PL3 shows that
price of good X is Rs. 7.5. When price of good X falls to Rs. 6, PL4 is the
relevant budget line.
Tangency points between the various budget lines and indifference curves,
which when joined together by a line constitute the price consumption curve
shows the amounts of good X purchased or demanded at various prices. With
the budget line PL1 the consumer is in equilibrium at point Q1 on the price
consumption curve (PCC) at which the budget line PL1 is tangent to
indifference curve IC1. In his equilibrium position at Q1 the consumer is buying
OA units of the good X. In other words, it means that the consumer demands
OA units of good X at price Rs. 15. When price falls to Rs. 10 and thereby the
budget line shifts to PL2, the consumer comes to be in equilibrium at point Q2
the price-consumption curve PCC where the budget line PL2 is tangent to
indifference curve IC2. At Q2, the consumer is buying OB units of good X.
In other words, the consumer demands OB units of the good X at price Rs. 10.
Likewise, with budget lines PL3 and PL4, the consumer is in equilibrium at
points Q3 and Q4 of price consumption curve and is demanding OC units and
OD units of good X at price Rs. 7.5 and Rs. 6 respectively. Thus, price
consumption curve shows the quantity demanded of the good X against various
prices.

120
 Consumer Behaviour :
Ordinal Approach

Money

Fig. 5.26: Derivation of demand curve from indifference curve

In most cases, the demand curve of individuals will slope downward to the
right, because as the price of a good falls both the substitution effect and
income effect pull together in increasing the quantity demanded of the good.
Even when the income effect is negative, the demanded curve will slope
downward to the right if the substitution effect is strong enough to overcome
the negative income effect. Only when the negative income effect is powerful
enough to outweigh the substitution effect can the demand curve slope upward
to the right instead of sloping downward to the left.
Deriving Demand Curve for a Giffen Good:
Giffen good is a good where higher price causes an increase in demand
(reversing the usual law of demand). The increase in demand is due to the
income effect of the higher price outweighing the substitution effect. In this
section we will derive the demand curve of a Giffen good.
In Fig. 5.26, demand curve DD in case of a normal good is downward sloping.
There are two reasons behind downward slope: a) income effect b) substitution
effect.
Both the income effect and substitution effect usually work towards increasing
the quantity demanded of the good when its price falls and this makes the
demand curve slope downward. But in case of Giffen good, the demand curve
slopes upward from left to right. This is because in case of a Giffen good,
income effect, which is negative and works in opposite direction to the
substitution effect, outweighs the substitution effect. This results in the fall in
121
Theory of quantity demanded of the Giffen good when its price falls and therefore the
Consumer demand curve of a Giffen good slopes upward from left to right. Fig. 5.27
Behaviour presents the Indifference curves of a Giffen good along with the various budget
lines showing various prices of the good. Price consumption curve of a Giffen
good slopes backward.

Fig. 5.27: Upward Sloping Demand Curve for a Giffen Good

It is evident from Fig. 5.27 (the upper portion) that with budget line PL1 (or
price P1) the consumer is in equilibrium at Q1 on the price consumption curve
PCC and is purchasing OM) amount of the good. With the fall in price from P1
to P2 and shifting of budget line from PL1 to PL2, the consumer goes to the
equilibrium position Q3 at which he buys OM2 amount of the good. OM2 is less
than OM1.
Thus, with the fall in price from P1 to P2 the quantity demanded of the good
falls. Likewise, the consumer is in equilibrium at Q3 with price line PL3 and is
purchasing OM at price P3. With this information we can draw the demand
curve, as is done in the lower portion of Fig. 5.26. It can be seen from Fig. 5.27
(lower part) that the demand curve of a Giffen good slopes upward to the right
indicating that the quantity demanded varies directly with the changes in price.
With the rise in price, quantity demanded increases and with the fall in price
quantity demanded decreases.
Check Your Progress 4
1) Differentiate between Hicksian or Compensating Variation approach and
Slutsky Cost difference approach.
......................................................................................................................
......................................................................................................................
......................................................................................................................
122
2) How can demand curve be derived from Indifference curve? Consumer Behaviour :
Ordinal Approach
......................................................................................................................
......................................................................................................................
......................................................................................................................

5.12 LET US SUM UP

In this unit, we have learnt consumer equilibrium through Indifference curve
analysis. Consumer equilibrium is a situation, in which a consumer derives
maximum satisfaction, with no intention to change it and subject to given
prices and his given income. In indifference curve analysis, the point of
maximum satisfaction is achieved by studying indifference map and budget
line together. We have discussed the concept of budget line to identify
consumer equilibrium. Price line or budget line represents all possible
combinations of two goods that a consumer can purchase with his given
income and the given prices of two goods. Budget line may shift due to change
in income or change in prices of either of the two commodities. We further
examined the two conditions of consumer equilibrium i.e. MRSXY = Ratio of
prices or PX/PY and continuous fall of MRS. We have also learnt how is Price
effect combination of income effect and substitution effect using Hicksian and
Slutsky’s analysis. Demand curve has been derived from price consumption
curve.

5.13 REFERENCES
1) Dwivedi, D.N.(2008) Managerial Economics, 7th edition, Vikas Publishing
House.
2) Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th
edition, 2010.
3) Hal R. Varian, Intermediate Microeconomics, a Modern Approach, 8th
edition, W.W. Norton and Company/Affiliated East-West Press (India),
2010.
4) Kumar, Raj and Gupta, Kuldip (2011) Modern Micro Economics: Analysis
and Applications, UDH Publishing House.
5) Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill
education.
6) Salvatore, D. (8th rd. 2014) Managerial Economics in a Global economy,
Oxford University Press.
7) http://www.learncbse.in/important-questions-for-class-12-economics-
indifference-curve-indifference-map-and-properties-of-indifference-curve/
8) https://www.businesstopia.net/economics/micro/indifference-curve-
analysis-concept-assumption-and-properties
9) https://www.transtutors.com/homework-help/business-
economics/consumer-theory/satisfaction.aspx
10) http://www.statisticalconsultants.co.nz/blog/utility-functions.html
11) https://businessjargons.com/budget-line.html
123
Theory of 12) http://www.shareyouressays.com/knowledge/8-most-important-properties-
Consumer of-a-budget-line/115699
Behaviour
13) {http://www.econmentor.com/microeconomics-hs/consumers/price-
change-and-the-budget-line/text/772.html#Price change and the budget
line}
14) http://www.learncbse.in/important-questions-for-class-12-economics-
budget-setbudget-line-and-consumer-equilibrium-through-indifference-
curve-analysis-or-ordinal-approach/
15) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/notes-on-
convex-indifference-curves-and-corner-equilibrium/1018
16) https://en.wikipedia.org/wiki/lncome%E2%80%93consumption curve
17) http://www.vourarticlelibrarv.com/economics/income-effect-substitution-
effect-and-price-effect-on-goods-economics/10757
18) http://www.economicsdiscussion.net/indifference-curves/measuring-the-
substitution-effect-top-2-methods-with-diagram/18290
19) http://www.vourarticlelibrarv.com/economics/income-effect-substitution-
effect-and-price-effect-on-goods-economics/10757
20) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/price-
demand-relationship-normal-inferior-and-giffen-goods/1069
21) http://www.vourarticlelibrary.com/economics/the-slutskv-substitution-
effect-explained/36663
22) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/how-to-
derive-individuals-demand-curve-from-indifference-curve-analysis-with-
diagram/1076

5.14 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Study Section 5.4 and answer
2) Study Sub-section 5.3.4 and answer
3) Indifference curve is convex to origin because of diminishing marginal
rate of substitution.
Check Your Progress 2
1) Study Section 5.5 and answer
2) Study Section 5.6 and answer
Check Your Progress 3
1) Study Section 5.9 and answer
2) Study Section 5.9 and answer
Check Your Progress 4
1) Study Section 5.10 and answer
2) Study Section 5.11 and answer
124
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
 BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
 Consumer Behaviour :
Ordinal Approach

BLOCK 3 PRODUCTION AND COSTS

125
Theory of
Consumer
BLOCK 3 PRODUCTION AND COSTS
Behaviour
Block 3 develops the theory of the firm and explains the laws that are observed
in course of production. This will enable you to know how firms combined
inputs such as capital, labour and raw materials to produce goods and services
in a way that minimises costs of production. In this process various concepts
like production function, Iso product curves, Iso-cost lines etc have been
explained.
The block comprises three units. Unit 6 throws light on production function
with one variable input, and discusses the law of variable proportions. Unit 7
deals with the Properties of isoquants and optimal combination of factors and
producer’s equilibrium. The economic region of production and ridge lines and
the expansion path have also been discussed. Unit 8 discusses the cost side of
production considering different types of costs.

126
UNIT 6 PRODUCTION WITH ONE
VARIABLE INPUT
Structure
6.0 Objectives
6.1 Introduction
6.2 Total, Average and Marginal Products
6.3 Total, Average and Marginal Product Curves
6.4 The Law of Variable Proportions: Returns to a Factor
6.4.1 The Three Stages of Production
6.4.2 Explanation of Increasing Returns
6.4.3 Explanation of Constant Returns
6.4.4 Explanation of Diminishing Returns

6.5 Let Us Sum Up

6.6 References
6.7 Answers or Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit, you will be able to :
 state the concept of total product, average product and marginal product;

 explain the nature and relationship of total, average and marginal product
curves;
 analyse the operation of the law of variable proportions; and
 identify the three stages of production.

6.1 INTRODUCTION
For the purpose of production, we require a combination of various inputs or
factors of productions. It is only with the joint efforts of these inputs (like
labour, machines, land, raw materials etc.) that output is produced. Normally,
production is carried out under conditions of variable proportions which
implies that the rate of input quantities may vary. Fixed proportions production
means that there is only one ratio of inputs that can be used to produce a good.
For example, only one driver can work one truck. In this case, the ratio of
driver and truck is technologically determined and is fixed. It is beyond the
capabilities of the producer to change it. However, the ratio of land and labour
in agriculture can be changed and is thus regarded as variable. In the short run,
not all inputs are variable. In the long run, however, all inputs are variable and
the ratio of inputs may also vary. This is the case of technological Progress. In
this unit, we shall focus only on short run production. In the short run, for the

*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi. 127
Production purpose of analysis, it is often assumed that only one input is variable and all
and Costs other inputs are fixed. We shall follow this convention.

6.2 TOTAL, AVERAGE AND MARGINAL

PRODUCTS
At the outset we shall explain the concept of total, average and marginal
products. The short run production function, whether it is shown as a table, a
graph or as a mathematical equation, gives the total output obtainable from
different quantities of the variable inputs given a specified amount of the fixed
input. Let us now consider the case in which capital is fixed, but labour is
variable, so that the firm can produce more output by increasing the labour
input. For example, consider a firm manufacturing garments. It has a fixed
amount of equipment, but it can hire more or less labour to operate the
machines. For decision making, the firm’s manager (or owner) must know how
the amount of total output or product (Q) increases (if at all) as the labour input
(L) increases. Table 6.1 provides this information about the production
function.
Table 6.1 shows the output that can be produced with different amounts of
labour and with capital fixed at 5 units. The first column shows the fixed
amount of capital, the second shows the amounts of labour from zero to 10
units and the third shows total product or output. From the table, it is clear that
when labour input is zero, output is zero because capital alone cannot produce
anything. Then, upto a labour input of seven units output increases first at an
increasing rate and then at a decreasing rate in response to increased use of
labour. The eighth unit of labour input does not raise output. Whether firm
applies 7 or 8 units of labour input to a fixed amount of capital input, total
output remains 224 units. Beyond this point using more units of labour input is
counter productive because output declines as use of labour is increased.
Table 6.1: Production with One Variable Input

Amount Amount of Total Average Marginal

of Capital Labour Product or Product Product
(K) (L) Output (Q) (Q/L) (∆Q/∆L)
5 0 0 -- --
5 1 20 20 20
5 2 60 30 40
5 3 120 40 60
5 4 160 40 40
5 5 190 38 30
5 6 216 36 26
5 7 224 32 8
5 8 224 28 0
5 9 216 24 -8
5 10 200 20 -16
Although the figures provided in Table 6.1 are hypothetical, the general
relationship they indicate is common. To examine the relationship further, we
128 introduce the concepts of average product and marginal product of an input.
The average product (or average physical product) of an input can be Production with One
defined as total output (or total product) divided by the amount of input Variable Input
used to produce that output. For example, 4 units of labour input produce
160 units of output, so the average product of labour is 40 units of output per
worker at that level of employment. In a more general way, we may express

APL =

where, APL = average product of labour

Q = total output or total product
L = amount of labour
The fourth column in Table 6.1 shows the average product of labour (APL).
The average product for each quantity of labour is derived by dividing total
output shown in column 3 by corresponding amount of labour in column 2 that
produces each output level. In our illustration, the average product of labour
increases initially but when labour input exceeds 4 units, it tends to fall.
The marginal product (or marginal physical product) of an input is
defined as the change in total output due to a unit change in the use of an
input while quantities of other inputs are held constant. For example, with
capital fixed at 5 units when the amount of labour increase from 3 to 4 units,
total output rises from 120 to 160 units or by 40 units. So the marginal product
of labour, when fourth unit of labour input is employed, is 40 units of output.
We may thus generalise,

MPL=

where, MPL = Marginal product of labour

∆Q = Change in output
∆L = Change in labour input
In Table 6.1, the fifth column shows the marginal product of labour. It may be
noted that like the average product, the marginal product increases initially and
then falls and finally becomes negative. In the present example, the marginal
product of labour becomes negative when labour input exceeds 8 units. This
happens when the variable input is used too intensively with the fixed input.
The marginal product is greater than average product when average
product is rising, equals average product when average product is at
maximum, and is less than average product when average product is
falling.

This proposition is, in fact, true of all marginal and average relationships.

6.3 TOTAL, AVERAGE AND MARGINAL

PRODUCT CURVES
Fig. 6.1 plots the information provided in Table 6.1 (it has been assumed in
drawing the graphs that both labour input and the product are divisible into
smaller units and thus the relationships are smooth curves rather than discrete
points). The total product curve shown in Fig. 6.1 indicates how the total
129
Production product varies with the quantity of labour input used. As indicated in Table 6.1,
and Costs Fig. 6.1 a also shows that first the total output increases at an increasing rate
upto point E as more labour is used. The point E where total product stops
increasing at an increasing rate and begins increasing at a decreasing rate is
called the point of inflexion. Total product reaches a maximum at 224 units
when 7 units of labour input are used. The use of an additional unit of labour
input at this stage does not lead to any increase in total product. Beyond this
point, further use of labour input results in a fall in total product.
That portion of total product curve (TP) is shown by dashed segment which
indicates a decline in output as a result of increased employment of labour. In
Fig. 6.1 a when labour input is expanded beyond eighth unit, output falls which
means that production is not technically efficient and is thus not a part of the
production function.
Fig. 6.1 b shows the average and marginal product curves for labour. (The
units of the vertical axis have been changed from output per period of time to
output per unit of labour). Hence, average product and marginal product curves
measure the output per unit of labour. It may be noted that as the use of labour
input increases, initially the marginal product of labour increases, reaches a
maximum at 3 units of labour, and then declines. The marginal product of
labour in our example becomes zero at 8 units of labour and thereafter turns
negative. However, technical efficiency rules out the possibility of negative
marginal products and is, therefore, not a part of the production function. The
average product of labour also increases initially, reaches a maximum at 4 units
of labour input, and then declines.
Relationship between MP and AP Curves:
Let us now consider the relationship between the marginal and average product
curves. As is true of all marginal and average curves, there are definite
relationships between the marginal and average product curves.
i) When marginal product increases, average product also increases though
at a rate lower than that of the marginal product. It is important to note in
this context that even when marginal product starts declining but remains
greater than the average product, the latter shows a tendency to increase.
ii) When the average product is maximum, the marginal product is equal to
it. This is the reason why the marginal product curve intersects the
average product curve at its highest point.
iii) Beyond this point, when the marginal product declines, it also pulls down
the average product. However, the rate of decline in the average product
is less than that of the marginal product.
Relationship between TP and MP Curves
The relationship between the total product curve and the marginal product
curve can be stated as under:
i) As long as marginal product is positive, total product curve will continue
to rise.

130
 Production with One
Variable Input

Fig 6.1: Production with one variable input (labour). In the upper part of the figure, the
total product curve (TP) of labour is shown. The lower part of the figure shows how
average product curve (AP) of labour and marginal product curve (MP) of labour are
obtained with the help of information contained in the upper part

ii) When marginal product is zero, total product curve reaches its highest
point. It may be noted that when eighth unit of labour input is employed,
marginal product of labour becomes zero and total product is at the
maximum.
iii) Thereafter, marginal product of labour is negative and total product curve
has a downward slope which means that total product falls.
Check Your Progress 1
1) Indicate the following statement as true (T) or false (F):
i) The marginal product is greater than average product when average
product is falling.
ii) As long as marginal product is rising, total product curve will
continue to rise.
2) Discuss the relationship between the marginal and average product
curves.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
131
Production
and Costs
6.4 THE LAW OF VARIABLE PROPORTIONS:
RETURNS TO A FACTOR
Knowledge regarding the conditions of production reveals that as more and
more of some input is employed, all other input quantities being held constant,
normally marginal and average product (of the variable input) increase upto a
point. Thereafter, marginal product starts declining and this pulls down the
average product also. In the production process generally land, capital
equipment and buildings remain fixed in the short run while quantities of
labour and raw materials can be conveniently varied. However, we may
consider a case where amount of capital is fixed and the quantity of labour is
increased.
i) In this case, initially the marginal product of labour will increase as its
amount is increased and the marginal product will also pull up average
product with it. In this situation, total product increases at an increasing
rate.
ii) If the variable input, say, labour is further increased, marginal product
stops increasing after a point. Therefore, the rate of increase of total
product also shows a tendency to fall.
iii) Ultimately marginal product turns negative and this causes a fall in total
product itself.
Since in the short run, changes in technology are ruled out, the tendency of
marginal product to decline after a point is inevitable. This statement of trends
in marginal product in response to changes in the quantities of a variable factor
applied to a given quantity of a fixed factor is called the law of diminishing
returns. It is also called the law of variable proportions because it predicts the
consequences of varying the proportions in which factors of production are
used. we can sum up the law of variable proportions as follows:
“As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point the
resulting increments of product will decrease, i.e, the marginal product
will diminish.”
The law of variable proportions can be easily followed with the help of Table
6.1 and Fig. 6.1 which has been drawn on the basis of illustration given in
Table 6.1. In Table 6.1, it has been assumed that capital is a fixed factor and its
quantity remains unchanged at 5 units. Labour is the variable factor and its
quantity increases from 1 to 10. It can be seen from Table 6.1.
i) As the amount of labour employed increases, the total output also
increases until the seventh unit of labour is employed. Initially the
increase in output takes place at an increasing rate because marginal
product rises. This tendency is observed upto the point E where marginal
product reaches a maximum. At point E, which is the point of inflexion,
the rate of increase in total product switches from increasing to
decreasing because marginal product begins to diminish. However,
average product continues to increase until it reaches a maximum at point
F on total product curve (point J on average product curve).
ii) When the amount of labour is further expanded, total product continues
to increase though at a diminishing rate. Both marginal product and
132
 average product remain positive, but both continue to diminish. Production with One
Eventually, total product reaches a maximum at point G and the marginal Variable Input
product becomes zero (note point K in Fig. 6.1 b). The average product,
however, remains positive but continues to diminish.
iii) Any attempt to increase output beyond this point by employing more
units of labour will not be fruitful. In fact, it will be counter-productive
because marginal product is negative which implies that total product
diminishes.
Product curves such as the one shown in Fig. 6.1 are general representations of
production function with fixed and variable inputs. To illustrate particular
instances, similar product curves could be drawn, though each different from
others in some way. The stage of increasing marginal product may be long or
brief or can be totally absent. Moreover, when marginal product diminishes,
the rate at which it happens may be different in each case. Table 6.2 sums up
the law of variable proportions.
Table 6.2: Properties of Product Curves

Marginal Average
Total Product Figure 6.1
Product Product
Stage I
first increases at Increases Increases to point E
increasing rate

then rate of reaches a continues at points E and H

increase changes maximum, and increasing
from increasing then starts
to diminishing diminishing
Stage II
continues to continues reaches a at points F and J
increase at diminishing maximum where
diminishing rate it equals MP and
then starts
diminishing

reaches a
maximum and continues
diminishing at points G and
then starts becomes zero K
diminishing
Stage III
diminishes is negative continues to right of points
diminishing J and K

6.4.1 The Three Stages of Production

Normally when the amount of a variable input is expanded, the marginal
product first rises and then falls and the product curves have the shapes shown
in Fig. 6.1. Conventionally, these product curves are partitioned into three
regions, shown as Stages I, II and III in Fig. 6.1.

133
Production Stage I is characterised particularly by the rising average product. In our
and Costs example, Stage I occurs when labour is employed from 1 to 4 units. In Stage 1,
total product first increases at an increasing rate and thus marginal product
rises. It reaches a maximum at labour input of 3 units. When fourth unit of
labour input is employed, diminishing returns set in implying that total product
increases at a diminishing rate and the marginal product falls.
In Stage II, total product increases at a diminishing rate and thus both marginal
product and average product decline. Marginal product being below the
average product, pulls the latter down. The right-hand boundary of Stage II is
at maximum total product where marginal product reaches zero. In our
example, Stage II ranges from 4 to 8 units of labour.
In Stage III, total product falls and marginal product is negative. In our
example, stage III occurs when labour is employed in excess of 8 units.
Actual Stage of Operation
The rational producer will operate in Stage II. It is not difficult to follow why
production will not be done in Stage III. In Stage III, less output is produced by
using more of the variable input which means that production costs would be
higher in Stage III than they were in Stage II. Obviously, any rational producer
will always avoid such inefficiencies in the use of production inputs.
In Stage I, average product of the variable input is increasing. Therefore, if the
amount of variable input is doubled, the output more than doubles and the unit
cost of producing output decreases. If a firm is operating in a competitive
market, it would avoid producing in this stage because by expanding output it
reduces the unit costs while the price it receives remains same for each
additional unit sold. This means that total profits increase if production is
expanded beyond the region of rising average product.
To sum up we can say: Initially, the variable factor-labour is not able to use all
the capacities of the fixed factor, hence MP and AP remain low. For instance,
one worker may not be able to make full use of the potential of a one hectare
plot of land. But two workers, together are is a better position to work on that
field. Hence rise in MP as Labour increases from 1 to 2.
Thus, any rational producer will operate in the second stage only when the law
of diminishing marginal return operates. This is why the law of variable
proportions is also called the Law of Diminishing Marginal Returns to a factor.

6.4.2 Explanation of Increasing Returns

According to modern economists, when in the initial stage of production
quantity of the variable factor is increased, the tendency of increasing returns
in production operates. The classical economists had also observed this
tendency and had termed it as the Law of Increasing Returns. However, they
felt that this law operated only in manufacturing industries. As against this, the
modern economists believe that this law can operate in any area of economic
activity. Below we give the views of Marshall (representing the former
position) and Joan Robinson (representing the latter position) in this regard.
Marshall opined that the tendency of increasing returns operates only in the
manufacturing industries. He believed that when the quantity of labour and
capital employed in the manufacturing industries is increased, the scale of
134
production expands and this leads to a better organisation of production. In Production with One
Marshall’s own words: Variable Input

“An increase in labour and capital leads generally to improved

organisation, which increases the efficiency of the work of labour and
capital... Therefore, in those industries which are not engaged in raising
raw produce, an increase in labour and capital generally gives a return
increased more than in proportion.”

Joan Robinson’s explanation of the tendency of increasing returns is more

scientific. She states:

“When an increased amount of any factor of production is devoted to a

certain use, it is often the case that improvements in organisation can be
introduced which will make natural units of the factor (men, acres or
money capital) more efficient, so that an increase in output does not
require a proportionate increase in the physical amount of the factors.”
From the above statement of Joan Robinson, it is clear that:
1) The tendency of increasing returns operates not only in manufacturing
industries but in all productive activities. Limiting the application of this
tendency to manufacturing industries alone is wrong.
2) The tendency of increasing returns comes into operation because the
efficiency of the factors of production is improved.
Let us now examine in detail why the tendency of increasing returns operates.
1) Optimum combination of factors of production: According to Joan
Robinson, full exploitation of some indivisible factors of production is
not possible until increased quantities of some other factors of production
are employed. Therefore, when the producer engages a small quantity of
different factors of production, an optimum proportion among them is not
established and the level of production remains low. When he increases
the quantities of those factors of production, which were employed less
(in relation to the requirements of optimum production), marginal product
increases till the point is reached where the factors are combined in
optimum proportion. Naturally, at this point, output level is the
maximum.
2) Large size of fixed factors: When the size of the fixed factors used for
producing a given good is very large while the quantity of the variable
factor used is very small, the level of efficiency remains very low. As
more and more quantities of the variable factors are employed, marginal
productivity increases (since the level of efficiency increases). For
example, if only one person is working on a ten hectare plot of land, his
productivity will be very low. As the number of workers increases,
division of labour and specialisation will lead to increasing returns as
marginal product will rise rapidly.

6.4.3 Explanation of Constant Returns

If even on continuously increasing the quantity of variable factors of
production in a firm, the marginal product neither increases nor decreases but
135
Production remains constant, the tendency of constant returns is in operation. In fact, there
and Costs is no industry in which increase in the quantity of variable factors of
production yields constant returns permanently. According to Marshall, “if the
actions of the law of increasing and diminishing returns are balanced, we have
the law of constant returns.”
Marshall feels that the operation of the law of constant returns is very limited.
According to him, this law can operate only when there is a balance between
the tendencies of increasing returns and diminishing returns. However, modern
economists regard the area of operation of constant returns as fairly large.
According to them, tendency of constant returns is generally found to operate
before the tendency of diminishing returns sets in. In no field of productive
activity increasing returns are obtained forever. Whether it is agriculture,
manufacturing, industry or any other productive activity, the tendency of
increasing returns can operate only up to a certain limit. After this limit is
reached, constant returns operate for some time. From the point of view of the
producer, this is an important stage because it exhibits an optimum
combination of the factors of production. In this stage, marginal cost is the
minimum. This is due to two reasons. First, the stage of constant returns is
reached only when the tendency of increasing returns comes to an end so that
there is no possibility of a further decline in marginal cost. Second, after the
stage of constant returns, the stage of diminishing returns sets in. Therefore, the
stage of constant returns is very significant from the point of view of the
producers.

6.4.4 Explanation of Diminishing Returns

The diminishing returns stage is the most important of the three stages of the
law of variable proportions. In Economics, the explanation of the law of
diminishing returns is presented in two ways. The classical economists
believed that this law applies only to agriculture. Basically accepting this
position of the classical economists, the neo-classical economist Marshall had
stated, “We say broadly that while the part which nature plays in production
shows a tendency of diminishing returns, that part which man plays shows a
tendency of increasing returns.”
Modern economists like Joan Robinson, Stigler, etc. constitute the second
category of economists. These economists regard the law of diminishing
returns of far greater applicability than the classical economists. According to
them, this law operates in all areas of productive activity.
Marshall had argued that this law operated only in agriculture. Therefore, he
discussed it only in reference to agriculture. According to him,
“An increase in the capital and labour applied in the cultivation of land
causes in general a less than proportionate increase in the amount of
produce raised unless it happens to coincide with an improvement in
the arts of agriculture.”
The implication is that when land is kept fixed in agriculture while the quantity
of labour and capital applied on that land is increased, total production
increases but not in the same proportion as the factors of production are
increased. It increases by a lesser proportion. For example, if an agriculturist
doubles the amount of labour and capital employed on a fixed plot of land, the
total production will undoubtedly increase but it will not double itself. Due to
136
this reason agriculturists do not consider it profitable to continuously increase Production with One
the application of other factors of production on their fixed plots of land. They Variable Input
know from their experience that unless there is some improvement in
agricultural techniques, increased application of labour and capital on a fixed
quantity of land leads to a situation of continuously declining marginal
product.
Marshall has accepted two limitations of the law of diminishing returns as
applied to agriculture:
1) The law generally operates in agriculture: Marshall was aware of the
fact that the law of diminishing returns does not always operate in
agriculture (hence the qualification that it generally operates in
agriculture). In some cases when the agriculturist applies the first unit of
labour and capital on his fixed plot of land, the fertility of the soil is not
properly exploited. Accordingly, the level of production remains low.
When the second unit of labour and capital is applied, output increases in
a greater proportion. However, this tendency does not remain for long
because the agriculturist soon finds that additional units of labour and
capital start yielding a lower and lower marginal product. On account of
the above reasons, Marshall was careful in pointing out that the law of
diminishing returns operates generally in agriculture. However, in certain
exceptional cases, it may not operate.
2) There should be no improvement in agricultural techniques: The
law of diminishing returns operates only if there is no improvement in
agricultural techniques. It is a law of static agriculture. If the agriculturist
is able to expand irrigation facilities on his land, or make use of better
seeds, better agricultural implements, more fertilisers, etc. or use new
scientific methods in production, he can stall the operation of this law.
Generally, an improvement in agricultural techniques leads to a more
than proportionate increase in output corresponding to an increase in
labour and capital.
As against the view of Marshall, modern economists like Joan Robinson,
Stigler and Boulding regard the law of diminishing returns as more pervasive
and universal. According to these economists, this law operates in all branches
of productive activity. Accordingly, they have presented this law in a general
fashion as would be clear from the definition of this law presented by Joan
Robinson:

“The Law of Diminishing Returns, as it is usually formulated, states

that, with fixed amount of any one factor of production, successive
increases in the amount of other factors will after a point yield a
diminishing increment of the product.”
From the above definition of the law by Joan Robinson, it is clear that she
regards this law as of universal value and does not restrict its application to
agriculture alone. According to her, this law operates in all branches of
productive activity and the principal reason behind the operation of this law is
that the optimum proportion between different factors of production breaks
down sooner or later.
The law of diminishing returns is a logical necessity. When in any productive
activity, the quantity of the variable factors of production employed with given
137
Production quantity of fixed factor of production is increased, the law of diminishing
and Costs returns sets in after the point of optimum proportion has been reached.
Initially, application of variable factors was sub-optional, given the size of
fixed factor. Later, the expansion in use of variable factors leads to sub-
optimality of a different kind: each doze or unit of variable factors have sub-
optional quantity of fixed factor to work on.
Another important reason for the operation of the law of diminishing returns is
that one factor of production (out of the various factors of production) is used
in a fixed quantity. Had all the factors of production been available in
abundance and had it been possible to increase their use in production to all
conceivable limits, the law of diminishing returns would not operate. However,
all factors of production land, labour, capital, enterprise, organisation, etc. are
scarce and often the supply of one of these is taken to be fixed. It is this factor
that results in diminishing returns.
Check Your Progress 2
1) Indicate the following statement as true (T) or false (F):
i) In statge II of production, both marginal product and average
product decline.
ii) In stage III of production, marginal product is negative.
iii) The law of diminishing returns operates only in agriculture.
2) State the law of diminishing marginal returns. There is a provision to the
law that other things be held constant. What are these things?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Explain the three stages of production. Why should a rational producer
under competitive conditions produce in stage II?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the (i) law of increasing returns, (ii) law of constant returns.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

6.5 LET US SUM UP

In this unit we have focused on short run production assuming that only one
input is variable and all other inputs are fixed. We then define total product,
138 average product of an input and the marginal product of an input. We note that
total product in the case of production with one variable input first increases at Production with One
an increasing rate as the amount of variable input expands and then switches to Variable Input
increasing with decreasing rate. Having reached a maximum, it eventually
declines. We then explain the law of variable proportions. Conventionally the
product curves drawn to depict the law of variable proportion are partitioned
into three stages. In stage I, average product increase throughout, in stage II
marginal product from the point where it equals average product falls
throughout but remains positive; and in stage III total product fall and marginal
product is negative. The diminishing returns stage is the most important of the
three stages of the law of variable proportions.

6.6 REFERENCES
1) Robert S.P rindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh edition, 2009), Chapter 5,
Section 5.1.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth edition, 2010), Chapter 7, Section 6.2.
3) A.Kontsoyianmis, Modern Microeconomics (The Macmillan Press Ltd.,
Second Edition, 1982/, Chapter 3.
4) John P Gould and Edward P Lazar, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 6.

6.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (i) (F); (ii) (T)
2) See Section 6.3
Check Your Progress 2
1) (i) F; (ii) (T); (iii) (F)
2) See Sub-section 6.4.4
3) See Sub-section 6.4.1
4) See Sub-section 6.4.2. for law of increasing returns and Sub-section 6.4.3
for law of constant returns.

139
 UNIT 7 PRODUCTION WITH TWO
AND MORE VARIABLE
INPUTS
Structure
7.0 Objectives
7.1 Introduction
7.2 Production Function: The Concept
7.3 Production Function with two Variable Inputs
7.3.1 Definition of Isoquants
7.3.2 Types of Isoquants
7.3.3 Assumptions of Isoquants
7.3.4 Properties of Isoquants

7.4 Economic Region of Production and Ridge Lines

7.5 The Optimal Combination of Factors and Producer’s Equilibrium
7.5.1 Input Prices and Isocost Lines
7.5.2 Maximisation of Output for a Given Cost
7.5.3 Minimisation of Cost for a Given Level of Output

7.6 The Expansion Path

7.6.1 Optimal Expansion Path in the Long Run
7.6.2 Optimal Expansion Path in the Short Run

7.7 Production Function with Several Variable Inputs

7.7.1 Increasing Returns to Scale
7.7.2 Constant Returns to Scale
7.7.3 Diminishing Returns to Scale

7.8 Economies and Diseconomies of Scale

7.8.1 Internal Economics of Scale
7.8.2 Internal Diseconomies of Scale
7.8.3 External Economics of Scale
7.8.4 External Diseconomies of Scale

7.9 Let Us Sum Up

7.10 References
7.11 Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you should be able to:
 know the meaning and nature of isoquants;
 identify the economic region in which production is bound to take place;

140 *Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi.
 find out the level at which output will be maximised subject to a given Production with
cost; Two and More
Variable Inputs
 for a given level of output, find the point on the isoquant where cost will
be minimised;
 describe the nature of optimal expansion path both in long run and short
run;
 state to concept of returns to scale; and
 discuss the concept of economies and diseconomies of the scale.

7.1 INTRODUCTION
How do firms combine inputs such as capital, labour and raw materials to
produce goods and services in a way that minimises the cost of production is
an important issue in the principles of microeconomics. Firms can turn inputs
into outputs in a variety of ways using various combinations of labour, capital
and materials. Broadly there can be three ways:
1) by making change in one input or factor of production.
2) by making change in two factors of production.
3) by making change in more than two or more inputs /factor of production.
The nature and characteristics of production function of a firm under the
assumption that firm makes variation in one input has been discussed in
previous unit. Here we would like to discuss the nature, forms and
characteristics of production function if firm decides to make variation in two
or more inputs.
Let us begin to recapitulate the concept of production function.

7.2 PRODUCTION FUNCTION: THE CONCEPT

The theory of production begins with some prior knowledge of the technical
and/or engineering information. For instance, if a firm has a given quantity of
labour, land and machinery, the level of production will be determined by the
technical and engineering conditions and cannot be predicted by the economist.
The level of production depends on technical conditions. If there is an
improvement in the technique of production, increased output can be obtained
even with the same (fixed) quantity of factors. However, at a given point of
time, there is only one maximum level of output that can be obtained with a
given combination of factors of production. This technical law which expresses
the relationship between factor inputs is termed as production function.
The production function thus describes the laws of production, that is, the
transformation of factor inputs into products (outputs) at any particular period
of time. Further, the production function includes only the technically efficient
methods of production. This is because no rational entrepreneur will use
inefficient methods.
Take the case of a production process which uses two variable inputs say,
labour (L) and capital (K). We can write the production function of this case as
Q = F (L, K)
141
Production This equation relates the quantity of output Q to the quantities of the two
and Costs inputs, labour and capital. A popular production function of such a case in
economics is Cobb Douglas production function which is given as
Q=
A special class of this production functions is linear homogenous production
function which states that when all inputs are expanded in the same
proportion, output expands in that proportion. The form of Cobb-Douglas
production function becomes
Q=
i.e. β= 1 – α
Here we can see that when labour and capital are increased λ times, output Q
also increased λ times as
( )
( ) ( ) =A[ ]=λ[ ]=λQ

7.3 PRODUCTION FUNCITON WITH TWO

VARIABLE INPUTS
The behaviour of the production function of a firm which makes use of two
variable inputs or factors of production is analysed by using the concept of
isoquants or iso product curves. Hence, let us understand the concept of
isoquants.
7.3.1 Definition of Isoquants
An isoquant is the locus of all the combinations of two factors of production
that yield the same level of output.
Let us understand the concept of an isoquant with the help of an example.
Suppose a firm wants to produce 100 units of commodity X and for that
purpose can use any one of the six processes indicated in Table 7.1.
Table 7.1: Isoquant Table showing combinations of Labour and Capital
producing 100 Units of X
Process Units of Labour Units of Capital
1 1 10
2 2 7
3 3 5
4 4 4
5 6 3
6 9 2
From Table 7.1, it is clear that all the six processes yield the same level of
output, that is, 100 units of X. The first process is clearly capital-intensive.
Since we assume possibilities of factor substitution, we find that there are five
more processes available to the firm and in each of them factor intensities
differ. The sixth process is the most labour-intensive or the least capital-
intensive. Graphically, we can construct an isoquant conveniently for two
factors of production, say labour and capital. One such isoquant is shown in
Fig. 7.1.
142
 Production with
Two and More
Variable Inputs

Fig. 7.1: This figure shows that at point A, B and C same level of output (=100 units) is
obtained by using different combinations of labour and capital.
Curve p is known as isoquant

7.3.2 Types of Isoquants

Depending upon the degree of substitutability of the factors, Isoquants can
assume three shapes categorised as:
1) Convex isoquant
2) Linear isoquant
3) Input-output isoquant
1) Convex Isoquants: This isoquant take the shape of curve sloping
downward from left to right as shown in Fig. 7.1. The explanation for
assumption of this shape has been given in next section.
2) Linear Isoquant: In case of perfect substitutability of the factors of
production, the isoquant will assume the shape of a straight line sloping
downwards from left to right as shown in Fig. 7.2. In Fig. 7.2 it is shown
that when quantity of labour is increased by RS, the quantity of capital
can be reduced by JK to produce a constant output level, i.e., 50 units of
X. Likewise, on increasing the quantity of labour by ST, it is possible to
reduce the quantity of capital by KL, and on increasing the quantity of
labour by TU, quantity of capital can be reduced by LM for producing 50
units of X. Since in respect of labour RS = ST = TU and in respect of
capital JK = KL = LM, it is clear that a constant quantity of labour
substitutes a constant quantity of capital. It implies that a given
commodity can be produced by using only labour or only capital or by
infinite combinations of labour and capital. In the real world of
production, this seldom happens. Therefore, a linear downward sloping
isoquant can be taken only as an exception.

143
Production
and Costs

Fig. 7.2: In the case of perfect substitutability of factors of production, the isoquant
becomes a straight line and is, therefore, known as linear isoquant

3) Input-Output Isoquant: When factors of production are not substitutes

but complementary, technical coefficients are fixed. This means that
optimum output is obtained only when the factors of production are used
in a fixed proportion. In this situation if a producer uses one factor of
production in excess of what is required by fixed proportion, there will be
no increase in output. In the case of complementarily of factors of
production, the shape of the isoquant is right angled or like the letter ‘L’
as shown in Fig. 7.3. As would be clear from the figure, the isoquant is
formed by two straight lines, one vertical and the other horizontal, and
these two lines are perpendicular to each other. The common point of
these lines is convex to the origin.
This type of isoquant is also called Leontief isoquant after Wassily
Leontief who did pioneer work in the field of input-output analysis.
Input-output isoquant does not imply that by increasing the quantities of
the two factors of production, viz., labour and capital the output will
increase proportionately; it implies only that for producing any quantity
of a commodity, capital and labour must be used in a fixed proportion. In
Fig. 7.3, the slope of isoquant P1 and P2 indicates the capital-labour ratio
has to be maintained for ensuring efficiency in production.
lsoquant Map
The production function shows how output varies as the factor inputs change.
Therefore, there are always a number of isoquants for a producer depicting
levels of production (one isoquant depicting one particular level of production).
Isoquants nearer the point of origin represent relatively lower level of
production. The level of production increases as one moves away from the
origin and goes to higher isoquants. A complete set of isoquants for the
producer is called an isoquant map. One such isoquant map showing four
isoquants is shown in Fig. 7.4.
144
 Production with
Two and More
Variable Inputs

Fig. 7.3: If factors of production can be used only in a fixed proportion, the isoquant is
‘L’ shaped and is known as an input-output isoquant

Fig. 7.4: When a number of isoquants are depicted together, we get an isoquant map

In Fig. 7.4, P is the highest isoquant and it represents the highest level of
output, i.e., 400 units. P , P and P represent lower output levels in that order.
It may, however, be noted that the distance between two isoquants on an
isoquant map does not measure the absolute difference between output levels.

7.3.3 Assumptions of lsoquants

Isoquant analysis is normally based on the following assumptions:
1) There are only two factors or inputs of production. This makes the
geometric exhibition of the concept easy since we can easily draw a
diagram.
2) The factors of production are divisible into small units and can be used in
various proportions.
3) Technical conditions of production are given and it is not possible to
change them at any point of time.
145
Production 4) Given the technical conditions of production, different factors of
and Costs production are used in the most efficient way. If this assumption is
abandoned, then any one combination of the factors of production will
yield a number of different levels of production of which the highest level
obtained would be efficient (and all lower levels of production
inefficient).
7.3.4 Properties of Isoquants
A smooth continuous isoquant that has been adopted in the traditional
economic theory possesses the following characteristics:
1) lsoquants are negatively sloped
2) A higher isoquant represents a larger output
3) No two isoquants intersect or touch each other
4) lsoquants are convex to the origin.
1) lsoquants are negatively sloped
Normally, isoquants slope downwards from left to right implying that they are
negatively sloped. The reason for this characteristic of the isoquant is that
when the quantity of one factor is reduced, the same level of output can be
achieved only when the quantity of the other is increased. This characteristic of
the isoquant, however, assumes that in no case marginal productivity of a
factor will be negative. In a more realistic case when this assumption is
dropped, one may find an isoquant which bends back upon itself or has a
positively sloped segment. in Fig. 7.5, such an isoquant is shown. AB and CD
segments of this isoquant are positively sloped.

Fig. 7.5: Isoquant having positively sloped segments

2) A higher isoquant represents a larger output

A higher isoquant is one that is farther from the point of origin. It represents a
larger output that is obtained by using either the same amount of one factor and
the greater amount of the other factor or the greater amounts of both the
factors. Two isoquants P and P have been shown in Fig. 7.6. They depict
output levels of 100 units and 200 units. Obviously, the output level
represented by isoquant P can be reached only by using more of factor inputs
as compared to the amount of factor inputs required to reach output level
146 represented by isoquant P .
 Production with
Two and More
Variable Inputs

Fig. 7.6: Two isoquants representing different output levels. A higher isoquant depicts a
higher amount of output
3) No two isoquants intersect or touch each other
Isoquants do not intersect or touch each other because they represent different
levels of output. If, for example, isoquants P and P (Fig. 7.7) represent output
levels of 100 and 200 units respectively, their intersection at some point, say A
would mean that two output levels (i.e., 100 and 200 units) will be reached by
using the same amount of capital and labour which is not likely to happen. For
the same reason, no two isoquants will touch each other.

Fig. 7.7: No two isoquants intersect each other because each isoquant depicts a different
level of output

4) lsoquants are convex to the origin

In most production processes the factors of production have substitutability.
Often, labour can be substituted for capital and vice versa. However, the rate at
which one factor of production is substituted for the other in a production
process, that is, the marginal rate of technical substitution (MRTS) often tends
to fall.

147
Production
Marginal rate of technical substitution of factor L for factor K
and Costs
(MRTSL,K) is the quantity of K that is to be reduced on increasing the
quantity of L by one unit for keeping the output level unchanged.

The isoquants are convex to the origin precisely because the marginal rate of
technical substitution tends to fall. Let us explain why this happens with the
help of Fig. 7.8. Here, the isoquant is curve P. Let us suppose that the producer
is at point ‘a’ of the curve. The meaning of this is that he uses OJ units of
capital and OR units of labour to produce 100 units of output. We shall assume
that one unit of labour is OR = RS = ST = TU = UV. Now, if he wants to
increase the amount of labour by RS, and keep the output at 100 units, he must
reduce the use of capital by JK. Similarly, when he increases the amount of
labour by ST, TU and UV, he must reduce the application of capital by KL,
LM and MN respectively if output has to be kept at the same level (i.e., 100
units). It is clear from the figure that JK > KL > LM > MV. In other words, as
additional units of labour are employed it becomes progressively more and
more difficult to substitute labour in place of capital so that lesser and lesser
units of capital can be replaced by additional units of labour. This means that
the marginal rate of technical substitution tends to fall. This is due to the reason
that factors of production are not perfect substitutes for one another. When the
quantity of one factor is reduced, it becomes necessary to increase the quantity
of the other at an increasing rate. For example, let us suppose that in a
particular productive activity two factors of production – labour and capital –
are employed. When the quantity of labour employed is reduced by one unit, it
is possible to undertake the activity by employing one more unit of capital
initially. However, when one more unit of labour is reduced, it might become
necessary to compensate this by employing, say, two units of capital. As the
quantity of labour employed is reduced successively at each stage, we would
require more and more units of capital to compensate for the loss of each
additional unit of labour.

Fig. 7.8: An isoquant is covex from below because the marginal rates of technical
substitution tends to fall

If the factors of production are perfect substitutes, the marginal rate of

technical substitution between them would be constant and the isoquant will be
148 linear and sloping downwards from left, to right as in Fig. 7.2. In the case of
strict complementarity, that is, zero substitutability of the factors of production Production with
the isoquant will be right angled or we may say that it will assume the shape of Two and More
‘L’ as in Fig. 7.3. However, the linear and right angled isoquants are the Variable Inputs
limiting cases in the production processes.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) In case of perfect substitability of the factors of production,
the isoquant is convex from below. ( )
ii) Isoquants are positively sloped. ( )
iii) A higher isoquant represents a larger output. ( )
iv) No two isoquants intersect each other. ( )
2) Define isoquant. Discuss its properties.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Draw the possible shapes which the isoquants may assume depending on
the degree of substitutability.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

7.4 ECONOMIC REGION OF PRODUCTION AND

RIDGE LINES
Generally, production functions generate isoquants which are convex to the
origin, negatively sloped throughout, do not intersect each other and the higher
the isoquants, greater the level of output. However, there are some production
functions which yield isoquants having all the properties of a normal isoquant
except that they are not negatively sloped throughout. In other words, they
have positively sloped segments. In Fig. 7.9, the production function is
depicted in the form of a set of isoquants which have positively sloped
segments.
Let us consider isoquant P . AB segment of this isoquant has a negative slope.
Beyond points A and B, this isoquant is positively sloped. Similarly, other
isoquants have the points where they bend back upon themselves implying that
they become positively sloped. The lines OK and OL joining these points are
called ridge lines. They form the boundaries for the economic region of
production. A careful interpretation of any of the isquants in Fig. 7.9 will make
this point clear.
Suppose the output represented by isoquant P is to be produced. For producing
this quantity, a minimum of OK amount of capital is required because any
smaller amount will not allow the producer to attain the P level of output.
With OK amount of capital, OL amount of labour must be employed. In case
the producer uses an amount of labour less than OL together with OK amount 149
Production of capital, his output level would be lower than the one represented by isoquant
and Costs P . This is quite normal, because use of inputs in smaller amounts would yield
a smaller output. But combining labour input in an amount larger than OL
with OK amount of capital would also result in output smaller than that is
represented by the isoquant P . In order to maintain the P level of output with
a larger labour input, capital input also in a larger amount has to be used.
Obviously, this is something which no rational producer would attempt
because it involves uneconomic use of resources.

Fig. 7.9: Area enclosed within the upper side line OK and the lower side lint OL indicates
the economic region of production

Point B on isoquant P represents the intensive margin for labour because an

increase in the amount of labour input beyond OL with a fixed amount of
capital input OK results in a fall in the output level. At this point, marginal
product of labour is zero and thus the marginal rate of technical substitution of
labour for capital (MRTS ) is zero. This implies that at point B labour has
been substituted for capital to the maximum extent. Thus, to the right of ridge
line OL in Fig. 7.9, we have Stage III for labour.
Similarly, for producing P level of output, a minimum of OL amount of
labour input is required. A smaller amount of labour input will not allow the
producer to attain P level of output. With OL amount of labour, OK amount
of capital must be used and any additions to capital input beyond OK would
result in smaller output. Therefore, the marginal product of capital is zero at
point A. This point represents intensive margin for capital because an increase
in the amount of capital input beyond OK with a fixed labour input of OL
will reduce rather than augment output. At point A on P , capital has been
substituted for labour to the maximum extent. Thus, above ridge line OK in
Fig. 7.9, we have Stage III for capital. The marginal rate of technical
substitution of capital for labour (MRTSKL) is zero, which means that the
marginal rate of technical substitution of labour for capital (MRTSKL) is
infinite or undefined.
The line OK in Fig. 7.9 connects the point of zero marginal product of capital.
We have designated it as the upper ridge line. Similarly, the line OL
designated as the lower ridge line joins the points of zero marginal product of
150 labour.
 Production with
The combinations of labour and capital inputs comprising the area Two and More
between ridge lines OK and OL constitute the generalised Stage II of Variable Inputs
production for both resources. These are the combinations that are
relevant for production decisions.

7.5 THE OPTIMAL COMBINATION OF FACTORS

AND PRODUCER’S EQUILIBRIUM
So far, we have explained as to how different combinations of inputs allow a
producer to attain a certain level of output. The producer is free to choose any
of these input combinations. However, his choice cannot be arbitrary if he
wishes to minimise cost of producing a stipulated output. Our task now is to
explain how the producer selects a particular input combination.

7.5.1 Input Prices and Isocost Lines

A producer may attempt maximisation of output subject to a given cost or
alternatively, he may seek to minimise cost subject to a given level of output.
In both cases, for choosing optimum quantities of two inputs, viz., labour and
capital, he must consider their physical productivities as well as their prices.
While isoquants represent the productivities of the inputs, their prices are
shown by isocost lines.

An isocost line represents various combinations of inputs that may be

purchased for a given amount of expenditure; that is, the producer’s
budget.

The firm or the producer has to purchase factors or inputs from the market.
How the prices of labour and capital are determined in the market is not our
present concern. Moreover, the firm is in no position to influesence the input
prices unless it is a monopsonist or oligopsonist. In other words, prices of
labour and capital have to be taken as given by the firm operating in a
competitive factor market. Let us now suppose that the firm’s total cost outlay
on labour and capital is Rs. 1000. The firm is free to spend this entire amount
on labour or capital or it may spend it on a combination of both labour and
capital. In Fig. 7.10, we have shown that if the firm chooses to spent the entire
amount of Rs. 1,000 on labour input, it can employ OL amount of labour, and
if the entire amount is to be spent on capital, it can get OK amount of capital.
The straight line K L is an isocost line representing all the combinations of
capital and labour which the firm can obtain for Rs. 1,000. In the figure, the
length of OL is twice the length of OK which means that the price of a unit of
labour is half that of a unit of capital. The slope of the line K L shows the
ratio of input prices. Hence, the slope of an isocost line is (w/r), which is the
ratio of the price of labour (w) to the price of capital (r) when X-axis denotes
labour input and Y-axis denotes capital input. We can thus generalise that for
any isocost line which is always linear because the firm has no control over the
prices of inputs, and the prices remain the same, no matter how much quantity
of these inputs the firm buys,

∆
Slope = = = / =
∆

151
Production
and Costs

Fig. 7.10: Isocost Lines- A higher cost line indicates a higher cost

This property of an isocost line is similar to that of the budget line of the
consumer. However, there is an important difference between the two lines.
Since the consumer’s budget is invariably fixed, he has a single budget line.
The firm generally has no such constraint and thus has more than one isocost
lines. In Fig. 7.10, we have shown three isocost lines. There can be many more
of them corresponding to firm’s cost outlay plans to attain various output
levels.
An isocost line farther to the right reflects higher costs; the one closer
to the origin reflects lower costs.

7.5.2 Maximisation of Output for a Given Cost

A rational producer is expected to maximise output for a given cost.

Alternatively, he may attempt to minimise cost subject to a given level
of output.

In this section, we shall explain how a producer maximises his output for a
given cost. Suppose the producer’s cost outlay is C and the prices of capital
and labour are r and w respectively. Subject to these cost conditions, the
producer would attempt to attain the maximum output level.
Let KL isocost line in Fig. 7.11 represents the given cost outlay at input prices
r and w. P , P and P , are isoquants representing three different levels of
output. It may be noted that P3 level of output is not attainable because the
available factor resources (various labour-capital combinations represented by
isocost line KL) are insufficient to reach that output level. In fact, any output
level beyond isocost line KL is not attainable. The producer, however, can
attain any output level in the region OKL, but that would not require all the
resources (labour and capital inputs) that are available to the producer for his
cost outlay. Therefore, in the case of a given cost, the producer’s attempt
would be to reach the isoquant which represents the maximum output level.
The producer can operate at points such as R and T. At these two points, the
combinations of labour and capital to produce P level of output are available
for a given cost represented by isocost line KL. In contrast, at point S, the
combination of labour and capital available for the same cost (as it is also on
isocost line KL) enables the producer to reach isoquant P which represents an
152
output level higher than that represented by P . Since at point S on isoquant P Production with
is jus tangent to isocost line, a greater output than P is not obtainable for the Two and More
given level of cost. A lesser output is not efficient because production can be Variable Inputs
raised without incurring additional cost. Hence, the optimal combination of
factors of production, viz., capital and labour is OK of capital plus OL labour
as it enables the producer to reach the highest level of production possible
given the cost conditions.

Fig. 7.11: With the given cost line KL, the highest isoquant that a producer can reach is
P2. Point S on this isoquant, therefore, indicates producer’s equilibrium

The above proposition should be obvious to those who have studied the theory
of consumer behaviour. At the same time, the reason that lies behind it must be
followed carefully. Let us suppose that the producer wishes to produce at point
T. The marginal rate of technical substitution of labour for capital indicated by
the slope of tangent AB at point T is relatively high. Suppose ∆K is equal to 3
and ∆L is equal to 1. Thus, the slope of tangent AB is 3:1 which implies that at
point T one unit of labour can replace 3 units of capital. However, the relative
factor price indicated by the slope of KL is less, say, 0.7:1 which means that
the cost of 1 unit of labour is the same as the cost of 0.7 unit of capital.
Therefore, it would be rational on the part of the producer that he substitutes
labour for capital so long as the marginal rate of substitution of labour for
capital is not equal to the factor price ratio, that is, the ratio of the price of
labour to the price of capital. At point R, the opposite situation prevails
because the marginal rate of technical substitution is less than the factor price
ratio.

The producer maximises output for a given cost (reaches equilibrium)

only when the marginal rate of technical substitution of labour for
capital is equal to the ratio of the price of labour to the price of capital.

Thus,

MRTS = =

153
Production 7.5.3 Minimisation of Cost for a Given Level of Output
and Costs
If a producer seeks to minimise the cost of producing a given amount of
output rather than maximising output for a stipulated cost, the
condition of his equilibrium remains formally the same. That is, the
marginal rate of technical substitution must be equal to the factor price
ratio.

This can be easily followed graphically. In Fig. 7.12, we have a single isoquant
P which denotes the desired level of output, but there is a set of isocost lines
representing various levels of total cost outlay. An isocost line closer to origin
indicates a lower total cost outlay. The isocost lines are parallel and thus have
the same slope w/r because they have been drawn on the assumption of
constant prices of factors.

Fig. 7.12: To obtain a level of production indicated by isoquant P, the minimum cost that
must be incurred is given by point E on the isocost line K2L2. Therefore, point E indicates
the point of producer’s equilibrium

It may be noted that isocost line K L is just not relevant because the output
level represented by the isoquant P is not producible by any factor combination
available on this isocost line. However, the P level output can be produced by
the factor combinations represented by the points F and G which are on isocost
line K L . Alternatively, the producer can attain the P level output by the
factor combination represented by the point E which is on isocost line K L .
Since the isocost line K L is closer to the origin as compared to the isocost
line K L , it represents relatively lower cost. Therefore, by moving either from
F to E or from G to E, the producer attains the same output level at a lower
cost. The producer thus minimises his costs by employing OB amount of
capital plus OA amount of labour determined by the tangency of the isoquant P
with the isocost line K L2. Points representing factor combinations below E
are certainly preferable because they represent lower costs but they cannot be
considered as they cannot help in producing the output level represented by the
isoquant P. Points above E represent higher costs. Hence, point E denotes the
least cost combination of the factors, viz., labour and capital for producing
output shown by isoquant P. This discussion thus leads us to the principle that
in the case of producer’s equilibrium, the marginal rate of technical
substitution of labour for capital must be equal to the ratio of the price of
154
labour to the price of capital. We can now sum up the whole discussion as Production with
follows: Two and More
Variable Inputs
1) The optimal combination of factors, whether the producer seeks to
maximise output for a given cost or he wishes to minimise cost for a
stipulated output, is that where marginal rate of technical
substitution and the factor price ratio are equal.
2) The producer is in equilibrium when there is optimal combination
of factors.

7.6 THE EXPANSION PATH

Producers expand their outputs both in the long run and in the short run. In the
long run, output expands with all factors variable, while in the short run,
expansion of output is possible with some factor(s) constant and some others
variable. We shall consider both cases.
7.6.1 Optimal Expansion Path in the Long Run
In the long run, there is no limitation to the expansion of output as all the
factors of production are variable. The firm’s goal being maximisation of its
profits, it seeks to expand outputs in the optimal way. With given factor prices,
the optimal expansion path is the locus of the points of tangency of successive
isocost lines and successive isoquants.
Consider now Fig. 7.13. Given the factor prices, the output corresponding to
isoquant P is producible at the lowest cost at point A where isocost line K L
is tangent to the isoquant P . This is the initial position of producer
equilibrium. Assuming that factor prices remain constant, suppose the producer
desires to expand output to the level indicated by the isoquant P . This will
cause a shift in the isocost line from K L to K L . The new equilibrium is
found at point B where isocost line K L is tangent to the isoquant P . Further
expansion in output to the level corresponding to the isoquant P will shift
equilibrium to point C where isocost line K L is tangent to the isoquant P .

Fig. 7.13: Expansion path in the case of non-linear production function

On connecting all points of producer equilibrium, such as A, B and C, we get
the curve OE which is called the expansion path. Since every point of the
expansion path denotes an equilibrium point of the producer, it indicates
155
Production the optimum combination of factors of production of some particular level
and Costs of output. It may be recalled that each point of producer equilibrium is defined
by equality between the marginal rate of technical substitution and the factor
price ratio. Since the latter has been assumed to remain constant, the former
also remains constant. Hence, OE is an isocline along which output expands
when factor prices remain constant.
In the case of linear homogeneous production function, the isoclines are
straight lines through the origin. Therefore, the expansion path will also be a
straight line as shown in Fig. 7.14. This means that given the prices of the
factors of production, the optimal proportion of the inputs of the firm will not
change with the size of the firm’s output or input budget.

Fig. 7.14: Expansion path in the case of linear homogeneous production function is a
straight line

The line formed by connecting the points determined by the tangency

between the successive isoquants and the successive isocost lines is the
firm’s expansion path. It identifies the least costly input combination
for each level of output and will slope upward in the long-run setting.
This means that the firm will expand use of both inputs as it expands its
output.

7.6.2 Optimal Expansion Path in the Short Run

In the short run, capital is a fixed factor and thus its amount remains constant.
Labour is, however, variable and the producer can expand his output by
increasing the amount of labour along a straight line parallel to the axis on
which this factor is measured. In Fig. 7.15, the straight line AB indicates the
expansion path as the total amount of capital is fixed at OA in the short run.
With the prices of the factors of production remaining constant, the firm
cannot maximise its profits while it expands its output in the short run, on
account of the constraint of the fixed amount of capital. This can be
followed from Fig. 7.15. The firm’s initial equilibrium is at point E where
isocost line K L is tangent to the isoquant P . If the firm wishes to raise its
output level corresponding to the isoquant P , it reaches the point F which,
given the factor prices, is not the least cost situation. Further expansion of
output to the level corresponding to the isoquant P leads the firm to reach the
156
point G which again does not represent the least cost situation. The optimal Production with
expansion path would be OR, were it possible for the firm to increase the Two and More
quantity of capital. However, given the amount of capital, the firm has no Variable Inputs
choice but to expand along the straight line AB in the short run.

Fig. 7.15: Expansion path in the short run in the case of linear
homogeneous production function
Check Your Progress 2
1) Indicate the following statements as True (T) or False (F):
i) The condition for optimal combination is that marginal rate of
technical substitution is greater than factor price ratio. ( )
ii) The area between ridge lines constitutes the Stage II of production
for both resources. ( )
iii) An isocost line represents various combinations of input that may
be purchased for a given amount of expenditure. ( )
iv) An isocost line farther to the right reflects higher cost. ( )
v) Every point on the expansion path denotes an equilibrium point of
the producer. ( )
vi) The line formed by connecting the points determined by the
tangancy between the successive isoquants and the successive
iocost lines is the firm’s expansion path. ( )
2) Explain the condition of a producer’s equilibrium.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Suppose that P = Rs. 10, P = Rs. 20 and TO (total outlay) = Rs. 160.
i) What is the slope of the isocost ?
ii) Write the equation of the isocost?
......................................................................................................................
......................................................................................................................
......................................................................................................................
157
Production
and Costs
7.7 PRODUCITON FUNCTION WITH SEVERAL
VARIBALE INPUTS
When all the factors of production (labour, capital, etc.) are increased in the
conditions of constant techniques, three possibilities arise:
1) Output increases in a greater proportion as compared to the increase in
the factors of production. This is the case of increasing returns to scale.
2) Output increases in the same proportion as the increase in the amount of
the factors of production. This is the case of constant returns to scale.
3) Output increases in a smaller proportion as compared to the increase in
the amounts of the factors of production. This is the case of diminishing
returns to scale.
The concept of returns to scale is associated with the tendency of production
that is observed when the ratio between the factors is kept constant but the
scale is expanded, i.e. use of all the factors is changed in same proportion.

7.7.1 Increasing Returns to Scale

When the ratio between the factors of production is kept fixed and the scale is
expanded, initially output increases in a greater proportion than the increase in
the factors of production.

Fig. 7.16: Increasing Returns to scale output increases in a greater proportion than the
increase in the factors of production

There are main factors which account for increasing returns to scale are given
below:
1) Indivisibility: The most important reason of increasing returns to scale is
the ‘technical and managerial indivisibilities’. The meaning of an
indivisible factor of production is that there is a certain minimum size of
the factor and even if it is large in relation to the size of the output, it has
to be used (i.e., it cannot be divided). For example, even if only 10-15
letters are to be despatched from an office, it would be necessary to keep
158
 a typewriter. It is not possible to purchase only half the typewriter since Production with
only a small number of letters have to be typed daily. We would, Two and More
therefore, say that typewriter is not divisible. In a similar way, plants and Variable Inputs
managerial services in modern factories are not divisible. Accordingly,
when the scale of production is enlarged initially there is no equi-
proportionate increase in the demand for the factors of the production.
2) Specialisation: Chamberlin does not regard indivisibility as an important
cause of ‘increasing returns to scale’. According to him, the main reason
of increasing returns to scale is specialisation. When due to division of
labour, workers are given jobs according to their ability, their
productivity increases while cost declines. According to Donald S.
Watson, acknowledgement of this fact contradicts the assumption that the
ratio of different factors of production remains constant. Accordingly, he
casts doubts whether specialisation can be regarded as leading to
increasing returns to scale. The importance of specialisation can be
accepted only if we assume that although an increase by an equal amount
in quantity of labour and capital employed is necessary for an expansion
in scale, this increase does not mean the doubling or trebling their units
employed but it does mean an increase in their fixed money cost. But this
can lead to technical changes and it is very much possible that increasing
returns emerge not due to an expansion in scale but due to technical
reasons.

7.7.2 Constant Returns to Scale

Increasing returns to scale can be obtained only upto a point. After this point is
reached, expansion of scale only leads to equal proportionate change in output.
Empirical evidence suggests that the phase of constant returns is a fairly long
one and is observed in the case of a number of commodities. In a scientific
sense, constant returns to scale implies that when the quantity of the factors of
production is increased in such a way that the ratio of the factors remains
unchanged, output increases in the same proportion in which the factors are
increased. Such a production function is often called linear homogeneous
production function or homogeneous production function of the first degree.
The phase of constant returns to scale can be understood with the help of Fig.
7.17.

Fig. 7.17: Constant Returns to Scale-output increases in the same proportion in which
inputs are increased
159
Production The question that now arises is what are the reasons which account for constant
and Costs returns to scale. Generally when inefficiencies of production on a small scale
are overcome and no problems regarding technical and managerial
indivisibilities remain, expansion in scale leads to a situation where returns
increase in the same proportion as the factors of production. Some economists
are of the view that when benefits of specialisation of a factor in the unit of
production are small or when such benefits have already been reaped at a small
level of production, then for a considerable period of time, production
increases according to the law of constant returns to scale.
Further if the factors of production are perfectly divisible, the production
function must exhibit constant returns to scale.

7.7.3 Diminishing Returns to Scale

Diminishing returns to scale ensure that the size of the productive firms cannot
be infinitely large. Generally after a limit when the quantity of the factors of
production is increased in such a way that the proportion of the factors remains
unchanged, output increases in a smaller proportion as compared to increases
in the amounts of the factors of production. For example, it may happen that an
increase in amount of labour and capital by 100 per cent leads to an increase in
output by only 75 per cent. In other words, if output has to be doubled, the
factors of production will have to be more than doubled. We can understand
this phenomenon with the help of Fig. 7.18.

Fig. 7.18: Diminishing Returns to Scale – output increases proportionally less than inputs
Economists do not agree on the causes which leads to operation of diminishing
returns to scale. Nevertheless, the two causes that are often mentioned are as
follows:
1) Enterprise: Some economists emphasise that enterprise is a constant and
indivisible factor of production and its supply cannot be increased even in
the long run. Accordingly, when the quantity of other factors is increased
and the scale of production expanded in a bid to boost up production, the
proportion of other factors in relation to enterprise increases. Beyond a
certain point, this results in diminishing returns as enterprise becomes
scarce in relation to other factors.
160
2) Managerial difficulties: According to some other economists, the main Production with
reason for the operation of diminishing returns to scale is managerial Two and More
difficulties. When the scale of production expands, the co-ordination and Variable Inputs
control of different factors of production tends to become weak and
therefore output fails to increase in the same proportion as the factors of
production increase. This results in diminishing returns to scale.

7.8 ECONOMIES AND DISECONOMIES OF

SCALE
Expansion of the scale confers a number of economies on the firm. Some of
these are in ‘real terms’ while others are in ‘pecuniary terms’. Economies that
are obtained in production work, marketing, management, transport, etc. are in
real terms, while economies that are obtained in terms of, say, purchase of
inputs at wholesale rate, availability of finance at lower rate of interest, saving
on advertisement costs, etc. are in money terms. Then, there are certain
economies that do not accrue to the firm whose scale of operation is large but
accrue to certain other firms which benefit from the large scale of this firm.

In Economics, those economies which accrue to a firm on expansion of

its own size are known as internal economies. As against this, those
economies which accrue to a firm not due to its own operations but due
to the operations of other firms are termed external economies.

7.8.1 Internal Economies of Scale

Generally, when the scale of production is sought to be enlarged, the firm
replaces its small plant by a larger plant. This increases the efficiency of
production. However, it is not always necessary to change the plant for
expanding the scale of production. The firm can keep the old plant in a running
condition and either establish a new plant of the same type or a new plant of
some new type. In all these alternatives, the firm obtains many different kinds
of economies. These economics that determine the nature of the long-run
average cost curve are listed below:
1) Real Internal Economies of Scale: When expansion in the scale of
production takes place, the firm obtains some real internal economies.
These economies accrue in the form of saving in the physical quantities
of raw materials, labour, fixed and variable capital, and other inputs.
Broadly speaking, real internal economies are of the following four types:
(1) production economies, (ii) selling or marketing economies, (iii)
managerial economies, and (iv) economies in transport and storage.
2) Pecuniary Internal Economies: Some pure pecuniary economies accrue
to a firm as its scale of operation expands. The more important ones are
the following:
1) A large sized firm can ask the suppliers of raw materials to give
specific concessions and discounts. No raw material supplier
usually ignores such requests (or pressures) of the large firm.
2) Perfect competition generally does not prevail in the capital market.
Since the large companies have greater goodwill in the capital
market, they are in a position to obtain loans on lower rates of
interest from the banks and financial institutions. 161
Production 3) Transport companies are also willing to provide discounts and
and Costs concessions if the cargo is substantially large. This enables the firm
to obtain monetary economies in transport costs by expanding its
scale of operations.
4) When production is large, the firm is required to spend a large
amount on advertising as well. However, advertising on a large
scale attracts discounts and concessions from the media in which
the advertisements appear.

7.8.2 Internal Diseconomies of Scale

If the scale of production is continuously expanded, is it possible that after a
certain point, increase in production is less proportionate than increase in the
factors of production? Many economists believe that such a situation can and
does arise if production is pushed beyond the point of optimum scale. The
reasons that they advance are as follows:
1) Limitations on the availability of factors of production: The factors of
production are always available in limited supply at the place of
production. When the scale of production is increased beyond a certain
point, it no longer remains possible to meet the requirements of some
factors from local sources and, accordingly, factors have to be transported
from other regions. This is generally possible only at higher prices.
2) Problems in management: When the scale of production is very large,
the task of management at the top level becomes increasingly more and
more burdensome and some inefficiency is bound to creep in. At times,
information vital for taking a decision does not reach the top managers of
the company in time. This delay, in turn, leads to a delay in decision
making and increases the per unit cost.
3) Technical factors: When the scale of production is expanded, per unit
cost increases due to a number of technical reasons. The establishment
cost of large and sophisticated plants and machinery is generally high.
The buildings of large factories should also have stronger foundations
and the factory itself must be equipped with coolers, air-conditioners, etc.
All these factors lead to an increase in per unit cost.
7.8.3 External Economies of Scale
External economies were discussed first of all by Alfred Marshall. According
to him, when a firm enters production, it obtains a number of economies for
which the firm’s own production strategy, managerial arrangements, etc. are
not responsible. In fact, these are economies external to the firm. For example,
let us suppose that a firm is established at a place where transport, advertising
facilities, etc. are not available. If the size of the firm remains small, it is
possible that these facilities are not locally available in the future as well.
However, if the size of the firm increases significantly, these facilities will
themselves start coming to the firm. These are, in fact, external economies.
When a firm expands its scale of production, other firms also earn many
economies. For example, when a large factory attracts various factors of
production fairly regularly, many other factories set up in the neighbourhood,
that could not have attracted these factors on their own, also stand to gain.
They obtain these factors at practically the same prices at which the large
factory obtained them.
162
Because of external economies of large-scale production, there is a gap Production with
between private and social returns. When a firm expands its scale of Two and More
production, it becomes possible for the other firms to reduce their cost of Variable Inputs
production. However, there is no method available in the prevalent price
mechanism to the firm expanding its scale of operations to charge for the
benefits it confers on the other firms.

7.8.4 External Diseconomies of Scale

When the scale of operations is expanded, many such diseconomies emerge
that have no particular ill-effect on the firm itself. In fact, their burden falls on
the other firms. On account of this reason, they are termed external
diseconomies. The smoke rising from the chimney of a factory pollutes the
atmosphere. When the firm is of a small size, the pollution is less and its ill-
effects on the people living in colony nearby is limited. However, if the scale
of the firm is large, the smoke will be very dense and can cause serious health
hazard to the people. Similarly, as the scale of production of the factories
increases, employment rises sharply. This creates problems of traffic
congestion and overcrowding in the city where these factories are located.
Check Your Progress 3
1) Indicate the following statements as true (T) or false (F):
i) When output increases in a greater proportion as compared to the
increase in the amount of the factors of productions, we have the
stage of increasing returns to scale.
ii) Those economies which accrue to a firm an account of the other
firms are known as external economies.
iii) Production economies are a part of pecuniary internal economies.
iv) In the case of linear homogenous production function, we have
constant returns to scale.
2) Discuss the factors which account for increasing returns to scale.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by external economies and external diseconomies?
......................................................................................................................
......................................................................................................................
......................................................................................................................

7.9 LET US SUM UP

The unit begins with the concept of production function which referes to
functional relationship between inputs and output. This is followed by the
definition of an isoquant and the explanation of three types of isoquant– (i)
convex isoquant, (ii) linear isoquant, and (iii) input-output isoquant. The
properties of isoquants are: (i) isoquant are negatively sloped (ii) a higher
isoquant represents a larger output, (iii) no two isoquants intersect or touch
163
Production each other, and (iv) isoquants are convex to the origin. From here we proceed
and Costs to a discussion of the concept of the economic region of production and ridge
lines. The next section is devoted to a discussion of the optimum combination
of factors and producer’s equilibrium. In this section, we first consider the
concept of isocost lines and then consider (i) maxmisation of output for a given
cost, and (ii) minimisaton of cost for a given level of output. When the ratio
between the factors is kept constant and several variable inputs are used this
give rise to three possibilities– increasing returns to scale, constant returns to
scale and diminishing returns to scale. Economics of scale are decided into two
parts- internal economies of scale and external economies of scale. Similarly
diseconomies of scale are both internal and external.

7.10 REFERENCES
1) Robert S Pindyck, Daniel L. Rubinfld and Prem L Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2009), Chapter 5,
Section 5.1 and Section 5.3.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth Edition, 2010), Chapter 7, Section 7.1, Section 7.3 and
Section 7.4.
3) A.Koutsoyiannis, Modern Microeconomics (The Macmillan Ltd., Second
edition, 1982). Chapter 3.
4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 7.

7.11 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) i) F) ii) F iii) T iv) T
2) See Sub-section 7.3.1 and 7.3.4
3) See Sub-section 7.3.2
Check Your Progress 2
1) i) F ii) T iii) T iv) T v) T vi) T
2) See-section 7.5.3
3) (i) Slope of isocost is –P /P = –2 and the eqution is 160 = 10K + 20L or
16 = K + 2L or K = 16 – 2L
Check Your Progress 3
1) i) T ii) T iii) F iv) T
2) See Sub-section 7.7.1 and answer
3) See Sub-section 7.8.3 and 7.8.4

164
UNIT 8 THE COST OF PORDUCTION
Structure
8.0 Objectives
8.1 Introduction
8.2 The Concept of Costs
8.2.1 Private Costs and Social Costs
8.2.2 Money Cost: Explicit and Implicit Costs
8.2.3 Real Costs
8.2.4 Sunk Cost and Incremental Cost
8.2.5 Economic Cost and Accounting Cost
8.2.6 Historical Cost and Replacement Cost

8.3 Cost Functions: Short-Run and Long-Run

8.3.1 Cost Function and the Time Element
8.3.2 Long-Run Cost Function
8.3.3 Short-Run Cost Function

8.4 Theory of Cost in the Short-Run

8.4.1 Fixed Cost
8.4.2 Variable Cost
8.4.3 Total Fixed Cost
8.4.4 Total Variable Cost
8.4.5 Total Cost
8.5 Short-Run Cost Curves
8.5.1 Average Fixed Cost
8.5.2 Average Variable Cost
8.5.3 Average Total Cost
8.5.4 Marginal Cost
8.5.5 Relationship between Marginal Cost and Average Cost

8.6 Long-Run Cost Curves

8.6.1 Long Period Economic Efficiency
8.6.2 The Long-Run Average Cost Curve
8.6.3 Long-Run Marginal Cost Curve
8.6.4 Relationship between Long-Run Marginal Cost and Short-Run Marginal
Cost

8.7 Let Us Sum Up

8.8 References
8.9 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you should be able to:

 state the various concepts of costs like private cost, social cost, money
cost, sunk cost, economic cost, accounting cost etc.;
*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi. 165
Production  differentiate between short-run and long-run cost functions;
and Costs
 know the difference between fixed cost and variable cost and the nature
of total cost curve;

 explain the concept of average fixed cost, average variable cost, average
total cost and marginal cost and nature of these curves;

 discuss the relationship between marginal cost curve and average cost
curve;
 appreciate the difference between short-run and long-run cost curves; and

 describe the relationship between long-run marginal cost and short-run

marginal cost.

8.1 INTRODUCTION
The decision of a firm regarding production of a good depends on two factors:
First, the demand for the good, and second, the cost of production of the good.
Accordingly, the concept of cost of production is basic to the understanding of
the price theory and requires a thorough discussion. A price taker firm wishes
to maximise its profits will be able to do so if it is able to minimise its costs.
Obviously a firm is interested in minimising what economists call the private
cost. The concept of social cost that is being often referred to in the context of
social welfare is not relevant for the theory of firm. However, it is necessary to
understand the distinction between the concepts of the private cost and the
social cost. In economic analysis, we often distinguish between money cost and
the opportunity cost. From analytical point of view both the concepts are
relevant and thus must be understood carefully. The concept of money cost
may be interpreted from the point of view of an accountant or an economist.
The two approaches differ on the treatment of implicit costs.
After settling these conceptual issues in the theory of costs, one has to analyse
the nature of costs in both the short-run and the long-run. In the short-run since
we have some fixed inputs and some other inputs are variable, one has to draw
the distinction between the fixed costs and the variable costs. However, in the
long-run because the amounts of all the inputs can be varied, all costs are
considered together. Finally, the theory of costs attempts to explain as to how
cost changes occur in response to changes in the size of production. In the last
two units we have discussed the theory of production at some length. This
discussion should help us to understand that the cost changes depend largely on
how changes in production take place as a result of changes in the amounts of
inputs.

8.2 THE CONCEPTS OF COSTS

8.2.1 Private Costs and Social Costs
In microeconomic theory, the concepts of both private cost and social cost are
used. The firm, in its attempt to attain the goal of profit maximisation, is
guided entirely by the private cost considerations. In its decision making, it
ignores all those costs which it may be imposing on others while carrying out
its production programme. However, in welfare studies, together with the
166
firm’s both explicit and implicit costs, all such costs are taken into account The Cost of
which are external to the ‘narrow economy’ of the firm. Production

Private costs: Every firm requires various inputs to produce a good. In order
to secure a command over these inputs, the firm has to pay some price for each
of these inputs. In common parlance, the amount of money so paid is known as
cost. Economists, however, include in the private cost not only the expenditure
incurred by the producer on purchasing (or hiring) of factors of production (or
inputs) from the market, but also the imputed cost of all those services which
the producer himself provides. The private cost of production of any output
may thus be defined as either the purchase or the imputed value of all
productive services used in producing the output and is equivalent to the total
monetary sacrifice of the firm made to secure it.
Generally, economists include the following expenditures in the cost: (i) cost
of the raw materials, (ii) wages of the labourers, (iii) interest payments on
capital loans, (iv) rent of the land and the buildings, (v) repairing costs of
machines and depreciation, (vi) tax payments to the government and local
bodies, (vii) imputed wage payment to the producer for the work performed by
him, (viii) imputed interest payment for the capital invested by the producer
himself, (ix) rent of land and buildings owned by the producer himself and (x)
normal profits of the firm.

This shows that three types of expenditures are included in the private
cost: (i) the purchase price of the factors of production employed in the
production process, (ii) imputed price of the resources provided by the
producer himself, and (iii) normal profits.
Social costs: Social costs differ from private costs on account of two reasons:
First, externalities are not included in private costs. For example, a factory
located in the residential area by polluting the atmosphere will expose the
residents of the colony to various ailments and will thereby raise their medical
expenditures. Though these costs are quite relevant from the point of view of
the society, they will never be considered by the firm as part of its costs.
Secondly, market prices of goods may not reflect their social value and
thus there may be divergence between private and social costs. The
imposition of government taxes, subsidies, and controls of various kinds distort
free market prices. Further, prices of factors of production may overstate or
understate the opportunity cost of using those factors. In heavily populated
countries where widespread disguised unemployment is to be found in the
agricultural sector, the industrial wage often exceeds the opportunity cost of
the labour which is drawn from the agricultural sector. In computing the social
costs, adjusted market prices for goods and factors of production are used.
While the adjusted prices for factors of production are called shadow prices,
the adjusted prices for goods are termed as social prices.

8.2.2 Money Cost: Explicit and Implicit Costs

The concept of the money cost in contrast to the concept of opportunity cost is
simple.

The money cost of production of any output is considered to be

equivalent to the total monetary sacrifice made to obtain that output.
167
Production Thus, costs are not sacrificed alternatives but monetary payments. This
and Costs conception of money cost is rather narrow and is used for accounting purposes.
From the point of view of the economists, this concept of cost is not very
relevant. Since economists wish to study as to how costs affect output choices,
employment decisions, and the like, costs should include imputed value of all
the inputs provided by the producer himself in addition to outright money
expenses. Hence, costs can be classified as explicit costs and implicit costs.
Explicit costs arise from transactions between the firm and other parties in
which the former purchases inputs or services of inputs for carrying out the
production. These costs are usually the costs shown in the accounting
statements and include wage payments, raw materials costs, interest on loans,
payments for insurance, electricity and so on. Implicit costs are the costs
associated with the use of the firm’s own resources. Since these resources will
bring return if employed elsewhere, their imputed values constitute the implicit
costs. Implicit costs are however difficult to measure. Economists nonetheless
assert that they must be taken into account in analysing the activities of a firm.

8.2.3 Real Costs

The concept of real cost was developed by Alfred Marshall. In his opinion, a
worker suffers discomfort while he renders his services for productive
purposes. Similarly, a person makes some sacrifice when he saves his income
and lends it to investors who use it for carrying out production. These
discomforts and sacrifices are in the nature of real costs of production. In
Marshall’s own words, “The exertions of all the different kinds of labour that
are directly or indirectly involved in making it; together with the abstinences or
rather the waitings required, for saving the capital used in making it; all these
efforts and sacrifices together will be called the real costs of the production of
the commodity.”
The concept of real cost is, however, based on subjectivity and cannot be used
for precise measurement of production cost. It is this reason why modern
economists do not consider it to be of much relevance in the price theory. They
admit that most of the labour involves hard work and is definitely unpleasant.
It, therefore, has a heavy real cost. In contrast, the real cost of simple and less
arduous work is generally low. But this fact is not at all relevant from the point
of view of price determination in a free enterprise economy. Moreover, to
modern economists, savings do not involve any sacrifice. Hence, these
economists regard the concept of real cost as inappropriate.

8.2.4 Sunk Cost and Incremental Cost

In economics and business decision-making, a sunk cost is a cost that has
already been incurred and cannot be recovered. Sunk costs (also known as
retrospective costs) are sometimes contrasted with prospective costs, which are
future costs that may be incurred or changed if an action is taken. In traditional
microeconomic theory, only prospective (future) costs are relevant for decision
making. Since sunk costs have already been incurred and cannot be recovered,
therefore they should not influence the rational decision-maker’s choices.
An incremental cost is the increase in total costs resulting from an increase in
production or other activity. For instance, if a company’s total costs increase
from Rs. 5.6 lakh to Rs. 6.0 lakh as a result of increasing its machine hours
from 7,000 to 8,000, the incremental cost of the 1,000 machine hours is Rs.
168 40,000.
8.2.5 Economic Cost and Accounting Cost The Cost of
Production
Economists and accountants view costs from different angles. Accountants are
concerned with the firm’s financial statement and tend to take a retrospective
look at the firm’s finances because they have to keep track of assets and
liabilities and evaluate past performance. Accounting cost includes
depreciation expenses for capital equipment at rates allowed by the tax
authorities.
Economists, on the other hand, are concerned with what cost is expected to be
in the future, and with how the firm might be able to rearrange its resources to
lower its cost and improve its profitability. Thus, they take a forward looking
view and must therefore be concerned with opportunity costs.
As stated earlier, there is a difference regarding the treatment of explicit and
implicit costs as well. Both, the economists and the accountants consider
explicit costs (like payment of wages and salaries, cost of raw material,
property rentals, etc.) because these involve direct payments by a company to
other firms and individuals that it does business with. However, while
economists also take into account the implicit costs, accountants ignore them.
For example, consider the owner of a retail store who manages his own retail
store but does not pay any salary to himself. Since no monetary transaction has
taken place, accountant will not include it in the accounting cost. However, the
economist will include this implicit cost in total cost as the retail store owner
could have earned a competitive salary by working elsewhere (that is, the
implicit cost of the owner will be his opportunity cost).
The treatment of depreciation is also different. When estimating the future
profitability of a business, an economist is concerned with the capital cost of
plant and machinery. This involves not only the explicit cost of buying and the
running of the machinery, but also the cost associated with wear and tear. On
the other hand, accountants use depreciation rates on different assets as
allowed under the tax laws in their cost and profit calculations. These
depreciation rates need not reflect the actual wear and tear of the equipment,
which is likely to vary asset by asset.
The above discussion shows that there are some important differences in the
methods of calculating costs as used by the economists and the accountants.
Accordingly, the calculation of profit will also differ. To illustrate, consider a
retail store owner who has invested Rs. 1,00,000 as equity in a store and
inventory. His monthly sales revenue is Rs. 2,60,000. After deduction of cost
of goods sold, salaries of hired labour, and depreciation of equipment and
buildings, the accounting profit to the store owner is Rs. 25,000 (see Table
8.1).
Table 8.1: Accounting income statement for the Retail-Store Owner
Sales Rs. 2,60,000
Cost of goods sold Rs. 1,80,000
Salaries 30,000
Depreciation expense 25,000 Rs. 2,35,000

Accounting profit Rs. 25,000

169
Production In Table 8.2 we consider the economic statement of profit of the same store.
and Costs The cost of goods sold and salaries remain the same. Let us suppose that the
market values of the equipment and building in fact declined by Rs. 25,000
over the current year and that the depreciation charge, therefore, reflects the
opportunity costs of these resources. Thus, depreciation expense is taken to be
Rs. 25,000 as in Table 8.1. However, the economist will add two items relating
to the implicit cost in the cost of production. Suppose that the owner-manager
could earn Rs. 25,000 per month as a departmental manager in a large store
and that this is his best opportunity for salary. Then we would add
Rs. 25,000 as the imputed salary of the owner-manager to the cost of
production. Similarly, the owner-manager has Rs.1,00,000 equity in the store
and inventory – a sum he could have easily invested elsewhere. Let us suppose
that he could have earned 10 per cent interest on this amount had he invested it
elsewhere. Thus, imputed interest cost on equity will be Rs. 10,000. Thus, as
can be seen from Table 8.2, the total economic costs, or the opportunity costs
of all resources used in the production process will add up to Rs. 2,70,000.
This implies an economic loss of Rs.11,000 to the owner-manager of the store
against the accounting profit of Rs. 25,000 depicted in Table 8.1.
Table 8.2: Economic statement of profit to the Retail-Store Owner
Rs. Rs.
Sale 2,60,000
Cost of goods sold 1, 80,000
Salaries 30,000
Depreciation expense 25,000
Imputed salary to owner-manager 25,000
Imputed interest cost on equity 10,000 2,70,000

Economic Profit -10,0000

In addition to the above differences in the calculation of profits by the

economists and the accountants, it is also important to point out that while for
economists, profits and losses are the driving force, business accounting does
not stop here. Business accounts also include the balance sheet, which is a
picture of financial conditions on a particular date. This statement records what
a firm is worth at a given point of time. On one side of the balance sheet are
recorded the ‘assets’ and on the other side are recorded the ‘liabilities’ and ‘net
worth’. A balance sheet must always balance because net worth is a residual
defined as assets minus liabilities.
The business accounting concepts can be summarised as follows:

1) The income statement shows the flow of sales, cost, and revenue
over the year or accounting period. It measures the flow of money
into and out of the firm over a specified period of time.
2) The balance sheet indicates an instantaneous financial picture or
snapshot. It is like a measure of the stock of water in a lake. The
major items are assets, liabilities and net worth.

170
8.2.6 Historical Cost and Replacement Cost The Cost of
Production
The historical cost is the cost that was actually incurred at the time of
the purchase of an asset. As against this, replacement cost is the cost
that will have to be incurred now to replace that asset (i.e., replacement
cost is the current cost of the new asset of the same type).
These two costs differ because of changes in prices over a period of time.
Naturally, if prices remain unchanged over time, both the costs will be the
same. But this seldom happens. Accordingly, historical cost and replacement
cost of an asset always differ. If the price rises over a period of time,
replacement cost will be higher than the historical cost. On the other hand, if
the price of the asset declines over a period of time, replacement cost will be
lower than the historical cost.
Because of the requirements of tax laws and the laws governing financial
reporting to shareholders, accountants generally express many costs in terms of
the actual or historic costs paid for the resources used in the production process
in accordance with the convention of financial accounts. However, both
economists and accountants agree on the fact that for decision making
purposes, it is not the historical cost that is relevant but the replacement cost.
This is due to the reason that for all decision making purposes, it is the
‘current’ (or the replacement) cost that is important and not the cost that was
incurred some years earlier at the time of the purchase of the asset.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) Externalities are not a part of private cost ( )
ii) Implicit costs are the costs associated with the use of firm’s own
resource ( )
iii) Retrospective costs are relevant for decision making ( )
iv) Accountants tend to take a retrospective look at the firm’s finances
( )
v) Economists are concerned with opportunity costs ( )
vi) The historical cost is the current cost of the new asset of the same
type ( )
2) Explain the difference between explicit cost and implicit cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Distinguish between private cost and social cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
171
Production 4) What is the difference between sunk cost and incremental cost?
and Costs
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Explain the difference between economic cost and accounting cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

8.3 COST FUNCTIONS: SHORT-RUN AND

LONG-RUN
The relationship between product and costs is known as the cost function.
There are two elements in determining the cost function of a firm. First, the
production of the firm, and second, the prices paid by the firm for the factors
used.
In practice, production functions can be of various types. At times, one factor
of production is variable and other factors fixed. It is also possible for some
factors to be variable. On account of this reason, cost function can also be of
various types. In economics, generally two types of cost functions are
considered under the price theory:
i) The short-run cost function, and
ii) The long-run cost function.
Cost functions can be illustrated in diagrammatic forms as cost curves.

8.3.1 Cost Function and the Time Element

To understand the theory of cost, it is necessary to be clear about the meaning
of short-run and long-run. In common usage, these terms may be used for
weeks, months and years but for the economist they indicate conditions of
production and have no reference to the calendar year. Even then, the concept
of time does creep in indirectly when the terms short-run and long-run are
discussed.
Generally, economists regard that period of time as short-run in which some
factors of production are fixed (at least one factor is fixed) and the firm
depends only on the variable factors of production to increase the level of
output. If the firm does not employ the variable factors at all, the output will be
zero in the short-run. However, the maximum quantity of output that can be
produced depends upon the quantity of the fixed factors of production. In the
long-run, all factors are variable and the quantity of the output can be increased
to any limit. For example, in a manufacturing industry the plants, machinery,
building of the factory, etc. are fixed resources in the short-run while the raw
materials, labour, power, etc. are variable. Therefore, to increase the amount of
output in this period, it will become necessary to employ more units of the
172 variable resources in conjunction with the fixed resources. Obviously, the
maximum output that can be obtained in this period will depend to a great The Cost of
extent upon the total quantity of the fixed resources of production. Production

8.3.2 Long-Run Cost Function

In the long-run, total cost is a multivariable function which implies that total
cost is determined by many factors. The long-run cost function may be written
as
C = f(Q, T, Pf)
Where, C = total cost of production
Q = output
T = technology
Pf = prices of the relevant factors of production.
Graphically, the long-run cost function is shown on two dimensional diagram
as C=f(Q), ceteris paribus. With the assumption that the technology and the
prices of relevant factors of production remain constant, the long-run cost
function may be written as
C = f(Q, T̅, P̅f or C = f(Q)
However, the technology and the factor prices need not remain constant. When
these factors change, their effect on cost is shown by a shift of the cost curve. It
is this reason why the factors other than output are known as shift factors.
Theoretically there is no difference between the various factors which
determine the costs, and the distinction we have drawn above between the
output level and other factors determining costs can sometimes be misleading.
However, for showing costs on two dimensional diagrams this distinction has
to be made.

8.3.3 Short-Run Cost Function

In the short-run, in addition to output level, technology and factor prices, the
fixed factors such as capital equipment, land, etc. also determine costs of
production. Therefore, the short-run cost function is written as
C = f (Q, T̅, P̅f, K̅)
Where, K̅ indicates fixed factors. In the discussion on the production function,
it has been stated that in the short-run certain factors like capital equipment,
land, factory building and top managerial staff remain constant. K̅ underlines
the fact of the constancy of the fixed factors. Since the amount of fixed factors
does not change in the short-run under any circumstances, K̅ is not a shift
factor like technology and factor prices.

8.4 THEORY OF COST IN THE SHORT-RUN

The short-run costs of a firm are divided into fixed and variable costs.
Therefore,
TC = TFC + TVC
where, TC = total cost
173
Production TFC = total fixed cost
and Costs
TVC = total variable cost

8.4.1 Fixed Cost

Fixed cost is also known as supplementary cost. While engaging in

productive activity, the producer always has to incur some expenditure
which remains fixed whatever the level of production, so much so that
even if the producer stops production altogether, these costs have to be
incurred.
This is known as fixed cost of production. Interest paid by the producer on the
capital borrowed for purchasing plant and machinery, rent of the factory
building, depreciation of the machinery, the wages of foremen and organisers,
etc. are all fixed costs. These costs remain fixed even when the level of output
is varied. Even if the producer decides to close down production, he has to bear
these costs since the factory rent, wages of managers, interest on capital, etc.
have to be paid. This discussion makes it clear that larger the level of
production in a firm, the lower will be the per unit fixed cost (or average fixed
cost).

8.4.2 Variable Cost

The cost which keeps on changing with the changes in the quantity of
output produced is known as variable cost.

For instance, raw material has to be used in the process of production in a

manufacturing industry, labour has to be employed for running machines, and
energy (electricity) has to be arranged. Generally expenditure on these inputs
increases or decreases due to changes in the level of production. It is important
to remember in this context that when the producer abandons production in the
short run, these costs also vanish completely. In fact, it is due to this direct
relationship between expenditure on such inputs and the level of production
that these expenditures are known as variable costs.
The concepts of total cost, total variable cost and total fixed cost in the short-
run can be easily followed with the help of Table 8.3.
Table 8.3 : Short-Run Costs of a Hypothetical Firm

Output Total Fixed Cost Total Variable Total Cost

(Unit) (Rupees) Cost (Rupees)
(Rupees)
0 240 0 240
1 240 120 360
2 240 160 400
3 240 180 420
4 240 212 452
5 240 280 520
6 240 420 660
174
8.4.3 Total Fixed Cost The Cost of
Production

Total fixed cost is the total expenditure by the firm on fixed inputs.

From Table 8.3, it is clear that the total fixed cost of the firm remains constant
at Rs. 240 irrespective of the level of output. In our illustration, output varies
from 1 unit to 6 units, but the total fixed cost remains 240 in each case. Even
when the firm stops production altogether, implying that output is at zero level,
the total fixed cost remains unchanged. The firm’s total fixed cost function is
shown in Fig. 8.1.

Fig. 8.1 : Total Fixed Cost curve is parallel to X axis as total fixed cost remains the same
for all levels of output

8.4.4 Total Variable Cost

Total variable cost is firm’s total expenditure on variable inputs used to

carry out production.

Since higher output levels require greater utilisation of variable inputs, they
mean higher total variable cost. Table 8.3 shows that the total variable cost of
the firm increases as its output increases. However, when the firm stops its
production altogether, it does not require any variable input and, therefore, its
total variable cost is zero. Fig. 8.2 shows the firm’s total variable cost function.
Notice one peculiar feature of TVC – initially it rises sharply, then, there is a
moderation in its rate of rise and ultimately it resumes rising at a faster pace.

175
Production
and Costs

Fig. 8.2 : Total Variable Cost Curve rises from left to right

8.4.5 Total Cost

Total cost is the sum of total fixed cost and total variable cost.
Thus, to obtain the firm’s total cost at a given output, we have only to add its
total fixed cost and its total variable cost at that output. The result is shown in
Table 8.3 and the total cost function is shown in Fig. 8.3. Since the total cost
function and the total variable cost function differ by only the amount of total
fixed cost which is constant, they have the same shape.

Fig. 8.3: Total Cost curve is obtained by adding the total fixed cost to total variable cost

176
In Fig. 8.4, all the three cost functions discussed above (total fixed cost The Cost of
function, total variable cost function and total cost function) have been shown Production
together. Cost functions, when depicted graphically, are often called cost
curves.

Fig. 8.4 : Total Fixed Cost, Total Variable Cost and Total Cost

In Fig. 8.4, TFC is the total fixed cost curve. Since it is parallel to X-axis, it
indicates that whatever be the level of output the total fixed cost remains the
same (i.e., it does not change in response to a change in the level of
production). TC is total cost curve. It indicates the sum of total fixed cost and
total variable cost for the various output levels. If the level of production is to
be raised, the use of variable inputs will have to be increased and this will push
up the costs. The rising total cost curve TC from left to right (the positive slope
of TC curve) indicates this fact. The vertical distance between the total cost
curve TC and the total fixed cost curve TFC indicates total variable cost. For
example, if the firm wishes to produce OQ units of output, the total variable
cost will be GQ – MQ = GM and if the level of output is OR, the total variable
cost will be HR – NR = HN. The total variable cost has been depicted by the
curve TVC in Fig. 8.4. This is parallel to the total cost curve TC and the
vertical distance between the two curves (TC and TVC) indicates total fixed
cost.
Check Your Progress 2
1) Indicate the following statements as true (T) or false (F):
i) Cost function explains the relationship between product and costs
( )
ii) In the long run all factors are variable ( )
iii) Fixed cost is also known as supplementary cost ( )
iv) Total variable cost is the total expenditure by the firm for fixed
input ( )
2) Define and distinguish between long run cost function and short run cost
function.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
177
Production 3) Distinguish between fixed cost and variable cost.
and Costs
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Define total fixed cost and total variable cost and trace the nature of the
total cost curve.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

8.5 SHORT-RUN COST CURVES

To find out the per unit profit, the firm has to compare the per unit cost (or
average cost) with per unit price. Therefore, it is necessary for us to understand
the concepts of average fixed cost, average variable cost and average total cost.

8.5.1 Average Fixed Cost

Generally, all those firms whose total costs of production include a significant
proportion of fixed costs try to increase the level of production to such an
extent that per unit fixed cost which is often known as average fixed cost, is
reduced substantially. To find out the average fixed cost, total fixed cost has to
be divided by the output.
In the form of a formula,

AFC =

where, AFC is the average fixed cost

TFC is the total fixed cost
Q is the output
Table 8.4: Average Fixed Cost, Average Variable Cost and Average Total
Cost of the Firm

Output Average Fixed Average Variable Average Total

(Units) Cost Cost Cost
TFC ÷ Q TVC ÷ Q TC ÷ Q
1 240 ÷ 1=240 120 ÷ 1=120 360 ÷ 1=360
2 240 ÷ 2=120 160 ÷ 2=80 400 ÷ 2=200
3 240 ÷ 3=80 180 ÷ 3=60 420 ÷ 3=140
4 240 ÷ 4=60 212 ÷ 4=53 452 ÷ 4=113
5 240 ÷ 5=48 280 ÷ 5=56 520 ÷ 5=104
6 240 ÷ 6=40 420 ÷ 6=70 660 ÷ 6=110

178
A mere look at Table 8.4 will show how the average fixed cost declines with a The Cost of
rise in the level of output. When the firm produces only 1 unit, average fixed Production
cost is Rs. 240. As the ouput is expanded, there is a sharp decline in average
fixed cost and it is as low as Rs. 40 when 6 units of the commodity are
produced.

Fig. 8.5: Average Fixed Cost curve is a rectangular hyperbole

The fact that average fixed cost must decline with increases in output can be
easily understood with the help of average fixed cost curve in Fig. 8.5. In this
figure, when output is 1 unit, the average fixed cost is Rs. 240. When the
output is increased to 3 units and then to 6 units, average fixed cost declines
first to Rs. 80 and then to Rs. 40.
The average fixed cost curve (AFC) is a rectangular hyperbole because
multiplication of average fixed cost with the quantity of output produced
always yields a fixed value (the area under the curve is always same and
is equal to the total fixed cost).

8.5.2 Average Variable Cost

To obtain the average variable cost, we divide the total variable cost by the
output. In the form of formula:

AVC=

where, AVC = the average variable cost

TVC = the total variable cost
and Q = the output.

In fact, the average variable cost curve (AVC) gives us the same
information in money terms that we obtain from the average product
curve of the variable factor in physical terms.

With an increase in the amount of variable factor, the efficiency in production

increases (resulting in an increase in average product) and the average variable
179
Production cost declines. If average productivity remains constant, average variable cost
and Costs will also remain constant. If it declines, average variable cost increases.

Thus, average variable cost curve is the reciprocal of the average

variable (factor) product curve.

After having understood the relationship between average variable factor

productivity and average cost, it is easy to understand the nature of the AVC
curve. While discussing the laws of production, we had stated that if other
factors are kept constant and only the quantity of one factor is increased, then
initially the tendency of increasing returns is observed. Later on, it is followed
by constant returns and diminishing returns in that order. This means that in the
initial stages, average variable cost declines and, after reaching a minimum
point, starts increasing. This increase is due to the operation of the law of
diminishing returns. From Table 8.4 we learn that at the output level of 1 unit
the firm’s average variable cost is Rs. 120. It declines when output is increased
and is Rs. 53 when 4 units of the commodity are produced. Thereafter, it
increases and is Rs. 70 when output level is raised to 6 units. The average
variable cost curve is thus U-shaped as in Fig. 8.6.

Fig. 8.6: Average variable cost curve is a U-shaped curve

8.5.3 Average Total Cost
The average total cost is also known as average cost. To find out average cost,
we divide total cost (which is the sum of total fixed cost and total variable cost)
by the output. In the form of a formula:
AC or ATC= = +
The modern economists are generally agreed that in all areas of economic
activity, average total cost declines initially. The reasons are the same which
lead to increasing returns in the initial stages. Average cost declines initially
because some of the resources are indivisible and there are possibilities of
specialisation in the production process. As long as the indivisible factors are
not fully utilised, the average total cost falls and when expansion in output
leads to a stage where the indivisible resources are fully utilised, an optimum
proportion is established between the factors of production. Output obtained at
this point is the optimum output. Here, the average total cost is minimum. If
the output is expanded beyond this point (which denotes an optimum
combination of resources) by increasing the amount of variable inputs, then
180 total production increases at a diminishing rate. This leads to a rise in average
total cost. This shows why the average total cost curve is U-shaped as shown in The Cost of
Fig. 8.7. The illustration given in Table 8.4 also makes this point abundantly Production
clear.

Fig. 8.7: Average Total Cost curve is obtained by dividing total cost by the output

We can understand the shape of average total cost curve ATC better with the
help of average variable cost curve AVC and average fixed cost curve AFC
drawn in Fig. 8.8. Since the ATC curve is obtained by vertically summing up
the AVC and AFC curves, when both AVC and AFC curves slope downward,
the ATC curve also slopes downwards. The point R on the AVC curve shows
the minimum average variable cost. After this point, the average variable cost
starts increasing and thus the AVC curve is sloping upward. However, the fall
in the average fixed cost more than compensates for the rise in average variable
cost. Hence, the ATC curve slopes downward. Since at point T on the AVC
curve the rate of increase of the average variable cost is the same as the rate at
which the average fixed cost falls corresponding to this level of output, average
total cost is minimum at this output level. As the level of output increases
beyond this point, the average variable cost rises far more rapidly than the rate
at which average fixed cost falls. Therefore, the ATC curve slopes upward.

Fig. 8.8: Average total cost is the vertical sum of AFC and AVC

8.5.4 Marginal Cost

The marginal cost is the increase in the total cost owing to a small increase in
output.
181
Production In symbols,
and Costs
MC = or

where, MC is marginal cost

∆TC is change in total cost associated with a small change in output
∆TVC is change in total variable cost associated with a small change in
output
∆Q is small change in output
The concept of marginal cost can be understood with the help of an example.
In Table 8.5, the total cost of producing 2 units of output is Rs. 400 and the
total cost of producing 2 + l or 3 units of output is Rs. 420. Therefore, marginal
cost is Rs. 20 which is Rs. 420 – Rs. 400.

Table 8.5: Calculation of Marginal Cost

Output Total Cost Total Variable Marginal Cost

Units (Rs. ) Cost ( Rs.)
(Rs. )

0 240 0 -
1 360 120 120
2 400 160 40
3 420 180 20
4 452 212 32
5 520 280 68
6 660 420 140

Since fixed cost remains unchanged in the short run, marginal cost can also be
defined as the increase in total variable cost consequent upon a small increase
in output. From Table 8.5, we learn that the variable cost of producing 2 units
is Rs. 160 and that of 3 units Rs. 180. The marginal cost, thus, will be
Rs. 180 – Rs. 160 = Rs. 20.
The marginal cost (MC) curve as it would be clear from Fig. 8.9 is U-shaped.
This implies that the marginal cost curve MC first slopes downward and then at
the point where marginal cost is minimum, it starts sloping upward because
marginal cost after decreasing with increases in output at low output levels,
increases with further increases in output. The shape of marginal cost curve is
in fact attributable to the law of variable proportions. According to the law of
variable proportions, the marginal product of the variable input rises at low
output levels and then falls with the expansion in output. Hence, the marginal
cost curve will first fall and then rise. There are two important points to
remember about the marginal cost curve:
i) The MC curve reaches its minimum point before the ATC and the AVC
curves reach their minimum points; and
182
ii) When the MC curves rises, it cuts the AVC and the ATC curves at their The Cost of
minimum points. Production

Fig. 8.9 : Marginal Cost Curve is a U-shaped Curve

8.5.5 Relationship between Marginal Cost and Average Cost

There is a close relationship between the marginal cost (MC) curve and the
average total cost (ATC) and average variable cost (AVC) curves. We shall
explain the relationship only between the MC curve and the ATC curve, but
the relationship between the MC curve and the AVC curve can be explained
along the same lines of reasoning.
Fig. 8.10 shows the MC curve together with the ATC curve and the AVC
curve. The relationship between the ATC curve and the MC curve is as
follows:

1) When the MC curve is below the AC curve (which means

marginal cost is less than average cost), the latter falls.
2) When the MC curve is above the AC curve (which means
marginal cost is more than average cost), the latter rises.
3) The MC curve intersects the AC curve at its minimum point.

Fig. 8.10 : MC curve intersects both AVC curve and ATC curve at their minimum points
183
Production The reason for the above stated relationship between the MC curve and the
and Costs ATC curve is simple. So long as the MC curve lies below the ATC curve, it
pulls the latter downwards; when the MC curve rises above the ATC curve, it
pulls the latter upwards. Consequently, marginal cost and average total cost are
equal where the MC curve intersects the ATC curve. Further when output is
small, marginal cost remains lower than average total cost; but when output is
expanded, marginal cost exceeds average total cost. Thus, it is natural that the
MC curve intersects the ATC curve at its minimum point.
Another important feature of the relationship between MC and AC curves is
that MC is affected only by variable costs. Fixed costs do not affect marginal
costs. This can be proved algebraically as follows:
MCN = TCN – TCN-1
= (TFCN + TVCN) – (TFCN-1 + TVCN-1)
Since, TFCN will always be equal to TFCN-1 we can also state as follows:
MCN = TFCN + TVCN – TFCN-1 – TVCN-1
= TVCN – TVCN-1
This proves that MC is affected only by TVC and not by TFC.
Check Your Progress 3
1) Indicate the following statement as true (T) or false (F):
i) Average fixed cost curve is a rectangular hyperbole ( )
ii) Average variable cost curve is the reciprocal of the average variable
factor productivity curve ( )
iii) The average total cost curve has inverted U shape ( )
iv) When the MC curve is below the AC curve, the latter rises ( )
2) What is average cost? What is the nature of the average total cost curve?
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Define and distinguish between average cost and marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) Explain the relation between the average cost and the marginal cost. How
is it possible that the marginal cost continues to rise while average cost
declines?
..................................................................................................................
..................................................................................................................
..................................................................................................................

184
5) The following table gives information on total cost, total fixed cost and The Cost of
total variable cost for a firm for different levels of output: Production

Output 0 1 2 3 4 5 6

TFC (Rs.) 120 120 120 120 120 120 120

TVC Rs.) 0 60 80 90 105 140 210
TC (Rs.) 120 180 200 210 225 260 330

Find (i) AFC (ii) AVC (iii) AC and (iv) MC.

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

8.6 LONG-RUN COST CURVES

In the long-run, all factors are variable. Due to the absence of fixed factors in
the production function, all costs of production are variable in the long-run and
therefore there is no need to distinguish between fixed and variable costs as is
done in the short-run. In the long-run, to increase the level of production, all
factors have to be increased and this results in an expansion of scale.
In the short-run, the production capacity of the firm depends upon the size of
the plant. Generally, there are many options before a firm. According to the
circumstance, it can choose any plant out of the large and small plants
available to it. Let us suppose that a firm has three options and corresponding
to them, the short-run average total cost (SATC) curves are as given in Fig.
8.11. We shall call the smallest plant as A, the medium size plant as B, and the
large size plant as C. The short-run average total cost curves corresponding to
these plants are designated SATCa, SATCb and SATCc.
The firm decides about the size of plant keeping the market considerations in
view. If the demand is small, the firm will use plant A for purposes of
production but in doing so it will have to incur a higher average total cost. If
the firm has to produce OQ2 quantity of output, it has two options open before
it: firstly, it can employ plant A. The optimum level of output that can be
produced with the help of this plant is itself OQ2. Secondly, it can opt for plant
B. If it does so, the capacity of plant B will not be fully utilised nevertheless
per unit cost of production will be lower than the cost of production the firm
will have to incur if it opts for producing OQ2 amount of output with the help
of plant A (even though OQ2 is the optimum level of output that can be
produced on plant A). This is due to the tendency of ‘increasing returns to
scale’. Not that plant C is larger in size than plant B yet, the curve SATCc is
higher than the SATCb curve. If the firm opts for plant C in this case, the
average total cost will increase due to the operation of ‘diminishing returns to
scale’.

185
Production
and Costs

Fig. 8.11 : Long-run average cost curve envelopes short-run average total cost curves

Theoretically speaking, the long-run average cost (LAC) curve touches the
short-run average total cost (SATC) curves on their minimum points.
Geometrically this is possible only under those circumstances when the
tendency of constant returns to scale prevails. It is due to the fact that initially
increasing returns to scale and after some time diminishing returns to scale
prevail in the production process that the LAC curve touches the lowest SATC
curve at its minimum point. In the phase of increasing returns to scale when
average total cost is falling, the LAC curve touches the SATC curves to the left
of the minimum points of the SATC curves and in the phase of diminishing
returns towards the right of minimum points of these curves. In Fig. 8.11, the
curve LAC touches the SATCb curve at its minimum point K, the SATCa curve
towards the left of its minimum point (at L) and the SAT Cc curve towards the
right of its minimum point (at M).

In Economics, we say that the long-run average cost curve (LAC)

‘envelopes’ the short-run average total cost (SATC) curves.

8.6.1 Long Period Economic Efficiency

The behaviour of the firm which seems to be efficient in the short-run may be
found to be inefficient in the long-run. To understand this let us consider Fig.
8.12. Let us suppose that the firm is producing OQ1 quantity of output. If, due
to an increase in demand, the firm wishes to increase output by Q1Q2, plant
cannot be changed in the short-run and only variable factors will be increased.
Thus, the firm will advance on the curve SATC1. As a result, the efficiency of
the variable resources will improve and per unit production cost will decline
from BQ1 to JQ2. In the short-run the level of efficiency cannot improve further
because this is the optimum level of production that can be achieved with the
help of the plant available to the firm. However, in the long-run to produce the
level of output OQ2, the use of plant of such a small size is inefficient. If the
firm uses a plant of a larger size, it will benefit from the increasing returns that
would thus become available. As a result, the per unit cost will fall and come
down to the level KQ2. Though the full capacity of this plant will not be fully
utilised, even then it would be more efficient as compared to the earlier plant.

186
 The Cost of
Production

Fig. 8.12: Explanation of long-run economic efficiency

In a similar way when an expansion in scale leads to diseconomies or

diminishing returns to scale emerge, it will be in the interest of the firm to
reduce the level of production. If the firm is producing the output OQ4 in Fig.
8.12, it will not be a right strategy from the point of view of maximising
profits. The firm can cut down production by Q3 Q4 in the short-run and this
will enable it to reduce the average total cost from DQ4 to MQ3. This will
result in optimum use of the plant. However, in the long-run, this position will
not be satisfactory as the firm can reduce the average cost to the level NQ3 by
reducing the size of the plant. Since NQ3 < MQ3, the position which was
optimum for the firm in the short-run becomes inefficient in the long-run. It is
clear that when the firm uses plant of a relatively small size, it produces output
much larger than is technologically optimum yet the cost remains low because
it becomes possible to reduce the diseconomies of the large plant.

8.6.2 The Long-Run Average Cost Curve

We have explained in detail above that the short-run average total cost curve is
U-shaped. Let us now discuss the shape of long-run average cost curve. There
is general agreement that the long-run average cost falls initially due to
economies of scale. But whether it falls to a certain point and then becomes
constant or rises again, cannot be conclusively said.
In traditional analysis, the long-run average cost (LAC) curve is assumed to be
U-shaped (as in Fig. 8.12). The shape of the long-run average cost curve is
based on the assumption that ultimately the tendency of diminishing returns
operates in the production process. If this belief of the economists is correct
that every producer wishes to maximise profits and conditions of production
are perfectly competitive, then it is true that the LAC curve must ultimately
rise to the right.

187
Production 8.6.3 Long-Run Marginal Cost Curve
and Costs
After having understood the meaning of short-run marginal cost, it is not
difficult to understand what long-run marginal cost is. Long-run marginal cost
designates the change in total cost consequent upon a small change in total
output when the firm has ample time to accomplish the output changes by
making the appropriate adjustments in the quantities of all resources used,
including those that constitute its plant. As can be seen, this definition of long-
run marginal cost is practically the same as the definition of short-run marginal
cost given by us earlier. The only difference between the two is that whereas in
the short-run the existing plant will continue to be used for affecting an
increase in output, in the long-run the plant itself will be changed.
As far as the relationship between the long-run marginal cost curve and long-
run average cost curve is concerned, it is precisely the same as exists between
the short-run marginal cost curve and the short-run average total cost curve.
This would be clear from a mere glance at Fig. 8.13.

Fig. 8.13: Long-run marginal and average cost curves

8.6.4 Relationship between Long-Run Marginal Cost and

Short-Run Marginal Cost
When to produce a certain given level of output, a firm sets up the most
efficient plant, its short-run marginal cost (SMC) becomes equal to its long-run
marginal cost (LMC). Let us explain this with the help of Fig. 8.14. In this
figure, the given quantity of output is OQ1. This output can be produced at
lowest unit cost with the help of plant A. The short-run average cost curve of
the firm when it produces with the help of plant A is given by SAC. Short-run
average cost curves corresponding to other plants have not been drawn in Fig.
8.14. It is clear from the figure that at OQ1 level of output, SMC and LMC are
equal. However, we must see why they should be equal.
188
 The Cost of
Production

Fig. 8.14: Equality of SMC and LMC on use of an optimum size plant

To find out why SMC and LMC must be equal at the level of output OQ1, let
us consider the implications of a small change in the output by a small amount.
For instance, let us take the level of output OQ2. At this output level, short-run
average cost will be greater than long-run average cost (SAC > LAC). In other
words, short-run total cost is greater than long-run total cost (STC > LTC).
When output rises from the level OQ2 to the level OQ1 the short run total cost
becomes equal to the long-run total cost. If the level of output is raised to OQ3
then since SAC is greater than LAC at this output, STC will also be greater
than LTC. In other words, when output level is raised beyond OQ1, we find
that SMC exceeds LMC. Actually as we move from OQ2 to OQ1, we find that
rate of decline in SMC is declining. In fact, beyond OQ1, it stands rising. On
the other hand, LMC keeps falling over the entire range. Therefore, between
OQ1 and OQ3 SAC is rising and LAC is falling.
On practical considerations, the equality of short-run marginal cost and the
long-run marginal cost is very significant for a firm. If the firm has to increase
the level of output only by a very small amount whether it continues to employ
the existing plant and changes only the quantity of the variable resources or
makes a small change in the size of the plant, the results are the same.
Therefore, from the point of view of the firm, both the methods are equally
correct.
Check Your Progress 4
1) Indicate the following statements as True (T) or False (F):
i) There is no need to distinguish between fixed costs and variable
costs in the long-run. ( )
ii) Long-run average cost curve envelopes the short-run average total
cost curves. ( )
iii) Long-run marginal cost curve cuts the long-run average cost curve
from below at the latter’s lowest point. ( )
189
Production 2) Discuss the nature of the long-run average cost curve.
and Costs
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Discuss the concept of long period economic efficiency.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) What is the relationship between long-run marginal cost curve and long-
run average cost curve.
..................................................................................................................
..................................................................................................................
..................................................................................................................
5) Discuss the relationship between long-run marginal cost and short-run
marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................

8.7 LET US SUM UP

In this unit, we start with a discussion of the various concepts of cost like
private cost, social cost, and economic cost and accounting cost. This is
followed by a discussion of short-run and long-run cost functions. We then
proceed to define the distinction between fixed cost and variable cost. We note
that total fixed cost curve is a straight line while the total variable cost curve
and the total cost curve rise upwards to the right. We then turn to a discussion
of short-run cost curves .We note that the nature of the average fixed cost curve
is that of a rectangular hyperbola. When average variable cost curve is added to
the average fixed cost curve, we get the average cost curve. This is followed by
a discussion of the marginal cost and the nature of the marginal cost curve. The
marginal cost curve cuts the average cost curve from below at the latter’s
minimum point.

8.8 REFERENCES
1) Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2010). Chapter 6,
Section 6.1, 6.2, 6.3 and 6.4.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Presss, Fifth Edition, 2010). Chapter 8, Section 8.1, 8.2, 8.3, 8.4 and 8.5.

190
3) A. Kountsoyiannis, Modern Microeconomics (The Macmillion Press The Cost of
Ltd., Second edition, 1982), Chapter 4. Production

4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India

Traveller Bookseller, Sixth edition, 1996). Chapter 8.
5) Ahuja H.L., Advanced Economc Theory (S.Chand & Company Ltd., New
Delhi 2001), Chapter 20 Page 396-439.

8.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (T) ; ii) (T) ; iii) (F) ; iv) (T) ; v) (T) ; vi) (F) .
2) See Sub-section 8.2.2 of Section 8.2.
3) See Sub-section 8.2.1 of Section 8.2.
4) See Sub-section 8.2.4 of Section 8.2.
5) See Sub-section 8.2.5 of Section 8.2.
Check Your Progress 2
1) (T) ; ii) (T) ; iii) (T) ; iv) (F)
2) See Section 8.3
3) See Sub-section 8.4.1 and 8.4.2 of Section 8.4
4) See Sub-section 8.4.3, 8.4.4 and 8.4.5 of Section 8.4
Check Your Progress 3
1) (T) ; ii) (T) ; iii) (F) ; iv) (F)
2) See Sub-section 8.5.3 of Section 8.5
3) See Sub-sections 8.5 .3 and 8.5.4 of Section 8.5
4) See Sub-section 8.5.5 of Section 8.5
∆( )
5) (I )AFC = (ii) AVC = (iii) AC = (iv) MC = ∆

Check Your Progress 4

1) (i) T (ii) T (iii) T
2) See section 8.6
3) See Sub-section 8.6.1 of Section 8.6
4) See Sub-sections 8.6.2 and 8.6.3 of Section 8.6
5) See Sub-section 8.6.4 of Section 8.6

191
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
 BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
 The Cost of
Production

BLOCK 4 MARKET STRUCTURE

193
Production
and Costs
BLOCK 4 MARKET STRUCTURE
Block 4 essentially concentrates on output markets i.e. markets for goods and
services that firms sell and consumers purchase under the different market
structures i.e. perfect competition, various forms of imperfect competition i.e.
monopoly, monopolistic competition and oligopoly. The Block comprises four
units.
Unit 9 on Perfect Competition: Firm and Industry Equilibrium provides
the characteristics of perfectly competitive market and exposes the learners to
equilibrium of Firm and Industry under perfect competition. Unit 10 on
Monopoly: Price and Output Decision deals with pricing and output
decisions and price discrimination under monopoly condition. The concept of
deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run
period, theory of excess capacity, the comparison of the various market forms
have been provided in Unit 11. Price and Output determination under
oligopoly have been covered in Unit 12.

194
UNIT 9 PERFECT COMPETITION:
FIRM AND INDUSTRY
EQUILIBRIUM
Structure
9.0 Objectives
9.1 Introduction
9.2 Perfect Competition: Characteristics of a Perfectly Competitive Market
9.3 The Firm as a Price Taker in Perfectly Competitive Market (PCM)
9.4 The Price-Taking Firm’s Cost Structure
9.5 The Perfectly Competitive Market: Firm in the Short Run and Long Run
9.5.1 Short Run Price and Output
9.5.2 Short Run Abnormal Profit – Market Entry
9.5.3 Short Run Loss
9.5.4 Long Run Price and Output of a PC Firm
9.5.5 Conclusions

9.6 Shut Down Point and Break-Even Output for PCM Firm
9.7 Supply Curve for a PC Firm and for PC Market
9.7.1 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries

9.8 Let Us Sum Up

9.9 References
9.10 Answers or Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After reading this unit, you will be able to :
 identify the characteristics a perfectly competitive market and their
implications;

 explain the concept of firm as a Price Taker in Perfectly Competitive

Market (PCM);

 state the profit-maximisation condition for a perfectly competitive (PC)

firm;

 explain the Equilibrium of a perfectly competitive market or a industry;

 talk about the shut Down Point and Break-Even Output for a PC Firm;

 derive a perfectly competitive firm’s short-run supply curve from the

firm’s profit-maximisation problem;

Dr. S.P. Sharma, Associate Professor in Economics, Shyam Lal College (University of
Delhi), Delhi. 195
Market  construct the short-run market supply curve from the short-run supply
Structure curves of individual firms;

 perform comparative statics analysis of the short-run equilibrium in a

perfectly competitive market; and

 state the conditions for the long-run perfectly competitive equilibrium.

9.1 INTRODUCTION
Market structure refers to arrangements that bring buyers and sellers together.
The market for a product may also refers to the whole region where buyers and
sellers of that product are spread and there is such free competition that one
price for the product prevails in the entire region. Whether a firm can be
regarded as competitive depends on several factors such as the number of firms
in the industry, degree of rivalry, degree of homogeneity of the product,
economies of scale and easiness with which any firm can enter in the market
and exit from it. On the basis of these characteristics, especially in terms of
degree of competition, a market can be classified as a perfectly competitive
market, monopoly, duopoly, oligopoly and monopolistic competition. In this
unit, we aim to explore the features of a perfectly competitive market,
equilibrium of industry and firms under such a market.

9.2 PERFECT COMPETITION:

CHARACTERISTICS OF A PERFECTLY
COMPETITIVE MARKET
A perfectly competitive market exhibits the following characteristics:
1) The industry is fragmented. It consists of large number of buyers and
sellers. Each buyer’s purchases are so small that they have an
imperceptible effect on market price. Each seller’s output is so small in
comparison to the market demand that it does not affect the market price.
In addition, each seller’s input purchases are so small that they have an
negliable impact on input prices.
2) Firms produce homogeneous products. i.e., consumers perceive the
products to be identical or homogeneous no matter who produces them.
Product of Firm A will in no way be differentiated from those of Firm B.
This results in price competition.
3) There is perfect knowledge/information amongst both firms and
consumers: Firms will have total knowledge of any improvement in
technology and manufacturing processes, while consumers will be fully
aware of all firms’ prices.
4) The industry is characterised by equal access to resources. All firms –
those currently in the industry, as well as prospective entrants – have
access to the same technology and inputs. Firms can hire inputs, such as
labour, capital, and materials, as they need them, and they can release
them from their employment when they do not need them.
5) There are no barriers to entry: Nothing hinders firms from entering the
market in order to compete with existing producers. Such barriers could
196 be insurmountably high initial (start-up) costs, lack of access to key
 technology or raw materials, and legal barriers such as not having Perfect Competition:
necessary patent rights. Firm and Industry
Equilibrium
Sometimes, economists distinguish prefect competition from pure competition
and impose the following two more conditions for a market to be perfectly
competitive:
1) Perfect mobility of factors of production between the industries
2) No transport costs involved in a perfectly competitive market.
However, if one closely looks into the characteristics described earlier, one can
easily find that the additional conditions mentioned above are implicit and
therefore for the purpose of convenience and to avoid any confusion, pure and
perfect completions are used as synonyms to each other.
These characteristics have three implications for how perfectly competitive
markets work:
1) The first characteristic – the market is fragmented – implies that sellers
and buyers act as price takers. That is, a firm takes the market price of the
products given when making an output decision and a buyer takes the
market price as given when making purchase decisions. This
characteristic also implies that a firm takes input prices as fixed when
making decisions about input quantities.
2) The second and third characteristics – firms produce homogeneous
products and consumers have perfect information about prices – imply a
law of one price: Transactions between buyers and sellers occur at a
single market price. Because the products of all firms are perceived to be
identical and the prices of all sellers are known, a consumer will purchase
at the lowest price available in the market. No sales can be made at any
higher price. The lowest price demanded by one firm will become the
market price – every firm will have to sell at that price only.
3) The fourth and fifth characteristics imply that the industry is
characterised by free entry. That is, if it is profitable for new firms to
enter the industry, they will eventually do so. Free entry does not mean
that a new firm incurs no cost when it enters the industry, but rather that
it has access to the same technology and inputs that existing firms have.
In the real world it is hard to find examples of industries which fit all the
criteria of ‘perfect knowledge’ and ‘perfect information’. However, some
industries are close to perfectly competitive markets:
 Foreign exchange markets. As currency is all homogeneous and traders
will have access to many different buyers and sellers and buyers also
have choice from which trader to buy the currency. A good information
about relative prices is available to the buyers and thus easy to compare
prices while buying currency.

 Agricultural markets. Normally, there are several farmers selling

identical products in the market which has many buyers. At the market, it
is easy to compare prices. Therefore, agricultural markets often get close
to perfect competition.

197
Market  Internet based markets: The internet has made many markets closer to
Structure perfect competition because the internet has made it very easy to compare
prices, quickly and efficiently (perfect information). Owing to the
relatively low cost of doing business through internet, it has become
easier to enter in the market. For example, selling a good on internet
through a service like Amazon or e-kart etc. is close to perfect
competition. Equal access to the market and availability of full
information about the prices of the products, enable the price of goods to
fall in line with the market price making the firms to earn only normal
profit in the long run.

Check Your Progress 1

1) Describe briefly the characteristics of a perfectly competitive market and
their implications?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Can you imagine in real world the markets akin to a perfectly competitive
market, if yes list them with their similarities?
......................................................................................................................
......................................................................................................................
......................................................................................................................

9.3 THE FIRM AS A PRICE TAKER IN

PERFECTLY COMPETITIVE MARKET (PCM)
The aggregate demand and supply of industry determine the equilibrium price
of the homogeneous product. The firm cannot influence this on its own, and
thus simply accepts that it is facing a fixed price. The demand curve for the
price taker firm is infinitely elastic, since the market can absorb any amount
produced by any one supplier (Fig. 9.1).

Fig. 9.1 : Demand and Revenue for a Perfectly Competitive Market (PCM)
198
In case for the perfectly competitive market firm, the price will be the same. Perfect Competition:
The horizontal demand curve, is also the average revenue (AR) and marginal Firm and Industry
revenue curve (MR), i.e. P = AR = MR. This can be verified as follows: Equilibrium

Total Revenue (TR) = Price × Quantity

TR = P. Q
.
AR = = = P - which is ‘given’
∆ ∆( . ) .∆
MR = = = = P (Price is given for a PCM firm)
∆ ∆ ∆

Supply curve for the firm. To know about the supply curve of the firm, it
would be necessary to look into the profit1 maximising behaviour of the price
taker firm.
Assuming that the firm produces and sells a quantity Q, its economic profit is
= TR(Q) – TC(Q), where TR(Q) is the total revenue derived from selling the
quantity Q and TC(Q) is the total economic cost of producing the quantity Q.
As the firm is a price taker, it perceives that its volume decision has a
negligible impact on market price and its goal is to choose a Q to maximise its
total profit. To illustrate the firm’s problem, suppose that a rose grower
anticipates that the market price for fresh-cut roses will be P = `1.00 per rose.
Table 9.1 shows total revenue, total cost, and profits for various output levels
and Fig. 9.2(a) graphs these numbers.
Table 9.1: Total Revenue, Cost and Profit for a Price Taking Rose
producer Firm

(Units in Thousands and value in `)

Q TR(Q)) TC(Q) Profit
0 0 0 0
60 60 95 35
120 120 140 20
180 180 155 25
240 240 170 70
300 300 210 90
360 360 300 60
420 420 460 40

Fig. 9.2(a) shows that profit is maximised at Q = 300 (i.e., 300,000 roses per
month). It also shows that the graph of total revenue is a straight line with a
slope of 1. Thus, as we increase Q, the firm’s total revenue goes up at a
constant rate equal to the market price, `1.00 which is also equal to MR.

1
A distinction is to be made between economic profit and accounting profit, i.e.
economic profit = sales revenue - economic costs
accounting profit = sales revenue - accounting costs
That is, economic profit is the difference between a firm’s sales revenue and the totality of its
economic costs, including all relevant opportunity costs, for example, reward or return of the
labour put in by the owner of the firm which is treated equivalent to the return expected in his
next best alternative use. Therefore, whenever we discuss profit maximisation, we are talking
about economic profit maximisation. 199
Market Marginal cost (MC), the rate at which cost changes with respect to a change in
Structure output, following usual return to scales, is exhibited as U-shaped curve.
Fig. 9.2 shows that for quantities between Q = 60 and the profit-maximising
quantity Q = 300, producing more roses increases profit. Increasing the
quantity in this range increases total revenue faster than total cost, i.e. MR >
MC or in our case P>MC.
When P > MC, each time the rose producer increases its output by one rose, its
profit goes up by P – MC, the difference between the marginal revenue and the
marginal cost of that extra rose.
Further, for quantities greater than Q = 300, producing fewer roses increases
profit. Decreasing quantity in this range decreases total cost faster than it
decreases total revenue – that is, marginal revenue is less than marginal cost, or
P < MC. When P < MC, each time the producer reduces its output by one rose,
its profit goes up by MC – P, the difference between the marginal cost and the
marginal revenue of that extra rose.
The producer can increase its profit when either P > MC or P < MC, quantities
at which these inequalities hold cannot maximise its profit. It must be the case,
then, that at the profit-maximising output, P = MC, i.e. a price-taking firm
maximises its profit when it produces a quantity Q* at which the marginal cost
equals the market price.

Fig. 9.2

Fig. 9.2 (b) however shows that there are two points (Q = 60, and Q = 300) at
which MR = MC. The difference between Q = 60 and Q = 300 is that at Q =
300, the marginal cost curve is rising, while at Q = 60 the marginal cost curve
is falling. The point at which Q = 60 represents the point at which profit is
200
minimised rather than maximised. This shows that there are two profit- Perfect Competition:
maximisation conditions for a price-taking firm: Firm and Industry
Equilibrium
a) P = MC.
b) MC must be increasing.
If either of these conditions does not hold, the firm cannot maximise its profit.
It would be able to increase profit by either increasing or decreasing its output.
Thus the rising part of the MC curve reflects the firm’s supply curve, and
horizontal summation of the entire firms’ supply curve will be the
market’s supply curve which is upward slopping. This concept would be
further elaborated in the later part of this Unit. Any change in market demand
will also shift the demand curve for the firm which would change the MC=MR
point along the MC curve. Fig. 9.3 shows that when market demand increases
from D0 to D1 and decreases to D2, the demand curve (which is also the MR
and AR curve) for the firm shifts upwards or downwards, along the upward-
sloping MC curve. Any change in MR will change the profit maximising
intersection of MC = MR, would accordingly change the supply of the firms,
whose horizontal summation would indicate the market supply curve.

Fig. 9.3: The PCM Firms’ Supply Curve

9.4 THE PRICE-TAKING FIRM’S COST

STRUCTURE
To understand the response of a price-taking firm in the short-run and also in
the long run, we need to explore the cost structure of a typical such firm in the
industry. The firm’s short-run total cost of producing a quantity of output Q is:
STC(Q) = SFC + NSFC + TVC(Q)
This equation identifies three categories of costs for this firm.
 TVC (Q) represents total variable costs. These are output-sensitive costs
— that is, they go up or down as the firm increases or decreases its
output. Total variable costs include materials costs and the costs of
certain kinds of labour (e.g., factory labour). Total variable costs are zero
if the firm produces zero output and thus are examples of non-sunk costs.
If a rose producer, in our example, decides to shut down its rose growing
201
Market operations, it would avoid the need to spend money on fertilizer and
Structure pesticide.

 SFC represents the firm’s sunk fixed costs. A sunk fixed cost is a fixed
cost that a firm cannot avoid if it temporarily suspends operations and
produces zero output. For this reason, sunk fixed costs are often also
called unavoidable costs. For example, suppose that a rose grower has
signed a long-term lease (e.g., for five years) to rent land on which to
grow roses and that the lease prevents it from subletting the land to
anyone else. The lease cost is fixed because it does not vary with the
quantity of roses that the firm produces. It is output insensitive. It is also
sunk because the firm cannot avoid the rental payments, even by
producing zero output.

 NSFC represents the firm’s non-sunk fixed costs. A non-sunk fixed cost
is a fixed cost that must be incurred if the firm is to produce any output,
but it does not have to be incurred if the firm produces no output. Non-
sunk fixed costs, as well as variable costs, are also often called avoidable
costs. For a rose grower, an example of a non-sunk fixed cost would be
the cost of heating the greenhouses. Because greenhouses must be
maintained at a constant temperature whether the firm grows 10 or
10,000 roses within the greenhouses, so the cost of heating the
greenhouses is fixed (i.e., it is insensitive to the number of rose stems
produced). But the heating costs are non-sunk because they can be
avoided if the grower chooses to produce no roses in the greenhouses.
The firm’s total fixed (or output-insensitive) cost, TFC, is thus given by TFC =
NSFC + SFC. If NSFC = 0, there are no fixed costs that are non-sunk. In that
case, TFC = SFC.
Check Your Progress 2
1) Why a firm is always a price taker in a perfectly competitive market?
Give adequate justification for your answer.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Briefly explain the cost structure of a PC firm and its relevance in
determining the price and output of such a firm?
......................................................................................................................
......................................................................................................................
......................................................................................................................

9.5 THE PERFECTLY COMPETITIVE MARKET:

FIRM IN THE SHORT RUN AND LONG RUN
9.5.1 Short Run Price and Output
The perfectly competitive market firm (‘PCM firm’ henceforth) is basically left
with two decisions in the short run to maximise the profit; whether to produce
202 and how much to produce. It is pertinent to note that profit maximisation
output choice also implies cost-minimising input choices, or in short, profit Perfect Competition:
maximisation implies cost minimisation. Assuming that the firm has decided Firm and Industry
to produce, regarding the second decision, in line with our assumption of profit Equilibrium
maximisation, the PC firm will set output at the point where MC equals MR.
Being a price-taker, the price is set by market forces (supply and demand) and
the firm will have three possible outcomes in the short run, as shown in Fig.
9.4 below:

Fig. 9.4: Short run possibilities of a PCM firm

Given that profit is π = TR(Q) – TC(Q), which in the unit-cost picture

corresponds to AR – AC, Fig. 9.4 shows three possibilities:
 Normal profit: When the market price equals the AC of the PC firm, the
firm will be at break-even, i.e. it will enjoy normal profits. This is shown
in the first diagram of Fig 9.4 as the MR = MC point coincides with
average costs. As AR = AC there is a normal profit.

 Abnormal/supernormal profit: The middle diagram illustrates a situation

where the market price (and thus the MR, AR curve) is above the average
cost. The firm sets output at Qπ-max and earns an abnormal profit.

 Loss: Finally, when the price is below any point on the AC-curve, the
firm will operate at a loss, as profit maximising output (Qπ -max – which is
the same as the loss minimising level of output; Qloss-min in the diagram)
results in an AR below AC.
A firm in a perfectly competitive environment can only enjoy abnormal profits
in the short run. The same holds for losses, which makes intuitive sense as no
firm will be willing/able to uphold long term losses. The market mechanism
together with the assumptions will act to create long run equilibrium where the
PC firm will earn normal profits only.

9.5.2 Short Run Abnormal Profit – Market Entry

The firm depicted in the Fig. 9.5 on the left has an AC curve where the ACmin
point is below the market price, P0. The firm sets output at the profit
maximisation point of MC = MR and thus has an average revenue which is
above average cost. This is the abnormal profit per unit, shown by the double-
edged arrow, and these times the quantity shows the total abnormal profit for
the PC firm.
203
Market
Structure

Fig. 9.5: Short run profit in a perfectly competitive market

What then happens, keeping in mind the assumptions of free market entry and
perfect knowledge/information, is that new firms will be attracted and of
course enter the market. This increases supply from S0 to S1 causing the price
to fall from P0 to P1. Falling market price will lower AR for the single PC firm,
creating a long run equilibrium where once again AR = AC. The firm’s short
run profit is thus eroded in the long run by market entry.

9.5.3 Short Run Loss

Assume that firms which have been attracted to the market in the situation of
abnormal profit, increased market output to the extent where the increase in
supply lowered the market price to a level where individual firms made losses.
This is the situation shown in Fig. 9.6 for a loss-making firm. At a market price
of P0, the firm’s AR is below AC. The firm will still produce at MC = MR
(‘loss-minimising’ point in this case) and will run at a loss, shown by the
double-sided arrow. Total loss is the rectangle. As firms begin to exit the
market over time – switching to more attractive producer substitutes – the
market supply curve will shift to the left.

Fig. 9.6: Short Run Loss in a PCM Firm

In the LR, some firms will exit the market and market supply will decrease –
shown by the shift from S0 to S1 in the market diagram on the right. As the
market price rises, the firm’s AR rises and when AR = AC once again, there is
LR equilibrium and every firms makes normal profits. What the firms can do
in the short run? As a PC firm is a price taker, not much can be done to
influence the AR side of the coin, so firms are focused on lowering costs. A
firm running at a loss will have to find ways to become more efficient (i.e.
lower MC) and/or decrease costs in general. One of the most common methods
204
used to decrease costs is to decrease the amount of labour used in production Perfect Competition:
and to try to use remaining labour more efficiently. Firm and Industry
Equilibrium
9.5.4 Long Run Price and Output of a PC Firm
A long-run PC firm’s equilibrium occurs at a price at which supply equals
demand and firms have no incentive to enter or exit the industry. More
specifically, a long-run PC equilibrium firm is characterised by a market price
P*, a number of identical firms’ n*, and a quantity of output Q* per firm that
satisfies three conditions:
a) Each firm maximises its long-run profit with respect to output and plant
size. Given the price P*, each active firm chooses a level of output that
maximises its profit and selects a plant size that minimises the cost of
producing that output. This condition implies that a firm’s long-run
marginal cost equals the market price, or P* = MC (Q*).
b) Each firm’s economic profit is zero. Given the price P*, a prospective
entrant cannot earn positive economic profit by entering this industry.
Moreover, an active firm cannot earn negative economic profit by
participating in this industry. This condition implies that a firm’s long-
run average cost equals the market price, or P* = AC(Q*).
c) Market demand equals market supply. At the price P*, market demand
equals market supply, given the number of firms n* and individual firm
supply decisions Q*. This implies that D(P*) = n*Q*, or equivalently, n*
= D(P*)/Q*.

Fig. 9.7: Long-Run Equilibrium in a Perfectly Competitive Market

Fig. 9.7 shows these conditions graphically. Because the equilibrium price
simultaneously equals long-run marginal cost and long-run average cost, each
firm produces at the bottom of its long-run average cost curve.
9.5.5 Conclusions
The PCM firm’s behaviour in determining its output in the short and long run
leads to make the following conclusions:

205
Market a) The PC firm can make abnormal profits in the short run, but will make a
Structure normal profit in the long run as lack of entry barriers allows new firms to
enter the market and increase supply and lower the market price.
b) The firm cannot run at a loss in the long run either since some firms will
leave the market and supply will converge to a long run equilibrium
which allows the (surviving) firms a normal profit once again.
c) The LR equilibrium level of output is thus: P = ACmin = MC = AR = MR.
Check Your Progress 3
1) State whether following statements are true or false:
a) A competitive firm in the long run will produce output up to the
point where price equals average variable cost.
b) A firm’s shutdown point comes where price is less than minimum
average cost.
c) A firm’s supply curve depends only on its marginal cost. Any other
cost concept is irrelevant for supply decisions.
d) The P = MC rule for competitive industries holds for upward-
sloping, horizontal, and downward-sloping MC curves.
e) The competitive firm sets price equal to marginal cost.
.............................................................................................................
.............................................................................................................
.............................................................................................................
2) Interpret this dialogue:
A: “How can competitive profits be zero in the long run? Who will
work for nothing?”
B: “It is only excess profits that are wiped out by competition.
Managers get paid for their work; owners get a normal return on
capital in competitive long-run equilibrium – no more, no less.”
.............................................................................................................
.............................................................................................................
.............................................................................................................
3) A firm is operating at a loss. Explain why the firm might stay rather than
exit the market.
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) Why can a PC firm only make a normal profit in the long run according
to our model?
......................................................................................................................
......................................................................................................................
206 ......................................................................................................................
 Perfect Competition:
9.6 SHUT DOWN POINT AND BREAK-EVEN Firm and Industry
OUTPUT FOR PC FIRM Equilibrium

When a firm is earning normal profit, output is at the point where AR = AC,
this is the break-even point of output. The shut-down point, the point at which
firm is likely to leave the market, is the output level where it is equally costly
for the firm to continue producing as it is for the firm to leave the market. If the
firm can cover all of the variable costs and at least some of the fixed costs (i.e.
non-sunk fixed costs as defined above) then it has an incentive to remain on the
market. If the price falls below the AVC then the firm will not cover even the
variable costs – and leave the market. Hence, the point where the firm must
decide whether to remain on the market or leave is when AR = AVC. This is
the shut-down point.
It will be easier to understand these critical issues clearly in a figure using the
actual numbers rather than points A, B, and C etc. Fig. 9.8 attempts to explain
these points. Assume that the original demand on the market gives a market
price of `10, which are the PCM firm’s MR and AR. This is the long run
equilibrium and also the break-even point, as the firm covers all its costs –
even opportunity costs – earning it a normal profit. Assume that for some
reason (either increasing supply or decreasing demand) the market price starts
to fall and subsequently the firm’s AR, MR, D-curve falls to a price level of `6.
Being a profit maximiser, the firm sets output where MC = MR, which is now
at 80 units rather than 100. At this output level the firm cannot cover all its
costs; ATC at an output of 80 is `11. The firm loses `5 on each unit produced,
giving an overall loss of `400 (`5 × 80 units).

Fig. 9.8: Shut Down and Break-even Price for a PCM Firm

Why doesn’t the firm leave the market at a price level of `6? Consider the
choices facing the firm:
a) Stay in the business and make a loss of `400
b) Leave the business and make a loss of `560, which is the total fixed cost
(see TFC calculation in Fig. 9.7), i.e. TFC = (ATC – AVC) × Q. At an
output of 70, we get (`12 – `4) × 70 = `560.

207
Market This is not much of a choice, rather a lack of options. The firm will have a
Structure strong incentive to stay in the market during the short run, hoping perhaps that
either market price will increase or that increased efficiency and/or cost-cutting
can lower MC and AC to a normal profit level again.
If, however, the market price falls even further, to `4, then the options become:
a) Stay in the business and make a loss of `560
b) Leave the business and make a loss of `560
The firm’s TR (`4 × 70 = `280) will be identical to the TVC, which means that
there is no contribution towards covering the fixed costs. The firm is making a
loss of `560 by staying in the business and would make the same loss by
leaving it. The point where P (AR) = AVC is therefore the shut-down point for
the firm. The firm will not produce at a lower price level – just consider the
options at a price of `2. The firm’s TR would be `120 (`2 × 60) and TC would
be `720 (`12 × 60) leading to a loss of `600. The reason is that at a price (e.g.
AR) of `2 the firm would not even be covering all its variable costs so total
costs would be greater than total fixed costs alone. At any price below AVC
the firm will leave the market.
Therefore the important consideration for a PC firm will be: as long as the
firm has an AR above AVC, the firm covers variable costs and at least some of
the fixed costs (i.e. non-sunk fixed costs) – therefore there is an incentive to
stay in the business in the short run. The shut-down point is when P (AR) =
AVC

9.7 SUPPLY CURVE FOR A PC FIRM AND FOR

PC MARKET
The important decision points for a PC firm to stay in the business or leave the
market, as derived above, requires revisiting the concept of supply curve of
both a PC firm as well as of a perfectly competitive market. The significant
modifications to be noted for the supply curve of a PC firm in short and long
run are given below:
a) The PC firm’s supply curve in the short run is thus the portion of the
MC curve which is above the AVC curve.
b) The long run supply would be the portion of the MC curve above ATC
as no firm could withstand indefinite losses and would ultimately have to
leave the market if it did not cover all costs.
Building on the proposition that firms will supply at any possible level above
the average variable cost curve in the short run, the market supply can be
derived from this. Fig. 9.9 assumes a market of three firms (it could however
be any number), having different marginal and average costs. As the portion of
the MC-curve above AVC is relevant, summing the individual firms’ output at
various prices yields the short run industry/market supply curve; 5,000 units
per month at a price of `5 up to 25,000 units per month at a price of `12.

208
 Perfect Competition:
Firm and Industry
Equilibrium

Fig. 9.9: Supply Curve for PCM FIrms and Markets (∑MCPCM firm = Market Supply)

The concept of increasing marginal costs coupled to the profit maximisation

condition of MC = MR renders each individual firm’s supply curve, and their
horizontal aggregation is the market supply curve.

9.7.1 Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries
As the market supply curve is derived from PC firms supply curves, it implies
that when firms’ marginal costs are affected by technology, production
improvements, lower costs of labour and raw material etc., the total market
supply will also change accordingly.
Theoretically, we may have three situations:
First, when changes in industry output have no effect on input prices, we have
a constant-cost industry. In such a case, after all adjustment to a change in
demand have taken place, the market price must have returned to the lowest
point on the LRAC curve, which is exactly where it was before. So in this
case, the LR supply curve must be horizontal (instead of upward-sloping as in
the picture above). We call this a constant-cost industry. This is most likely to
be the case when the industry in question uses only a small portion of inputs,
available in the market and usable by all the industries.
Second, if the industry in question has a large impact on the markets for its
inputs, then the LR supply curve may slope upward or downward. If the effect
of entry into the industry is to bid up the price of inputs, so that a firm’s cost
curves rise as a result of the entry of new firms, then the market price after
adjustment will be higher than it was before. In this case, the LR supply curve
must be upward-sloping as in the picture above; this is called an increasing-
cost industry, which results from external diseconomies.
Third, on the other hand, if entry into the industry creates a greater demand for
inputs that allows those inputs to be produced through mass production
techniques (i.e., at lower average cost), then the industry can benefit from
lower costs of production. In this case, the LR supply curve is downward-
sloping. This is called a decreasing-cost industry, which results from external
economies.

209
Market Check Your Progress 4
Structure
1) Explain why the sum of individual firms’ MC curves is the market
supply curve.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What is the shutdown price when all fixed costs are sunk? What is the
shutdown price when all fixed costs are non-sunk?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Would a perfectly competitive firm produce if price were less than the
minimum level of average variable cost?
......................................................................................................................
......................................................................................................................
......................................................................................................................

9.8 LET US SUM UP

We have studied in this unit how price-taking firms adjust their production
decisions in the light of the market price and how the market price is
determined. Since a PC firm is a price taker, in order to earn normal profit even
in the long run, they need to adopt the strategies concentrating on enhancing
their productivities so that they supply more output at given price with reduced
average and marginal costs. The salient features of a perfectly competitive
market are summarised below:
Supply Behaviour of the Competitive Firm
 A perfectly competitive firm sells a homogeneous product and is too
small to affect the market price. To maximise profits, the competitive
firm will choose that output level at which price equals the marginal
cost of production, that is, P = MC.
 Variable costs need to be taken into consideration in determining a firm’s
short-run shutdown point. Below the shutdown point, the firm loses more
than its fixed costs. It will therefore produce nothing when price falls
below the shutdown price.
 In the long run, PC firm will stay in business only if price is at least as
high as long-run average costs including some non-sunk fixed costs.
Supply Behaviour of Competitive Industries
 Each firm’s rising MC curve is its supply curve; the horizontal
summation of all firms in the industry will provide the supply curve of
the industry.

210
 Because firms can adjust production over time, we distinguish two Perfect Competition:
different time periods: (a) short-run equilibrium, when variable factors Firm and Industry
like labour can change but fixed factors like capital and the number of Equilibrium
firms cannot, and (b) long-run equilibrium, when the numbers of firms
and plants, and all other conditions, adjust completely to the new
demand conditions.
 In the long run, when firms are free to enter and leave the industry and no
one firm has any particular advantage of skill or location, competition
will eliminate any excess profits earned by existing firms in the industry.
So, just as free exit implies that price cannot fall below the zero-profit
point; free entry implies that price cannot exceed long-run average cost in
long-run equilibrium.
 When an industry can expand its production without pushing up the
prices of its factors of production, the resulting long-run supply curve
will be horizontal. When an industry uses factors specific and scarce
factors, its long-run supply curve will slope upward, e.g. important
special cases include relatively or completely inelastic supply which
produces economic rent shared between the firm and that factor of
production.
Disadvantages of Perfect Competition Generally Mentioned
 No scope for economies of Scale, this is because there are many small
firms producing relatively small amounts.
 Industries with high fixed costs would be particularly unsuitable to
perfect competition. This is one reason why existence of such a market is
highly unlikely in the real world.
 Undifferentiated products lead to a monotonous situation for the
consumers as little choice available to them. Differentiated products are
very important in industries in FMCGs.
 Lack of supernormal profit may make investment in R&D unlikely. This
would be important in an industry such as pharmaceuticals which require
significant investment.
 With perfect knowledge there is no incentive to develop new technology
because it would be shared with other companies.
Notwithstanding these facts, perfect competition is worth studying for two
reasons. First, a number of important real-world markets consist of many small
firms, each producing nearly identical products, each with approximately equal
access to the resources needed to participate in the industry. The theory of
perfect competition developed in this unit will help us to understand the
determination of prices and the dynamics of entry and exit in these markets.
Second, the theory of perfect competition forms an important foundation for
understanding theory of price determination as many of the key concepts such
as the vital roles of marginal revenue and marginal cost in output decisions will
apply when we study other market structures such as monopoly, duopoly,
monopolistic and oligopolistic competitive markets

211
Market
Structure
9.9 REFERENCES
1) Koutsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan, p. 67-103
2) Sanjay Rode, (2013), Modern Microeconomics, First Edition,
bookboon.com, First Edition, 2008, bookboon.com,
3) KristerAhlersten, (2008) Essentials of Microeconomics, First Edition,
bookboon.com, p. 76-87
4) David A. Besanko, Ronald R. Braeutigam and Michael J. Gibbs,
Microeconomics, 4th Edition, John Wiley and Sons, p. 327-376
5) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society, p. 201-259

9.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 9.2 and answer
Check Your Progress 2
1) Read Section 9.3 and answer
2) Read Section 9.4 and answer
Check Your Progress 3
1) a) False b) False c) False d) False e) False
3) Read Section 9.5, sub-sections 9.5.1 to 9.5.5 and answer
4) Read Section 9.5.4 and answer
Check Your Progress 4
1) Read Section 9.7 and answer
2) Read Section 9.6 and answer
3) No

212
UNIT 10 MONOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
10.0 Objectives
10.1 Introduction
10.1.1 Meaning of Monopoly
10.1.2 Some Definitions
10.1.3 Characteristics of Monopoly
10.1.4 Causes of Monopoly

10.2 Demand and Revenue Curves under Monopoly

10.2.1 Relationship between AR, MR, and Price Elasticity under Monopoly

10.3 Equilibrium of the Monopoly Firm: Price and Output Decision

10.3.1 Total Revenue and Total Cost Approach
10.3.2 Marginal Revenue and Marginal Cost Approach
10.3.3 Long Run Equilibrium under Monopoly

10.4 Comparison of Monopoly with Perfect Competition

10.5 Efficiency and Deadweight Loss under Monopoly
10.6 Price Discrimination under Monopoly: Types and Degrees
10.6.1 Types of Price Discrimination
10.6.2 Degrees of Price Discrimination

10.7 Pricing in Public Monopoly

10.7.1 Marginal Cost Pricing
10.7.2 Average Cost Pricing
10.7.3 Mark-up Pricing

10.8 Let Us Sum Up

10.9 References
10.10 Answers or Hints to Check Your Progress Exercises

10.0 OBJECTIVES
We have learned in Unit 9 that there are different forms of market. Broadly
speaking market can either be perfectly competitive or imperfectly
competitive. In Unit 9 we have already discussed price and output decisions of
a firm and industry under perfectly competitive market. There are various
forms of market under imperfect competition. These include monopoly,
oligopoly, and monopolistic competition. Some of them are extreme forms. In
this unit we will discuss an extreme form of market, that is monopoly, where,
there is only one seller.
After going through this unit, you will be able to:
 state the meaning, causes and characteristics of monopoly;
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 213
Market  explain pricing and output decision under monopoly;
Structure
 discuss the concept of deadweight loss under monopoly;

 explain price discrimination under monopoly; and

 illustrate pricing in a public monopoly.

10.1 INTRODUCTION
10.1.1 Meaning of Monopoly
The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control. In this
way, monopoly refers to a market situation in which there is only one seller of
a commodity.
There are no close substitutes for the commodity that monopoly firm produces
and there are barriers to entry. The single producer may be in the form of
individual owner or a simple partnership or a joint stock company. In other
words, under monopoly there is no difference between firm and industry.
Monopolist has full control over the supply of commodity. Having control over
the supply of the commodity, it exercises the market power to set the price.
Thus, as a single seller/producer monopolist may be a king without a crown. If
there is to be an effective monopoly, the cross elasticity of demand between the
product of the monopolist and the product of any other seller must be very
small.

10.1.2 Definitions
“Pure monopoly is represented by a market situation in which there is a single
seller of a product for which there are no substitutes; this single seller is
unaffected by and does not affect the prices and outputs of other products sold
in the economy.” -Bilas
“Monopoly is a market situation in which there is a single seller. There are no
close substitutes of the commodity it produces, and there are barriers to entry”.
-Koutsoyiannis
“Under pure monopoly there is a single seller in the market. The monopolist’s
demand is market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation”. -A. J. Braff
“A pure monopoly exists when there is only one producer in the market. There
are no dire competitors.” -Ferguson

10.1.3 Characteristics of Monopoly

1) Single Seller: There is only one seller; he can control supply of his
product. But he cannot control demand for the product, as there are
many buyers.
2) No close Substitutes: There are no close substitutes for the product.
Either they have to buy the product or go without it.
3) Control over price: The monopolist has control over the supply and
thereby on price. Sometimes he may adopt price discrimination. He may
214
 fix different prices for different sets of consumers. A monopolist can Monopoly: Price
either fix the price or quantity of output; but he cannot do both, at the and Output
same time. Decisions

4) No Entry: There is no freedom to other producers to enter the market as

the monopolist is enjoying monopoly power. Barriers for new firms to
enter are strong. There are legal, technological, economic and natural
obstacles, which may block the entry of new producers.
5) No difference between Firm and Industry: Under monopoly, there is
no difference between a firm and an industry. As there is only one firm,
that single firm constitutes the whole industry.
10.1.4 Causes of Monopoly
1) Natural: A monopoly may arise on account of some natural
causes. Some minerals are available only in certain regions. For example,
South Africa has the monopoly of diamonds; nickel in the world is
mostly available in Canada and oil in Middle East. This monopoly is
caused by natural availability of resources.
2) Technical: Monopoly power may be enjoyed due to technical reasons. A
firm may have control over raw materials, technical knowledge, special
know-how, scientific secrets and formula that enable a monopolist to
produce a commodity, e.g., Coco Cola.
3) Legal: Monopoly power is achieved through patent rights, copyrights and
trade marks by the producers. This is called legal monopoly.
4) Large Amount of Capital: The manufacture of some goods requires a
large amount of capital or lumpiness of capital. All firms cannot enter the
field because they cannot afford to invest such a large amount of capital.
This may give rise to monopoly. For example, iron and steel industry,
railways, etc.
5) State: Government will have the sole right of producing and selling some
goods. They are State monopolies. For example, in India we have public
utilities like electricity, railways, water supply. These public utilities are
generally run by the State.

10.2 DEMAND AND REVENUE CURVES UNDER

MONOPOLY
It is important to understand the nature of the demand curve facing a
monopolist. The demand curve facing an industrial firm under perfect
competition, is a horizontal straight line, but the demand curve facing the
whole industry under perfect competition is sloping downward.
This is so because the demand is made by all the consumers and the demand
curve of total consumers for a product usually slopes downward. The
downward-sloping demand curve of the consumers faces the whole
competitive industry. An individual firm under perfect competition does not
face a downward-sloping demand curve. But in the case of monopoly one firm
constitutes the whole industry. Therefore, the entire demand of the consumers
for a product faces the monopolist. Since the demand curve of the consumers
for a product slopes downward, the monopolist faces a downward sloping
demand curve.
215
Market A perfectly competitive firm merely adjusts the quantity of output it has to
Structure produce, price being a given and constant datum for him. But the monopolist
encounters a more complicated problem. He cannot merely adjust quantity at a
given price because each quantity change by him will bring about a change in
the price at which the product can be sold.
Consider Fig. 10.1. DD is the demand curve facing a monopolist. At price OP
the quantity demanded is OM, therefore he would be able to sell OM quantity
at price OP. If he wants to sell a greater quantity ON, then he has to price it
OL. If he restricts his quantity to OG, the price will rise to OH.
Thus, every quantity change by him entails a change in price at which the
product can be sold. The problem faced by a monopolist is to choose a price-
quantity combination which is optimum for him, that is, which yields him
maximum possible profits.
Demand curve facing the monopolist will be his average revenue curve. Thus,
the average revenue curve of the monopolist slopes downward throughout its
length. Since average revenue curve slopes downward, marginal revenue curve
will lie below it. This follows from usual average-marginal relationship. The
implication of marginal revenue curve lying below average revenue curve is
that the marginal revenue will be less than the price or average revenue.

Fig. 10.1: Demand Curve of Monopolist slopes downward

Fig. 10.2: Marginal and Average revenue curves under monopoly

216
When monopolist sells more, the price of his product falls; marginal revenue Monopoly: Price
therefore must be less than the price. In Fig. 10.2, AR is the average revenue and Output
curve of the monopolist and slopes downward. MR is the marginal revenue Decisions
curve and lies below AR curve. At quantity OM, average revenue (or price) is
MP and marginal revenue is MQ which is less than MP. The same can be
shown by a numerical example in the Table 10.1 below:
Table 10.1 : Computation of MR for given AR

Price P=AR Quantity (q) TR= P*Q MR= TR/ q

11 0 0 -
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
10.2.1 Relationship between Average Revenue, Marginal
Revenue and Price Elasticity under Monopoly
Average and marginal revenue at a quantity are related to each other through
price elasticity of demand and in this connection, we had derived the following
formula in:
( )
MR = AR , where e stands for price elasticity

Since, AR is the same thing as price

( )
Therefore, MR = price

or price = MR ( )

Since the expression (e–1)/e will be less than unity, MR will be less than price,
or price will be greater than MR. The extent to which MR curve lies below AR
curve depends upon the value of the fraction (e – 1)/e.
The monopolist has a clearly distinguished demand curve for his product,
which is identical with the consumers’ demand curve for the product in
question. It is also worth mentioning that, unlike oligopolist or a firm under
monopolistic competition, monopolist does not consider the repercussions of
the price change by him upon those of other firms.
Monopoly, as defined here, requires that the gap between the monopoly
product and those of other firms is so sharp that change — in the price policies
of the monopolist will not affect other firms and will therefore not evoke any
readjustments of the policies by these firms.
The first thing to understand is that, apart from the special case of constant
elasticity where the demand curve is of the form Q = aP-b, the elasticity will
217
Market vary along different points of the demand curve. This is true even when the
Structure gradient of the demand curve is constant (i.e. the demand curve is linear). This
is a point that sometimes confuses you about elasticity, you think “constant
gradient = constant elasticity”…no it doesn’t.
Here is an example, this is a simple demand function Q = 20 – 0.5P.

Fig. 10.3

We can calculate the elasticity at different points, a, b, c, d and e.

With this demand function, = −0.5, so the elasticity at different points will
be e = × −0.5

So at point a, the elasticity is 36/2 × –0.5 = –9

At point b, the elasticity is 24/8 × –0.5 = –1.5
At point c, the elasticity is 20/10 × –0.5 = –1
At point d, the elasticity is 18/11 × –0.5 = –0.818
At point e, the elasticity is 4/18 × –0.5 = –0.111
Notice that at point c, the midpoint of the curve, the elasticity is –1, this is
where the curve is unit elastic. Above point c, the curve is elastic. It gets more
elastic at higher level of price and lower the quantity. At the point where the
price is 40 and the quantity is 0, the elasticity will be infinity. Below point c,
the curve is inelastic and gets less elastic at lower the price and higher the
quantity. At the point where the price is 0 and the quantity is 20, the elasticity
will be 0.
( )
We can now think of this situation with marginal revenue. MR = and TR
( )
= PQ so MR = .
218
Here the inverse demand function is P = 40 – 2Q so PQ = 40Q – 2Q2 Monopoly: Price
( ) and Output
and = 40 − 4Q. So we can draw the marginal revenue curve MR = 40 –
Decisions
4Q:

Fig. 10.4

Notice how the marginal revenue is positive when the demand curve is
elastic, it is zero when the demand curve is unit elastic and it
becomes negative when the demand curve is inelastic.
This is the answer to the question. Given that the marginal revenue is the
amount of revenue gained by selling an extra unit, nobody is going to sell an
extra unit if the marginal revenue is negative (i.e. they lose money by selling
it).
( )
You can also think of this in an algebraic way. Given that MR = , we can
( )
use the product rule to say =P + Q so MR = P + Q

Now multiply both top and bottom parts of the right hand side of that equation
by P so you get MR = P + PQ . We can factorise the P out of this to
get MR = P 1 + Q which can be rewritten slightly differently as MR =
P 1+ .

The right hand side of that equation is the inverse of the elasticity, , so MR =
P 1 + . This is a useful equation to remember.

Elastic demand is where e< –1 and inelastic demand is where –1 < e < 0. So
now we can think of why a monopolist won't produce in the inelastic part of its
demand curve. When demand is inelastic then –1 < e < 0 so 1 + < 0 . And
219
Market
given that the price, P, is positive, it also follows that P 1 + < 0. So the
Structure
marginal revenue will be negative, and no firm will produce an extra unit if it
means it loses money.

10.3 EQUILIBRIUM OF THE MONOPOLY FIRM:

PRICE AND OUTPUT DECISION
Under monopoly, for the equilibrium and price determination, two different
conditions need to be satisfied:
1) Marginal revenue must be equal to marginal cost.
2) MC must cut MR from below.
However, there are two approaches to determine equilibrium price under
monopoly viz.;
1) Total Revenue and Total Cost Approach.
2) Marginal Revenue and Marginal Cost Approach.

10.3.1 Total Revenue and Total Cost Approach

Monopolist can earn maximum profits when difference between TR and TC is
maximum. By fixing different prices, a monopolist tries to find out the level of
output where the difference between TR and TC is maximum. The level of
output where monopolist earns maximum profits is called the equilibrium
situation. This can be explained with the help of Fig. 10.5.

Fig. 10.5

In Fig. 10.5, TC is the total cost curve. TR is the total revenue curve. TR curve
starts from the origin. It indicates that at zero level of output, TR will also be
zero. TC curve starts from P. It reflects that even if the firm discontinues its
production, it will have to suffer the loss of fixed costs.
Total profits of the firm are represented by TP curve. It starts from point R
showing that initially firm is faced with negative profits. Now as the firm
increases its production, TR also increases. But in the initial stage, the rate of
increase in TR is less than that of TC.
Therefore, RC part of TP curve reflects that firm is incurring losses. At point
M, total revenue is equal to total cost. It shows that firm is working under no
profit, no loss basis. Point M is called the breakeven point. When firm
220
produces more, beyond point M, TR will be more than TC. TP curve also Monopoly: Price
slopes upward. It shows that firm is earning profit. Now as the TP curve and Output
reaches point E then the firm will be earning maximum profits. This amount of Decisions
output will be termed as equilibrium output.

10.3.2 Marginal Revenue and Marginal Cost Approach

According to marginal revenue and marginal cost approach, a monopolist will
be in equilibrium when two conditions are fulfilled i.e., (i) MC = MR and (ii)
MC must cut MR from below. The study of equilibrium price according to this
analysis can be conducted in two time periods.
1) The Short Run
2) The Long Run
1) Short Run Equilibrium under Monopoly
Short period refers to that period in which the monopolist has to work with a
given existing plant. In other words, the monopolist cannot change the fixed
factors like, plant, machinery etc. in the short period. Monopolist can increase
his output by changing the variable factors. In this period, the monopolist can
enjoy super-normal profits, normal profits and sustain losses.
These three possibilities are described as follows:
Super Normal Profits
If the price determined by the monopolist in more than AC, he will get super
normal profits. The monopolist will produce up to the level where MC=MR.
This limit will indicate equilibrium output. In Fig. 10.6 output is measured on
X-axis and price on Y-axis. SAC and SMC are the short run average cost and
marginal cost curves respectively while AR and MR are the average revenue
and marginal revenue curves respectively.

Fig. 10.6
The monopolist is in equilibrium at point E because at point E both the
conditions of equilibrium are fulfilled i.e., MR = MC and MC intersects the
MR curve from below. At this level of equilibrium the monopolist will produce
OQ1 level of output and sells it at CQ1 price which is more than average cost
DQ1 by CD per unit. Therefore, in this case total profits of the monopolist will
be equal to shaded area ABDC.

221
Market Normal Profits
Structure
A monopolist in the short run would enjoy normal profits when average
revenue is just equal to average cost. We know that average cost of production
is inclusive of normal profits. This situation can be illustrated with the help of
Fig 10.7.

Fig. 10.7

In Fig. 10.7 above the firm is in equilibrium at point E. Here marginal cost is
equal to marginal revenue. The firm is producing OM level of output. At OM
level of output average cost curve touches the average revenue curve at point
P. Therefore, at point ‘P’ price MR is equal to average cost of the total product.
In this way, monopoly firm enjoys the normal profits.
Minimum Losses
In the short run, the monopolist may have to incur losses. This situation occurs
if in the short run price falls below the variable cost. In other words, if price
falls due to depression and fall in demand, the monopolist will continue to
produce as long as price covers the average variable cost. Once the price falls
below the average variable cost, monopolist will stop production. Thus, a
monopolist in the short run equilibrium may bear the minimum loss, equal to
fixed costs. Therefore, equilibrium price will be equal to average variable cost.
This situation can also be explained with the help of Fig. 10.8.

Fig. 10.8

In Fig. 10.8 above monopolist is in equilibrium at point E. At point E marginal

cost is equal to marginal revenue and he produces OM level of output. At OM
level of output, equilibrium price fixed by the monopolist is OP1. At OP1 price,
AVC touches the AR curve at point A.
222
It signifies that the firm will cover only average variable cost from the Monopoly: Price
prevailing price. At OP1 price, firm will bear loss of fixed cost i.e., A per unit. and Output
The firm will bear the total loss equal to the shaded area PP1 AN. Now if the Decisions
price falls below OP1, the monopolist will stop production. It is so, because, if
he continues production, he will have to bear the loss of variable costs along
with fixed costs.
Illustration 1: Let the cost of production of monopoly firm be given as : C =40
+ Q2 and demand be P = 20 – Q.
Find the profit maximising level of output and price.
Solution: Since cost is given as:
C = 40 + Q2
∆
MC = ∆ = 2Q

and
Since demand is given as:
P = 20 – Q
Total Revenue = P . Q = (20 – Q) Q = 20 Q – Q2
∆
MR = = 20 − 2Q
∆

and
Profit maximisation occurs where:
MR = MC
20 – 2Q = 2Q
Q=5
Thus profit maximising level of output is 5 units and profit maximising price is
P = 20 – Q = 20 – 5 = 15
Illustration 2. Only one firm produces and sells soccer balls in the country of
Wiknam, and as the story begins, international trade in soccer balls is
prohibited. The following equations describe the monopolist’s demand,
marginal revenue, total cost, and marginal cost:
Demand : P = 10 – Q
Marginal Revenue : MR = 10 – 2Q
Total Cost : TC = 3 + Q + 0.5 Q2
Marginal Cost : MC = 1 + Q
Where Q is quantity and P is the price.
(a) How many units does the monopolist produce? At what price are they
sold? What is the monopolist’s profit?
Solution:
P = 10 – Q
223
Market MR = 10 – 2Q
Structure
TC = 3 + Q + 0.5Q2
MC = 1 + Q
Monopolist will produce where:
MR = MC
10 – 2Q = 1 + Q
3Q = 9
Q=3
Quantity are sold at price given by:
P = 10 – Q
= 10 – 3
∴ P = $7

Monopolist profit (Rupees) is given by:

Profit = TR–TC
= [7 × 3] – [3 + 3 + 0.5 × 33 ]

= 21 – [6 + ] = [21 – ] = 10.5

Profit = $10.5

10.3.3 Long Run Equilibrium under Monopoly

Long-run is the period in which output can be changed by changing the factors
of production. In other words, all variable factors can be changed and
monopolist would choose that plant size which is most appropriate for specific
level of demand. Here, equilibrium would be attained at that level of output
where the long-run marginal cost cuts marginal revenue curve from below.
This can be shown with the help of Fig. 10.9.

Fig. 10.9
224
In Fig. 10.9 above monopolist is in equilibrium at OM level of output. At OM Monopoly: Price
level of output marginal revenue is equal to long run marginal cost and the and Output
monopolist fixes OP price. HM is the long run average cost. Price OP being Decisions
more than LAC i.e., HM which fetch the monopolist super normal profits.
Accordingly, the monopolist earns JM – HM = JH super normal profit per unit.
His total super normal profits will be equal to shaded area PJHP1.
Check Your Progress 1
1) How does the monopolist determine his price and output in the short
period?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Based on market research, a film production company in Mumbai obtains
the following information about the demand and production costs of its
new DVD:
Demand: P = 1,000 – 10Q
Total Revenue TR = P × Q = 1000Q – 10Q2
Marginal Revenue: MR = 1,000 – 20Q
Marginal Cost MC = 100 + 10Q
Where Q indicates the number of copies sold and P is the price in dollars.
Find the price and quantity that maximises the company’s profit.
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.4 COMPARISON OF MONOPOLY WITH

PERFECT COMPETITION
Following points make clear difference between both the monopoly and perfect
competition:
1) Output and Price
Under perfect competition, price is equal to average cost which is equal to
marginal cost at the equilibrium output. Under monopoly, the price is always
greater than marginal cost, it may be less than, equal to or greater than average
cost.
2) Equilibrium
Both under perfect competition and monopoly equilibrium is possible only
when MR = MC and MC cuts the MR curve from below.

225
Market 3) Entry
Structure
Under perfect competition, there exists no restrictions on the entry or exit of
firms into the industry. Under simple monopoly, there are strong barriers on
the entry and exit of firms.
4) Discrimination
Under monopoly, a monopolist can charge different prices from the different
groups of buyers. But, in the perfectly competitive market, it is absent by
definition. We shall discuss the price discriminations by a monopolist in
Sections 10.6 below.
5) Profits
The difference between price and average cost under monopoly results in
super-normal profits to the monopolist. Under perfect competition, a firm in
the long run enjoys only normal profits.
6) Supply Curve of Firm
Under perfect competition, supply curve can be known. It is so because all
firms can sell desired quantity at the prevailing price. Moreover, there is no
price discrimination. Under monopoly, supply curve cannot be known. MC
curve is not the supply curve of the monopolist.
7) Slope of Demand Curve
Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the
industry and each firm has to accept that price. On the other hand, under
monopoly, average revenue curve slopes downward. AR and MR curves are
separate from each other. Price is determined by the monopolist.

Fig. 10.10

8) Goals of Firms
Under perfect competition and monopoly the firm aims at to maximise its
profits. The firm which aims at to maximise its profits is known as rational
firm.
9) Comparison of Price
Monopoly price is higher than perfect competition price. In long period, under
perfect competition, price is equal to average cost. In monopoly, price is higher
as is shown in Fig. 10.11 below. The perfect competition price is OP1, whereas
monopoly price is OP. In equilibrium, monopoly sells ON output at OP price
226 but a perfectly competitive firm sells higher output ON1 at lower price OP1.
 Monopoly: Price
and Output
Decisions

Fig. 10.11

10) Comparison of Output

Perfect competition output is higher than monopoly output. Under perfect
competition the firm is in equilibrium at point M1 where AR = MR = AC = MC
are equal. The equilibrium output is ON1. On the other hand monopoly firm is
in equilibrium at point M where MC=MR. The equilibrium output is ON. The
monopoly output is lower than perfectly competitive firm output.
Summary of Comparison:
A general comparison between monopoly and perfect competition for easy
understanding has been depicted as under:

S. No. Features Monopoly Perfect Competition

1 Description Extreme market A fair, direct
situation, where there is competition between
only one seller. He has buyers and buyers, seller
no competition and so and sellers, and finally
controls supply and between buyers and
price. sellers.
2 Buyers and Only one seller and Large number of buyers
Sellers practically all buyers and sellers. Hence no
depend on him. Hence sellers or buyers can
he has absolute control alter the price in the
over the market. market.
3 Supply Supply from only one i) Supply comes from
seller, hence absolute large number of sellers
control over the supply. ii) Individual supply is
negligible, compared to
market supply.
4 Demand Demand is not perfectly. Demand is perfectly
Demand curve slopes elastic. Demand curve
downward. faced by a seller is a
horizontal straight line.
5 Product Homogeneous product. Homogenous product.
6 Nature of No competition at all. No Pure and perfect
Competition price or product competition in price.
competition.
227
Market
7 Price Higher price, higher than Normal Price P = MR =
Structure
all competitive price. P MC
> MR = MC
8 Output Small output fixed by the Large output fixed by
sole seller. MR = MC
9 Profit Excess profit monopoly Normal profit realised
gain. by price competition.
10 Application Pure Monopoly is rare Quite unreal.
but elements of
monopoly are there in
markets.

10.5 EFFICIENCY AND DEADWEIGHT LOSS

UNDER MONOPOLY
The outcome of a competitive market has a very important property. In
equilibrium, all gains from production activities are realised. This means that
there is no additional surplus to obtain from further trades between buyers and
sellers. In this situation, we say that the allocation of goods and services in the
economy is efficient. However, markets sometimes fail to operate properly and
not all gains from trade are exhausted. In this case, some buyer surplus, seller
surplus, or both are lost. Economists call this a deadweight loss.
The deadweight loss from a monopoly is illustrated in the Fig. 10.12 below.
The monopolist produces a quantity such that marginal revenue equals
marginal cost. The price is determined by the demand curve at this quantity. A
monopoly makes a profit equal to total revenue minus total cost. When the
total output is less than socially optimal, there is a deadweight loss, which is
indicated in the figure.
Deadweight loss arises in other situations, such as when there are quantity or
price restrictions. It also arises when taxes or subsidies are imposed in a
market. Tax incidence is the way in which the burden of a tax falls on buyers
and sellers — that is, who suffers most of the deadweight loss. In general, the
incidence of a tax depends on the elasticities of supply and demand.
Price

Quantity
228 Fig. 10.12
 Monopoly: Price
10.6 PRICE DISCRIMINATION UNDER and Output
MONOPOLY: TYPES AND DEGREES Decisions

In monopoly, there is a single seller of a product called monopolist. The

monopolist has control over pricing, demand, and supply decisions, thus, sets
prices in a way, so that maximum profit can be earned.
The monopolist often charges different prices from different consumers for the
same product. This practice of charging different prices for identical product is
called price discrimination.
According to Robinson, “Price discrimination is charging different prices for
the same product or same price for the differentiated product.”

10.6.1 Types of Price Discrimination

Price discrimination is a common pricing strategy used by a monopolist having
discretionary pricing power. This strategy is practiced by the monopolist to
gain market advantage or to capture market position.
There are three types of price discrimination, which are shown below:

i) Personal
Personal price discrimination refers to a situation when different prices are
charged from different individuals. The different prices are charged according
to the level of income of consumers as well as their willingness to purchase a
product. For example, a doctor charges different fees from poor and rich
patients.
ii) Geographical
This type of price discrimination occurs when the monopolist charges different
prices at different places for the same product. This type of discrimination is
possible if those who buy at lower price cannot sell to those being charged a
higher price by the firm.
iii) On the basis of use
This kind of price discrimination occurs when different prices are charged
according to the use of a product. For instance, an electricity supply board
charges lower rates for domestic consumption of electricity and higher rates for
commercial consumption. Similar discrimination occurs when buyers are
charged different prices at different hours of the day – it is referred to as peak-
load pricing.

229
Market 10.6.2 Degrees of Price Discrimination
Structure
i) First-degree Price Discrimination
Refers to a price discrimination in which a monopolist charges the maximum
price that each buyer is willing to pay. This is also known as perfect price
discrimination as it involves maximum exploitation of consumers. In this price
discrimination, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.
ii) Second-degree Price Discrimination
Refers to a price discrimination in which buyers are divided into different
groups and different prices are charged from these groups depending upon
what they are willing to pay. Railways and airlines practice this type of price
discrimination.
iii) Third-degree Price Discrimination
Refers to a price discrimination in which the monopolist divides the entire
market into submarkets and different prices are charged in each submarket.
Therefore, third-degree price discrimination is also termed as market
segmentation.
In this type of price discrimination, the monopolist is required to segment
market in a manner, so that products sold in one market cannot be resold in
another market. Moreover, he/she should identify the price elasticity of
demand of different submarkets. The groups are divided according to age, sex,
and location. For instance, railways charge lower fares from senior citizens.
Students get discount in cinemas, museums, and historical monuments. We are
explaining it with help of Fig. 10.13, which has three segments (a), (b) and (c).

Fig. 10.13

Segments (a) and (b) depict markets with inelastic and elastic demand curves
respectively. The segment (c) has horizontal sum of the AR and MR curves of
(a) and (b), denoted as AR t and MR t. The firm has a single Average Total Cost
curve and corresponding Marginal Cost Curve. Inter-section of this MC with
MR t gives us equilibrium output OQ for the firm. It also shows the MR for the
firm, which maximises its profits. The firm will like to realise the same MR
from each of the units sold in either of those two market segments. So,
wherever the extended line EM cuts MRa and MRb (points Ea and Eb
respectively) will be used to determine equilibrium outputs Q aO and Q bO for
the two market segments. The prices will be what the consumers are ready to
pay for the respective quantities, that is, Pa and P b.
230
Note two points: The monopolist offers larger quantities in market with Monopoly: Price
relatively elastic demand curve and smaller in market with inelastic demand. and Output
We find that Q b > Q a. However, the price change in the segment (a)with Decisions
inelastic demand, P a is greater than price in segment (b) P b. So we can say
that buyers with inelastic demand will face a double disadvantage at the hands
of a monopolist: They end up buying smaller quantities and have to pay higher
prices.
Check Your Progress 2
1) What is Price Discrimination?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain the degrees of Price Discrimination.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) How Monopolist firm faces efficiency loss?
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) How is price determination under Monopoly is different from Perfect
Competition?
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.7 PRICING IN PUBLIC MONOPOLY

So far we have discussed the behaviour of a private monopolist whose
objective is to maximise her profits, given the economic and technical
constraints. In this section, we analyse the behaviour of a public monopoly — a
firm owned and controlled by the government. The objective of a public
monopoly is to provide more output and charge lower price so as to increase
the welfare of people. The optimal pricing and output decisions by such an
undertaking is not based on profit or sales maximisation principles but on
maximisation of welfare.
Average-cost-pricing and marginal-cost-pricing are the two possible options
for the determination of output and price by a public utility firm. In fact, these
two options can become policy guidelines for the government for price
regulation of a private monopoly firm as well.
There is a need to regulate monopoly because monopolists have ability to
restrict output and raise prices of their product and this way earn super normal
231
Market profits. Such behaviour increases inequalities in the distribution of income and
Structure wealth leading to exploitation of the consumers and also causes inefficiency in
allocation of resource. A net result of all these actions is reduction of consumer
welfare in the society. Therefore, the main objective behind regulation of
monopoly is the maximisation of welfare. A monopoly may be regulated either
through fixation of a maximum price that a monopolist may charge or
appropriate taxation policy. Here, we are concerned with price regulation of
monopoly only. The issue involved in average and marginal cost pricing
discussed here are useful in fixing of prices in a public utility as well.

10.7.1 Marginal Cost Pricing

As discussed above, a monopolist sets price of its product higher than marginal
cost. Monopolist maximise profit at the level of output where MR=MC and
charges price according to equilibrium condition. The government may decide
to regulate a monopoly by fixing maximum price that equals marginal cost of
production. The monopolist will be forced to raise the output higher then the
equilibrium level and charges price, which would have prevailed had the
market been perfectly competitive. Such a price would ensure efficiency in
allocation of resources as well, since it is equal to marginal cost. It also
enhances welfare of the consumers, as they get larger output al lower price.
The consumer’s surplus under regulated monopoly is more then it was in non-
regulated monopoly.
It may be noted that given the conditions of demand and cost ‘Marginal cost’
pricing may still allow a monopolist to earn super normal profits as the price
may still be higher than the average cost. This is a case of ‘capacity-
constrained situation’, that is the demand for the product is quite high as
compared to the production capacity. But, in a different situation, when there is
excess capacity, marginal cost pricing results in direct loss to the firm as its
average cost is higher than marginal cost. Thus, the firm will produce marginal
cost price output only if it is compensated by the government for the direct loss
at this level of production.

10.7.2 Average Cost Pricing

The aim of the public policy is to regulate monopoly in such a manner that is
possible to provide maximum output at minimum price. One policy option is to
fix price according to the average cost, i.e, at a point where AR = AC. This
allows the firm to earn normal profit. In case of capacity-constrained situation,
average cost pricing leads to higher output and lower price. This means there
will be higher level of consumer’s surplus compared to marginal cost pricing.
However, in excess capacity situation, there shall be a somewhat higher price
with average cost pricing but there shall be no direct loss to the producer as
P = AC. Marginal cost pricing adopted to reach full economic efficiency or
maximum social welfare. But in case of excess capacity, where AC > MC,
marginal cost pricing necessitates state subsidies to induce the monopolist to
stay in the market.

10.7.3 Mark-up Pricing

It is observed that in real life, prices are not fixed by marginal analysis, viz, by
the use of marginal revenue and marginal cost concepts. An alternative
approach is to set the prices in accordance with the average cost principle.

232
The firm sets a price equal to its average cost which includes some profit Monopoly: Price
margin, that is. and Output
Decisions
P = AVC + GPM
where P is the price, AVC is the average variable cost, and GPM is the gross
profit margin which include average fixed cost and net profit margin.
The purpose of this note is to show that average cost principle and marginal
analysis would give the same long-run profit maximisation solution. The
setting of the price on the basis of the average cost principles incorporates as
estimation of the elastic of demand in the long run equilibrium. Recall that the
necessary condition for profit maximisation is MC=MR. It has already been
proved that MR=P(e–1/e). Given that MC >0. MR must be positive for profit
maximisation. This implies e>1, provided that AVC is constant over the
relevant range of output, that is, AVC=MC. For equilibrium, AVC=MR, that
is, AVC=P(1–1/e)=P{(e–1)/e}. In other words P = AVC {e/(e–1)}. Given that
e>1, we may write {e/(e–1)}=(1+k), where k>0. Therefore, P=AVC(1+k),
where k is the gross profit margin. For example, if the firm sets a 20 per cent of
AVC as its profit margin, we have (1+k) = [1 + 0.20] = . Thus, the
elasticity of demand is 6. Setting a gross profit margin is equivalent to
estimating the price elasticity of demand and applying marginalist analysis.
Check Your Progress 3
1) How a public monopoly is different from a private monopolist firm?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) How does the public monopoly firm make price and output decisions?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by Mark up pricing?
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.8 LET US SUM UP

Monopoly is a market structure in which there is a single seller with large
number of buyers. Assumptions of monopoly are: Single firm, No close
substitutes, Barriers to entry, Goal is profit maximisation, Perfect knowledge.
In monopoly, market Firm’s demand curve is industry’s demand curve. The
demand curve is downward sloping because monopolist is a price maker and
not a price taker. The demand curve of monopolist is the AR curve or the price
line. According to the marginal principle, equilibrium takes place where: MR =
MC and slope of MC should be greater then Slope of MC. In the long-run, the
firm will either continue to earn profit or may breakeven. Two market 233
Market structures, i.e. Perfect Competition and Monopoly are extreme situations.
Structure Monopolist charges higher price and sells lesser output as compared to
perfectly competitive firm. Price discrimination is the practice of charging
different prices from different consumers for the same good. AC and MC
pricing are undertaken by a public monopoly for social or public welfare.

10.9 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

10.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 10.3.2 and answer
2) Q = 30 units
P = Rs. 700
Check Your Progress 2
1) Read Section 10.6 and answer
2) Read Sub-section 10.6.2 and answer
3) Read Section 10.5 and answer
4) Read Section 10.4 and answer
Check Your Progress 3
1) Read Section 10.7 and answer
2) Read Sub-section 10.7.1 and answer
3) Read Sub-section 10.7.2 and answer

234
UNIT 11 MONOPOLISTIC
COMPETITION: PRICE AND
OUTPUT DECISIONS
Structure
11.0 Objectives
11.1 Introduction
11.2 Concept and Features of Monopolistic Competition
11.3 Demand Curve under Monopolistic Competition
11.4 Equilibrium under Monopolistic Competition
11.4.1 Individual Firm’s Equilibrium in Short-Run Period
11.4.2 Individual Firm’s Equilibrium in Long Run
11.4.3 Group Equilibrium in Monopolistic Competition
11.4.4 Equilibirium with Selling Costs

11.5 Perfect Competition, Monopoly and Monopolistic Competition:

Comparison
11.6 Theory of Excess Capacity under Monopolistic Competition
11.7 Let Us Sum Up
11.8 References
11.9 Answers or Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After studying this unit, you will be able to:
 define the term monopolistic competition;
 explain the demand curve under monopolistic competition;
 state the equilibrium conditions of monopolistic competition;
 make comparison under perfect competition, monopoly and monopolistic
competition; and
 explain the theory of excess capacity under monopolistic competition.

11.1 INTRODUCTION
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 235
Market firms which sell closely related but differentiated products. Markets of
Structure products like soap, toothpaste AC, etc. are examples of monopolistic
competition.

11.2 CONCEPT AND FEATURES OF

MONOPOLISTIC COMPETITION
Monopolistic competition is a market in which firms can enter freely each
producing its own brand or a differentiated product. Thus, a firm under
monopolistic competition
a) Enjoys ‘monopoly position’ as far as a particular brand is concerned.
b) Since the various brands are close substitutes, its monopoly position is
influenced by the stiff ‘competition’ from other firms.
Examples of Monopolistic Competition:
1) When you walk into a departmental store to buy toothpaste, you will find
a number of brands, like Pepsodent, Colgate, Neem, Babool, etc.
i) On one hand, the market for toothpaste seems to be full of
competition, with thousands of competing brands and freedom of
entry;
ii) On the other hand, its market seems to be monopolistic, due to
uniqueness of each toothpaste and power to charge different price.
Such a market for toothpaste is a monopolistic competitive market.
2) A firm supplies branded good ‘Lux Soap’ in the market. There are many
other firms in the market which sell similar soaps (not identical) with
different brand names like Rexona, Palm Rose, etc., etc. Some times we
can find one company manufacturing and selling similar products with
several brand names at different prices. Their idea is to place each of
their products in ‘niches’ or slots which capture attention of a different
set of consumers. The firm supplying ‘Lux Soap’ enjoys a monopoly in
the sale of its own product. It also faces competition from firms selling
similar products. Same is the case with many other firms in the market
like plywood manufacturing, jewellery making, wood furniture, book
stores, departmental stores, repair services of all kinds, professional
services of doctors, technicians, etc. These firms and others which have
an element of monopoly power and also face competition over the sale of
product or service in the market are called monopolistically competitive
firm.
The following are the features or characteristics of monopolistic competition:-
1) Large Number of Sellers
There are large number of sellers producing differentiated products. So,
competition among them is very keen. Since number of sellers is large, each
seller produces a very small part of market supply. Every firm is limited in its
size.

236
In other words, there are large numbers of firms selling closely related, but not Monopolistic
homogeneous products. Each firm acts independently and has a limited share Competition: Price
of the market. So, an individual firm has limited control over the market price. and Output Decisions
Large number of firms leads to competition in the market.
2) Product Differentiation
It is one of the most important features of monopolistic competition. In perfect
competition, products are homogeneous in nature. On the contrary, here, every
producer tries to keep his product dissimilar than his rival’s product in order to
maintain his separate identity. This boosts up the competition in market and at
the same time every firm acquires some monopoly power. Hence, each firm is
in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are
also willing to pay different prices for the same product produced by different
firms. This gives some monopoly power to an individual firm to influence
market price of its product. Following points provide insight about the product
differentiation:
a) The product of each individual firm is identified and distinguished from
the products of other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on
either ‘real’ or ‘imaginary’ differences.
i) Real Differences may be due to differences in shape, flavour,
colour, packing, after sale service, warranty period, etc.
ii) Imaginary Differences mean differences which are not really
obvious but buyers are made to believe that such differences exist
through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes
demand for the product less elastic and enables the firm to charge a price
higher than its competitor’s products. For example, Pepsodent is costlier
than Babool.
f) Some more examples of Product Differentiation: i) Toothpaste:
Pepsodent, Colgate, Neem, Babool, etc., ii) Cycles: Atlas, Hero, Avon,
etc., iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
3) Freedom of Entry and Exit
This feature leads to stiff competition in market. Free entry into the market
enables new firms to come with close substitutes. Free entry or exit maintains
normal profit in the market for a longer span of time.
4) Selling Cost
It is a unique feature of monopolistic competition. In such type of market, due
to product differentiation, every firm has to incur some additional expenditure
in the form of selling cost. This cost includes sales promotion expenses,
advertisement expenses, salaries of marketing staff, etc. 237
Market But on account of homogeneous product in perfect competition and zero
Structure competition in monopoly, selling cost does not exist there.
5) Absence of Interdependence
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All
are independent.
6) Two Dimensional Competition
Monopolistic competition has two types or aspects of competition aspects viz.
Price competition i.e. firms compete with each other on the basis of price. Non-
price competition i.e. firms compete on the basis of brand, product quality
advertisement.
7) Concept of Group
In place of Marshallian concept of industry, Chamberlin introduced the concept
of Group under monopolistic competition. An industry means a number of
firms producing identical product. A group means a number of firms producing
differentiated products which are closely related.
8) Falling Demand Curve
In monopolistic competition, a firm is facing downward sloping demand curve.
It means one can sell more at lower price and vice versa.
9) Lack of Perfect Knowledge
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it
becomes very difficult for a consumer to evaluate different products available
in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same
quality.
Check Your Progress 1
1) What is monopolistic competition? Explain with few examples.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Identify the features that shows the presence of monopolistic competition
in market.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) A market with few entry barriers and with many firms that sell
differentiated products is
A) purely competitive.
B) a monopoly.
C) monopolistically competitive.
D) oligopolistic.

238
 Monopolistic
11.3 DEMAND CURVE UNDER MONOPOLISTIC Competition: Price
COMPETITION and Output Decisions

Under monopolistic competition, large number of firms selling closely related

but differentiated products make the demand curve downward sloping. It
implies that a firm can sell more output only by reducing the price of its
product.
As seen in Fig. 11.1, output is measured along the X-axis and price and
revenue along the Y-axis. At OP price, a seller can sell OQ quantity. Demand
rises to OQ1, when price is reduced to OP1. So, demand curve under
monopolistic competition is negatively sloped as more quantity can be sold
only at a lower price.

Fig. 11.1

MR < AR under Monopolistic Competition: Like monopoly, MR is also less

than AR under monopolistic competition due to negatively sloped demand
curve.
Demand Curve: Monopolistic Competition Vs. Monopoly:
At first glance, the demand curve of monopolistic competition looks exactly
like the demand curve under monopoly as both faces downward sloping
demand curves. However, demand curve under monopolistic competition is
more elastic as compared to demand curve under monopoly. This happens
because differentiated products under monopolistic competition have close
substitutes, whereas there are no close substitutes in case of monopoly.
Let us prove this with the help of Fig. 11.2.

239
Market
Structure

Fig. 11.2

We know, price elasticity of demand (by geometric method) at a point on the

demand curve is given by: Ed = Lower segment of demand curve / Upper
segment of demand curve.
At price ‘OP’, price elasticity of demand under monopolistic competition is
BC/AB and under monopoly is EF/DE. Fig. 11.2 reveals that BC > EF and DE
> AB. So, BC/AB > EF/DE.
It means, demand curve in case of monopolistic competition is more elastic as
compared to demand curve under monopoly.

11.4 EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
A firm under monopolistic competition has to face various problems which are
absent under perfect competition. Since the market of an individual firm under
perfect competition is completely merged with the general one, it can sell any
amount of the good at the ruling market price.
But, under monopolistic competition, individual firm’s market is isolated to a
certain degree from those of its rivals with the result that its sales are limited
and depend upon:
1) Its price,
2) The nature of its product, and
3) The advertising outlay it makes.
Thus, the firm under monopolistic competition has to confront a more
complicated problem than the perfectly competitive firm. Equilibrium of an
individual firm under monopolistic competition involves equilibrium in three
respects, that is, in regard to the price, the nature of the product, and the
amount of advertising outlay it should make.
Equilibrium of the firm in respect of three variables simultaneously – price,
nature of product, selling outlay – is difficult to discuss. Therefore, the method
of explaining equilibrium in respect of each of them separately is adopted,
keeping the other two variables given and constant.
Moreover, as noted above, the equilibrium under monopolistic competition
involves “individual equilibrium” of the firms as well as “group equilibrium”.
We shall discuss these two types of equilibrium first in respect of price and
240 output and then in respects of product and advertising expenditure adjustments.
11.4.1 Individual Firm’s Equilibrium in Short-Run Period Monopolistic
Competition: Price
The demand curve for the product of an individual firm, as noted above, is and Output Decisions
downward sloping. Since the various firms under monopolistic competition
produce products which are close substitutes to each other, the position and
elasticity of the demand curve for the product of any of them depend upon the
availability of the competitive substitutes and their prices.
Therefore, the equilibrium adjustment of an individual firm cannot be defined
in isolation from the general field of which it is a part. However, for the sake of
simplicity in analysis, conditions regarding the availability of substitute
products produced by the rival firms and prices charged for them are held
constant while the equilibrium adjustment of an individual firm is considered
in isolation.
Since close substitutes for its product are available in the market, the demand
curve for the product of an individual firm working under conditions of
monopolistic competition is fairly elastic. Thus, although a firm under
monopolistic competition has a monopolistic control over its variety of the
product but its control is tempered by the fact that there are close substitutes
available in the market and that if it sets too high a price for its product, many
of its customers will shift to the rival products.

Fig. 11.3

Assuming the conditions with respect to all substitutes such as their nature and
prices being constant, the demand curve for the product of a firm will be given.
We further suppose that only variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic competition is graphically
shown in Fig. 11.3. DD is the demand curve for the product of an individual
firm, the nature and prices of all substitutes being given. This demand curve
DD is also the average revenue (AR) curve of the firm.
AC represents the average cost curve of the firm, while MC is the marginal
cost curve corresponding to it. It may be recalled that average cost curve first
falls due to internal economies and then rises due to internal diseconomies.
241
Market Given these demand and cost conditions a firm will adjust its price and output,
Structure at the level which gives it maximum total profits. Theory of value under
monopolistic competition is also based upon the profit maximisation principle,
as is the theory of value under perfect competition.
Thus a firm, in order to maximise profits, will equate marginal cost with
marginal revenue. In Fig. 11.3, the firm will fix its level of output at OM, for at
OM output marginal cost is equal to marginal revenue. The demand curve DD
facing the firm in question indicates that output OM can be sold at price MQ =
OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and output at OM, the
firm is making profits equal to the area RSQP which is maximum. It may be
recalled that profits RSQP are in excess of normal profits because the normal
profits which represent the minimum profits necessary to secure the
entrepreneur’s services are included in average cost curve AC. Thus, the area
RSQP indicates the amount of supernormal or economic profits made by the
firm.
In the short-run, the firm, in equilibrium, may make supernormal profits, as
shown in Fig. 11.3 above, but it may make losses too if the demand conditions
for its product are not so favourable relative to cost conditions. Fig. 11.4
depicts the case of a firm whose demand or average revenue curve DD for the
product lies below the average cost curve, indicating thereby, that no output of
the product can be produced at positive profits.

Fig. 11.4

However, the firm is in equilibrium at output ON and setting price NK or OT.

By adjusting price at OT and output at ON, it is able to minimise its losses. In
such an unfavourable situation, there is no alternative for the firm except to
make the best of the bad bargain.
We thus see that a firm in equilibrium under monopolistic competition, as
under pure or perfect competition, may be making supernormal profits or
losses depending upon the position of the demand curve relative to the position
of the average cost curve. Further, a firm may be making only normal profits
even in the short run if the demand curve happens to be tangent to the average
242 cost curve.
It should be carefully noted that in individual equilibrium of the firm in Fig. Monopolistic
11.3 and 11.4, the firm having once adjusted price at OP and (respectively will Competition: Price
have no tendency to vary the price any more. If it varies its price upward, the and Output Decisions
loss due to fall in quantity demanded will be more than possible gain owing to
the higher price. If it cuts down its price, the gain due to the increase in
quantity demanded will be less than the loss due to the lower price. Hence,
price will remain stable at OP and OT in the two cases respectively.

11.4.2 Individual Firm’s Equilibrium in Long Run

In the preceding sections, we have discussed that in the short run, firms can
earn supernormal profits. However, in the long run, there is a gradual decrease
in the profits of the firms. This is because in the long run, several new firms
enter the market due to freedom of entry.
When these new firms start production the market supply would increase and
the price would fall. This would automatically increase the level of competition
in the market. Consequently, AR curve shifts from right to left and
supernormal profits are eliminated. The firms will be able to earn normal
profits only.
In the long run, the AR curve is more elastic than that of in the short run. This
is because of an increase in the number of substitute products in the long-run.
The long-run equilibrium of monopolistically competitive firms is achieved
when average revenue is equal to average cost. In such a case, the firms receive
normal profits.

Fig. 11.5: Shows the long-run equilibrium position under monopolistic competition

In Fig. 11.5, P is the point at which AR curve touches the average cost curve
(LAC) as a tangent. P is regarded as the equilibrium point at which the price
level is MP (which is also equal to OP') and output is OM.
In the present case average cost is equal to average revenue that is MP.
Therefore, in long run, the profit is normal. In the short run, equilibrium is
attained when marginal revenue is equal to marginal cost. However, in the long
run, both the conditions (MR=MC and AR=AC) must hold to attain
equilibrium.

11.4.3 Group Equilibrium in Monopolistic Competition

The concept of group equilibrium was introduced by Chamberlin. The price-
output equilibrium of all firms is known as group equilibrium. Group
equilibrium represents the price and output of firms having close substitutes.
243
Market However, due to product differentiation, it is difficult to form market demand
Structure schedules and supply.

For overcoming the problem Chamberlin gave a concept called product group,
which includes products that are technological and economic substitute of each
other. Technological substitutes are the products having technical similarity,
while economic substitutes are the products that have same prices and fulfill
the same want of consumers.

A product group refers to a group in which the demand for each product is
highly elastic. Here, the demand for a product changes with the changes in the
prices of other products within the group, and, the price and cross elasticity of
demand for products forming the group is high.

In an industry, different types of groups exist automatically. In automobile

industry makers of cars and trucks are two different product groups.

The main competition would be among those organisations manufacturing

similar products (cars or trucks) which are close substitutes of each other. Due
to product differentiation, there is a large variation in the demand and cost
curves of firms. Their price, output, and profits also differ.

Therefore, to simplify product group analysis, Chamberlin has given two

assumptions, which are as follows:

i) The demand and cost curves of all products in the group are the same or
uniform. The uniformity assumption. The preferences of consumers are
evenly distributed and the difference in preferences does not lead to
variation in cost.

ii) In monopolistic competition, a large number of sellers are not able to

influence each other’s decisions. The changes in prices or level of output,
of firm would have insignificant influence on its competitors. This is
termed as the symmetry assumption.

These two assumptions form the basis for group equilibrium analysis. If an
organisation within the group has established a popular brand, it is more likely
to earn supernormal profits. However, in the long run, other organisations
would strive to emulate the product design and features. In such a case,
supernormal profits would vanish. This is a general case of all monopolistically
competitive organisations.

On the other hand, if the entire group is earning supernormal profits, then
external organisations would get attracted towards the group, until the legal or
economic barriers are imposed.
In Fig. 11.6, P is the equilibrium point at which output is OM, price is MP, and
average cost is MT. In such a case, marginal cost is equal to marginal revenue.
Therefore, firms are earning supernormal profits (P'PTT'). However, these
supernormal profits disappear in the long run.

244
 Monopolistic
Competition: Price
and Output Decisions

Fig. 11.6: The short-run group equilibrium

Fig.11.7: The long-run group equilibrium

In Fig. 11.7, it can be seen that the supernormal profits have disappeared. It
also depicts that average revenue (AR) is tangent to LAC, which implies that
price is equal to average revenue. Marginal revenue gets equal to marginal cost
at the output level of OM. This shows that in the long run, all firms in the
industry are making normal profits.

11.4.4 Equilibrium with Selling Costs

Selling Costs: Concept
“Selling costs are costs incurred in order to alter the position or shape of the
demand curve for the product.” E.H. Chamberlin
Selling costs play the key role in monopolistic competition and oligopoly.
Under these market forms, the firms have to compete to promote their sale by
spending on advertisements and publicity.
Moreover, producer has not to decide about price and output only. He also
keeps in view how to maximise the profit.
Thus, cost on advertisement, publicity and salesmanship add to the cost or
supply curve of the product while also contributing to rise in its demand. The
Selling costs is a broader concept than the advertisement expenditures.
Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, incentives to retailers
to display the products, besides the advertisements. It was Chamberlin who
introduced the analysis of selling costs and distinguished it from the production 245
Market costs. The production costs include all those expenses which are spent on the
Structure manufacturing of the commodity, its transportation cost of handling, storing
and delivering of the commodity to actual customers because these add utilities
to a commodity.
On the other hand, all selling costs include expenditures in order to raise
demand for a commodity. In short, selling costs are those which are made to
‘create’ the demand for the product. Transport costs should not be included in
selling costs; rather these should be included in the production costs. Transport
costs actually do not increase the demand; it only helps in meeting the demand
of the consumers.
In general, “those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of
selling.”
The concept of selling cost is based on the following two assumptions:
1) Buyers do not have any perfect knowledge about the different types of
product.
2) Buyers’ demand and tastes can be changed.
While production costs include outlays incurred on services engaged in the
manufacturing of the product like land, labour and capital etc, the selling costs
include all the costs incurred to change the consumer’s preference from one
product to another. These raise the demand of a product at any given price.
“Production costs create utilities in order that demands may be satisfied while
selling costs create and shift the demand curves themselves.”
Selling costs influence equilibrium price-output adjustment of a firm under
monopolistic competition. In the Fig. 11.8 APC is the initial average
production cost. AR1 is the initial average revenue curve or initial demand
curve. The initial price is OP and the firm earns profits shown by the first
shaded rectangle PQRS.

Fig. 11.8: Equilibrium with selling costs

246
ACC1 is the average composite costs curve, which includes the average selling Monopolistic
cost (ASC). Average selling cost is equal to the vertical distance between APC Competition: Price
and ACC1. The new demand curve is AR2. It is obtained after incurring selling and Output Decisions
costs or after making advertisements.
It is, obvious, that the demand for the product has increased as a result of
selling costs. The profits have also increased as a result of selling costs. The
profits after incurring selling costs at OM1 level of output become equal to the
shaded area P1Q1R1S1. Note that these profits are greater than the initial level
of profits when no selling cost was incurred, i.e., P1 Q1 R1 S1 > PQRS.
ACC2 is the average composite cost when more additional selling cost is
incurred, as a result of which the demand for the product further increases. The
new demand curve is AR3 which indicates a higher demand for the product.
The profits are also greater than before since the shaded area P2Q2R2S2 >
P1Q1R1S.
It is, thus, obvious that the demand for the product is increasing as a result of
the selling costs. Since selling costs are included in the cost of production,
therefore price of the product is also increasing as a result of selling costs.
Profits are also increasing as a result of higher selling costs and increased
demand.
Here, question arises, how long a firm may go on incurring expenditure on
selling costs? It will continue to make expenditure on selling costs as long as
any addition to the revenue is greater than the addition to the selling costs. The
firm will stop incurring expenditure on selling costs when the total profits are
at the highest possible level.
This would be the point at which the additional revenue due to advertising
expenditure equals the extra expenditure on advertisement. It should, however,
be noted clearly that the effects of advertisement on prices and output are
uncertain. Advertisement by a firm may be considered successful if the
elasticity of demand for its product falls.
Check Your Progress 2
1) Will the demand curve for a firm under monopolistic competiton be
horizontal or downward sloping?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) On which factors equilibrium of individual firm depend under
monopolistic condition?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Construct the diagram showing long run equilibrium of firm in
monopolistic competition.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
247
Market
Structure
11.5 PERFECT COMPETITION, MONOPOLY,
AND MONOPOLISTIC COMPETITION:
COMPARISON
The upcoming discussion will help you to make a comparison between perfect
competition, monopoly and monopolistic competition.
1) Structural Differences
Under perfect competition, there are innumerable numbers of firms who
produce homogeneous goods. Each firm in the market is so small that it cannot
exert any influence on price and output. Each firm, thus, behaves as a price-
taker.
Under monopolistic competition, there is quite a large number of sellers who
sell slightly different products. Product differentiation enables a firm to
exercise some power over price and output. This means that sellers behave
as ‘price-makers’. However, a monopoly seller has full control over its price-
output decision.
There is complete freedom of entry and exit of firms — both in perfect
competition and in monopolistic competition. This condition is true during the
long period only. In the short run, entry or exit is ruled out in both these market
forms. But a monopoly business is characterised by the absence of a rival
seller. Entry of new firms is either legally prohibited in monopoly, or may not
be financially feasible.
2) Behavioural Differences
A firm behaves as a price-taker under perfect competition, and the demand
curve faced by it is a horizontal one. Since price is fixed, AR curve coincides
with the MR curve. A monopoly firm, however, faces a negatively sloped
demand curve because it can have perceptible influence over price and output.
Consequently, MR curve is also negative sloping and lies below the AR curve.
This is also true under monopolistic competition. The only difference between
monopoly and monopolistic competition is that the demand curve faced by a
monopolistically competitive seller is relatively more elastic.
Since price is fixed for a competitive firm, it has only to undertake output
decisions. Further, products sold by competitive firms are perfect substitutes.
Because of complete product homogeneity, no firm finds any incentive to
spend money on any kind of sales promotional activity.
A monopoly firm also does not find any urgency to spend money on
advertisement since there is no rival seller. But a monopolistically competitive
seller has to incur some sort of “selling costs” just to provide information
about its product or rivals’ products. In fact, in order to attract more and more
customers, additional expenditure on selling cost is a necessity.
In every market, sellers adopt independent price-output policy. But all sellers
of all market forms follow one basic principle. The basic behavioural rule is
the equality between MC and MR. Under perfect competition, since AR = MR,
MC = MR = AR = P. But, in monopoly and in monopolistic competition, this
behavioural rule is slightly altered to MC = MR < AR = P, since in these two
markets, AR > MR.
248
A monopoly firm or a monopolistically competitive firm produces in that Monopolistic
region of its demand curve where the coefficient of elasticity of demand is Competition: Price
greater than one. But, under perfect competition, coefficient of elasticity of and Output Decisions
demand is infinite.
3) Optimum Capacity and Sub-Optimal Capacity of Production
A competitive firm always produces at the minimum point of its AC curve.
This means that a firm utilises its plant optimally. Since AR curve is a
horizontal one, a competitive firm will always produce at the lowest point of its
AC curve. It is then said that perfect competition leads to optimum economic
efficiency.
But, under monopoly, or under monopolistic competition, the demand curve is
negative sloping. It is due to the nature of this demand curve that a firm fails to
operate at the minimum point of its AC curve. It operates somewhere to the left
of the lowest point of the AC curve.
The implication of this is that resources are not utilised optimally under
imperfect competition. Imperfect competition leads to economic inefficiency.
As a result, a higher price for the product is charged and lower output is
produced. In this sense, perfect competition is an ideal market where social
welfare gets maximised. But social welfare gets reduced in monopoly or in
monopolistic competition.
4) Supply Curve
Under perfect competition, MC curve above the shut-down point is the short
run supply curve. But, under monopoly, or monopolistic competition, the
supply curve remains indeterminate. In other words, in these market forms,
MC curve is not the supply curve.

11.6 THEORY OF EXCESS CAPACITY UNDER

MONOPOLISTIC COMPETITION
The doctrine of excess (or unutilised) capacity is associated with monopolistic
competition in the long-run and is defined as “the difference between ideal
(optimum) output and the output actually attained in the long-run.”

Fig. 11.6
We know that under perfect competition, the demand curve (AR) is tangential
to the long-run average cost curve (LAC) at its minimum point and conditions
of full equilibrium are fulfilled: LMC = MR and AR (price) = Minimum LAC.
This means that in the long-run, the entry of new firms forces the existing firms
to make the best use of their resources to produce at the lowest point of average
total costs. At point E in Fig. 11.6, abnormal profits will be competed away 249
Market because MR = LMC = AR = LAC at its minimum point E and OQ will be the
Structure most efficient output which the society will be enjoying. This is the ideal or
optimum output which firms produce in the long-run.
Under monopolistic competition, the demand curve facing the individual firm
is not horizontal as under perfect competition, but it is downward sloping. A
downward sloping demand curve cannot be tangent to the LAC curve at its
minimum point.
The double condition of equilibrium LMC = MR = AR (P) = Minimum LAC
will not be fulfilled. The firms will, therefore, producing at less than the
optimum level even when they are earning normal profits. No firm will have
the incentive to produce the ideal output, since any effort to produce more than
the equilibrium output would involve a higher long-run marginal cost than
marginal revenue.
Thus each firm under monopolistic competition will be producing at less than
the optimum level and work under excess capacity. This is illustrated in Fig.
11.7 where the monopolistic competitive firm’s demand curve is d and MR1 is
its corresponding marginal revenue curve. LAC and LMC are the long-run
average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1curve from
below and OQ1 output is set at the price Q1 A1. OQ1 is the equilibrium output
but not the ideal output because d is tangent to the LAC curve at A1 to the left
of the minimum point E. Any effort on the part of the firm to produce beyond
OQ1 will mean losses as beyond the equilibrium point E1, LMC > MR1. Thus
the firm has negative excess capacity measured by OQ1 which it cannot utilise
working under monopolistic competition.
A comparison of the equilibrium positions under monopolistic competition and
perfect competition with the help of Fig. 11.7 reveals that the output of a firm
under monopolistic competition is smaller and the price of its product is higher
than under perfect competition. The monopolistic competition output OQ1 is
less than the perfectly competitive output OQ, and the monopolistic
competitive price Q1A1 is higher than the competitive equilibrium price QE.
This is because of the existence of excess capacity under monopolistic
competition.

Fig. 11.7
250
Check Your Progress 3 Monopolistic
Competition: Price
1) In what respects monopolistic competition is different from other two and Output Decisions
extreme forms of market structure.

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

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

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

2) What do you understand by the term ‘excess capacity’?

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

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

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

11.7 LET US SUM UP

Monopolistic competition is a market structure in which there are many firms
selling closely related commodities. Its assumptions are: Large number of
buyers and sellers, Differentiated products, Free entry and exit, aim of the firm
is profit maximisation. Product differentiation exist which can be real or
artificial. Its effect is that the firm has some degree of price-making power.
Under monopolistic competition in the short-run, firm maximises profit where
MR=MC and the MC curve intersects MR curve from below. In the long-run,
due to free entry and exit of firms, firm earns normal profit. Economic profits
are zero.
Excess Capacity Theory states that it is a long-run concept and is the difference
between least cost output and profit maximising output. While, under perfect
competition, there is no excess capacity and under monopolistic competition,
excess capacity always exists.

11.8 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

11.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 11.1 and answer
2) Read Section 11.2 and answer
3) (c) 251
Market Check Your Progress 2
Structure
1) Read Section 11.3 and answer
2) Read Section 11.4 and answer
3) Read Sub-section 11.4.1 and answer
Check Your Progress 3
1) Read Section 11.5 and answer
2) Read Section 11.6 and answer

252
UNIT 12 OLIGOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
12.0 Objectives
12.1 Introduction
12.1.1 Definition of Oligopoly
12.1.2 Features of Oligopoly Market
12.1.3 Causes for the Existence of Oligopoly

12.2 Price and Output Determination under Oligopoly

12.2.1 Cournot’s Model
12.2.2 Stackelberg’s Model
12.2.3 Paul Sweezy’s Model: Kinked Demand Curve Analysis
12.2.3.1 Why the Kink in the Demand Curve?
12.2.3.2 Analysis of the Kinked Demand Curve Model

12.3 Co-operative vs. Non-cooperative Behaviour

12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
12.3.2 Types of Co-operative Behaviour
12.3.3 Types of Non-Cooperative Behaviour

12.4 Cartel Theory of Oligopoly

12.5 Let Us Sum Up
12.6 References
12.7 Answers or Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After studying this unit, you shall be able to:
 state the meaning and features of oligopoly;
 discuss the causes of existence of oligopoly;
 throw light on different models that explain the oligopoly price and
output determination;
 explain the co-operative and non-cooperative behaviour of oligopolistic
firms; and
 appreciate cartel theory of oligopolist.

12.1 INTRODUCTION
Oligopoly refers to a market wherein only a few firms account for most or all
of total production.

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi.
253
Market 12.1.1 Definition of Oligopoly
Structure
Oligopoly referes to the presence of few sellers in the market selling the
homogeneous or differentiated products. In other words, the Oligopoly market
structure lies between the pure monopoly and monopolistic competition, where
few sellers dominate the market and have control over the price of the product.
Under the Oligopoly market, a firm either produces homogeneous or
heterogeneous products:
 Homogeneous Product: The firms producing the homogeneous products
are called as Pure or Perfect Oligopoly. It is found in the case of
industrial products such as aluminum, copper, steel, zinc, iron, etc.

 Heterogeneous Product: The firms producing the heterogeneous

products are called as Imperfect or Differentiated Oligopoly. Such type of
Oligopoly is found in the production of consumer goods such as
automobiles, soaps, detergents, television, refrigerators, etc.

12.1.2 Features of Oligopoly Market

1) Few Sellers: Under the Oligopoly market, the sellers are few, and the
customers are many. Few firms dominating the market enjoy a
considerable control over the price of the product.
2) Interdependence: It is one of the most important features of an
Oligopoly market, wherein, the seller has to be cautious with respect to
any action taken by the competing firms. Since there are few sellers in the
market, if any firm makes a change in the price or promotional scheme,
all other firms in the industry have to comply with it to remain in the
competition.
Thus, every firm remains alert to the actions of others and plan their
counterattack beforehand to escape the turmoil. Hence, there is a
complete interdependence among the sellers with respect to their price-
output policies.
3) Advertising: Under Oligopoly market, every firm advertises their
products on a frequent basis with the intention to reach more and more
customers and increase their customer base. This advertising makes the
competition intense.
If any firm does a lot of advertisement while the other remained silent,
then you will observe that his customers are going to the firm which is
continuously promoting its product. Thus, in order to be in the race, each
firm spends lots of money on advertisement activities.
4) Competition: It is genuine that with a few players in the market, there
will be an intense competition among the sellers. Any move by one firm
will have a considerable impact on its rivals. Thus, every seller keeps an
eye over its rivals and be ready with the counterattack.
5) Entry and Exit Barriers: The firms can easily exit the industry
whenever they want, but has to face certain barriers to enter into it. These
barriers could be Government license, Patent, large firm’s economies of
scale, high capital requirement, complex technology, etc. Also,
sometimes the government regulations favour the existing large firms,
thereby acting as a barrier for the new entrants.
254
6) Lack of Uniformity: There is a lack of uniformity among the firms in Oligopoly: Price and
terms of their size, some are big, and some are small. Since there are less Output Decisions
number of firms, any action taken by one firm has a considerable effect
on the other. Thus, every firm must keep a close eye on its counterpart
and plan the promotional activities accordingly.

12.1.3 Causes for the Existence of Oligopoly

There are certain reasons which have led to the emergence of oligopoly. These
are:
1) Large Investment of Capital
The number of firms in an industry may be small due to the large requirements
of capital. No entrepreneur will like to venture into investing large sums in an
industry in which addition to output to the existing level may depress prices.
Further, the new entrant may also fear of provoking a price-war by the
established firms in the industry. This is always true that in the midst of
differentiated products, it is difficult to introduce a new product.
2) Control of Indispensable Resources
A few firms may control some indispensable resources which may enable them
to secure several advantages in costs over all others. This enables them to
operate profitably at a price at which others cannot survive.
3) Legal Restriction and Patents
In public utility sector, the entry of new firms is closely regulated through the
grant of certificate by the State. This policy of exclusion of rivals may be due
to diseconomies of small scale or of duplication of services. Another factor for
the emergence of oligopoly is the patent right which a few firms acquire in
matter of some goods. Patents have led to many important industrial
monopolies in America and elsewhere.
4) Economies of Scale
Another factor responsible for emergence of oligopoly is the operations at large
scale. In some industries, a few firms can meet the entire demand for the
product. It is possible that the demand may be satisfied by a large number of
firms, but small firms cannot secure the economies of large scale production.
In the industries where there is a lot of mechanisation and where economies of
large scale are considerable, only a few firms will survive.
The firms attain such a huge size that just a few of them can satisfy the entire
demand. For example, automobiles, steel industry, petroleum etc. Oligopolies
are also found in local markets. In small towns, a few firms may be sufficient
to satisfy the demand, e.g., petrol, banks, building material suppliers etc. The
market is small and therefore can be satisfied by a few firms.
5) Superior Entrepreneurs
In some industries there may be some superior entrepreneurs whose costs are
lower than inferior rivals. These entrepreneurs under sell and eliminate most of
their rivals.
6) Mergers
Many oligopolies have been created by combining two or more independent
255
Market firms. The combination of two or more firms into one firm is known a merger.
Structure The main motives of mergers include increasing market powers, more
resources, economies of scale and market extensions etc.
7) Difficulties of Entry into the Industry
Lastly, oligopoly may come to exist because of difficulties of entry into the
industry. One big difficulty in some industries is the large requirements of
capital. Businessmen do not like to venture into those industries entry to which,
even of one firm, is likely to depress prices to such an extent as to make it
unprofitable for all. They may also be afraid of the price war that their entry
may provoke from the established firms in the industry. Prospective entrants to
an industry are also deterred by the difficulty of marketing new products or
new brands in the presence of already well-established, well-entrenched
brands.
Check Your Progress 1
1) What is Oligopoly? Explain with few examples.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Identify and explain the features that shows the existence of oligopoly in
market.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) A market with many buyers and a few dominant sellers is :
A) purely competitive
B) a monopoly
C) monopolistically competitive
D) oligopolistic

12.2 PRICE AND OUTPUT DETERMINATION

UNDER OLIGOPOLY
Unlike other market forms, price and output under oligopoly is never fixed.
Interdependence of firms led uncertainty always exists in the market. In such a
situation, it becomes difficult to determine the equilibrium price and output for
an oligopolistic firm. An oligopolist cannot assume that its competitors will not
change their price and/or output if it changes. Price change by one firm will be
followed by other competitors, which will change the demand conditions
facing this firm. Therefore, demand curve for any firm is not fixed like other
markets. Demand curve for a firm keeps changing as firms change their prices.
Therefore, in the absence of a fixed demand (Average Revenue) curve, it is
difficult to determine the equilibrium price and output. However, economists
have developed some price-output models to explain the behaviour of
256 oligopolistic firms. They are as follows:
I. Some economists ignore the interdependence among the firms when they Oligopoly: Price and
explain the oligopoly market. In such case the demand will be known and Output Decisions
equilibrium price and output can be determined.
II. Another approach is based on collusion. Oligopolists can form a group
and maximise their joint output and profit. Best example of such
collusion is Cartel (it is a situation when oligopolists agree to work
together in the international market). One firm is chosen as a leader. The
prices determined by the leader are followed by others in such a case.
III. Third approach assumes that an oligopolist predicts the reaction of its
competitors. Problems regarding prices and output determination are
solved by such assumptions. Various models based on different
assumptions exist in this category. Few of them are: Chamberlin Model,
Cournot’s Model, and Paul Sweezy Kinked Demand curve Model etc.

12.2.1 Cournot’s Model

In 1838, Augustin Cournot introduced a simple model of duopolies that
remains the standard model for oligopolistic competition.
This modal is based on the following assumptions:
1) The two firms produce homogeneous and indistinguishable goods.
2) There are no other firms in the market who produce the same or
substitute goods.
3) No other firms can or will enter the market.
4) Collusive behaviour is prohibited. Firms cannot act together to form a
cartel.
5) There exists one market for the produced goods.
In addition to the assumptions stated above, the Cournot duopoly model relies
on the following:
1) Each firm chooses a quantity to produce.
2) All firms make this choice simultaneously.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
4) The cost structures of the firms are public information.
In the Cournot model, the strategic variable is the output quantity. Each firm
decides how much of a good to produce. Both firms know the market demand
curve, and each firm knows the cost structures of the other firm. The essence of
the model is that each firm takes the other firm’s choice of output level as fixed
and then sets its own production quantities.
Before explaining the model, let us define the reaction curve.
A reaction curve for Firm 1 is a function Q1 that takes input as the quantity
produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's
production decisions. In other words, Q1 (Q2) is Firm 1's best response to Firm
2's choice of Q2. Likewise, Q2 (Q1) is Firm 2's best response to Firm 1's choice
of Q 1.
257
Market Let’s assume that the two firms face a single market demand curve as follows:
Structure
Q = 100 – P
where P is the single market price and Q is the total quantity of output in the
market. For simplicity’s sake, let’s assume that both firms face cost structures
as follows:
MC1 = 10
MC2 = 12
Given this market demand curve and cost structure, we want to find the
reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and
proceed. Firm 1's reaction curve will satisfy its profit maximising
condition, MR = MC . In order to find Firm 1's marginal revenue, we first
determine its total revenue, which can be described as follows:
Total Revenue = PQ1 = (100 – Q) Q1 = 100Q1 – (Q1+ Q2) Q1
= [100 – (Q1 + Q2)] Q1 = 100Q1 – Q12 – Q2Q1
= 100Q1 – Q12 – Q2 Q1
The marginal revenue is simply the first derivative of the total revenue with
respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for
Firm 1 is thus:
MR1 = 100 – 2Q1 – Q2
Imposing the profit maximising condition of MR = MC , we conclude that
Firm 1's reaction curve is:
100 – 2 Q1 – Q2 = 10
90 Q2
Q1 = –
2 2
Q1 = 45 – Q2
That is, for every choice of Q2, Q1 is Firm 1's optimal choice of output. We can
perform analogous analysis for Firm 2 (which differs only in that its marginal
costs are 12 rather than 10) to determine its reaction curve. We find Firm 2's
reaction curve to be:
Q2 = 44 – Q1/2.
The solution to the Cournot model lies at the intersection of the two reaction
curves. We solve now for Q1. Note that we substitute Q2 for Q2 because we are
looking for a point which lies on Firm 2's reaction curve as well.
Q1 = 45 – Q2/2 = 45 – (44 – Q1/2)/2
= 45 – 22 + Q1/4
= 23 + Q1/4
=> Q1 = 92/3
By the same logic, we find:
Q2 = 86/3
Note that Q1 and Q2 differ due to the difference in marginal costs. In a
perfectly competitive market, only firms with the lowest marginal cost would
survive. In this case, however, Firm 2 still produces a significant quantity of
258 goods, even though its marginal cost is 20% higher than Firm 1's.
An equilibrium cannot occur at a point not at the intersection of the two Oligopoly: Price and
reaction curves. If such an equilibrium existed, at least one firm would not be Output Decisions
on its reaction curve and would therefore not be playing its optimal strategy. It
has incentive to move elsewhere, thus invalidating the equilibrium.
The Cournot equilibrium is a best response made in reaction to a best response
and, by definition, is therefore a Nash equilibrium. Unfortunately, the Cournot
model does not describe the dynamics behind reaching equilibrium from a non-
equilibrium state. If the two firms began out of equilibrium, at least one would
have an incentive to move, thus violating our assumption that the quantities
chosen are fixed. Rest assured that for the examples we have seen, the firms
would tend towards equilibrium. However, we would require more advanced
mathematics to adequately model this movement.

Fig. 12.1

12.2.2 Stackelberg’s Model

The Stackelberg duopoly model of duopolies is very similar to the Cournot
model. Like the Cournot model, the firms choose the quantities they produce.
However, here the firms do not move simultaneously. One firm holds the
privilege to choose production quantities before the other. The assumptions
underlying the Stackelberg model are as follows:
1) Each firm chooses a quantity to produce.
2) A firm chooses before the other in an observable manner.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
To illustrate the Stackelberg model, let’s take an example. Assume Firm 1 is
the first mover with Firm 2 reacting to Firm 1's decision. We assume a market
demand curve of:
Q = 90 – P
Furthermore, we assume all marginal costs are zero, that is:
MC = MC1 = MC2 = 0
We calculate Firm 2's reaction curve in the same way we did for the Cournot
Model. Verify that Firm 2's reaction curve is:
Q2 = 45 – Q1/2
259
Market To calculate Firm 1's optimal quantity, we look at Firm 1's total revenues.
Structure
Firm 1's Total Revenue = P Q1 = (90 – Q1 – Q2) Q1
= 90 Q1 – Q12 – Q2 Q1
However, Firm 1 is not forced to assume Firm 2's quantity is fixed. In fact,
Firm 1 knows that Firm 2 will act along its reaction curve which varies
with Q1 . Firm 2's quantity very much relies on Firm 1's choice of quantity.
Firm 1's Total Revenue can thus be rewritten as a function of Q1:

R1 = 90 Q1 – Q12 – Q1 (45 – Q1/2)

Marginal revenue for firm 1 is thus:
MR1 = 90 – 2 * Q1 – 45 + Q1
= 45 – Q1
When we impose the profit maximising condition (MR = MC), we find:
Q1 = 45
Solving for Q2 , we find:
Q2 = 22.5
In the Cournot model, both firms make their choices simultaneously and have
no communication beforehand. In the Stackelberg model, Firm 1 not only
announces first, but Firm 2 knows that when Firm 1 announces, Firm 1's
actions are credible and fixed. This demonstrates how a slight change in the
flow of information can drastically impact the outcome of a market. Note that
Firm 1 decided first. Its decision is to meet half of the market demand. The
second firm decides to meet half of remaining market demand. Note that firm
which decides first will be able to produce and sell larger quantity. It amounts
to capturing larger market share. That is why we say that essence of
Stackleberg model lies in its First Movers’ Advantage feature.
Illustration 1:
Two firms have marginal costs of 10. They face a market demand curve of P =
100 – 4Q . The government imposes a tax of 10 dollars per unit sold.
Determine the Cournot equilibrium quantity.
Assuming that the tax will be paid by the consumer, the effective demand
curve becomes 90 – 4Q .
R1 = (90 – 4Q1 –4Q2).Q1
MR 1 = 90 – 8Q1 – 4Q2
Setting MR = MC:
–
Q1 = 10 – Q 2/2 =
By symmetry:
–
Q1 = Q2 =
Illustration 2 :
Assume three firms face identical marginal costs of 20 with fixed costs of 10.
They face a market demand curve of P = 200 – 2Q. Find the Cournot
equilibrium price and quantity.
260
 R1 = (200 – 2(Q1 + Q2 + Q3))Q1 Oligopoly: Price and
Output Decisions
MR1 = 200 – 4Q1 – 2Q2 – 2Q3
Applying MR = MC:
Q1 = 45 – Q2/2 – Q3/2
By symmetry:
Q1 = Q2 = Q3 = 22.5
12.2.3 Paul Sweezy Model : Kinked Demand Curve Analysis
This model was developed independently by Prof. Paul M. Sweezy on the one
hand and Profs. R. C. Hall and C. J. Hitch on the other hand.
The assumptions of this model are:
i) There are only a few firms in an oligopolistic market.
ii) The firms are producing close-substitute products.
iii) The quality of the products remains constant and the firms do not spend
on advertising.
iv) A set of prices of the product has already been determined and these
prices prevail in the market at present.
v) Each firm believes that if it reduces the price of its product, the rival
firms would follow suit, but if it increases the price, the rivals would not
follow it. They would simply keep their prices unchanged. We shall see
presently that, because of this asymmetric pattern of reaction of the
rivals, the demand curve of each firm would have a kink at the prevailing
price of its product.
12.2.3.1 Why the Kink in the Demand Curve?
In the figure we have drawn two negatively sloped straight line demand curves,
viz., dd' and DD'. Of these two curves, dd' is more flat than DD'. Now, when
one particular firm in the industry changes the price of its product, all other
firms keeping their prices constant, the firm’s demand curve will be relatively
flatter like dd', i.e., the magnitude of the change in the demand for its product
as its price changes would be relatively larger.

Fig. 12.2

This is because, as the firm reduces or increases the price of its product, the
prices of the products of other firms remaining constant, the product of the firm
becomes relatively cheaper or dearer, respectively, than those of the other
firms. This will make the demand curve flatter for this firm.
261
Market On the other hand, if a firm increases its price, the office firms will not follow
Structure the suit. So there will be an asymmetry in responses of the rivals.
If one firm reduces price, all others follow the suit – otherwise they run the risk
of losing their customers to this firm.
If one raises the price, others do not as they expect to win some customers
from this firm. Together, these responses create a kink in demand curve.
Let us suppose that initially the price of the product of the firm is p1 or Op1 and
the demand for the product is q1 or Oq1 If the firm now increases its price from
p1, the rival firms would keep their prices unchanged according to assumption
(v) of this model.
In this case, the firm’s demand would decrease along the segment Rd of the
relatively more elastic demand curve dd'. On the other hand, if it goes on
decreasing its price from p1, its rivals also would be decreasing their prices
according to assumption (v). In this case, the quantity demanded of the firm’s
product will increase along the segment RD' of the relatively steeper demand
curve DD'.
Therefore, at the price p1, the firm’s demand curve would be dRD'. Obviously,
because of assumption (v), the segment dR of this demand curve would be
more flat or more elastic than the segment RD' (and the segment RD' would be
more steep or less elastic than the segment dR).
As a result, there would be a kink at the prevailing price p1, or, at the point R
on the firm’s demand curve d RD', i.e., the demand curve in this model would
be a kinked demand curve.
12.2.3.2 Analysis of the Kinked Demand Curve Model
In the oligopoly model under discussion, the properties of the kinked demand
curve as well as its significance are especially discussed. In the first place, as
the demand curve or the average revenue (AR) curve of the firm has a kink, its
MR curve cannot be obtained as a continuous curve. We may, therefore, begin
with the properties of the MR curve of the kinked demand curve with the help
of Fig. 12.3.
The kinked demand curve of the firm in Fig. 12.3 is dRD'. There is a kink at
the point R (p1, q1) on this curve, because the curve consists of a segment dR of
the relatively flatter curve dd' and another segment RD' of the relatively steeper
curve DD'.
Therefore, in the case of the kinked demand curve dRD', the firm’s MR curve,
up to q = q1, would consist of the MR curve dM associated with the dR
segment of the kinked demand curve and for q > q1, the MR curve would be
the segment NB associated with the segment RD' of the demand curve.

262 Fig. 12.3

We have obtained above that the firm’s MR curve for its kinked demand curve Oligopoly: Price and
would consist of two parts, viz., the segments dM and NB, and there would be Output Decisions
a vertical gap between the points M and N at q = q1.
This implies that as the firm’s output goes on increasing up to q1, its MR would
go on decreasing along the segment dM up to the amount Mq1 and if the firm’s
output increases even by an infinitesimally small quantity at q = q1, its MR
would fall to Nq1, and, thereafter, as q increases, MR would decrease along the
segment NB.
In other words, there would be no MR value between Mq1 and Nq1, i.e., the
dotted segment MN is the discontinuity in the firm’s MR curve. We may also
say that at the point R on the dR segment of the kinked demand curve, the
firm’s MR would be Mq1 and, at the point R on the RD' segment of the demand
curve, MR would be Nq1.
We may now easily see that the numerical coefficient of elasticity of demand
(e1) at the point R on the demand curve segment dR is different from the
coefficient (e2) at the point R on the demand curve segment RD', and the larger
the difference between e1 and e2, the larger would be the length of the
discontinuity of the MR curve at the output q1.
As we know, at any point R (p1, q1) on the firm’s demand curve in Fig.12.4,
numerical coefficient (e) of price-elasticity of demand is
e= × reciprocal of the numerical slope at that point on the demand curve

now, the reciprocal of the numerical slope of the demand curve dRd' at the
point R on the segment dR > the reciprocal of the numerical slope of the
demand curve at the point R on the segment RD'.
Because, the segment dR is more flat than the segment RD', therefore, we have
e1 > e2
Now, MR (= MR1, say) at the point R on the segment dR' is

MR1 = Mq1 = p1 1 −

Also, MR (=MR2, say) at point R on the segment RD' is

MR2 = Nq1 = p1 1 −

Therefore, from the above two equations, we obtain

e1 > e2 ⇒ 1 − >1− ⇒ p1 1 − > p1 1 −

⇒MR1 (=Mq1) > MR2 (=Nq1)

That is, at the point of kink, R, on the demand curve dRD', or at q = q1, we
have two different values (e1 and e2) of e, and that is why at q = q1, we obtain
two different values (MR1 and MR2) of MR and two different parts of the MR
curve. The vertical gap between the two parts of the MR curve at q = q1 is
Mq1 – Nq1 = MN.
It follows from the above discussion that the larger the difference between e1,
and e2, i.e., the more flat the segment dR would be than the segment RD', i.e.,
the more prominent the kink would be at the point R, the larger would be the
value of MR1 than that of MR2 and the larger would be the discontinuity in the
MR curve at q = q1. 263
Market Second, in the model under discussion, the prices of the products are given
Structure initially, and a relation between these prices has been established already. The
model does not explain how these prices have been determined.
But there is a good chance that the price of the product of a firm would be
consistent with its goal of profit maximisation. For example, in Fig. 12.4, the
firm’s demand curve is dRD' and the associated MR curve is MR1 – the
discontinuity or the vertical gap between the two parts of the MR1 curve is MN.
Now, if the marginal cost (MC1) curve of the firm passes through this gap of
MN, then the firm’s price-output combination R(p1, q1) is consistent with profit
maximisation although here, at q = q1, we have MR (= Mq1) > MC (= Lq1), and
not MR = MC.
Here we see that at q < q1 MR > MC, making the firm increase its output to
reach the profit-maximising point. Now, as q increases and becomes equal to
q1, then also we have MR > MC. But if the firm increases q beyond q1, MR
becomes less than MC (MR < MC), i.e., from the production and sale of the
marginal unit of its output, the firm now would incur a loss.
Therefore, it would not produce more than q1, and its profit would be
maximum at q = q1, in spite of the fact that at q = q1, we have MR > MC, and
not MR = MC.
Third, although the assumption (v) of the model regarding the reaction pattern
of the rival firms may explain the kink in the firm’s demand curve, it cannot
explain how the price of the firm’s product, or, for that matter, the prices of the
rivals’ products are determined.
However, the reaction pattern of the rivals, as given by assumption (v), is able
to explain why the prices would not tend to change, i.e., why they would be
sticky, once they get determined.
For example, if, in Fig. 12.4, the firm’s quantity sold increases from q1 to q2, it
would not be inclined to change the assumption regarding the reaction pattern
of the rivals, for its conception about the rivals’ reactions, is, by no means,
dependent on its quantity sold.
Therefore, it would regard the increase in quantity sold, or an increase in the
demand for its product, as caused by a rightward shift in its demand curve—it
would think that its demand curve has shifted to the right from dRD' to dR'D''.

Fig. 12.4
264
We may note here that although the demand curve has shifted to the right, it Oligopoly: Price and
has kept the price of its product unchanged, resulting not necessarily in the Output Decisions
unfulfilment of its profit maximising goal.
In Fig. 12.4, we have assumed that the two curves, viz., dRD' and dR'D'', are
iso-elastic, and the MC1 curve passes also through the discontinuity (M1N1) of
the MR2 curve which is the marginal curve for the demand curve dR'D''.
Therefore, here the firm is able to maximise its profit at the same price p1 =
R'q2 = Rq1.
Fourth, in the model under discussion, the firm may not have to change the
price of its product, even if its cost of production rises. For example, let us
suppose that initially the firm’s AR and MR curves are dRD' and MR1, and the
MC, curve is the firm’s MC curve.
In this case, the firm’s profit would be maximised if it sells q1 of output at the
price of p1. Now, if the firm’s cost position changes resulting in an upward
shift in its MC curve from MC1 to MC2, and if the MC2 curve also, like MC1,
passes through the discontinuity (MN) of its MR curve, then the firm would
not have to change the price of its product in order to earn the maximum profit.
It would be able to maximise profit if it, like the previous case, sells of output
at the price of p1.
If the cost of production rises along with a shift in the demand curve, then also,
profit maximisation may not require the firm to change the price of its product.
For example, in Fig.12.4, let us suppose that the firm’s AR, MR and MC
curves are, respectively, dRD', MR1and MC1, In this case, the firm’s profit-
maximising price-output combination would be R (p1 q1).
Now, if the firm’s MC curve rises to MC2 along with a rightward shift in its
demand curve to dR'D'', then also the firm would not be required to change the
price of its product if the MC2 curve passes through both the discontinuities,
MN and M1N1, of its dRD' and dR'D'' curves.
It would still be able to earn the maximum profit at the price P1; but now its
quantity of output produced and sold would be q2; that is, now the firm’s price-
output combination would be obtained at the point R' (p1, q2).
On the basis of the above discussion, we may conclude that in the kinked
demand curve model of oligopoly, the firm would not consider it profitable or
rational to change the prevailing price of its product because of the assumption
(v) relating to the reaction pattern of its rivals.
[This assumption states, that if a particular firm increases the price of its
product, its rivals will not increase theirs, but if it reduces the price, they will
promptly reduce their prices.] We have seen that, because of these reactions,
the demand curve of each oligopolistic firm will be kinked, and the MR curve
of this demand curve will have two separate segments, and there will be a
vertical gap between them.
However, it is not that the firm’s goal of profit maximisation can never be
achieved because of the existence of this vertical gap. Even when the firm’s
demand increases, i.e., its demand curve shifts to the right and/or its MC curve
shifts upwards, it is not impossible for it to achieve profit maximisation at the
prevailing price.
Therefore, although the kinked demand curve model cannot explain the process
265
Market of price determination, it can well explain why the prices are sticky in an
Structure oligopolistic market.
Check Your Progress 2
1) Let there be two firms under Cournot’s model having market demand
curve as P = 20 – Q where Q the total production of the two firms 1 and
2. These firms are assumed to be producing under zero cost of
production. Determine:
i) Reaction curves of the two firms,
ii) Equilibrium level of output for both the firms
iii) Equilibrium market price
iv) Show graphically the Cournot’s equilibrium
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Let there be two firms which produce output under zero cost of
production. The market demand curve is given by P = 20 – Q (Where Q =
total output). Calculate output solution for the two firms under
Stakelberg’s model.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) In a duopolist market two firms can produce at a constant average and
marginal cost of AC = MC = 2. They face the market demand curve
P = 14 – Q, Where Q = Q1 + Q2' where Q1 is the output of Firm 1, Q2 is
the output of Firm 2. In the Cournot’s model:
i) Find action-reaction functions of the two firms.
ii) Calculate the profit maximising equilibrium price and output.
iii) What are the profits of the two firms?
iv) Compare it with competitive equilibrium.
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) Assume three firms face identical marginal costs of 20 with fixed costs of
10. They face a market demand curve of P = 200 – 2Q . Find the Cournot
equilibrium price and quantity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
266
5) What do you mean by kink in demand curve? Oligopoly: Price and
Output Decisions
......................................................................................................................
......................................................................................................................
......................................................................................................................

12.3 CO-OPERATIVE VS. NON-

COOPERATIVE BEHAVIOUR
12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
Co-operative behaviour in oligopoly is a situation when firms jointly decide the
prices and output and maximise their joint profit. This situation is called
collusion. In this situation it becomes profitable for one firm if it defects and
undercuts the prices and raises output, as long as others do not do so. Non-
cooperative behaviour is a situation when they do not co-operate and decides
their prices and output separately and compete with each other. When firms in
oligopoly do not co-operate it is called non-cooperative equilibrium or Nash
equilibrium (Named after US mathematician John Nash).
In oligopoly, the basic dilemma the firms face is whether to co-operate or to
compete. If they co-operate, profit will be maximum and if they do not, profit
for all will decrease. Now we will see the behaviour of an oligopolistc firm
through an example of game theory. Game theory is the study of decision
making in situations where strategic interaction (moves and countermoves)
between rival firms occurs. We will assume a case of only two firms in the
market, called Duopoly. The case is as follow:
The Oligopolist’s dilemma: to co-operate or to compete.
Table 12.1

Firm A’s Output

One-half Two-third
Monopoly output Monopoly
output
One-half 20 20 15 22
Monopoly output
Firm B’s Output
Two-third 22 15 17 17
Monopoly output

The figure above explains the dilemma faced by oligopolists of whether to co-
operate or to compete. It is called Payoff Matrix for a two Firm duopoly game.
The right side figures on each cell shows the profits of Firm A and left side
figures on each cell show the profits of Firm B (in Rs. Crores). It can be
explained that if the two firms co-operate and produce one half of market share
each will earn Rs. 20 crores of profit. In case of co-operation they can
maximise their profits. If Firm A defects and produces two thirds of output and
Firm B produces half of monopoly output then Firm A will earn Rs. 22 crores
and Firm B Rs. 15 crores. Similarly if Firm B defects and produces two-third
and Firm A produces one-half then Firm B will earn Rs. 22 crores and Firm A
will earn only Rs. 15 crores. If both decide to compete and produce two-third
267
Market of monopoly output each then profits for both will fall to Rs. 17 crores. This
Structure type of game, where they reach a non-cooperative solution when they could co-
operate, is called Prisoner’s Dilemma. Prisoner’s Dilemma is shown below:
Table 12.2 : The Prisoner's Dilemma

Mr. Ram
Confess Not confess
Mr. Shyam Confess 6 09
Not confess 9 1

Two prisoners Mr. Ram and Mr. Shyam are arrested for committing a crime
and interrogated separately. They are told the following:
a) If both are claimed to be innocent, they will get a light sentence that is 1
year in jail.
b) If one confesses and the other does not, then who confesses will be
released free and the other will be punished for 9 year in jail, and
c) If both confess, then both of them will get a punishment of 6 years in jail.
The payoff matrix presented in Table 12.2 shows the dilemma of the prisoners
about whether to confess or not to confess. If none of them confess then both
will get 1 year of jail, but if Ram confesses and Shyam does not then Ram will
be left free and Shyam will get 9 year of imprisonment and the vise-versa. And
if both of them confess then both will get 6 years of imprisonment. Not
confessing is the best solution in this game (Pareto efficient solution) but this
leaves one always in uncertainty. This solution is not a stable solution as one
gets an imprisonment of 9 years if he/she does not confess and the other does.
Therefore, confession dominates in the mind of both the prisoners. If both of
them confess then they end up with 6 years jail for both. This kind of
equilibrium is called Nash equilibrium. From both the figures above it is clear
that it they co-operate then they will earn the maximum profit than if they
compete.

12.3.2 Types of Co-Operative Behaviour

In order to avoid uncertainty arising out of interdependence and to avoid price
war and cut throat competition, firms under oligopoly often enter into some
agreement about determining uniform price and output. The agreement can be
of the following two types.
 Explicit Collusion: It is situation when firms under oligopoly do formal
(explicit) agreement to determine uniform price and output and maximise
their joint profit. Such an agreement at international level is called Cartel,
Many such agreements have taken place in the past. The best example of
cartel is that of OPEC – Organisation of Petroleum Exporting Countries.
Saudi Arabia and other countries after 1973 formed this cartel. An
individual firm always has incentive to cheat. Possibility of cheating is
larger if number of firms is large. Cheating by a small firm has negligible
effect on the market price.
 Tacit Co-operation: When firms co-operate without any explicit
268 agreement it is called tacit co-operation. For example in Table 12.1, if
 Firm A produces one-half of monopoly output hoping that Firm B will do Oligopoly: Price and
the same and Firm B does so then they achieve the co-operative Output Decisions
equilibrium without any formal agreement.
12.3.3 Types of Non-Cooperative Behaviour
In the absence of formal or informal agreements about co-operation, firms
under oligopoly compete with each other. Non-Cooperative or Competitive
behaviour under oligopoly can be of following types.
Competition for Market Share: Firms under oligopoly always compete with
each other for market share. They use various forms of non-price competition
such as advertising, quality products etc. to increase their market share. For
example in Delhi major mobile service providers like Airtel, Hutch and Idea
compete for increase their mobile connections.
Covert Cheating: In oligopoly, because of huge market share, firms sell their
products through contract. Large scale production and distribution is done
through contracts. When firms provide secret discounts and rebates to their
buyers to increase sales it is called covert cheating.
Contestable Markets and Potential Entry: Theory of contestable markets
explains that in the long-run, abnormal profits earned by oligopolists can be
eliminated without actual entry. Potential entry can also affect the market as
much as an actual entry does. It is possible only when the following two
conditions are fulfilled:
1) Entry must be easy to accomplish: There should not exist any barriers
to entry, either natural or firm created.
2) The existing firms must consider potential entry while making price
and output decisions: The existing firms must react when new firms try
to enter into the market. They must cut their prices and sacrifice profits
(short run) to restrict the new entrants.
Contestable markets always expect potential entry because of huge profits
earned by the existing firms in the market. But entry to such markets is too
costly. Fixed costs are very high. To develop, design, and sale a new product in
such a market involve huge sunk cost. Sunk costs are those costs which cannot
be recovered if a firm leaves the market soon. Firms which produce multiple
and differentiated products can easily distribute these costs among those many
products. For new firms, producing huge number of differentiated products is
not easy. Therefore, these costs are very high for a firm which produces single
product in the market.
If a new firm can enter and leave the market without any sunk costs of entry,
such markets are called perfectly contestable markets. A market can be
perfectly contestable, even if, firms have to pay some costs of entry if these
costs are recovered when firms leave the market. If the sunk costs are lower,
the market will be more contestable and vise-versa.
Sunk costs of entry constitute entry barriers. Higher the sunk costs, larger will
be profits earned by the existing firms. If the firms operate in the market
without large sunk costs of entry, then they will not earn large profits. As part
of strategy, existing firms keep their prices as low as that can only cover the
total costs. If they charge high prices and earn abnormal profits, the new firms
will enter and may capture the profits. Contestability forces the existing firms
to keep the prices low. The threat of entry into a market is as effective as actual
entry to limit profiteering by existing firms. 269
Market
Structure
12.4 CARTEL THEORY OF OLIGOPOLY
A cartel is defined as a group of firms that gets together to make output and
price decisions. The conditions that give rise to an oligopolistic market are also
conducive to the formation of a cartel. In particular, cartels tend to arise in
markets where there are few firms and each firm has a significant share of the
market. In the U.S., cartels are illegal; however, internationally, there are no
restrictions on cartel formation. The Organisation of Petroleum Exporting
Countries (OPEC) is perhaps the best known example of an international
cartel. OPEC members meet regularly to decide how much oil each member of
the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase their market power. Members of the
cartel work together to determine jointly the level of output that each member
will produce and/or the price that each member will charge. By working
together, the cartel members are able to behave like a monopolist. For example,
if each firm in an oligopoly sells an undifferentiated product like oil, the
demand curve that each firm faces will be horizontal at the market price. If,
however, the oil producing firms form a cartel like OPEC to determine their
output and price, they will jointly face a downward sloping market demand
curve, just like a monopolist. In fact, the cartel’s profit maximising decision is
the same as that of a monopolist. The cartel members choose their combined
output at the level where their combined marginal revenue equals their
combined marginal cost. The cartel price is determined by market demand
curve at the level of output chosen by the cartel. The cartel’s profits are equal
to the area of the rectangular box labelled abcd in Fig. 12.5. Note that a cartel,
like a monopolist, will choose to produce less output and charge a higher price
than would be found in a perfectly competitive market.

Fig. 12.5

Once established, cartels are difficult to maintain. The problem is that cartel
members will be tempted to cheat on their agreement to limit production. By
producing more output than it has agreed to produce, a cartel member can
increase its share of profits. Hence, there is a built in incentive for each cartel
member to cheat. Of course, if all members cheated, the cartel would cease to
270
earn monopoly profits, and there would no longer be any incentive for firms to Oligopoly: Price and
remain in the cartel. The cheating problem has plagued the OPEC cartel as well Output Decisions
as other cartels and perhaps explains why so few cartels exist.
Check Your Progress 3
1) Explain the prisoner’s Dilemma in oligopoly market.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) State the types of Non-cooperative behaviour under oligopoly.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by Cartel?
......................................................................................................................
......................................................................................................................
......................................................................................................................

12.5 LET US SUM UP

Oligopoly is the most prevailing form of markets. It is defined as a market
structure in which there are a few sellers of the homogeneous or differentiated
products. Oligopoly can be pure or differentiated. Characteristics of Oligopoly
are: Few dominant firms, Mutual interdependence, Barriers to entry,
Homogeneous or differentiated products. Factors causing oligopoly are: Huge
capital investment, Absolute cost advantage to the existing firm, Product
differentiation, Economies of large scale production, Mergers.
Price and Output determination in oligopoly is different from other three forms
of market structure. Since there are few rival firms and there is mutual
interdependence, the price and output policy of a firm will affect the price and
quality sold by other firms. There is no general theory under oligopoly. Price
and output indeterminateness is an essential feature of oligopoly.
Among models of Non-Collusive Oligopoly, Cournot’s Duopoly Model states
that firms attain Nash equilibrium. In equilibrium each firm is doing the best it
can given its competitor’s behaviour. It is based on the assumption that each
firm is attempting to maximise its total profits assuming that other firm holds
its output constant.
Stackelberg’s Duopoly Model is ‘First Mover Advantage’ Model as an
alternative explanation of oligopolistic behaviour. In this model, one firm sets
its output before other firms do. In this model, neither firm has an opportunity
to react. The leader firm produces more output and earns more profit than the
other firm. Sweezy’s ‘Kinked demand’ Curve Model explains price rigidity in
an oligopoly market by postulating that oligopolist’s will match price decrease
but not price increases.
271
Market
Structure
12.6 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton & Co,

New York, Chapter 24 & 25, page no. 415-455.

12.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 12.1.1 and answer
2) Read Sub-section 12.1.2 and answer
3) (D)
Check Your Progress 2

1) i) Reaction curve for Firm 1: Q1 = 10 – Q2

Reaction curve for Firm 2: Q2 = 10 – Q1

ii) The equilibrium level of output for both the Firms: Q = Q1 + Q2

= 6.67 + 6.67 = 13.34
iii) Equilibrium market price P is: P = 6.66
2) Let Firm 1 set its output first (i.e., be a leader) and Firm 2 be a follower
which makes its output decision after studying Firm 1’s output and
assuming that Firm 1’s output as fixed. Cournot’s reaction curve of Firm
2 will decide Firm 2’s profit maximising output.
The calculation of Firm 2’s profit maximising output is as follows:
MR2 = MC
∆
=0
∆

Or …(MC is zero is given)

R2 (total revenue) is calculated as:
R2 = P.Q2 = (20 – Q) Q2
= 20 Q2 – (Q1 + Q2) Q2

= 20Q2 – Q1Q2 – Q 22
∆
MR2 = ∆ =20 – Q1 – 2Q2

272
 Putting MR2 = 0, and solving for P2 we get: Oligopoly: Price and
Output Decisions
2Q2 = 20 – Q1

Q2 = 10 – Q1 (1)

This is Firm 2’s reaction curve.

The calculation of Firm 1’s profit maximising output is as follows:
MR1= MC
R1 = P.Q1 = (20 – Q) Q1= [20 – (Q1 + Q2)] Q1
= 20Q – Q12 – Q1Q2 (2)
It is clear from the above equation that total revenue earned by Firm 1 depends
upon output of Firm 2. Firm 2 will choose Q2 according to its reaction curve Q2
= 10 – Q1 .

Substituting (1) in (2) we get:

R1 = 20 Q1 – Q12 – Q1 (10 – Q1)

= 20Q1 – Q12 – 10Q1 + Q12

= 10Q1 – Q12
∆
MR1 = ∆ = 10 − Q

∴ MR1 = MC = 0 gives Q1 = 10 (3)

Substituting (3) in (1), we get:

Q2 = 10 – . 10

Q2 = 5 (4)
Thus, under the Stackelberg Model, profit maximum output of Firm 1 is
10 and of Firm 2 is 5. Firm 1 produces twice as much as Firm 2.
3) i) Given that the duopolists faces the following market demand curve:
P = 14 – Q
∴ Q = Q1 + Q2
 P = 14 – (Q1 + Q2)
Both the firms have
AC = MC = 2
Case 1:
Reaction Curve for Firm 1
Total revenue R1 is given by
R1 = PQ1 =[14 – ( Q1 + Q2)] Q1
 R1 = 14Q1 – Q12 – Q1Q2 273
Market Marginal revenue, MR1 is just the incremental revenue ΔR1 resulting
Structure from an incremental change in output ΔQ1.
∆
MR1 = ∆ = 14 − 2Q − Q

MR1 = MC…………………………..in equilibrium

∴ 2 = 14 – 2Q1 – Q2

 Q1 = (12 – Q2) Reaction curve of Firm 1

Similarly,

Reaction curve for Firm 2 will be: Q2 = (12 – Q1)

i) Cournot’s Output is:

Q2 = 12 − (12 − Q )

Q2 = 12 − 6 + Q

2Q2 = − 6+ Q

2Q2 – Q =6

=6
×
Q2 = =4

and Q1 = 4
Cournot’s price is:
P = 14 – (Q1 + Q1)
P = 14 – (4 + 4)
P = 14 – 8
P=6
ii) Profit of Firm 1 and Firm 2 is:
= R1 – C1
= PQ1 – AC × Q1
=6×4–2×4
iii) Comparison of output under perfect competition and Duopoly:
Under Perfect Competition:
P = MC
14 – Q = 2
Q = 14 – 2
∴ Q = 12
274
4) R 1 = (200 – 2(Q 1 + Q 2 + Q 3))Q 1 Oligopoly: Price and
MR 1 = 200 – 4Q 1 – 2Q 2 – 2Q 3 Output Decisions

Applying MR = MC:
Q 1 = 45 – Q 2/2 – Q 3/2
By symmetry:
Q 1 = Q 2 = Q 3 = 22.5
5) Read Sub-section 12.2.3.1 and answer
Check Your Progress 3
1) Read Sub-section 12.3.1 and answer
2) Read Sub-section 12.3.3 and answer
3) Read Section 12.4 and answer

275
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
 BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
 Oligopoly: Price and
Output Decisions

BLOCK 5 FACTOR MARKET

277
Market
Structure
BLOCK 5 FACTOR MARKET
In Block 4 we have focused on output market i.e. markets for goods and
services that firms sell and consumers purchase. Although the demand for
factors of production is derived in nature and hence the forces that shape the
supply and demand in output markets also affect factor markets. Yet, due to
some peculiar features of factors of production particularly that of land and
labour, the pricing of factors of production need separate treatment. Hence the
pricing of factors of production is being discussed separately in this block. This
block comprises three units.
Unit 13 provides an overview of how rent and wages are determined. It also
provides a bird’s eye view on the theories of interest and profit. Unit 14
acquaints the learners of the role of demand and supply mechanisms in
determinations of wages under perfectly competitive labour markets and
imperfectly competitive labour markets. It also provides the role of labour
unions and explanation of wage differentials. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.

278
UNIT 13 FACTOR MARKET AND
PRICING DECISIONS
Structure
13.0 Objectives
13.1 Introduction
13.2 Meaning of Factor Markets
13.3 Concepts of Demand and Supply of a Factor
13.3.1 Demand for Factor
13.3.2 Supply of Factor

13.4 Factor Pricing by Marginal Productivity Theory

13.5 Determination of Returns to a Factor
13.5.1 Rent
13.5.2 Wages
13.5.3 Interest
13.5.4 Profits

13.6 Role of Factor Prices in Pricing Decision of the Firm

13.7 Let Us Sum Up
13.8 References
13.9 Answers or Hints to Check Your Progress Exercises

13.0 OBJECTIVES
After learning about the different market structures viz. Perfect Competition
Monopoly, monopolistic competition and oligopoly in Unit 9 to 12 which
explain the different equilibrium conditions of price and output in the product
market, this unit introduces the concept of factor market i.e. the market for
factors of production in an economy. This unit will develop your understanding
about how factor markets operate distinctly from product markets, how pricing
decisions take place in factor markets and how returns to factors of production
are determined.
After going through this unit, you will be able to:
 state the concept of a factor market;
 explain the demand and supply mechanisms in factor markets;
 discuss marginal productivity theory of factor pricing;
 articulate pricing decisions for a factor and; and

 determine returns to factors of production viz. Wages, interest, rent and

profit.

Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
279
Petrolium University, Ahmedabad.
Factor Market
13.1 INTRODUCTION
Any platform that facilitates sale and purchase of a good or service is known as
a market. In order to produce goods and services, factors of production are
required. Just like product and service markets, factors of production of an
economy also have their markets. Markets are required to determine their
demand, supply and market prices. The primary four factors of production are
land, labour, capital and entrepreneurship. This unit explains briefly the
essence, importance and operations of land, labour and capital market and the
last two units of this block provide detailed explanation on labour and land
markets.
To begin with, it is important to understand why there is a need for factor
markets. For understanding this, there is a need to understand the importance
of factors of production in an economy. As the name suggests, ‘factors’ of
production are important entities in the process of production without which
production cannot take place. It is not possible to produce a computer without a
machine (capital), not possible to produce software without an IT professional
(labour) and not possible to produce anything without some space for
production (land) where capital and labour are engaged through an IT
employer (entrepreneur). All four factors of production are required in an
economy for production to take place irrespective of the fact whether what is
getting produced is a product or a service. However the ratios in which factors
of production are used can differ as per production requirements and
advancement of technology. In the era of artificial intelligence, virtual markets
and robots, production process using the above technologies are likely to
become more capital intensive (and less labour intensive).
Having understood the importance and dynamics of factor markets in an
economy, the following sub-sections will throw light on the meaning of factor
markets and theories of factor market pricing.

13.2 MEANING OF FACTOR MARKETS

Factor markets are the markets where sale and purchase of factors of
production like land, labour and capital takes place. These factors of
production, along with entrepreneur, interact to produce goods and services in
an economy. The broad characteristics and meaning of these factors of
production has been outlined below:
i) Land: It is a physical/tangible factor of production and is a stock
concept. It consists of the total physical resources that are available.
Land not just includes ground, but also includes the forests, water
resources, soil, minerals, mines, etc.
ii) Labour: It is an intangible factor of production as labour services are
endowed with a labourer and cannot be separated from him. The effort
used by households for production purposes, whether manual or
intellectual, is known as labour. Labour is a flow concept.
iii) Capital: It is a tangible factor of production and refers to all forms of
machinery, buildings, transport services, etc. that are used in the
production process.
iv) Entrepreneurship: This refers to the intangible abilities of an
entrepreneur to conduct and organise the production process for
280 producing goods and services.
 Generally, households own or control these factors of production and sell Factor Market and
them to producers. Households provide their services as labour and earn Pricing Decisions
wages in return. They also mobilise their savings for buying physical
capital and also own land. Some households also have members with
entrepreneurial skills and act as entrepreneurs. Households earn by
selling these factors of production in the factor markets and thus
contribute positively to the production process. This interaction can be
shown through a circular flow of income and spending between
households and firms in Fig. 13.1 given below.

HOUSEHOLDS SUPPLY LAND, LABOUR, CAPITAL AND ENTREPRENURIAL SKILLS

FIRMS (PRODUCERS OF HOUSEHOLDS (OWNERS OF

GOODS AND SERVICES) FACTORS OF PRODUCTION)

PRODUCE AND SUPPLY GOODS AND SERVICES TO HOUSEHOLDS

Fig. 13.1: Circular flow of factors of production and goods & services between households
and firms in a simple two-sector economy

13.3 CONCEPT OF DEMAND AND SUPPLY OF A

FACTOR
As a student of microeconomics, you may already be well-versed with the
concepts of demand and supply. The concepts and the laws of demand and
supply that you have previously studied apply largely to the goods market. In
order to understand the demand and supply of a factor, it is important to
understand the inter-relationship between the goods market and factor markets.
Derived Demand
Let us consider the demand for office space by a data analytics firm. A data
analytics company generally requires a rented office space for its analysts,
programmers, managers and other workers. Similarly a bakery owner requires
space for producing and selling bakery products. In each geographical area,
there would be a downward sloping demand curve for office space whose
rental is linked to the quantity of office space demanded by firms i.e. the lower
the rental price, the higher is the demand of firms for office space. An
important distinction between demand for goods and demand for factors is with
regards to utility. While on one hand, consumers demand goods as they derive
utility from its consumption, on the other hand firms do not demand factors of
production for satisfaction of utility but for the purpose of conducting
production operations using the four factors of production. The purpose is to
maximise revenue and gains from production using factors of production.
Moreover the demand for factors of production is dependent on the demand for
goods and services from the consumers. Higher is the demand for goods, 281
Factor Market higher would be the demand for factors of production and vice-versa.
Economists therefore regard demand for factors of production shown in Fig.
13.2 given below as a derived demand.

Fig. 13.2

Interdependent demand
As explained earlier, you may recall that production cannot take place using a
single factor of production. It takes place through an interaction of different
factors of production. Imagine a producer who wants to produce gold
jewellery. This producer would require services of designers (labour), office
space for conducting production process (land) and some machinery for
moulding and heating metals (capital). It is to be noted that interdependence in
production leads to interdependence in productivities of factors of production.
Thus productivity of labour would get directly affected if the casting or rolling
machine used in making gold jewellery gets jammed for two days. In effect, it
is the interdependence of productivities of land, labour and capital that makes
distribution of factor incomes a complex task. In order to estimate the
contributions of the different factors of production in the process of production,
the concept of marginal productivity is used wherein the marginal productivity
of each factor of production is calculated and used for determination of returns
to them.
Marginal Physical Product (MPP), Value of Marginal Product (VMP) and
Marginal Revenue Product (MRP)
The marginal physical product (MPP) of a factor of production (like labour) is
the additional output produced when an extra unit of that factor of production
(worker) is added, other factors of production remaining constant.
MPP = Change in Total product / Change in number of units of factor
of production
The concept of value of marginal product also known as marginal value
product refers to the value of output as estimated using information on market
prices. Thus when price of a product is multiplied with the marginal physical
product of a factor of production, one can derive value of marginal product.
VMP = Price of output × Marginal Physical Product of factor
Marginal revenue product is the additional revenue due to highering of an
additional of worker.
282
 Factor Market and
Pricing Decisions
MRP = Change in Total revenue / change in number of units of a factor
of production
OR
MRP = Marginal revenue × Marginal physical product
These concepts can be easily understood using an illustration of a firm making
decisions on how many workers to hire. The Table 13.1 shows the hypothetical
case of a bread manufacturer with given factors of production. Information on
workers who are variable factors of production is given. In order to calculate
value of marginal product, information on market price of bread is given as
Rs.10.
Table 13.1
Units of Total Marginal Market Value of Total Marginal Marginal
Workers Product Product Price of Marginal Revenue Revenue Revenue
(TP) (MPP) Bread Product (TR) (MR) Product
(VMP) (MRP)
0 0 --------- 10 ------- ------ ----- -------
1 20 20 10 200 200 10 200
2 30 10 10 100 300 10 100
3 35 5 10 50 350 10 50
4 38 3 10 30 380 10 30
5 39 1 10 10 390 10 10

As you can see in the above table, the entries in the VMP column are identical
to the entries in the MRP column. However this is taking place due to the
assumption of perfect competition where price is equal to marginal revenue.
The entries would change in case of imperfectly competitive markets.
Demand for Factors of Production
Demand curve of factors of production can differ depending upon the type of
market structure we are discussing. We have discussed examples of perfectly
competitive market structure so far and observed that in such a market VMP is
equal to MRP. Here VMP gives information about the maximum number of
factors that may be hired. As VMP refers to the value addition of each worker
in the production process, it can be inferred that in perfectly competitive
markets, it is the VMP (as well as MRP) curve which reflects the demand
curve of a perfectly competitive firm. Thus VMP as well as MRP curve
becomes the demand curve for a factor of production. This also implies that
factors which affect the MRP of a firm would also affect the demand curve for
the factor. Factors which may affect MRP of a firm are substitutability of a
factor by other factors, change in demand for finished product as well as the
total cost incurred on a factor of production.
Does VMP as well as MRP curve give the market demand of a factor? A single
MRP curve would not give the market demand for a factor as it reflects
demand only for a single firm. Thus aggregation of the MRP curves of all the
firms of the industry would give industry wide market demand for a factor. In
addition to this, if the market demand for a factor for all the industries is added,
then one can derive the aggregate market demand curve for a factor of
production. 283
Factor Market
Marginal Revenue Product (MRP) as Demand
Curve
250

Marginal Revenue Product

200
150
100
50 Marginal Revenue
0 Product (MRP)
0 2 4 6
No. of workers

Fig. 13.3
Supply of Factors of Production
Most factors of production are privately owned in a free market economy.
Moreover decisions on supply of factors of production like labour, capital and
land are governed by a number of economic and noneconomic factors. The
important determinants of labour supply are the price of labour and
demographic factors such as age, gender, education and family structure.
Factors that affect the supply of land are mostly the one that affects the quality
such as conservation and change in settlement patterns. Factors that affect the
supply of capital are past investments made by businesses, households and
governments.
The supply curve for all inputs may slope positively or be vertical. In some
cases, it may have even a negative slope. To begin with as the supply of land is
fixed, the supply curve of land has a vertical shape. As the supply of capital is
directly affected by a change in its returns, higher the returns, higher would be
the supply of capital. Thus the supply curve of capital is positively sloped.
LAND MARKET CAPITAL MARKET

Fig. 13.4
284
LABOUR MARKET Factor Market and
Pricing Decisions
On the other hand, the supply curve of labour is either positively sloped in the
short-run or backward-bending in the short-run. Reasons for the backward
bending shape of the labour supply curve have been discussed in detail in the
next unit. The interaction of the demand curves of factors of production and the
supply curves of factors determines their equilibrium price level.
Check Your Progress 1
1) What do you understand by the term factor pricing? What are factor
markets?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Is demand for capital a derived demand? Explain the concept of
interdependent demand also.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) How is the equilibrium determined in factor markets?
......................................................................................................................
......................................................................................................................
......................................................................................................................

13.4 FACTOR PRICING BY MARGINAL

PRODUCTIVITY THEORY
So far you have studied that households provide the different factors of
production used in the production process and how their demand and supplies
are determined. You may be curious to understand that how owners of factors
of production get paid for the factors they provide. For understanding this
process, it is important to understand marginal productivity theory of income
distribution.
The theory of marginal productivity of income distribution analyses the way
the national income gets distributed among the different factors. The theory
says that returns to a factor are directly determined by their marginal product of
that factor. This occurs due to the competition among numerous landowners,
labourers and capital-owners. Another fundamental point about the distribution
theory is that the demands for various factors of production are derived from
the revenues that each factor yields on its marginal product. The profit
maximising firms would choose factor combinations according to their
marginal revenue products.

13.5 DETERMINATION OF RETURNS TO A

FACTOR
A) RENT
Land is such a factor of production whose total supply is fixed. The demand for
land is also a derived demand. Suppose a particular piece of land is being used
285
Factor Market to grow soyabean. If the demand for soyabean increases in the market, the
demand for land for growing soyabeans would also increase. However as
supply of land is fixed, an increase in the demand for land would increase the
rental rate of land.

Demand SSupply

Rent
R*

Quantity of Land
Fig. 13.5: Equilibrium in Land market

As per the Fig. 13.5, R* is the equilibrium rental rate of land which has been
determined by the interactions between demand and supply of land. The
various theories of rent have been provided in Unit 15.
B) WAGES
Wages are the price of labour supplied. In competitive markets wages are equal
to the marginal product of labour. Wages are in equilibrium when the
downward sloping labour demand curve crosses the upward sloping labour
supply curve. When due to an external shock, there is lower demand for the
product of the industry, then there is a fall in the price of product. Due to this,
the value of marginal product of labour (VMP) would also fall resulting into
lower wages for the labour. Conversely, a surge in the demand for product of
an industry would raise the prices. This, in turn, would increase the value of
marginal product of labour leading to a rise in wages. This mechanism has
been explained in the Fig. 13.6.

Fig. 13.6: Equilibrium in Labour Market

The determination of wage rates is however different in case of perfectly

competitive and imperfectly competitive markets as you would see in Unit 14.
286
C) INTEREST Factor Market and
Pricing Decisions
Capital is a factor of production made by human beings. The cost of using
capital services is known as the rental rate for capital and the returns to the
owners of capital is known as interest. Interest is a reward for the services of
capital. Rental rate of capital is the opportunity cost of holding capital. Unlike
labour, capital goods can be bought and sold and have an asset price. Buying a
car for Rs.10 lakh entitles one to use it for a number of transport services in
future directly or by renting it to someone. The price of an asset is the sum for
which the capital asset can be purchased outright. The required rental rate of
capital depend on three things: the price of capital good, the real interest rate
and the depreciation rate. The price of capital good depends on the interactions
between demand and supply of capital goods. In general, the price of capital
assets and services is higher when the anticipated rental stream is higher or the
interest rate is lower. Both of these raise the present value of the future rental
streams of capital. The real interest rate depends on the prevailing rate of
inflation and the nominal interest rate. The difference between the nominal rate
of interest and the rate of inflation is known as real interest rate. Depreciation
depends largely on technology and also on how fast the machine wears out
with usage and time.
Theories of Interest
There are a number of theories, which seek to determine the rate of interest.
These theories try to explain the phenomenon of interest in terms of different
set of variables.
i) Loanable Funds Theory
This theory relies on demand for borrowings and supply of loanable funds to
determine the rate at which transaction will take place. It assumes that at any
moment of time there will be some people who would spend less then their
current income (savers) and others who plan to spend more than their income.
The former will constitute the supplies of loanable funds while the latter
constitutes the group which demands such funds. The rate at which demand for
funds equals supply of funds will be the rate of interest. Such a situation is
depicted in Fig 13.7.

Fig. 13.7

Fig. 13.7 Presents a simple demand and supply curve diagram you are so
familiar by now. The curve DD is demand curve for the funds. This shows
287
Factor Market amounts the borrowers would like to borrow at different rates of interest.
Likewise, the amounts all the savers in the society are willing to save and lend
are shown by supply curve marked SS. The intersection of these two at point E
gives us equilibrium rate of interest re and the quantity QE that will be
borrowed and lent at that rate.
At re rate of interest, QE quantity of funds is borrowed (and lent). Note that
demand for funds may arise on account of any three of the following:
a) Investment demand, b) consumption demand and c) financial demand. It is
more likely to be a composite of all the three demands.
Similarly, we can say that supply of funds may arise from net savings, de-
hoarding of past savings and also from new creation of money.
ii) Liquidity-Preference Theory
Keynes had developed this approach and he related demand for money and rate
of interest to aggregate level of income in the society. In his formulation
demand for liquid money would depend on transaction, precaution or
speculation, given the level of income. But supply of money was policy
determined variable. The rate of interest was thus determined by interaction of
a demand function with a given supply of money. However, in his approach,
the rate of interest has nothing to do with determination of rate of remuneration
of factor of production.
iii) Time Preference Approach
Irving Fisher developed this approach. His idea was that consumer tries to
compare present consumption and future consumption. The rate at which future
consumption can substitute for present consumption (and vice-versa) will be
marginal rate of substitution between present and future consumption. This is
called the rate of time preference. It shall be equal to slope of indifference
curve between present and future consumption.
D) PROFITS
We regard entrepreneurship to be the fourth economic factor of production.
Recall that an entrepreneur brings together land, labour and capital and thus
facilitates production. Her role in production is clear. If other factors of
production are not brought together, there may not be any production at all. In
capitalist system, the possibility of profit becomes key determinant of whether
an activity will be undertaken or not. Even under various non-capitalistic
forms of organisation, profit may serve as a benchmark for efficiency of firm
or efficiency of some innovation or technological change. Thus, in all
situations, if a firm is making larger profit compared to some other similarly
placed firm, it must be more efficient or must be using either better resources
or better techniques. But decision like introduction of better techniques
involves some risk as well. Hence, often attempts are made to relate profit to
elements of uncertainty and risk. To understand her role, we can divide
entrepreneurial functions into two parts:
a) Organisation and
b) Risk bearing
a) Organisation: This consists of routine day-to-day activities associated
with a business organisation and is called management. We find that
288 these days, most companies are being managed by professional
 managers, who receive salaries and other benefits. Such an arrangement Factor Market and
places a part of entrepreneurship at par with labour. Pricing Decisions

b) Risk Bearing: Every business activity runs some risk of failure in the
market. This arises because of uncertainty of marketplace, natural causes,
political factors etc. If a business fails, the entrepreneur looses substantial
parts of investment. Thus, risk of loss is always present. However, some
activities like introducing a new product, using a new technology etc.,
involve much greater risks and reward for these activities must be higher.
Otherwise, these would not be undertaken. Hence it is said that profits are
reward for risk bearing.
1) Accounting Profits and Economic Profits
An account defines the profit as the difference between total revenue earned
during the year and cost (including depreciation) incurred during the same
period. The cost comprises payments for raw materials, fuels/energy, wages
and salaries, rents, insurance and interests. The depreciation is provided for
taking care of wear and tear of capital stock. So the net surplus earned during
the year, after meeting the above costs, is called profit by the accountant.
However, such calculations do not seem to account for some implicit costs.
Take for example the remuneration to the person when she is actually working
for her business. Similarly, companies accumulate some funds of their own in
course of time. Should interest of those funds be also calculated and added to
the cost? Economic profit will take into account this kind of implicit cost as
well. So economic profit will be less than accounting profit by the amount of
such implicit costs.
2) Theories of Profits
Economists have, over the years, developed several theories regarding profits.
For example, Joseph Schumpeter attributed profits to innovation. But Frank
Knight associated them with uncertainty.
a) Profits as Rewards for Innovation
Schumpeter regards profit a phenomenon, which is related to a dynamic
economy only. He identifies five types of changes that lead to economic
development or make the society dynamic. These changes are:
i) Introduction of new products
ii) Introduction of new methods of production
iii) Discovery of new raw materials
iv) Discovery of new markets
v) Introduction of new forms of organisation
Innovations are actual application of some new body of knowledge to real
business situation. An innovator need not be an inventor. But she uses some
invention to change her production function or the relationship between inputs
and outputs. Such innovation might be in form of new technique of production,
may involve reaching out to new markets, involving all the activities pertaining
to marketing etc.
Schumpeter is of the opinion that one who innovates is able to earn more
profits, and thus gets more incentive to innovate further. She will soon attract 289
Factor Market followers or imitators. These people, very soon catch up with original
innovator. As a consequence, she makes more efforts to stay ahead. Thus,
innovation leads to profits and profits make it possible to innovate (acting as
incentive).
b) Uncertainty and Profit
Frank Knight defined profit as the difference between selling price and costs.
In such situation profit emerges as a residual. Selling price and costs depend on
a host of factors. Some of those can be covered by ‘risk’. Such risks can be
anticipated and provisions can be incorporated into the cost structure. Most of
predictable risks are ‘insurable’ as well. Hence, company can get an
appropriate insurance policy to cover such risks. The premium paid for such
policy is included in cost of production. This type of risk condition is
completely predictable and discountable. Hence it would be as good or as bad
as production under perfect certainty.
But Knight points to another dimension of uncertainty and says that producer is
all the time anticipating consumer’s wants and preferences in advance. She
must do so, as she has to produce things that can satisfy those swans at a point
of time in future. This essentially happens because of time lag involved
between anticipation of demand, production and offering goods to consumer.
To some extent, future results of her operations to produce things to satisfy that
demand are also uncertain. Further, even the manager doing routine
organisation work is liable to make error of judgement. Here, she bears
uncertainty and risk in the sense of having to protect factors of production
against fluctuation in their income from an uncertain market. Thus, the income
of entrepreneurs consists of two components, a salary or wage component,
which is contractual in nature and another residual income that may fluctuate
in response to change in market place. Some economists prefer to call only this
second component as ‘profit’.
Thus, we find that one significant difference between other factor incomes and
profit. Whereas wage, rent interest are all payments, which have been agreed to
and settled in advance, profits cannot be put on a similar footing. Uncertainty
leads to fluctuation in both costs and revenue. They may not balance. Thus,
ultimately profits are the ‘surplus’ that remain after meting the entire
contractual payment obligation.
c) Profits and Market Structure
Some economists insist that profit as one generally understood is essentially a
result of market imperfections. If perfect competition prevailed, every producer
will use same technology, will have perfect knowledge about product, cost and
market condition. Such a scenario leads to cost minimisation for all the
production. They sell at going market price. All the cost and revenue
determinants are perfectly certain. Hence, entrepreneurship is just organisation
or day-to-day supervision only. So, profits should drop down to bare minimum
or ‘normal’ compensation for supervision etc.
However, if market is not perfect, firm can determine quantities or prices in
such a manner that suits it best. It may involve breaching the condition of
perfect information. Firms may devise some innovation and keep it a secret
from others. So long as that secret is maintained, the concerned firm continues
to earn more than others do.
290 A.P. Lerner tried to measure the effect of monopoly power over profit. We
know that equilibrium condition for a firm is equality between marginal cost Factor Market and
and marginal revenue. When competition is perfect, price (average revenue) is Pricing Decisions
also equal to marginal revenue. Prices tend to deviate from marginal revenue
only when competition is no longer perfect. Hence, the difference between
price and marginal revenue, that is, P – MR (or P – MC) will indicate firms
control over market. It is expressed as a fraction of price. Thus, the degree of
monopoly is (P – MC)/P. Higher this ratio, higher will be the rate of profits
earned by a firm.

13.6 ROLE OF FACTOR PRICES IN PRICING

DECISION OF THE FIRM
Several factors play a role in the decision making of a firm regarding
production of goods and services. The intrinsic factors are cost of production,
marketing, product differentiation and objectives of the firm. These factors
directly shape the production process of the firm. A firm needs to decide its
cost of production which is dependent on the availability and cost of factors of
production. A firm also needs to differentiate its product from similar products
to increase its demand. The quantity of output to be produced depends on the
objectives of the firm. If the objective is to maximise profits, only that much
output would be produced where the cost of production is less than the price.
Similarly a firm needs to decide its marketing strategy and the expenditure for
it. The extrinsic factors are demand, competition, suppliers and economic
conditions.
How can a change in factor prices affect the pricing decisions of the firm?
Suppose due to a government regulation, there is a rise in minimum wage rates
of construction labourers. As wages are an essential part of cost of production
of any industry, rise in the minimum wage rate leads to a rise in the cost of
production of a real estate firm. In this case, the firm has two alternatives.
Either the firm can continue to use the services of the same number of
construction labourers and absorb the rise in cost of production or try to
substitute some amount of capital for labour. For e.g. in place of using services
of 10 labourers to lift the load of cement, the firm may buy a trolley with
wheels which may be dragged by 2 labourers. Thus change in the prices of
factors of production can alter the pricing decisions as well as production
decisions of the firms.
Check Your Progress 2
1) What is theory of marginal productivity? How does it explain the process
of determination of factor prices?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Distinguish between interest and profits as rewards of factors of
production.
......................................................................................................................
......................................................................................................................
......................................................................................................................
291
Factor Market 3) Explain loanable fund theory in 50 words.
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) What are the main functions of entrepreneur?
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................

13.7 LET US SUM UP

This unit introduces the concept of factor markets by discussing the meaning
and need for factors of production in an economy. There are four factors of
production in an economy namely land, labour, capital and entrepreneur. These
factors of production are required in the production of goods and services. As
demand for factors of production is linked to the demand for goods and
services, their demand is derived demand. Moreover more than one factor of
production is used in the production process and so their demand is interlinked
and interdependent. This interdependency between product and factor markets
results into interactions between demand and supply of goods and services.
Each factor of production is paid its return for its contribution in the process of
production. The returns to land are called rent and it is the price paid for the
use of land which is fixed in supply in the short run as well as in long run. The
returns to labour are known as wages and both rent and wages are determined
through the interaction between demand and supply. Interest is the return to
capital. The theories determined the rate of interest are: Loanable fund theory,
liquidity – Preference theory, and time Preference approach. Profits are the
returns to entrepreneurs for their organisation and management skills used in
conducting the production process. Several theories have been developed
regarding profits.

13.8 REFERENCES
1) Economics, Joseph E. Stiglitz and Carl E. Walsh, 4th Edition, W.W.
Norton and Company, Inc. London. 2010.
2) Lipsey. R.G., An Introduction to Positive Economics. (6th edition),
E.L.B.S and Weidenfeld and Nicolson: London.
3) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,
New York, Chapter 26, page no. 456-466.
4) Robert H Frank and Ben S Bernanke, Principles of Economics, Chapter 14
292 and 21, Third Edition, Tata-McGraw Hill, Indian Reprint.
 Factor Market and
13.9 ANSWERS OR HINTS TO CHECK YOUR Pricing Decisions
PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 13.1 and 13.2 and answer.
2) Read Section 13.3 and answer.
3) Read Section 13.3 and answer.
Check Your Progress 2
1) Read Section 13.4 and 13.5 and answer.
2) Read Section 13.5 and answer.
3) Read Section 13.5 (Interest) and answer.
4) Read Section 13.5 (Profit) and answer.

293
 UNIT 14 LABOUR MARKET
Structure
14.0 Objectives
14.1 Introduction
14.2 Meaning of Labour Markets
14.3 Labour Market: Different Market Structures
14.3.1 Perfect Competition
14.3.2 Imperfect Competition

14.4 Labour Market Policies

14.4.1 Minimum Wage Laws
14.4.2 Role of Labour Unions

14.5 Why Wages Differ?

14.6 Let Us Sum Up
14.7 References
14.8 Answers or Hints to Check Your Progress Exercises

14.0 OBJECTIVES
You have already studied the basics of factor markets in the Unit 13. This unit
discusses in detail the characteristics of and price mechanism in labour market
as labour differs significantly from the other factors of production. Households
supply labour and are paid wages in return of their services. Labour is
inseparable from a labourer and this characteristic distinguishes labour market
from land and capital markets. After going through this unit, you will be able
to:
 state the meaning of labour markets;
 explain the demand and supply mechanisms in perfectly competitive
labour markets;
 analyse demand and supply mechanisms in imperfectly competitive
labour markets;
 discuss the policies in labour markets; and
 identify the reasons behind variations in wage rates.

14.1 INTRODUCTION
The decisions that people make about work determine the economy’s supply of
labour. Their decisions about savings determine the economy’s supply of funds
in the capital market. Economists use the basic model of choice to help
understand the patterns of labour supply. The choice of work is a choice
between consumption and leisure. Holding technology and other inputs
constant, there exists a direct relationship between the quantity of labour inputs
and the amount of output. The law of variable proportions states that after a
certain level, each additional unit of labour input will add a smaller and smaller
294
Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
Petrolium University, Ahmedabad.
amount to the total output. Thus, there are diminishing returns to labour. This Labour Market
unit aims at analysing the meaning and mechanism of labour markets by
undertaking a demand-supply analysis of a labour market in both perfectly
competitive and imperfectly competitive market structures.
There are government interventions, labour market policies, labour rights and
labour laws in an economy. This unit has looked into the implications of the
presence of minimum wage laws and labour unions in detail. The last section
of the unit looks into the reasons leading to variation in wage-rates across
professions. A deeper understanding of labour markets would help you to
understand how labour as a resource functions in an economy.

14.2 MEANING OF LABOUR MARKETS

In order to understand the meaning of labour markets, one needs to understand
who are the demanders and suppliers in the labour market. Firms and other
employers demand labour to produce goods and services. Households supply
their labour services and in return, get wages. The labour market is studied by
microeconomists as well as macroeconomists as both use the tools of demand
and supply. The labour market refers to the supply and demand for labour, in
which employees provide the supply and employers the demand. It is a major
component of any economy, and is intricately tied in with markets for capital,
goods and services. At the macroeconomic level, supply and demand are
influenced by domestic and international market dynamics, as well as factors
such as immigration, the age of the population, and education levels.
Commonly used measures in labour markets are unemployment rate, labour
productivity, labour intensity, participation rates and total wage income as a
percentage of GDP. Wages represent the price of labour, which provide an
income to households and represent a cost to firms. In a hypothetical free
market economy, wages are determined by the unregulated interaction of
demand and supply. However, in real mixed economies, governments and trade
unions can exert an influence on wage levels. At the microeconomic level,
individual firms interact with employees, hiring them, firing them, and raising
or cutting wages and hours of work. The interaction between supply and
demand influences the hours the employees work and compensation they
receive in form of wages, salary and other benefits.

14.3 LABOUR MARKET: DIFFERENT MARKET

STRUCURES
As labour is generally demanded for producing goods and services, the demand
for it would depend on the structure of the market for goods and services too.
We would study it under two major heads:
 Perfectly competitive market
 Imperfectly competitive market
14.3.1 Perfect Competition
DEMAND FOR LABOUR
We begin the discussion by analysing what determines the number of workers
the employers would like to hire at any given wage rate. Demand for labour
depends on both productivity of labour and the price that market sets for
295
Factor Market worker’s output. The more productive the workers are, the more is the value of
the goods and services produced by them and the greater the number of
workers an employer wants to hire at the given wage-rate. Table 14.1 shows
the relationship between output and the number of workers employed in a
computer hardware company. Column 1 shows the possible number of workers
that may be employed by the company and Column 2 shows the output
produced depending on the number of workers hired. Column 3 shows the
marginal product of labour which is the additional production due to addition
of one more worker. As discussed earlier, as more and more workers are hired
by an organisation, beyond a certain limit there are decreasing returns to
labour. The law of diminishing returns to labour states that if the quantities of
capital and other inputs are held constant, then the greater the quantity of
labour employed, lesser would be their marginal contributions to production.
This can be observed in Column 3 which depicts marginal product of labour.
Column 4 shows the value of marginal product at each level of employment.
The value of marginal product of labour is the amount of extra revenue that an
additional worker generates for the firm. Specifically, the value of the marginal
product of workers is workers’ marginal product multiplied by the price of
output. Here the price of output is taken as Rs. 20,000 per unit. Monthly wage
rate of computer hardware workers in the market is Rs. 20,000/-.
Table 14.1 : Relationship between output and number of workers

Number of Computers Marginal Value of Marginal

Workers Produced Product Product (In Rs)
per Year
(1) (2) (3) (4)
0 0 - -
1 15 15 15 × 20,000 =
3,00,000
2 28 13 13 × 20,000 =
2,60,000
3 39 11 11 × 20,000 =
2,20,000
4 47 8 8 × 20,000 = 1,60,000
5 52 5 5 × 20,000 = 1,00,000
6 55 3 3 × 20,000 = 60,000
7 57 2 2 × 20,000 = 40,000
8 57 0 0 × 20,000 = 00

The company would hire an extra worker if and only if the value of his
marginal product is at least as great as the wage payable to him. In our example
above, the second worker’s marginal product is 13 computers during the year.
These are valued at Rs. 2,60,000/- but, at the rate of Rs. 20,000 per month, this
worker gets only Rs. 2,40,000/- as wages during the year. Thus, the company
clearly earns Rs. 2,60,000 – Rs. 2,40,000 = 20,000/- as a surplus on giving
employment to this worker. The company will not employ the 3rd worker, his
marginal product will be valued at Rs. 2,20,000/- only, which is Rs. 20,000/-
296
less than the wage payment necessary to employ him.
Suppose market wage rate drops down to Rs. 15000/- per month. There will be Labour Market
a change in employment decision of the company. Every worker will not
receive Rs. 1,80,000/- per annum. We can read from Column 4 of the Table
14.1 that marginal product of the third worker is valued at Rs. 2,20,000/- and
this exceeds annual wage payment to him by Rs. 40,000/-. The company will
definetly employ this person as his employment adds to the surplus. However,
the fourth person will still not be considered ‘employable’ by the company as
his marginal product (Rs. 1,60,000/-) will be less than his wage bill (Rs.
1,80,000/-).

Fig. 14.1: Demand curve of labour

FACTORS AFFECTING DEMAND FOR LABOUR

The number of workers the company hires at any given real wage rate depends
on the value of their marginal product. Changes in the economy that increase
the value of workers’ marginal product will increase the value of extra workers
to the company and would thus affect the demand for labour at any given real
wage. This implies that any factor which raises the value of the marginal
product of the company’s workers will also shift the company’s labour demand
curve to the right. In short, the two factors which directly affect and increase
labour demand are:
a) An increase in the price of company’s output
b) An increase in the labour productivity of company’s workers
This can be easily shown using the above example (Table 14.2). Suppose the
price of output increases from Rs. 20,000 per unit to Rs. 30,000 per unit. The
value of marginal product of labour would change in accordance to the price
change and will also change the number of workers to be hired by the company
if the ongoing wage rate remains the same.
Table 14.2 : Value of Marginal Product and Firm’s decision to Hire

Number of Computers Marginal Value of

Workers Produced per Year Product Marginal Product
(In Rs)
0 0
1 15 15 450000
297
Factor Market 2 28 13 390000
3 39 11 330000
4 47 8 240000
5 52 5 150000
6 55 3 90000
7 57 2 60000
8 57 0 0

Here, if market wage rate remains Rs. 20,000/- per month the 4th worker is also
hired- as value of his marginal product (Rs. 2,40,000/-) equals the wage
payable to him during the year (Rs. 2,40,000/-). But hiring the 5th worker will
not be in the company’s interest – he would add only Rs. 1,50,000/- to the total
revenue, but claim Rs. 2,40,000/- as wages.
The next possibility is rise in labour productivity. We are showing it in Table
14.3. The wage rate is retained at Rs. 20,000/- per month and the market price
of computers is assumed to be Rs. 20,000/- as in Table 14.1.
Table 14.3 : Improvement in labour productivity and Demand for labour

Number of Computers Marginal Value of

Workers Produced per Product Marginal
Year Product
0 0
1 25 25 5,00,000
2 48 23 4,60,000
3 68 20 4,00,000
4 84 16 3,20,000
5 96 12 2,40,000
6 105 9 1,80,000
7 112 7 1,40,000
8 115 3 60,000

The Table 14.3 shows that workers are able to produce more computers at
every level of employment. Now, the value of 5th worker’s marginal product
will be just equal to his wage claim. The company can consider employing him
as well.
We can, now say, in the light of our examples in Tables 14.1 to 14.3 that:
i) if the wage rate declines, employment increases;
ii) if the price of output rises, employment increases; and
iii) if the productivity of labour increases, employment increase, given the
market price of the product, value of the marginal product of labour rises.
SUPPLY OF LABOUR
Economists use the basic model of choice to help understand patterns of labour
298 supply. The decision about how much labour to supply is a choice between
consumption and leisure. Leisure implies the time available to a person when Labour Market
not working. By giving up leisure, a person receives additional income and this
enables him/her to increase consumption. On the other hand, by working less
and giving up some consumption, a person enjoys more leisure.
The suppliers of labour are workers and potential workers. At any given real
wage, potential suppliers of labour must decide if they are willing to work. The
total number of people who are willing to work at each real wage is the supply
of labour. The minimum payment or the reservation price which one sets for
labour is the compensation level that leaves one indifferent between working
and not working. In economic terms, deciding whether to work at any given
wage depends on the cost-benefit principle. The willingness to supply labour is
greater when the wage rate is higher. This results into the upward slope of
supply curve upto a point and then bends backward supply curve.

Fig. 14.2 : Supply curve of labour

The backward-bending shape of labour supply curve results from the fact
higher wage rates create disincentive for longer hours of work. Why? This is so
because longer working hours imply less leisure hours. As the wage rate
increases, the individual’s income rises enabling workers to have access to
more leisure activities. So beyond a certain level of the wage rate, the supply of
labour decreases as the worker prefers to use his income on more leisure
activities.
FACTORS AFFECTING SUPPLY OF LABOUR
Any factor that affects the quantity of labour offered at a given real wage will
shift the labour supply curve. At the macroeconomic level, the most important
factor affecting the supply of labour is the size of the working-age population
which is influenced by factors such as the domestic birth rate, immigration and
emigration rates, and the ages at which people normally enter the workforce
and retire.
Check Your Progress 1
1) State the features of a labour market?
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...................................................................................................................
...................................................................................................................

299
Factor Market 2) Derive the demand for labour in a competitive market. How is Value of
Marginal product and Marginal revenue product curve relevant in the
derivation of labour demand?
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) What is the slope of supply curve of labour in perfectly competitive
markets? Comment on its shape.
...................................................................................................................
...................................................................................................................
...................................................................................................................

14.3.2 Imperfect Competition

Demand for Labour
The firms in this market can sell larger output only if they are willing to accept
a lower price. The demand curve facing a typical firm will be downwards
sloping. Employment of an additional worker leads to rise in output which can
be sold at a lower price only. The firm has to compare its rise in cost which
change in revenue because of increase in output on account of hiring of one
more worker.
Consider demand schedule for a product faced by monopolistically competing
firm. It is presented in Table 14.4.
Table 14.4 : Demand schedule of product by a Monopolistic Firm

Price Quantity Total Marginal

Demanded Revenue Revenue
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
3 8 24 -4
2 9 18 -6

Since MR is falling at a rate faster than AR = Price, MRP = MR × MP will

decline at a rate faster than the rate of decline of VMP = Price × MP.
Thus, we get two curves: VMP & MRP, which are depicted in Fig. 14.3.

300
 Labour Market

Fig. 14.3

Under the competitive conditions of the labour market, any firm can hire as
many workers as it deems necessary at the going market wage rate. Therefore,
the supply curve of labour for the firm will be horizontal. It is depicted by its.
Line WSL.
VMP can be regarded as demand curve for labour for a firm which is operating
in competitive, than its demand for labour is represented by MRPL.
Now compare the two situations. The wage rate paid by both firms remains
same, OW- But a competitive firm will employ OLC number of workers while
a monopolistic firm will stop at OLm. This latter firm hires fewer workers. It
shall produce smaller output even when size of plant and state of technology
was one used by competitive firm.
SUPPLY OF LABOUR
The supply of labour is not affected by the fact that firms have monopolistic
power. Market supply of labour is the summation of the supply curves of
individual households. Supply curve that an individual firm faces is however
perfectly elastic and that of the market is positively sloped at the given wage
rate.

(a) Market (b) Individual firm

Fig. 14.4: Supply curve of labour

EQUILIBRIUM
The market price of the factor is determined by the intersection of the market
demand and the market supply. An important difference in this case is that the 301
Factor Market market demand is based on the MRP and not on the VMP. This means that
when the firms have monopolistic power in goods market, the labour is paid its
MRP which is smaller than the VMP. So the workers are paid less than case of
perfect competition where MRP was equal to VMP.
Check Your Progress 2
1) Distinguish the demand for labour in perfectly competitive and
imperfectly competitive markets.
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) Draw and explain the supply curve of labour of an imperfectly
competitive firm.
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) How is equilibrium achieved in an imperfectly competitive market? How
is it different from equilibrium under perfectly competitive markets?
...................................................................................................................
...................................................................................................................
...................................................................................................................

14.4 LABOUR MARKET POLICIES

Labour markets are segmented and are of different types.

14.4.1 Minimum Wage Laws

Minimum wage laws prescribe a wage rate which the employers must pay to
their workers. Minimum wages are most useful to the low-skilled workers. The
mechanism of minimum wage and its effects can be understood using a
diagram.

Fig. 14.5: Implications of Minimum wage laws on labour market

302 You may observe that W is the market-clearing wage at which the quantity of
labour demanded equals the quantity of labour supplied and the corresponding Labour Market
level of employment of low-skilled workers is N. Suppose there is a legal
minimum wage Wmin that exceeds the market-clearing wage W. At the
minimum wage, the number of people who want jobs Nb exceeds the number
of workers that employers are willing to hire. This results into unemployment.

14.4.2 Role of Labour Unions

Labour unions are organisations that negotiate with employers on behalf of
workers. Among the issues that unions negotiate are the wages workers earn,
rules for hiring and firing, duties of different types of workers, work hours and
working conditions, procedures for resolving disputes between workers and
employers. Unions gain negotiating power by their power to call a strike i.e. to
refuse to work until an agreement is reached. Demand for higher wages by the
union comes with its own costs and benefits. The effect of a high union wage
would be similar to minimum wage. Higher union wage would enable union
members and staff to enjoy higher salaries at the cost of other workers who are
unemployed as a result of artificially higher union wage rate. Critics are of the
view that although labour unions are important to safeguard the conditions of
work and workers, yet in today’s times firms having them are finding difficult
to compete with their counterparts that have no unions as the former has
artificially higher wages and thus higher costs.

14.5 WHY WAGES DIFFER?

This section deals with the fundamental question asked in labour economics
that what makes people earn different wages. Why wage rates of doctors are
higher than the wage rates of medical assistants? Why wage-rates of actuaries
are higher than the wage-rates of fire-fighters? Is it the skill or the background
or the age that brings about differential in wages of different workers? The
answer is none of these. Differential wages are a result of the difference in
demand-supply of jobs available. There are several possibilities to the
differential existence of jobs. It is possible that workers currently employed as
clerks may prefer their jobs despite the difference in their salaries as they do
not want to become an engineer. Even acquiring skills of an engineer may have
a significant cost. Wages for engineers may not be sufficiently high to
compensate clerks for the training costs they would have to bear to become
engineers. Moreover even if there were no training costs, clerks may not have
the aptitude for science and mathematics necessary to work as engineers. Thus,
training costs as well as differences in worker’s abilities and preferences for
particular jobs can lead to differences in equilibrium wage rates among persons
and jobs; there is no tendency toward adjustments that would wipe out wage
differentials due to such factors. Let us discuss such factors affecting wage
differentials in some detail:
1) Compensating wage differentials: Many a times workers themselves
make a decision to remain in a certain job even though they may be
qualified for a higher pay package in a different job. For e.g., an
experienced researcher in a university may be offered a job profile
requiring him to work on some country project with a high package but
may not choose to accept it as it may result into less time and freedom for
his independent research.
When workers view some jobs as intrinsically more attractive than
others, the forces of supply and demand produce differences in the wages
303
Factor Market paid. These differences are called ‘compensating wages differentials’
because the less attractive jobs must pay more to equalise real advantages
of employment across jobs. For e.g., a certain person’s abilities are
identical to fit him in a teaching job or as a consultant in an MNC. At
equal wages, he would prefer to be a teacher rather than consultant as the
number of working hours of teacher is less than that of a consultant. So
only if the wage rate of a consultant is 20 per cent higher than that of a
teacher, then would the person shift from a teaching job to a consultancy
job. Difference in money wages are necessary to equate the quantity of
labour supplied and demanded in different occupations when the non-
monetary attractiveness of jobs differs.
2) Differences in human capital Investment: Our ability to perform useful
services can be augmented by training, education and experience. People
can become more productive workers and more productive workers
receive higher wage rates. This process through which workers augment
their earning capacity is sometimes called human capital investment.
Such jobs tend to pay higher wages. The reason is simple: if the wages
were not higher, a few people would be willing to incur the training costs.
The higher wages associated with highly skilled work are, in part, the
returns on past investments in human capital.
3) Differences in ability: Worker’s productive capacities depend not only
on their training and experience (human capital investment) but also on
certain inherited traits. The relative importance of these two factors is
greatly disputed. For years people have debated whether genetic or
environmental factors are more important in explaining IQs. Similarly
possessing abilities that are scarce is no guarantee to a higher wage. What
matters is the supply of persons with abilities required to perform certain
jobs relative to the demand for their services.
Check Your Progress 3
1) What is the minimum wage? Does it influence the level of employment at
firm’s level?
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) How does labour Unions in an economy influence the wage rate and level
of employment?
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) Why do you find variations in the wage-rates across different
professions? Give reasons as to why a professor is paid higher salary than
a school teacher?
...................................................................................................................
...................................................................................................................
...................................................................................................................
304
 Labour Market
14.6 LET US SUM UP
The unit has dealt in some detail with the working of labour markets in an
economy. The first part introduces the meaning of labour markets and explains
how wages are returns to the services rendered by a labourer. In the second
part, perfectly competitive and imperfectly competitive market structures have
been discussed. The first sub section explains the determination of demand and
supply curves of labour in the perfectly competitive markets. It shows how
intersection of value of marginal product curve or marginal revenue product
curve with the supply curve determines the equilibrium in this market
structure. The second sub-section distinguishes demand, supply and
equilibrium mechanisms of the imperfectly competitive markets by discussing
the special case of a monopoly. As price and marginal revenue are different in
case of monopoly, the determination of equilibrium wages and number of
workers hired by a firm entirely depends on the intersection of the marginal
product curve with the supply curve of the labour. The next section discusses
the prominent labour market policies implemented for the welfare of workers
across the world. Minimum wages are the minimum wages that need to be paid
to labour for use of his/her services. Labour unions provide collective
bargaining powers to workers of a firm and can bring about improvements in
work conditions of workers.
The last section of the unit discusses about the most interesting debate in
labour economics that why wages differ across different professions across the
world. This section explains the various factors that lead to variations in the
wage-rates of workers which includes compensating wages, human capital
investment and differences in skill of workers. Yet relative scarcity of supply
of a particular skill compared to the demand for the same remains critical
determinant of its higher price.

14.7 REFERENCES
1) Robert H Frank and Ben S Bernanke, Principles of Economics, Chapter
14 and 21, Third Edition, Tata-McGraw Hill, Indian Reprint.

2) Edgar K Browning and Mark A Zupan, Microeconomics: Theory and

Applications, Chapter 16-17, 8th Edition, John Wiley and Sons, USA.

3) Pindyck , Robert S. and Daniel Rubinfield (2005) Microeconomics,

Collier Macmillan, London, Chapter 13, page 399 to 417.

14.8 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 14.2 and answer.
2) Read Section 14.3 and answer.
3) Read Section 14.3 and answer.
Check Your Progress 2
1) Read Sub-section 14.3.2 and answer.
305
Factor Market 2) Read Sub-section 14.3.2 and answer.
3) Read Sub-section 14.3.2 and answer.
Check Your Progress 3
1) Read Sub-section 14.4.1 and answer.
2) Read Sub-section 14.4.2 and answer.
3) Read Sub-section 14.5 and answer.

306
UNIT 15 LAND MARKET
Structure
15.0 Objectives
15.1 Introduction
15.2 Rent as Return to Land Use
15.3 Effects of Tax on Land
15.4 Theories of Rent
15.4.1 Ricardian Theory of Rent
15.4.2 Marshall’s Theory of Rent
15.4.3 Modern Theory of Rent

15.5 Let Us Sum Up

15.6 References
15.7 Answers or Hints to Check Your Progress Exercises

15.0 OBJECTIVES
After learning in detail about the factor markets and labour markets in Unit 13
and 14, here you will able to know the functioning of land markets. Land
markets are very important in an economy as land is fixed in supply and so
land markets are vulnerable to frequent changes in demand and price. Legally,
the ownership of land consists of a bundle of rights and obligations such as
rights to occupy, to cultivate, to deny access, to build, etc. It is a very crucial
factor of production for any business. An unusual feature of land is that its
fixed quantity (supply) is unresponsive to changes in prices. This is so because
in general the supply curve of any factor of production is upward sloping
implying that a rise in price causes rise in supply of that factor of production.
However, this does not happen in the case of land markets as its supply is
fixed. A detailed reading of this unit would enable you to:
 state the meaning of land markets;
 appreciate how rent can be viewed as a return to land;
 explain what would happen if there is tax on land; and
 discuss the theories of rent.

15.1 INRODUCTION
In common language, the term ‘rent’ is often used for contractual payment for
use of an asset such as a house, shop, vehicle, machine, etc. However
economists have traditionally used the term only for land. In fact, the term has
its origin in feudal societies, where most of land was owned by landlords or
zamindars. They used to charge some payment from the farmers who
cultivated these plots of land. Rent is that payment which is given for
productive use of soil. There is also another important difference in the
Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
Petrolium University, Ahemedabad. 307
Factor Market terminology of rent and that is between land rent and land value. While land
rent refers to the price for using one unit of land for a certain period of time,
land value refers to the price for buying one unit of land at a point of time.

15.2 RENT AS RETURN TO LAND USE

The price of a fixed factor is generally known as rent or pure economic rent.
Economists apply the term ‘rent’ not only to land but to any factor of
production which is fixed in supply. The supply curve of land is completely
inelastic i.e. vertical as its supply is fixed. The demand curve for land is
downward sloping. Equilibrium is attained when the demand and supply curves
intersect each other. The point of equilibrium gives the rent of land.
Equilibrium is a stable equilibrium. If rent were above the equilibrium, amount
of land demanded by all firms would be less than the fixed supply. Some
landowners would be unable to rent their land and would have to offer their
land for less and thus bid down the rent. Similarly rent could no longer remain
below equilibrium. Only at a competitive price where the total amount of land
demanded is equal to the total amount of land supplied, the market will be in
equilibrium.
Land is ‘a’ factor of production which comprises free gifts of the nature to
mankind. It includes, besides the surface, all the mineral, forests, water streams
etc. So, some of the statements we make about non-responsiveness of supply of
land to price changes will gave limited applicability to all facts of the resources
grouped into single nomenclature ‘the land’. The surface available for
cultivation may be ‘limited’ – but we can always add to it by clearing forests,
re-claiming barren lands, etc. Similarly, supply of natural resources like
metallic and non-metallic minerals, mineral oils etc. may respond to prices
which permit use of better technology that lets us dig deeper and utilise even
those ores which were earlier regarded as inferior or non-viable for economic
use. Even the fertility of soil can be improved/ enhanced/ restored through
resort to ‘new’ technical and scientific knowledge.
Suppose a certain piece of land can be used to grow only cotton. If demand for
cotton rises, then the demand curve for cotton land will shift up and to the right
and the rent would rise. This leads to an important effect: The price of cotton
land would become high because the price of cotton is high. This shows that
demand for land is also a derived demand which signifies that the demand for
the factor is derived from the demand for the product for which the factor is
employed. Thus, the rent of land derives entirely from the value of the product
and not vice-versa.
Demand for an input is a derived demand. This implies that price of input will
be the value of the input’s marginal product multiplied by the price of the
output being produced. In other words, the amount a firm is willing to pay for
another unit of the input equals the money it will earn when that input is
purchased. This equals the quantity of product that additional unit will produce
multiplied by the marginal revenue that quantity of product will generate in the
marketplace. The horizontal sum of the demand curves of individual firms
equals the market demand for the product. The market supply of an input
typically depends on the behaviour of the owners of that input. In the case of
land, however, the supply is approximately fixed. For most cases, therefore, the
overall supply curve for land can be treated as vertical. In some cases, the
possibility of creating usable land from landfill may move the supply curve
308 somewhat away from vertical. Moreover, the supply of land for a particular
type of activity is not vertical in general because land can be moved from one Land Market
use to another. In competitive markets, all actors are price takers. Hence no
individual can affect the market price of an input. The price of land is found at
the intersection of the (derived) demand curve and the (vertical) supply curve,
and each user of land adjusts the quantity of land he rents (or buys) so that the
value of her marginal product equals the market land rent (or value).

Supply
Rent

E R*(Equilibrium
rent)

Derived Demand for

Quantity of Land Land
Fig. 15.1 : Determination of Equilibrium in Land Markets

The above figure shows how interaction of demand and supply curve in land
market leads to determination of equilibrium rent. It can be observed that R* is
the equilibrium rent where demand curve for land (which is a derived demand)
intersects the supply curve of land (which is fixed).
15.3 EFFECTS OF TAX ON LAND
There is a need to understand the implications of the fixed supply of land.
Suppose the Government wants to tax the incomes of the land-owners and
introduces a land tax of 50 per cent on all land rents ensuring that there is no
further tax on buildings or improvements. What would be the impact of this tax
on total demand and supply of land? The reality is that after the tax, the total
quantity demanded for land’s services does not change even though the
demand curve shifts. Even with a tax at the rate of 50%, people will continue to
demand the entire fixed supply of land. Hence with land fixed in supply, the
market rent on land services (including the tax) will be unchanged and remain
at its original equilibrium at point E1 in the Fig. 15.2.
What will happen to the rent received by the landowners? As the demand and
quantity supplied of land remain unchanged, the market price will also be
unaffected by the tax. Therefore, the tax must be completely paid out of the
landowner’s income. This brings a difference in the price paid by a farmer and
the price received by the landowner. In case of landowners, when the
government steps in to collect the 50 per cent tax, effect is the same as it would
be if the net demand to the owners had shifted down from D1D1 to D2D2 in the
diagram. Landowner’s equilibrium return after taxes is now only E2. The entire
tax would be shifted backwards on to the owners of the factor in perfectly
inelastic supply. However this reduction in factor incomes does not create
economic inefficiencies. This happens because tax on pure rent does not
change anyone’s economic behaviour. Those who demand land are unaffected
because the price of land remains the same. The behaviour of suppliers of land
also remains the same as the supply of land is fixed in nature. Thus, the
economy operates in the same way after tax, as tax leads to no distortions or
inefficiencies in the system.
309
Factor Market

Rent D1D1 SS (Supply)

D2D2

Effect of
E1 Tax on Land

E2

Quantity of Land

Fig. 15.2: Effects of Tax on Land

This result is based on Henry George’s Single-Tax movement, later used by

English economist Frank Ramsey to develop Ramsey tax theory. George
argued, because the value of the unimproved land is unearned, neither the
land’s value nor a tax on the land’s value can affect productive behaviour. If
land were taxed more heavily, the quantity available would not decline, as with
other goods; nor would demand decline because of land’s productive uses. The
reasoning behind Ramsey taxes is essentially the same as that shown in the
diagram above. If a commodity is highly inelastic in supply or demand, a tax
on that sector will have very little impact on production and consumption and
the resulting distortion will be relatively small.
Check Your Progress 1
1) What do you mean by the term economic rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Suppose the current rental rate of a 1BHK house in City X is Rs. 4000.
What would happen to the supply of this type of houses if the
Government decides to impose 5 per cent tax on rent? Give reasons in
support of your answer.
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.....................................................................................................................
.....................................................................................................................
3) What is the essence of Henry George’s tax theory?
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15.4 THEORIES OF RENT

It is important to understand why rent is paid and how rent is determined. In
310 order to answer these questions three theories of rent have been propounded:
(i) the classical theory alternatively known as Ricardian theory of rent, (ii) Land Market
Marshall’s theory of rent and (iii) Modern theory of rent.

15.4.1 Ricardian Theory of Rent

David Ricardo, an eminent economist of the 19th century defines rent as, ‘that
portion of the produce of the earth which is paid to the landlord for the use of
the original and indestructible powers of the soil’. So as per this definition,
land possesses original and permanent properties with reference to its nature,
situation, environment and conformation and rent is paid for the use of land
only. However, rent accrues to the landlord both from extensive and intensive
cultivation of land.
What is intensive cultivation? When a farmer keeps on employing more of
other factors of production on the same piece of land in order to increase
production he is using land more intensively. He employs more labour as long
as the marginal revenue product of hiring additional worker is greater than the
market wage rate, it is known as intensive cultivation. Ricardo assumes that the
law of diminishing returns operates in this case in the sense that when more
and more units of labour and capital are used in cultivation, there are
diminishing returns from the agriculture. The following diagram throws light
on how the agricultural yield may decline due to excessive usage of capital and
labour inputs due to law of diminishing returns.

25
Agriculture yield (In kg)

20
15
10
5 Agriculture yield (In kg)
0
1 2 3 4
Capital and Labour Inputs

Fig. 15.3: Diminishing Returns due to Intensive Cultivation

Observe Fig. 15.3 carefully. You can see, that the agricultural yield is declining
from 20 to 9 kgs as the usage of capital and labour increases from 1 to 3.
Would this land earn rent? The answer is yes and requires you to recall the
concept of factor demand curve covered in Unit 13. The demand curve of
labour is given by the marginal revenue product curve of the variable factor.
This demand curve is used to determine the share of labour in total product i.e.
the wage bill and the surplus is called rent as seen the Fig. 15.4 below.
What is extensive cultivation? Extensive cultivation implies that as the demand
for output increases, land under cultivation is also increased. However there is
a difference in the quality of land used for cultivation as the area under the
plough changes owing to increase in demand. Suppose there are 5 different
types of land available to a farmer: A, B, C, D, E arranged in the descending
order of their fertility with plot A as the most fertile land available and plot E
the least fertile land available to the farmer in Fig. 15.5. To begin with, a
farmer would sow crops only in the most fertile plot of land as it would give
him high agriculture yields. Due to rise in population, if the demand for

311
Factor Market

Here it assumed that there are only two factors of production

Fig. 15.4: Determination of Rent in Recardian Theory

agriculture goods increases in such a way that the supply of food grains from
plot A is found insufficient to meet the demand, the farmer would bring plot B
into use. However plot B being of inferior quality would generate lesser
revenue even if same amount of inputs are used.

Fig. 15.5: Extensive Cultivation and Rent

Similarly, due to an increase in demand for agricultural output, plots C, D and

E would also be used by the farmer to increase production so as to be able to
meet the market demand. However plot E being of inferior quality and least
fertile would generate no surplus and plot A generates the highest surplus. This
312
surplus is known as rent. In order to be able to earn rent, the market value of Land Market
agriculture output produced on a plot of land should be higher than the cost of
cultivation on that land and this is the highest on plot A. For inferior quality
lands, the cost of cultivation is very high and so it can be inferred that only the
land of superior quality can generate surplus or rent. Ricardo also explained
that rent of land depends on price of the land’s produce. Rent is thus the excess
of the market value of land produce to the cost of cultivation as seen in the Fig.
15.5.
Ricardo’s theory of rent is based on the following assumptions:
1) There is perfect competition in the economy
2) Supply of land is limited
3) Law of diminishing returns operates
4) Rent is applicable only on land
5) Rent is price determined
6) Land is cultivated in a quality varying sequence in the sense that the most
fertile land is cultivated first and the least fertile is the last.
An interesting aspect of the Ricardian theory is the role of location of land in
determination of rent. The theory says that apart from the fertility of soil, rent
also arises from the difference in the cost of transporting agricultural produce
of a land to the market. As land situated farther and farther away from the
market is brought under cultivation with increase in demand for agriculture
produce, the transportation charges increase. Those plots of land which are
nearer to the market pay lesser transportation charge compared to the distant
lands. Thus, rent would be higher for land situated near the market compared to
the ones away from the market.
The critique of the Ricardian theory of rent can be summarised in few lines.
There is absence of perfect competition in real agricultural markets. The
difference between superior and inferior land occurs due to intervention of the
owner/farmer through use of technology and inputs and does include costs.
Superior quality of land may be inaccessible if it is flooded, covered with
shrubs or under disputed private ownership. The original and indestructible
powers of land are prone to change with the advent of technological progress.
It is now possible to increase the fertility of land and bring more and more land
under cultivation through heavy capital machinery. However despite these
criticisms, Ricardian description of rent as unearned differential surplus that
arises due to economic progress has helped in the policy making across the
world. Abolition of zamindari system in India as well as other countries was on
the grounds of this ‘unearned surplus’ to the owners.
Check Your Progress 2
1) What is the Ricardian concept of rent? How is it different from the usual
notion of rent?
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Factor Market 2) Do you think supply of land is limited? If yes, in what sense?
.....................................................................................................................
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15.4.2 Marshall’s Theory of Rent

Alfred Marshall developed the concept of quasi-rent in order to extend the
Ricardian concept of rent to other factors of production. He referred it to the
surplus earnings generated by the factors of production excluding rent.
Marshall’s concept of quasi-rent was a short run concept unlike Ricardian long
run concept of rent. This concept can be easily understood using an example of
housing. Suppose that the demand for houses in an area of Ahmedabad
increase suddenly due to onset of construction of metro rail in that area. It is
not possible to increase the supply of houses in accordance to the demand. The
increase in demand for houses would push up the prices and those who sell
their houses during this period would get surplus earnings. This sudden
increase in their earnings is called as quasi rent. Similarly the rental price of
houses would increase during this period resulting into quasi-rent.
Quasi-rent will disappear in the long-run competitive equilibrium. Professors
Stonier and Hague rightly remark, “The supply of machines is fixed in the
short run whether they are paid much money or little so they earn a kind of
rent. In the long run, this rent disappears for it is not a true rent, but only an
ephemeral reward — a quasi-rent”. But the case of land is quite different. The
supply of land being a free gift of nature and non-reproducible, its supply is
perfectly inelastic in the short run as well as in the long run. Thus the surplus
earnings or rent earned by land persist in the long run also. It is thus clear that
the earnings of land and of capital equipment (machines etc.) are similar only
in the short run.

Fig. 15.6: Determination of Rent in Marshall’s Theory

314
Distinction between quasi-rent, rent and interest: Quasi-rent is similar to Land Market
rent in more than two ways. It arises when the demand for man-made goods
increases, while rent arises when the demand for land increases. Just as the
supply of man-made goods is fixed in the short-run, the supply of land is also
fixed. Transfer earnings help in determination of both rent and quasi-rent.
However still the two differ in the sense that quasi-rent is fixed in the short-run
due to fixed supply of man-made goods and rent is fixed in the short-run as
well as long-run due to fixed supply of land. Quasi-rent is a temporary
phenomena which does not exist in the long run after supply of man-made
goods is resumed. However rent persists in both the periods as supply of land
cannot be changed.

15.4.3 Modern Theory of Rent

The modern theory of rent develops Marshallian theory of rent even further.
This theory is different in terms of the determination of mechanism of rent.
Here rent is determined using the demand-supply framework. The theory
stipulates that even if land is very fertile, rent would arise owing to its fixed
nature i.e. due to scarcity. The modern theory of rent assumes perfect
competition, homogenous product and land of equal quality. Also, rent is
dependent on the marginal revenue productivity of land and its demand curve
is downward sloping indicating that more land would be used at lower rates of
rent. The supply curve of an individual firm is perfectly inelastic but the supply
curve of all the land owners taken together is upward sloping implying that
with higher rates of rent, more and more land is offered for use. This has been
depicted in Fig. 15.7.
The area under the supply curve denotes ‘transfer earnings’ which is the
minimum payment needed to retain the given factor units in the present
employment. In simple words, it is the opportunity cost of the factor. It refers
to the earning of capital/land/labour in its next best use. Let us understand this
concept using an illustration. Suppose cotton is grown in a piece of land and
the cost of its cultivation is Rs.100. The cost of cultivation for wheat remains
the same on this land and so there would be no transfer earnings. However if
by producing soyabean, the cost of cultivation on this land comes down to
Rs.70, then the transfer earning would be Rs. 30 and Rs. 40 would be the rent.
Thus,
Rent = Actual earnings – Transfer earnings.
The above diagram shows the usual demand and supply curves for land. Point
E is the point of intersection of the demand and supply curves. This
equilibrium point shows OP as the equilibrium price at which suppliers of land
are willing to supply OQ units of land. Note that the supply curve also depicts
that how many different units of land are going to be supplied at each price.
This area under the supply curve thus depicts the transfer earnings and the area
above the supply curve depicts the quasi-rent.
As the supply of land is inelastic in nature, one can show how quasi-rent of
land would differ depending on the different elasticities of the supply curves.
Consider the Fig. 15.7, here demand curve intersects the three supply curves S1,
S2 and S3.

315
Factor Market

Fig. 15.7: Rent as per Different Elasticities of Land Supply Curve

These supply curves intersect the demand curve at E. At each of the supply
curves, the equilibrium price and quantity are given by OP and OQ
respectively. Area under a supply curve upto point Q is called transfer earning.
The total factor payment in all the three cases is given by OPEQ. One can note
that with supply curve S1, transfer earning is zero while with S3 supply curve,
the entire factor payment becomes the transfer earning.
It is to be noted that Marshall’s concept of rent was different from Ricardian
concept of rent in the sense that the former calls the excess over the transfer
earnings as rent while Ricardo considers it as the excess earnings of the owner
over the cost of production. The modern theory of land is different from the
original theory of Marshall and was built further by J.S.Mill, Joan Robinson
and other neo classical economists because it was built further using the
demand and supply framework.
Check Your Progress 3
1) What is quasi-rent? How is it different from economic rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) State the distinction between modern theory and Marshallian theory of
rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
316
3) Explain how rent can differ depending on the elasticity of supply curve of Land Market
land?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

15.5 LET US SUM UP

This unit has introduced the concept of land using different approaches. The
term rent has been originally coined by economists to refer to earnings from
ownership of land only. The unit further discusses the implications of a tax on
land. When tax is imposed on land, it does not affect the demand for land as
the price of land remains the same owing to fixed supply of land. Tax directly
affects the landowner’s income and is paid from their earnings without
affecting the total demand and supply of land in the market.
Theories of land give an insight on the different approaches of determining rent
in economic theory. The Ricardian theory of rent determines rent on the basis
of the surplus earnings from land owing to its superior quality. The theory has
two approaches: extensive cultivation and intensive cultivation which depict
how there are surplus earnings and how they differ owing to different quality
of land. The theory has been criticised on the grounds of its assumptions i.e.
perfect competition, original and indestructible power of land which may alter
through use of technology. Marshall’s theory of rent is based on the concept of
transfer earnings wherein the concept of quasi-rent has been developed.
Marshall defines rent as the difference between actual earnings and transfer
earnings from land and uses the notion of quasi-rent for other factors of
production as well. Transfer earnings are those which are just enough to retain
the factor of production in the present use. Rent is anything which is in excess
to transfer earnings. The modern theory of rent developed by later classical
economists like J. S. Mill, Joan Robinson, etc. have built upon the Marshallian
framework by introducing the demand-supply framework.

15.6 REFERENCES
1) Stonier A.W. and Hague D.C. (1980), A Textbook of Economic Theory,
MacMillan: London.
2) M L Jhingan (2006), Principles of Microeconomics, Chapter 42-44, Third
edition, Vrinda Publications Pvt Ltd, New Delhi.

15.7 ANSWERS OR HINTS FOR CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 15.1 and 15.2
2) See Section 15.2 and 15.3
317
Factor Market 3) See Section 15.3
Check Your Progress 2
1) See Sub-section 15.4.1
2) See Section 15.2
Check Your Progress 3
1) See Sub-section 15.4.2
2) See Sub-sections 15.4.2 and 15.4.3
3) See Sub-section 15.4.3

318
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
 BECC-101

INTRODUCTORY
MICROECONOMICS

School of Social Sciences

Indira Gandhi National Open University
 Course Contents

BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50

BLOCK 2 THEORY OF CONSUMER BEHAVIOUR

UNIT 4 Consumer Behaviour: Cardinal Approach 73
UNIT 5 Consumer Behaviour: Ordinal Approach 92

BLOCK 3 PRODUCTION AND COSTS

UNIT 6 Production with One Variable Input 127
UNIT 7 Production with Two and More Variable Inputs 140
UNIT 8 The Cost of Production 165

BLOCK 4 MARKET STRUCTURE

UNIT 9 Perfect Competition: Firm and Industry Equilibrium 195
UNIT 10 Monopoly: Price and Output Decisions 213
UNIT 11 Monopolistic Competition: Price and Output Decisions 235
UNIT 12 Oligopoly: Price and Output Decisions 253

BLOCK 5 FACTOR MARKET

UNIT 13 Factor Market and Pricing Decisions 279
UNIT 14 Labour Market 294
UNIT 15 Land Market 307

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE OF

GOVERNMENT
UNIT 16 Welfare: Allocative Efficiency under Perfect Competition 321
UNIT 17 Efficiency of the Market Mechanism: Market Failure and the Role
of the State 335
GLOSSARY 345
SOME USEFUL BOOKS 356
INTRODUCTORY MICROECONOMICS
This course is designed to expose the students pursuing BA Hons. Economics Programme
to the basic Principles of Microeconomic theory. It aims to provide the conceptual
foundation of Microeconomic theory in a manner to enable the students to understand
the Intermediate Microeconomics I & II so as to analyse real life situations.
Economics is a live subject and helps the economic agents in their decision making like:
Which commodities to produce? How to produce? Which techniques to use? Which
factors or resources to use, in which combinations to produce and What quantity of a
commodity to produce? How consumers make purchasing decisions and how their
choices are affected by changing prices and incomes? How firms decide how many
workers to hire and how workers decide where to work and how much work to do? In
other words, economics has moved away from financing the activities of state to helping
the common man in the street to make many a crucial decisions impinging on their day-
to-day life.
We, today incorporate a wide spectrum of activities in the domain of economics. These
activities include: (a) consumer’s behaviour or choice process; (b) producers’ behaviour
or how is the production organised and carried on, what is the special role of cost
functions? (c) What are the different forms of market organisations; (d) how different
individuals co-operate in the process of production to contribute factors owned by
them. (e) What are the various types of efficiencies? (f) Under what situations markets
fail and how the state can play its role in such situations? The present course on
Introductory Micro Economics aims to expose the learners to the issues pertaining to
(a) to (f). The course is divided into six blocks.
Introducing the nature of Economics, Block 1 throws light on the basics of demand
and supply and how the demand and supply curves are used to describe market
mechanism. The block comprises 3 units. Unit 1 on Introduction to Economics and
Economy covers the essential nature of economics and the basic concepts and
methodology used in the discipline. Unit 2 deals with the Principles of Demand and
Supply, measurement of their elasticities, and determinants. Unit 3 discusses the Market
Mechanism by putting the Supply curve and Demand curve together.
Block 2 deals with the theory of consumer behaviour and consists of two units. Unit 4
discusses Cardinal Utility Approach for measurement of utility and how a consumer
attains equilibrium with the help of equi-marginal utility. Unit 5 analyse the Consumer
Behaviour under Ordinal Approach.
Block 3 covers production function and theory of cost. It consists of three units. Unit
6 throws light on production function with one variable input, Unit 7 deals with the
nature of production function with two and more variable inputs. Unit 8 discusses the
cost side of production considering different types of costs.
Block 4 throws light on the various forms of market i.e. perfect competition, monopoly,
monopolistic competition, and oligopoly. The block comprises 4 units. Unit 9 on
Perfect Competition: Firm and Industry Equilibrium provides the characteristics of
perfectly competitive market and exposes the learners to equilibrium of Firm and Industry
under perfect competition. Unit 10 on Monopoly: Price and Output Decision deals
with pricing and output decisions and price discrimination under monopoly condition.
The concept of deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run period,
theory of excess capacity, the comparison of the various market forms have been provided
in Unit 11. Price and Output determination under oligopoly have been covered in Unit
12.
Block 5 discusses the Pricing of the factors of production. It comprises three units.
Introducing the Marginal Productivity theory of distribution, Unit 13 provides an overview
of how rent and wages are determined. It also provides a bird’s eye view on the
theories of interest and profit. Unit 14 acquaints the learners of the role of demand and
supply mechanisms in determinations of wages under perfectly competitive labour
markets and imperfectly competitive labour markets. Unit 15 throws light on features
of land as a peculiar factor of production and the various theories of rent.
Block 6 covers the Welfare Market failure and the role of state. This block comprises
two units. Unit 16 exposes the learners to the various forms of efficiencies under perfectly
competitive market economy and the outcome of departures from the assumptions of
perfectly competitive market conditions. Unit 17 highlights the various situations where
markets fail and hence the role of state comes into picture.
 Land Market

BLOCK 6 WELFARE, MARKET FAILURE AND THE ROLE

OF GOVERNMENT

319
Factor Market
BLOCK 6 WELFARE, MARKET FAILURE AND
THE ROLE OF GOVERNMENT
Having discussed on how firms behave in Block 4 and how the prices of
factors of production are determined under different market structures in
Block 5, in this block we would like to illustrate how perfect competition is
conducive to different forms of efficient outcomes. Further, it has also been
highlighted how the departure from the assumption of perfectly competitive
market results in market failure and hence the need of state intervention. The
block comprises of two units.
Unit 16 exposes the learners to the various forms of efficiencies under
perfectly competitive market economy and the outcome of departures from the
assumptions of perfectly competitive market conditions. Unit 17 highlights the
various situations where markets fail and hence the role of state comes into
picture.

320
UNIT 16 WELFARE: ALLOCATIVE
EFFICIENCY UNDER
PERFECT COMPETITION
Structure
16.0 Objectives
16.1 Introduction
16.2 Efficiency – Definition and Concepts
16.2.1 Productive Efficiency
16.2.2 Technical Efficiency
16.2.3 Efficient Allocation of Resources among Firms
16.2.4 Efficiency in Output Mix

16.3 Efficiency in a Perfectly Competitive Market Firm

16.4 Efficiency in a Perfectly Competitive Market Economy
16.5 Competitive Prices and Efficiency: The First Fundamental Theorem of
Welfare Economics
16.6 Departing from the Competitive Assumptions
16.6.1 Imperfect Competition
16.6.2 Externalities
16.6.3 Public Goods
16.6.4 Imperfect Information

16.7 Let Us Sum Up

16.8 References
16.9 Answers or Hints to Check Your Progress Exercises

16.0 OBJECTIVES
After studying this unit, you will be able to:
 clearly state the concept of economic efficiency (Pareto efficiency);
 identify various types of efficiencies and their interrelationship to achieve
the Pareto Efficiency;
 distinguish between Pareto efficient and inefficient situations;

 describe the Production possibilities frontier and the marginal rate of

transformation;

 appreciate that a perfectly competitive market will exhibit the

‘Productive’ and ‘Allocative’ Efficiencies;

Dr. S.P. Sharma, Associate Professor of Economics, Shyam Lal College (University of
Delhi), Delhi.
321
Welfare, Market  describe the conditions for economic efficiency in a simplified perfectly
Failure and the Role competitive market economy;
of Governemnt
 explain the essence of the relationship between perfect competition and
the efficient allocation of resources also known as First Fundamental
Theorem of Welfare Economics;

 describe the conditions under which perfectly competitive markets will

fail to achieve the efficient allocation of resources;

 explain that efficient outcome of a perfectly competitive market may not

necessarily be socially desirable; and

 briefly explain the policy implications of efficient outcomes reached

under the perfectly competitive markets.

16.1 INTRODUCTION
The fundamental problem of a society, that led the ‘Economics’ discipline to
emerge and take the driver’s seat, is scarcity of resources. The scarcity, which
is the originator of ‘efficiency’, calls for the optimal production, consumption
and distribution of these scarce resources. In a general sense, an economy is
efficient when it provides its consumers with the most desired set of goods and
services, given the resources and technology of the economy. One of the most
important results in economics is that the allocation of resources by a perfectly
competitive market is efficient. This important result assumes that such a
perfectly competitive market does not have externalities like pollution or
imperfect information. In Unit 9, we have studied the basic characteristics of
such a market and how the firms determine their equilibrium level of output
given the price of the product. It is a widely accepted view that perfect
competition is an idealised market structure that achieves an efficient
allocation of resources.
This unit will focus and elaborate in detail this aspect of perfectly competitive
market structures which ensure economic and allocative efficiency and
maximising profit in the perfectly competitive industries. Our analysis of a
close correspondence between the efficient allocation of resources and the
competitive pricing of these resources will however be based on the definition
of economic efficiency in input and output choices, as given by Vilfred Pareto
during the 19th century. The unit will also bring out the situations where
operation of a perfectly competitive market structure breaks down and thereby
loses its property of achieving the efficient allocation of resources.

16.2 EFFICIENCY – DEFINITION AND

CONCEPTS
We begin with Pareto’s definition of economic efficiency:
Pareto efficient allocation: An allocation of resources is Pareto efficient if it is
not possible (through further re-allocations) to make one person better-off
without making someone else worse-off.
It is, however, important to note that the achievement of Pareto efficiency in
resource allocation requires efficiency in production which is possible only
with technically efficient allocation of resources and technical efficiency could
322
be achieved with efficient allocation of resources amongst the firms. Further to Welfare: Allocative
ensure overall Pareto optimality, efficiency in production needs to be tied up Efficiency under
with the individual preferences. These concepts are systematically developed Perfect Competition
in subsequent sub-sections.

16.2.1 Productive Efficiency

An economy is efficient in production if it is on its production possibility
frontier (Fig. 16.1). In terms of Pareto’s terminology, an allocation of
resources is efficient in production (or “technically efficient”) if no further
reallocation would permit more of one good to be produced without
necessarily reducing the output of some other good. It seems easier to grasp
this definition by studying its converse — an allocation would be inefficient if
it were possible to move existing resources around a bit and get additional
amounts of one good and no less of anything else.

Fig. 16.1 : Production possibility frontier of an economy

Suppose resources were allocated so that production was inefficient; that is,
production was occurring at a point inside the production possibility frontier
(point C in Fig. 16.1). It would then be possible to produce more of at least one
good and no less of anything else. This increased output could be given to
some person, making him or her better-off (and no one else worse-off). Points
A and B being on the production possibility curve are productively efficient. It
is impossible to produce more goods without producing less service. Point C is
inefficient because you could produce more goods or services with no
opportunity cost. Hence, inefficiency in production is also Pareto inefficiency.
The trade-offs among outputs necessitated by movements along the production
possibility frontier reflect the technically efficient nature of all of the
allocations on the frontier.
Productive efficiency will also occur at the lowest point on the firms average
costs curve. Thus, Productive efficiency is concerned with producing goods
and services with the optimal combination of inputs to produce maximum
output for the minimum cost. This point is elabourated in Section 16.3 of this
unit.

16.2.2 Technical Efficiency

Technical efficiency is the effectiveness with which a given set of inputs is 323
Welfare, Market used to produce an output. A firm is said to be technically efficient if a firm is
Failure and the Role producing the maximum output from the minimum quantity of inputs, such as
of Governemnt labour, capital and technology. Technical efficiency is thus a precondition for
overall Pareto efficiency1.

16.2.3 Efficient Allocation of Resources among Firms

In order to achieve technical efficiency, resources must be allocated correctly
among firms. Intuitively, resources should be allocated to those firms where
they can be most efficiently used. More precisely, the condition for efficient
allocation is that the marginal physical product of any resource in the
production of a particular good is the same no matter which firm produces that
good.
Although equality of marginal productivities will ensure the efficient allocation
of resources among firms producing any one good, that condition is not enough
to ensure that inputs are allocated efficiently among firms producing different
goods. The additional condition for such efficiency is that the rates of technical
substitution (RTS) among inputs must be the same in the production of each
good if production is to be on the production possibility frontier. For better
understanding of this condition, we have shown it graphically in Fig. 16.2.
Figure shows technically efficient ways to allocate the fixed amounts of k and l
between the productions of the two outputs. The line joining Ox and Oy is the
locus of these efficient points. Along this line, the RTS (of l for k) in the
production of good x is equal to the RTS in the production of y.

Fig. 16.2: Efficiency in Production

In Fig. 16.2, the length of the box represents total labour-hours and the height
of the box represents total capital-hours. The lower left-hand corner of the box
represents the “origin” for measuring capital and labour devoted to production

1
Technical efficiency however, does not guarantee a situation of a Pareto efficiency. For
instance, an economy can be efficient at producing the wrong goods — devoting all available
resources to producing left shoes would be a technically efficient use of those resources, but
324 surely some Pareto improvement could be found in which everyone would be better-off.
of good x. The upper right-hand corner of the box represents the origin for Welfare: Allocative
resources devoted to y. Using these conventions, any point in the box can be Efficiency under
regarded as a fully employed allocation of the available resources between Perfect Competition
goods x and y. We have now introduced the isoquant maps for good x (using
Ox as the origin) and good y (using Oy as the origin). In this figure it is clear
that the arbitrarily chosen allocation A is inefficient. By reallocating capital
and labour one can produce both more x than x2 and more y than y2.
The efficient allocations in Fig. 16.2 are those such as P1,P2,P3, and P4, where
the isoquants are tangent to one another. At any other points in the box
diagram, the two goods’ isoquants will intersect, and we can show inefficiency
as we did for point A. At the points of tangency, however, this kind of
unambiguous improvement cannot be made. In going from P2 to P3, for
example, more x is being produced, but at the cost of less y being produced, so
P3 is not “more efficient” than P2 — both of the points are efficient. Tangency
of the isoquants for good x and good y implies that their slopes are equal. That
is, the Rate of Technical Substitution (RTS) of capital for labour is equal in x
and y production. The curve joining Ox and Oy that includes all of these points
of tangency therefore shows all of the efficient allocations of capital and
labour. Points off this curve are inefficient in that unambiguous increases in
output can be obtained by re-shuffling inputs between the two goods. Points on
the curve OxOy are all efficient allocations, however, because more x can be
produced only by cutting back on production of y and vice versa.

16.2.4 Efficiency in Output Mix

Technical efficiency will not necessarily ensure overall Pareto optimality
unless the individuals’ preferences are tied up with the production possibilities.
The necessary condition to ensure the Pareto optimum product mix is that
goods produced with technical efficient allocation of resources are those which
are most demanded by the consumers. Technically, this condition could be
achieved when the marginal rate of substitution (MRS) for any two goods by
consumers is equal to the rate of product transformation (RPT) of these two
goods. The requirement for efficiency in product mix is illustrated graphically
in Fig. 16.3 in one person economy, which could also be applied to an
economy of many individuals with identical preferences.
It assumes that one person in this economy produces only two goods (x and y).
Those combinations of x and y that can be produced are given by the
production possibility frontier PP. Any point on PP represents a point of
technical efficiency. By superimposing the individual’s indifference map on
the figure, we see that only one point on PP provides maximum utility. This
point of maximum utility is at E, where the curve PP is tangent to the
individual’s highest indifference curve, U2. At this point of tangency, the
individual’s MRS (of x for y) is equal to the technical RPT (of x for y); hence,
this is the required condition for overall efficiency.
In a single-person economy, the curve PP represents those combinations of x
and y that can be produced. Every point on PP is efficient in a production
sense. However, only the output combination at point E is a true utility
maximum for the individual. At E the individual’s MRS is equal to the rate at
which x can technically be traded for y (RPT).

325
Welfare, Market
Failure and the Role
of Governemnt

Fig. 16.3: Graphical representations of efficiency condition

for Optimum Product Mix

Check Your Progress 1

1) What is an economically efficient allocation? How does an economically
efficient allocation differ from an inefficient allocation?
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2) What is the production possibilities frontier? What is the marginal rate of
transformation? How does the marginal rate of transformation relate to
the production possibilities frontier?
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3) What do you mean by the term ‘technical efficiency’?
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326
 Welfare: Allocative
16.3 EFFICIENCY IN A PERFECTLY Efficiency under
COMPETITIVE MARKET FIRM Perfect Competition

As mentioned in the previous sub-section that there are two versions of

efficiency: productive efficiency and allocative efficiency. By now, it would be
clear that productive efficiency means ‘doing things right’, while allocative
efficiency means ‘doing the right things’.
A firm is productively efficient when total use of resources (factor inputs)
results in the lowest possible cost per unit of output. This would be the point
where average total cost is minimised. Any other level of average costs would
be sub-optimal. In regards to individual firms, the definition of allocative
efficiency is that the individual firm is producing the correct quantity of the
right goods – “doing the right things”. In stating that the correct quantity is
produced, in fact, implies that the last unit produced costs (i.e. marginal costs)
exactly what the consumer is willing to pay (i.e. the price of unit), resources
have been optimally allocated. Resources have been optimally allocated when
there is no waste, i.e. when the price equals marginal cost of the last unit
produced. This occurs when the output level is where P (AR) = MC for the
firm. When all firms fulfil this criterion then supply equals demand on the
market.
The firm operating within a perfectly competitive market will be both
productively and allocatively efficient in the long run. It was proved in Unit 9
that the firm cannot have abnormal profit in the long run due to the entry of
new firms, whereby the subsequent increase in supply and lower market price,
will dissolve any such profits. Nor can the firm survive endless losses.

Fig. 16.4: Productive and Allocative Efficiency and LR Equilibrium

for a PCM firm
Fig. 16.4 shows the LR equilibrium for a PC firm; output is at P = ACmin= MC
= AR = MR.
327
Welfare, Market In sum, we may conclude that the PC firm in the long run produces at an output
Failure and the Role level where P = ACmin = MC = AR = MR. This identity fulfils the criteria for
of Governemnt both productive and allocative efficiency in the long run, i.e.
 Productive efficiency: The LR equilibrium for the perfectly competitive
market shows that AR = ACmin. The firm is productively efficient.

 Allocative efficiency: The horizontal demand curve will set output along
the upward sloping MC curve, inevitably forcing the firm to produce
where the marginal revenue equals the marginal cost. In LR equilibrium,
P (AR) = MC. The firm is allocatively efficient.

16.4 EFFICIENCY IN A PERFECTLY

COMPETITIVE MARKET ECONOMY
Consider a simplified competitive economy where all individuals are identical
and engaged in growing food. Further assume: (a) as per law of diminishing
returns, each extra minute of work on fixed land brings less and less extra food,
(b) each extra unit of food consumed brings diminished marginal utility (MU).
Fig. 16.5 shows supply and demand for our simplified competitive economy.

Fig. 16.5: Efficiency in Competitive Market

When we sum horizontally the identical supply curves of our identical farmers,
we get the upward-stepping MC curve. As we have seen in Unit 9, the MC
curve is also the industry’s supply curve, so the figure shows MC = SS. Also,
the demand curve is the horizontal summation of the identical individuals’
marginal utility (or demand-for-food) curves; it is represented by the
downward-slopping MU = DD curve for food in Fig. 16.5. The intersection of
the SS and DD curves shows the competitive equilibrium for food. At point E,
farmers supply exactly what consumers want to purchase at the equilibrium
market price. Each person will be working up to the critical point where the
declining marginal-utility-of-consuming-food curve intersects the rising
marginal-cost-of-growing-food curve.

328
ECONOMIC SURPLUS AND EFFICIENCY Welfare: Allocative
Efficiency under
Fig. 16.5 also shows a new concept, economic surplus, which is the area Perfect Competition
between the supply and demand curves at the equilibrium. The economic
surplus is the sum of the consumer surplus, which is the area between the
demand curve and the price line, and the producer surplus, which is the area
between the price line and the SS curve. The producer surplus includes the rent
and profits to firms and owners of specialised inputs in the industry and
indicates the excess of revenues over cost of production. The economic surplus
is the welfare or net utility gain from production and consumption of a good; it
is equal to the consumer surplus plus the producer surplus.
Analysis of the competitive equilibrium will show that it maximises the
economic surplus available in that industry. For this reason, it is economically
efficient. At the competitive equilibrium at point E, the representative
consumer will have higher utility or economic surplus than would be possible
with any other feasible allocation of resources. At this point, it is observed as
follows:
a) P = MU, i.e. consumers choose food purchases up to the amount where P
= MU, implying that every person is gaining P utils of satisfaction from
the last unit of food consumed (util is a unit for measuring the utility or
satisfaction).
b) P = MC, i.e. as producers, each person is supplying food up to the point
where the price of food exactly equals the MC of the last unit of food
supplied (the MC here being the cost in terms of the forgone leisure
needed to produce the last unit of food). The price then is the utils of
leisure-time satisfaction lost because of working to grow that last unit of
food.
c) Putting these two equations together, we see that MU = MC. This means
that the utils gained from the last unit of food consumed exactly equal the
leisure utils lost from the time needed to produce that last unit of food. It
is exactly this condition – that the marginal gain to society from the last
unit consumed equals the marginal cost to society of that last unit
produced — which guarantees that a competitive equilibrium is efficient.
The result will remain unchanged even if the model is extended to any number
of commodities. In such a generalised case too, the rule remains the same, i.e.
utility-maximising consumers spread their ` income among different goods
until the marginal utility of the last rupee is equalised for each good consumed.
Since this marginal utility of money is equal to the price ratios which in turn
will be equal to ratio of marginal costs of the corresponding commodities in the
perfectly market economy. Thus, under certain conditions, perfect competition
guarantees efficiency, in which no consumer’s utility can be raised without
lowering another consumer’s utility.
Check Your Progress 2
1) Define the fundamental role of the marginal cost in achieving efficiency
in a perfectly competitive market?
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Welfare, Market 2) What role does consumer utility maximisation and firm cost minimisation
Failure and the Role play in a general equilibrium analysis?
of Governemnt
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3) Briefly explain the cost structure of a PCM firm and its relevance in
determining the price and output of such a firm?
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16.5 COMPETITIVE PRICES AND EFFICIENCY:

THE FIRST FUNDAMENTAL THEOREM OF
WELFARE ECONOMICS
The essence of the relationship between perfect competition and the efficient
allocation of resources can now be easily summarised as below:
 Attaining a Pareto efficient allocation of resources requires that (except
when corner solutions occur) the rate of trade-off between any two goods,
say x and y, should be the same for all economic agents. In other words,
Marginal Rate of Technical Substitution for all producers and Marginal
Rate of Substitution for all consumers should be equal.

 In a perfectly competitive economy, the ratio of the price of x to the price

of y, i.e. px/py provides this common rate of trade-off to which all agents
will adjust. Because prices are treated as fixed parameters both in
individuals’ utility-maximising decisions and in firms’ profit-maximising
decisions, all trade-off rates between x and y will be equalised to the rate
at which x and y can be traded in the market (px/py), i.e.
p
MRTS , = MRS , =
p

 As all agents face the same prices in perfectly competitive market, all
trade-off rates will be equalised and an efficient allocation will be
achieved. This is the First Theorem of Welfare Economics.
The Fig. 16.6 illustrates the efficiency properties of the theorem.

330
Although all the output combinations on PP are technically efficient, only the Welfare: Allocative
combination x*, y* is Pareto optimal. A competitive equilibrium price ratio of Efficiency under
Perfect Competition
Px* = Py* will lead this economy to this Pareto efficient solution.

Fig. 16.6: Competitive Equilibrium and Efficiency in Output Mix

In Fig. 16.6, given the production possibility frontier PP and preferences

represented by the indifference curves, it is clear that combination x*, y*
represents the efficient output mix. Possibly x*, y* could be decided upon in a
centrally planned economy by the planning board or alternatively, in a
competitive market, the self-interest of firms and individuals will also lead to
this allocation. Only with a price ratio of px*/py* will supply and demand be in
equilibrium in this model, and that equilibrium will occur at the efficient
product mix, E, where MRSx,y (the slope of indifference curve) and MRTSx,y
(slope of the isoquant) and px/py (slope of the budget line are all equal. The
price mechanism ensures not only that production is technically efficient (that
output combinations lie on the production possibility frontier) but also that the
forces of supply and demand lead to the Pareto efficient output combination.
This is the First Fundamental Theorem of Welfare Economics.
The correspondence between competitive equilibrium and Pareto efficiency
provides “scientific” support for the laissez-faire position (which is based upon
the free market mechanism without intervention of the Government. For
example, Adam Smith in his book ‘Wealth of Nations’asserted in support for
such a policy with an example, “it is not the “public spirit” of the baker that
provides bread for individuals’ consumption. Rather, bakers (and other
producers) operate in their own self-interest when responding to market
signals. Individuals also respond to these signals when deciding how to
allocate their incomes”. Government intervention in this smoothly functioning
process may only result in a loss of Pareto efficiency.
However, it is difficult to draw policy recommendations from such a
theoretical analysis that pays so little attention to the institutional details of the
real world. The efficiency properties of the competitive system however do
provide a benchmark — a place to start examining reasons why competitive
markets may fail.

331
Welfare, Market
Failure and the Role
16.6 DEPARTING FROM THE COMPETITIVE
of Governemnt ASSUMPTIONS
You will learn in Unit 17 that various factors distort the ability of competitive
markets to achieve efficiency. These include (1) imperfect competition, (2)
externalities, (3) public goods, and (4) imperfect information. A brief summary
of these categories is given below:

16.6.1 Imperfect Competition

“Imperfect competition” includes all those situations in which economic agents
exert some power over the market in determining price. A firm that faces a
downward-sloping demand curve for its product, for example, will recognise
that the marginal revenue from selling one more unit is less than the market
price of that unit. Because it is the marginal return to its decisions that
motivates the profit-maximising firm, marginal revenue rather than market
price becomes the important magnitude. Market prices no longer carry the
informational content required to achieve Pareto efficiency.

16.6.2 Externalities
The competitive price system can also fail to allocate resources efficiently
when there are interactions among firms and individuals that are not adequately
reflected in market prices. For example, a firm polluting the air with industrial
smoke and other debris. Such a situation is termed an externality: an interaction
between the firm’s level of production and individuals’ welfare that is not
accounted for by the price system. With externalities, market prices no longer
reflect all of a good’s costs of production. There is a divergence between
private and social marginal cost, and these extra social costs (or possibly
benefits) will not be reflected in market prices. Hence market prices will not
carry the information about true costs necessary to establish an efficient
allocation of resources.

16.6.3 Public Goods

A similar problem in pricing occurs in the case of “public” goods. These are
goods, such as public education and public health institutions providing free
services, which (usually) have two properties that make them unsuitable for
production in markets. First, the goods are non-rival in that additional people
can consume the benefits of them at zero cost. This property suggests that the
“correct” price for such goods is zero, which obviously a problem for market
mechanism to operate. A second feature of many public goods is non-
exclusion: no individual can be precluded from consuming the good. Hence, in
a market context, most consumers will adopt a “free rider” stance, waiting for
someone else to pay. Both of these technical features of public goods pose
substantial problems for market economies.
16.6.4 Imperfect Information
The efficiency of perfectly competitive pricing is based on the assumption of
availability of full information with both producers and buyers in the market. It
implicitly assumes that buyers and sellers have complete information about the
goods and services they buy and sell. Firms are assumed to know about all the
production functions operating in their industry. Consumers are presumed to
know about the quality and prices of goods. If this assumption breaks down
332
and consumers are uncertain about prices and quality of a good and/or firms Welfare: Allocative
are unaware of the production processes in the industry, it will be difficult to Efficiency under
achieve the efficiency through competitive pricing. Perfect Competition

These four impediments to efficiency suggest that one should be very careful
in applying efficiency properties of perfectly completive markets for policy
formulation in the arena of public welfare.
Check Your Progress 3
1) Explain how the conditions of utility maximisation, cost minimisation,
and profit maximisation in competitive markets imply that the allocation
arising in a general competitive equilibrium is economically efficient.
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2) State the distortions leading to failure in achieving the efficiency in
perfectly competitive market.
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16.7 LET US SUM UP

The efficient allocation of resources requires that the rate of trade-off between
any two goods should be the same for all economic agents. In a perfectly
competitive economy, the ratio of the prices of the goods produced provides
this common rate of trade-off to which all agents will adjust and eventually be
equated. The firm operating within a perfectly competitive market will be both
productively and allocatively efficient in the long run, i.e. in the long run
perfectly competitive market shows that AR = ACmin (the firm is productively
efficient) and P (AR) = MC (The firm is allocatively efficient).
It is, however, very pertinent to note that even though the competitive
equilibrium outcome is efficient, there is no guarantee that all consumers fare
equally well under the equilibrium. The welfare of an individual consumer
depends on his or her endowment of scarce economic resources, which in the
societies are not equally distributed. An economy with great inequalities in
distribution of endowments is not necessarily efficient. In such a society, the
economy might be squeezing a large quantity of guns and butter from its
resources. But the rich few may be eating the butter and feeding it to their cats,
while the guns are mainly protecting the butter of the rich. A society, therefore,
does not live on efficiency alone. A society may choose to alter market
outcomes to improve the equity or fairness of the distribution of income and
wealth. Nations may levy progressive taxes on those with high incomes and 333
Welfare, Market wealth and use the proceeds to finance food, schools, and health care for the
Failure and the Role poor.
of Governemnt
It was also noted that the term ‘Marginal’ (cost, price, revenue and utility) is a
fundamental concept for efficiency.

16.8 REFERENCES
1) David A. Besanko, Ronald R. Braeutigam and Michael J. Gibbs,
Microeconomics, 4th Edition, John Wiley and Sons, p. 648-721.
2) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
3) KristerAhlersten, (2008) Essentials of Microeconomics, First Edition,
bookboon.com, p. 76-87.
4) Sanjay Rode, (2013), Modern Microeconomics, First Edition,
bookboon.com, p. 173-227.

16.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 16.2 and answer
2) Read Sub-section 16.2.1 and answer
3) Read Section 16.2 and answer
Check Your Progress 2
1) Read Section 16.3 and answer
2) Read Section 16.4 and answer
3) Read Section 16.4 and answer
Check Your Progress 3
1) Read Section 16.5 along with Section 16.3 and Section 16.4 and answer
2) Read Section 16.6 and Section 16.7 and answer

334
UNIT 17 EFFICIENCY OF THE
MARKET MECHANISM:
MARKET FAILURE AND THE
ROLE OF THE STATE
Structure
17.0 Objectives
17.1 Introduction
17.2 Departures from the Assumptions of Perfect Competition
17.2.1 Imperfect Markets
17.2.2 Externalities
17.2.3 Public Goods
17.2.4 Imperfect Information
17.2.5 Adverse Selection
17.2.6 Moral Hazard

17.3 Deviations between Marginal Social Costs & Marginal Private Costs
and Social & Private Benefits
17.4 Internalising Externalities
17.4.1 Need for Public Interventions
17.4.2 Taxes and Subsidies
17.4.3 Direct Regulation: Administrative Steps
17.4.3.1 Regulating Privately Determined Prices
17.4.3.2 Regulation of Activities
17.4.4 Public Provision: Expanding Supply of Public Goods

17.5 Let Us Sum Up

17.6 References
17.7 Answers or Hints to Check Your Progress Exercises

17.0 OBJECTIVES
After going through this unit, you will be able to appreciate that in actual
practice, the market may suffer from imperfections on account of several
factors. In fact there may be unavoidable deviations from the assumptions of
perfect competition. So, you will be able to have a fairly good idea about:
 imperfections in the market;
 the problem of externalities;

 the existence of public goods, which have properties of non-exclusion

and non-rivalry leading to some external costs/benefits;

Dr. Mamta Mehar, Post Doctoral Fellow, Value Chain and Nutrition Programme. World
Fish, Malaysia.

335
Welfare, Market  imperfection of information which vitiate the decision making process;
Failure and the Role
of Governemnt  the problem of adverse selection and moral hazards in the functioning of
different agents/ actors in the market;

 how all the above problems lead to the deviation between social and
private marginal costs on the one hand and benefits on the other hand;

 the need for internalising externalities through public interventions which

may take form of taxes and subsidies, regulation of privately determined
prices.

17.1 INTRODUCTION
You have studied in the previous unit that in a perfectly competitive market
system, we are able to achieve technological and economic efficiency in
allocation of resources among alternative usage and distribution of income
among owners of resources. You have also come across 1st Welfare Theorem
which summed up all these ideas based on Pareto Efficiency. We tend to
develop overconfidence in the optimality and desirability of market based
solutions to the day to day economic problems of the society on the basis of
that narration of Unit 16.
However, now we are turning to an examination of possible departures from
the assumptions of perfectly competitive markets. Those assumptions are:
 A very large number of both buyers and sellers;
 Homogenous product;
 Perfect information;
 Free flow of information which is free for both buyers and sellers;
 No barriers to entry into the market or exit there from;
 No body exercises control over the market price through ones own
actions; and
 There does not exist any externality.
In the present unit, in Section 17.2, we are going to examine how deviations
form the above assumptions create situations which lead the markets away
from the path of efficiency and optimality. We give a common name to such
situations – the market failure. In that section, we will examine 6 such sets of
circumstances. We have kept the treatment elementary. You will study such
issues in much greater depth when you pursue a course in economics at a
higher and more rigorous level.
The Section 17.3 is devoted to examine of one single consequence of chain of
events which leads to failure of “efficiency” of the market mechanism. It is
divergence between private and social marginal costs and marginal benefits.
Section 17.4 suggests some approaches to that take care of the factors which
lead to externalities – we call it internalising the externalities. Interestingly,
one approach to solving the problem is to enhance the provisions of “public
goods” – especially in the field of health and education. It is believed by the
economists that positive externalities created by the public provision will help
the society to minimise the negative externality causing distortions present in
the society.
336
 Efficiency of the
17.2 DEPARTURES FORM ASSUMPTIONS OF Market Mechanism:
PERFECT COMPETITION Market Failure and
the Role of the State
The Unit 16 had introduced you to the implications of perfect competition. In
particular, efficiency in production, technical efficiency, efficiency in
allocation of different resources among different uses and firms and efficiency
in decisions regarding product mix were explained. The “efficiency” in general
means “Pareto efficiency”.
We then moved on to describe efficiency in a perfectly competitive market
firm and that of a perfectly competitive market economy. This led us to the
First Fundamental Theorem of Welfare Economics.
You were briefly introduced to the departure from perfect competition in
Section 16.6. The present unit aims at giving you a detailed analysis of what
happens when we stray from the idealised situation of perfect competition –
what will be, in particular, the implications for efficiency in allocation and
distribution, of which particular type of departure.
Here, in this section we will deal with imperfections in the market, positive and
negative externalities, effects of existence of public goods, imperfections of
information, adverse selection and moral hazards.
17.2.1 Imperfect Markets
This occurs with violation of assumption of perfect competition that the
number of buyers and sellers in each market is very large. There are situations
where some goods are produced and sold by one or fewer seller as well as
some goods purchased by few buyers. Following are the examples of each
situations:
a) where some goods are produced and sold by one seller – this is also
called monopoly market structure
 For instance, Indian railways has monopoly in railroad
transportation.
 Electricity boards have monopoly in their respective states.
b) Where some goods are produced and sold by few sellers. This is also
called oligopoly market structure
a) Airlines industry has few providers like Jet airways, Air India,
Indigo etc.
b) Mobile Service Provider like Airtel, Vodafone, Reliance etc.
c) Automobile Industry like Honda, Maruti etc.
c) Where there are a few buyers of product – this is called Oligopsonic
market structure
a) Agriculture products like cocoa, tea, tobacco has few big buying
industries.
b) Indian Railways is the only employer for locomotive engineers in
the country.
17.2.2 Externalities
Externality occurs when the violation of assumptions entail cost or benefit to
third parties. Or in other words, one person’s action affects another person’s
well-being positively or negatively and the relevant cost or benefits accrued to
337
Welfare, Market another persons are not reflected in market prices. For example, a smoker will
Failure and the Role enjoy smoking and smoke alone, but other person near to him will be affected
of Governemnt by the smoke. Another example: a private function where loud music is played
may disturb the peace of neighbourhood.
17.2.3 Public Goods
Another major source of inefficiency or market failure lies in the fact that there
are some goods which are not in interest of private seller or firms to produce.
These goods are usually beneficial for the society but private firms find no
reason to produce them. So in other words, Public goods are those goods
whose consumption cannot be restricted to only those who pay for them. For
instance, road lights will benefit all who use the road, but the exact buyers
cannot be identified and charged for it. [Though it has become possible to
exclude motorists who do not pay toll-tax on highways]. Another classical
example is defense services which protect whole society. These goods and
services are called public goods or social goods.
A public good has two key characteristics: its consumption is non-excludable
and non-rival. These characteristics make it difficult for market producers to
sell the good to individual consumers.
 Non-excludability means that we cannot exclude non-payers from
consuming it. For example, defense services at national borders protect
whole nation, no one can be excluded from that protection. Opposite to
this is an excludable good, if one needs phone services, they have to buy
the phone and pay the call charges.
 Non-rivalry means that when a person consumes a good, it will not
diminish other persons’ share. For example, adding one more person in
the society available to the existing members of the society. Opposite to
this, can be a rival good, say, a Pizza. If one slice of the Pizza is
consumed by one person, the share available to the rest will be reduced
by that slice.
Table 17.1, provides combinations of non-exclusion and non-rival goods.
There are goods which are pure public or pure private good. But there are also
goods which are semi public goods, for example, common resources are
resources where there are many users but no owner. For example, ocean has no
owner and anyone can go for fishing there.
Table 17.1: Combinations of non-exclusion and non-rival goods

Non-Rival
Yes No
Pure Public goods: national Common
defense, street lights, judicial resources- farm
Yes system grazing in
Non- villages, fish
Exclusion taken from
ocean, irrigation
water from river
Toll goods: theaters, toll-tax Pure Private
No roads, cable TV goods: Pizza,
mobile phones

338
Public goods have extreme positive externality. One major problem that arises Efficiency of the
with public good is of ‘free riding’. Free Rider means a person who is using Market Mechanism:
the good without paying anything for it. There is always some over- Market Failure and
consumption of shared resources due to this problem. the Role of the State

17.2.4 Imperfect Information

The second major source of inefficiency or market failure is imperfect
information on the part of buyers and sellers. This implies violation of
assumption that consumers and producers have full knowledge of product
characteristics, available prices etc. Below are few examples to understand the
situation of imperfect information:
a) Second hand vehicle (say car) seller has more information about its
quality than the buyer.
b) In labour market, workers know about their skills, but employers have
limited information about the quality of workers to compare.
c) Insurance agency has less information about the risks taken by their
clients, as the risk varies across clients due to the differences in their
socio-economic background etc.
17.2.5 Adverse Selection
Adverse selection refers to a market process in which buyer and seller have
different access to product information. For example, there are two groups, i.e.,
smokers and non-smokers for health insurance in the market. As the insurance
company cannot differentiate between the two, both groups have to pay the
same premium. This health policy is better for smokers. They are likely to die
younger than average due to bad effects of smoking. The nonsmoker are at
disadvantage as they are paying higher premium, as there exists no policy
which will take care of smoking characteristics. So market failure is involved.
In simple terms, adverse selection tends to result from ineffective price signals
as most information in a market economy is transferred through prices.

17.2.6 Moral Hazard

Moral hazard problem arises when one party to a contract changes behaviour in
response to that contract and thus passes the cost of its behaviour on to the
other party to the contract. We consider the smoker and non-smoker example
again. In normal scenario, smokers have incentive to quit smoking as it
increases cost of premium to them. However, smoker knows that a large
portion of cost of their risk behaviour will be borne by insurance company and
indirectly by non-smoking policy holders. This results in market failure.

17.3 DEVIATIONS BETWEEN MARGINAL

SOCIAL COSTS & MARGINAL PRIVATE
COSTS AND SOCIAL & PRIVATE BENEFITS
Remember, perfectly competitive firms objective is to maximise profits by
producing output where price is equal to marginal cost (P=MC). In absence of
externality, this private marginal cost of firm equals its social marginal cost.
However, in presence of externality there are costs (or benefits) that fall on
someone else, which are called external costs (or external benefits). These
external effects of an activity are in addition to the private costs. The sum total
339
Welfare, Market of private and these third party costs is called social costs. The same logic
Failure and the Role applies to calculation of social benefits.
of Governemnt
As you know, the supply curve for a good or service shows marginal cost (MC)
to those individuals who are producing it. It shows the lowest prices producers
are willing to accept for different quantities of product. In case of externality,
we consider it as marginal private cost (MPC). If there are no negative
externality associated with the producing it, then it is equal to marginal social
cost (MSC). In presence of negative externality, MSC is greater than MPC by
amount of marginal external cost (MEC). Marginal external costs (MEC) are
cost to third-person or society who are directly not involved in the activity
from an extra unit of production. So we can also say that
MSC=MPC+MEC
From consumer side, the demand curve for a good or service shows marginal
benefits (MB) to those individuals who are consuming it. It shows the highest
prices consumers are willing to pay for different quantities of product. In
absence of externality, we consider it as marginal private benefit (MPB). If
there is no positive externality associated with producing it, then it is equal to
marginal social benefit (MSB). In presence of positive externality, MSB is
greater than MPB by the amount of that marginal external benefit (MEB).
MEB shows the benefit to third-person or society who are directly not involved
in the activity of consumption of an extra unit. So we can also say that
MSB=MPB+MEB
Price/ Cost

MPC

q
P
*

MPB

Output
Fig. 17.1: Profit maximising market - no externality case

Fig. 17.1, shows the market equilibrium in presence of no externality.

Consumer preferences are depicted by demand curve as shown by marginal
private benefit curve (MPB) and producer’s production are shown by supply
curve or marginal private cost (MPC) curve. The equilibrium quantity of the
product is where MPB=MPC, where optimum level of price and output are P*
and q* respectively. The presence of market failures, i.e. positive or negative
externalities will result in market producing either too much or too little of the
commodity from society’s perspective. Fig. 17.2, presents socially optimal
outcome in presence of negative production externality. In presence of external
cost, MSC will be higher than MPC. So the MSC curve lies above the supply
340
curve (i.e. MPC) representing the additional external costs. The new
equilibrium will be at a point where price will increase to Ps from P* and Efficiency of the
output will fall from q* to qs. The market level of output is inefficiently larger Market Mechanism:
than the output in presence of external cost. This means there is a loss in Market Failure and
societal benefit i.e. dead weight loss. Dead-weight loss is the triangle as shown the Role of the State
by the shaded area as shown below in Fig. 17.2.
Price/ Cost

MSC

MPC
Dead-weight

Ps
P

qs q Output

Fig. 17.2: Profit maximising market-negative externality

So, with negative externality P>MPC, hence market inefficiency. The

efficiency direction varies with the type of externality. The results of all
possible type of externality are as follows:
 Negative production externalities lead to over production (Seller)
 Positive production externalities lead to under production (Seller)
 Negative consumption externalities lead to over consumption (Buyer)
 Positive consumption externalities lead to under consumption (Buyer)

17.4 INTERNALISING EXTERNALITIES

Our discussion in Sections 17.2 and 17.3 above leads to an inescapable
conclusion: The externalities are simply unavoidable. One reason or the other
will lead to such a situation that some external benefits will be conferred on
some members of society or some external costs will be imposed on some
social group. This implies that the ideal situations visualised in Unit 16 of all
around efficiency and optimality is a misnomer – it is never going to come
true! But is the situation really so “hopeless”? No. The present section outlines
some via-media – we can try to internalise some externalities – that is we can
incorporate them in market calculations to reduce the “external” positive or
negative elements. We can go to the extent of using creation of some positive
externalities to counter-balance the pre-existing negative ones Sub-section
17.4.4. But one thing is absolutely clear – the presence of externalities calls for
state-intervention.

17.4.1 Need for Public Intervention

As we discussed above, when an activity generates either positive or negative 341
Welfare, Market externality, social optimality of output is affected. Thus in presence of
Failure and the Role externality, individual (consumer or producer) objective will not result in
of Governemnt maximum social welfare, hence an economic rationale for some form of
government interventions in such situations. The appropriate way is to
internalise the externality that exists. Take the producers or consumers that
create the externality into account when making policies. The two most
common approaches to solve the problem of externality considered are given
below:

17.4.2 Taxes and Subsidies

The classic way to adjust for the externalities is to tax those who create
externalities. This approach is called Pigouvian Tax. Consider an example: A
coal based thermal power plant generates q* units of electricity. However, in
the process, it pollutes environment imposing negative externalities on the rest
of society. So, in addition to private marginal cost of producing electric power,
there exist external marginal cost also. The total or social marginal cost is sum
of the two (MSC = MPC + MEC). In the absence of no social control, the plant
operators keeps on increasing power generation and pollution. But what
happens if the State imposes a tax equal to marginal external cost? Now, the
MPC plus tax will be equal to the MSC. The producer’s surplus from excessive
power generation will be eliminated. So the socially optimum level of power
will be generated.
Consider different situations. Production of a certain item/service is not
optimal. Private cost calculations restrict supply to q* whereas the consumers
will like to consume qc >qs. This can happen when consumption generates
additional social benefits, not accounted for in the private calculations. Here, it
will be advisable for the state to subsidise the production/distribution/
consumption. We can count examples of subsidised sale of essential fertilizer
by the state agencies – as higher application of, say, Urea, leads to higher food
productions, which is critical for alleviation of hunger and mal-nutrition in the
society.

17.4.3 Direct Regulation: Administrative Steps

17.4.3.1 Regulating the Privately Determined Prices
The price regulation can become an important administrative measure to curb
profiteering on part of firms and to make available essential services and
commodities to the end users at a reasonable price. Two recent examples from
India can be mentioned here: The private (unaided) schools in Delhi did
increase the tuition fee charged from the students disproportionately, on the
pretext of meeting additional cost on account of the implementation of 6th
Central Pay Commission Award. Their bluff was called by the Honourable
High Court of Delhi and they are ordered to refund the excess amount along
with the interest thereon to the pupils. If they fail to do so, the private
managements may lose the control over those organisations.
The second example is that of inordinately high prices charged by pharma-
suppliers for the medical devices – like stents etc. The government has been
forced to impose price ceilings on such devices. Many of essential medicines
also attract the price ceilings.
These measures try to eliminate excessive profits only the costs plus a
reasonable returns are still being recovered by the manufacturers.
342
17.4.3.2 Regulation of the Activities Efficiency of the
Market Mechanism:
Regulation: The problem with taxes and subsidies is that the level of tax or Market Failure and
subsidy cannot be measured accurately in monetary terms. Another way of the Role of the State
controlling externality is to set standard limits for such activities. For example:
 Setting minimum standards for health and safety at the workplace
 Pollution permits: setting maximum quantity of polluting activity and
above that, stricter penalties for firms and consumers who break
regulations
 Banning cigarette advertising and making workplaces no-smoking
environments
Other than these, private bargaining and negotiations by agents are also used to
solve the problem of externality.

17.4.4 Public Provision: Expanding Supply of Public Goods

Now it is being increasingly realised that the society cannot depend on the
market forces to ensure optimum provision of essential services like education,
public health and tertiary health services. On account of presence of massive
divergence between private cost based calculations of the suppliers and the
social needs (signifying huge social benefits), it is being argued that the state
must increasingly enter into these two areas.
Check Your Progress 1
1) What are the assumptions of perfect competition market?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) What do you understand by the market failure? Explain the sources of
market failures?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) How do public and private goods differ?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the policy instruments available for government intervention to
regulate inefficient market situations.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Place each of these goods and services in the list below into the four
boxes in Table 17.2.
a) Private parks b) potato chips c) street lights d) Public toll roads &
bridges e) police and fire protection f) grazing land g) fish taken from
ocean h) timber i) Army j) Cable television k) mobile phones l) ice- 343
Welfare, Market cream m) Public radio n) laptop o) Free Mid-day meal at Public school
Failure and the Role p) parking spaces
of Governemnt
Table 17.2: Combinations of non-exclusion and non-rival goods
Non-Rival
Yes No

Non- Yes
Exclusion No

17.5 LET US SUM UP

We began the unit with narration of some sets of circumstances which
essentially are related to breakdown of some assumptions or other of the
perfect competition. Then, we demonstrated that this breakdown leads to
deviations between private and social costs as well as benefits. Our quest for
internalising the phenomena of externalities lead us to work for some public or
government interventions, in forms of taxes and subsidies, or regulating
minimum /maximum prices, or regulating certain private activities through
legal dictates. We go to the extent of using the instruments of the state to
generate some such externalities which can possibly mitigate the adverse
effects of some pre-existing externality causing maladies.

17.6 REFERENCES
1) Case, Karl E. & Ray C. Fair, Principles of Economics, Pearson
Education, Inc., 8th edition, 2007., Chapter 12.

17.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 17.1
2) See Section 17.2.
3) The two characteristics of public goods: non-exclusion and non-rivalry
make them different from private good.
4) See Section 17.4
5) See below
Non-Rival
Yes No
Yes Army, street lights, judicial grazing land, fish taken from
system, police and fire ocean, timber
protection, Free Mid-day
Non- meal at school
Exclusion
No Public toll roads & bridges potato chips, mobile phones,
cable television, Public laptop, ice-cream, cloths, parking
radio, private parks. spaces

344
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.

350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356
UNIT 1 INTRODUCTION TO
ECONOMICS AND ECONOMY
Structure

1.0 Objectives

1.1 Introduction

1.2 Concept of Scarcity

1.3 Meaning of Production

1.4 Central Problems of an Economy

1.4.1 What to Produce?
1.4.2 How to Produce?
1.4.3 For Whom to Produce?
1.4.4 The Problem of Growth
1.4.5 Choice between Public and Private Goods
1.4.6 The Problem of ‘Merit Goods’ Production

1.5 Production Possibility Curve

1.6 Allocation of Resources: Solution of Central Problems

1.6.1 Resource Allocation in a Mixed Economy

1.7 Economic Methodology and Economic Laws

1.7.1 Inductive and Deductive Reasoning
1.7.2 Equilibrium

1.8 Positive versus Normative Economics

1.9 Microeconomics and Macroeconomics

1.10 Stocks and Flows

1.11 Statics and Dynamics

1.12 Let Us Sum Up

1.13 References

1.14 Answers or Hints to Check Your Progress Exercises

1.15 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College (University of Delhi), Delhi.
7
Introduction
1.0 OBJECTIVES
After studying this unit, you will be able to:

• explain the problem of scarcity of resources for satisfying ever-increasing

wants of society;
• state the meaning and nature of an economy;
• describe the concept of economic entities;
• discuss the concept of production possibility curve;
• state the issues relating to allocation of resources between investment and
consumption, and between private and public goods;

• explain the methods of resource allocation in a market economy in a

socialist economy and in a mixed economy;
• clearly describe the basic concepts and methodology of Economics;
• state the nature of economic laws; and
• explain some of the analytical concepts associated with economic
reasoning.

1.1 INTRODUCTION
Let us begin with defining the discipline of Economics.
Definition of Economics
Economics has been variously defined. As summarised by Samuelson, some of
the definitions seek to explain that economics:

• analyses how a society’s institutions and technology affect prices and the
allocation of resources among different uses.

• explores the behaviour of the financial markets, including interest rates

and stock prices.

• examines the distribution of income and suggests ways that the poor can
be helped without harming the performance of the economy.

• studies the business cycle and examines how monetary policy can be
used to moderate the swings in unemployment and inflation.

• studies the patterns of trade among nations and analyses the impact of
trade barriers.

• looks at growth in developing countries and proposes ways to encourage

the efficient use of resources.
• asks how government policies can be used to pursue important goals such
as rapid economic growth, efficient use of resources, full employment,
price stability, and a fair distribution of income.

8
A common theme running through all these definitions is that scarcity is a fact Introduction to
of life and that an efficient use of these scarce resources is to be found. That is Economics and
how we define economics as a science that deals with scarcity. Economy

It explains the behaviour of different economic units, households, firms,

government and the economy as a whole, when they are faced with scarcity.

1.2 CONCEPT OF SCARCITY

“Scarcity” lies at the root of all economic activities. The concept of scarcity
finds an expression in two basic facts of economic life:
A. Unlimited wants or ends, and
B. Scarce resources or means.
A. Unlimited wants or ends
Every person has some wants. Different persons have generally different
wants, and wants of even the same person keep changing with the passage of
time, change of place and status.
Human wants are unlimited and keep on increasing. Different wants differ
in their intensity. Subject to the availability of resources, higher order wants
need be satisfied first and if the resources are still available these may be used
to satisfy lower order wants.
B. Scarce resources or means
Satisfaction of wants requires resources (or the means to satisfy wants).
Availability of resources is limited in relation to requirements.
However, scarce means have alternative uses.
The resources therefore need be allocated among different uses in a systematic
coordinated manner. Every individual and economy has to devise a mechanism
for this.
Different societies try to solve these issues in different ways and in the process
each society creates a set-up called ‘an economy’. The term ‘economy’ or
‘economic system’ is a comprehensive one. It covers the entire set of
institutions and arrangements, (including rules and regulations which facilitate
their interactions) for resolving the basic and permanent problem of an
imbalance between means and wants.
The human society has evolved several sets of such institutional arrangements
each is termed an economic system and they have their own distinguishing
features and nomenclatures. These systems try to adopt their own means and
methodologies for solving the basic problems.
For example, take the case of a capitalist economy. In this case the means of
production are owned and inherited by individuals, and various economic
decisions are guided by prices of goods and services in the market. The income
of an individual is determined by means of production supplied by him to the
market and the price which they are paid for their service. On the other hand, in
a strict socialist economy all the means of production are owned by the state.
The state takes all the decisions regarding the use of available resources.
9
Introduction However, whatever its nature, every economy has to solve the basic problem of
scarcity of means in relation to the ever-increasing and varied wants. The
means and wants can be combined in alternative ways. The problem of scarcity
exists in every society, irrespective of the levels of its development. Hence it
has to address itself to two issues:
1) increasing the availability of means of satisfaction, and
2) laying down the priorities of the wants to be satisfied.
Check Your Progress 1
1) State two important characteristics of wants which make them unlimited
in number.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What is an economy?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Pick up the correct option among the following:
Which of the following can be called scarce:
a) Stock of rotten vegetables
b) Useless plants in a jungle
c) Number of flowers in a nursery
d) Water in a dirty pit.

1.3 MEANING OF PRODUCTION

The term ‘Production’ implies the transformation of various inputs into
output thereby increasing the want-satisfying capacity of the inputs. The
process of production transforms the things occurring in nature into goods and
services which are capable of satisfying human wants. The things which are so
transformed are called inputs while output is nothing but the transformed form
of inputs, that is, the goods and services. This involves some human effort,
both physical and intellectual. The transformation may be physical (a different
appearance which enhances want satisfying capacity), spatial (relocate or
transfer the things from one place to another to make them available to the end
users) or inter-temporal (saving/preserving things which arise/grow/made
today for use at a later date-storage and warehousing). A particular
transformation is production if the want-satisfying capacity of the output (also
called ‘product’) is more than that of inputs used. To put it differently
production is nothing but the creation of utility.

10
 Introduction to
1.4 CENTRAL PROBLEMS OF AN ECONOMY Economics and
Economy
Because of the scarcity of resources every economy is faced with certain basic
or fundamental problems which it must try to solve within its socio-economic
framework. These central problems are:

1.4.1 What to Produce?

An economy does not have enough resources to produce everything required
by it. So, it must be selective and decide what to produce and what not to
produce. When some goods are not produced, some wants of the society
remain unsatisfied. The decisions regarding the wants to be satisfied and the
goods and services to be produced are interrelated and are taken in a
coordinated manner. This is called allocation of productive resources. If some
factors of production are employed in the production of product X, to that
extent, these will no longer be available for production of product Y. The
problems can be illustrated by Production Possibility Curve which we will
introduce shortly.

1.4.2 How to Produce?

This is a problem which covers the details of the allocation of productive
resources in the production of various goods and services. More precisely, we
can say that when an economy decides to produce X , it has also to work out
exactly how much of labour, capital, land, etc., would go into its production.
The exact proportion of factor-inputs used in the production of goods needs to
be decided, irrespective of the size and nature of an economy. This is called the
technique of production of that item. For example, we may think of goods
which are produced by using more of labour than capital. In such cases labour
intensive techniques of production are said to be in use. On the other hand, if
more of capital goes into the production of an item, then we say that it is being
produced by a capital-intensive technique.
When an individual producer is to decide about the technique of producing any
particular product, he considers the prices and productivities of alternative
inputs, say labour and capital, since frequently their relative usage can be
varied. He tries to use those inputs in such a combination which costs him the
least and will yields him the maximum output.
His decision is based on consideration of following two factors:
i) the relative price of labour and capital, and
ii) the relative efficiency of the two inputs

1.4.3 For Whom to Produce?

A society comprises a large number of individuals and households. All the
output of consumption goods and services is ultimately meant for their use.
Therefore, all goods and services produced are to be distributed amongst the
individuals and households. The share of each individual and household has to
be determined and also the quantities of specific goods and services which
comprise that share.
We can see that it is possible to propose different principles whereby this
distribution may be carried out. In an economic system organised on market
11
Introduction principles, the income shares of individual members of the society are
determined in the following manner:
In a market economy, productive resources are privately owned. They are sold,
bought and hired like any other goods or services. The price of a productive
resource is determined by the market forces of demand and supply. Whenever
it is to be employed by a producer, he has to pay its market price to its owner.
It is for the owner to supply it to the market or withhold it. The income of each
individual under these conditions, is determined by the amounts of different
productive resources owned and supplied by him to the market and their
respective price.

1.4.4 The Problem of Growth

Every economy seeks to increase its stock of capital to increase its production
capacity and thereby generate more income. The generated income in an
economy has two alternative uses, viz. consumption expenditure (C) and
saving (S). Thus, Y = C + S. Saving is source of finance for investment in an
economy. Investment adds to the capital stock of an economy. And therefore,
there is a need to reduce the share of consumption expenditure (and thereby
increase investment); this helps in capital formation.

1.4.5 Choice between Public and Private Goods

1) Private Goods: There are certain goods (the term goods here includes
services also) whose availability can be restricted to selected individuals
only. For example, a product may be priced in the market and only those
who pay its price may be allowed to have it. This characteristic of a
product by which some people can be prevented from its use is referred
to as the ‘principle of exclusion’. Accordingly, those persons who
cannot pay for it or who are not ready to pay, are not allowed to use it.
The use of the goods is thus divisible between different persons. Any
goods which can be priced and whose use can be restricted to selected
persons is termed as private goods.
2) Public Goods: When it is not possible to restrict the availability of a
product to selected individuals, they are termed as public goods or social
goods. Such goods cannot be so priced as to deprive some persons from
using it. That way, it is indivisible. Defence service is a typical example
of a public service. When a country is protected against foreign
aggression, every citizen is protected.
With its limited resources, an economy cannot have enough of both public and
private goods. It must try to achieve an optimum combination of both.

1.4.6 The Problem of ‘Merit Goods’ Production

Those goods whose consumption is considered highly desirable for the
members of the society are termed as merit goods. The important feature of
the merit goods is that their consumption benefits both the user and non-users.
For example, if a person is educated and healthy, it not only helps him but also
the society as a whole. Health and education, therefore, are called a merit
product/service and it is desirable that every member of the society gets
education. Consumption of merit goods benefits the society as a whole and
raises the level of its efficiency and well-being. Therefore, every society has to
12 decide the extent it can and should produce and consume merit goods.
Check Your Progress 2 Introduction to
Economics and
1) State the central problems of an economy? Economy
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What is capital formation?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What is a technique of production?
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) What are merit goods?
......................................................................................................................
......................................................................................................................
......................................................................................................................
5) Differentiate between public and private goods.
......................................................................................................................
......................................................................................................................
......................................................................................................................

1.5 PRODUCTION POSSIBILITY CURVE

The economy has to choose between alternative combinations of various goods
and services. This problem of choice can be illustrated by a simple graph
known as Production Possibility Curve or a Product Transformation
Curve. A typical Production Possibility Curve (PPC) is drawn on the
following assumptions:
i) The country has to choose between alternative combinations of only two
goods, say. LED (L) and computer monitor (M).
ii) All productive resources of the country are taken as given and so is the
state of technology, no changes are made in them.
iii) All productive resources of the economy are fully employed. There is no
wastage or under utilisation.
iv) The productive resources are suitable for the production of both goods
(L) and (M). They can, therefore, be shifted from the production of one to
the other goods. However, such a shift would reduce the production of
the first good and increase that of the other.
v) No factor of production is considered to be specific in the production of
one good alone and inappropriate for the production of the other.
vi) We consider the productive efficiency of the productive resources only in
physical terms, i.e., the units of LED (L) and Computer Monitor which
they can produce. 13
Introduction Based upon these assumptions, we can illustrate the set of production
possibilities available to a country by a hypothetical example. Look at Table
1.1. The figures in the table show that all the productive resources of the
country put together can produce a maximum of either 30 L or 30 M or some
other combinations thereof. The production possibilities illustrated in Table 1.1
are also represented in Fig. 1.1 in the form of a production possibility curve
(PPC).
Quantity of M is measured along X-axis and the numbers of L are measured
along Y-axis. The respective pairs of the quantities of L and M are plotted and
joined with each other to yield a curve which is called the Production
Possibility Curve. Thus, the PPC represents all the possible combinations of L
and M which can be produced by using all the productive resources of the
economy, efficiently. In that sense, each point on the curve represents the
maximum possible output and, for that reason, it is also termed as the
production frontier of the economy.
Table 1.1: Production Possibilities Available to a Country

Combination LED Computer Loss of M for Loss of L for

(Numbers) Monitor each each
(L) (M) Additional Additional
L Produced M Produced
(Tones) (Numbers)
1 30 0 2.8
2 25 14 1.2 0.357
3 20 20 0.8 0.833
4 15 24 0.6 1.250
5 10 27 0.4 1.667
6 5 29 0.2 2.500
7 0 30 5.000

Fig. 1.1

14
The economy can produce any combination of L and M represented by a point Introduction to
either on the PPC or in the shaded area of the diagram. Production Economics and
combinations represented by the shaded area imply that the economy can Economy
produce either L or M or both. For example, combinations represented by
points A, B and C are feasible, as these lie either on the PPC or in the shaded
area. But the combination represented by A is feasible but not efficient.
Combination represented by points B and C are both feasible and efficient. If it
produces at Point A it is not utilising some of its productive resources and let
them go waste. Thus consider point A which represents a combination of 10
tonnes of M and 14 L. The PPC, however, shows that with this much of M, the
economy can produce 27 L (as shown by point C on PPC). Alternatively, with
14 L, the quantity of M can be increased to 25 tonnes (see point B).
Any point beyond the PPC, which is in the non-shaded area of the diagram,
shows a combination of L and M which the economy cannot produce. For
example, point D represents a combination of 30 M and 20 L. However, when
30 M is produced, no resources are left for the production of L. On the other
hand, if 20 L are produced, then the quantity of M has to be reduced to 20.
Characteristics of PPC
A typical PP curve has two characteristics:
1) Downward sloping from left to right
It implies that in order to produce more units of one good, some units of the
other good must be sacrificed (because of limited resources).
2) Concave to the origin
A concave downward sloping curve has an increasing slope. The slope is the
same as MRT. So, concavity implies increasing MRT, an assumption on which
the PP curve is based.
Can PP curve be a straight line?
Yes, if we assume that MRT is constant, i.e. slope is
constant. When the slope is constant the curve must
be a straight line. But when is MRT constant? It is
constant if we assume that all the resources are
equally efficient in production of all goods.
Note that a typical PP curve is taken to be a concave
curve because it is based on a more realistic
assumption that all resources are not equally efficient
in production of all goods. (Fig. 1.2)

Fig. 1.2

Does production take place only on the PP curve?

Yes and no, both. Yes, if the given resources are fully and efficiently utilised.
No, if the resources are under-utilised or inefficiently utilised or both. Refer to
the Fig. 1.3.
On point F, and for that matter on any point on the PP curve AB, the resources
are fully and efficiently employed. On point U, below the curve or any other
15
Introduction point but below the PP curve, the resources are either under-utilised or
inefficiently utilised or both. Any point below the PP curve thus highlights the
problem of unemployment and inefficiency in the economy.

Fig. 1.3

Can the PP curve shift?

Yes, if resources increase. More labour, more capital goods, better technology,
all means more production of both the goods. A PP curve is based on the
assumption that resources remain unchanged. If resources increase, the
assumption breaks down, and the existing PP curve is no longer valid. With
increased resources, there is new PP curve to the right of the existing PP curve.

Fig. 1.4 Fig. 1.5

It can also shift to the left, if the resources decrease. It is a rare possibility but
sometimes it may happen due to fall in population, and due to destruction of
capital stock caused by large scale natural calamities, war, etc.

16
 Introduction to
1.6 ALLOCATION OF RESOURCES: SOLUTION Economics and
OF CENTRAL PROBLEMS Economy

Theoretically, there are two types of economic systems, viz.. Capitalistic

economy and socialistic economy. In practice, all the countries have adopted a
system which is broadly identified as mixed economy.
The problem of resources allocation may be tackled in several ways and each
economy tries to solve it in line with its own chosen objectives.

1.6.1 Resource Allocation in a Mixed Economy

A mixed economy is one in which some decisions are left to the market forces
while others are taken under direct government regulation or even ownership.
Some selected areas of economic activities are reserved for the government
sector. The government acquires the necessary productive resources for these
activities and employ them in conformity with its priorities. The production
pattern of the public sector, the prices of items produced by the public sector
and other measures are used to regulate the allocation of resources in private
sector as well. These other measures include price controls, licensing, taxation,
subsidies and others. Additionally, various labour welfare measures are
implemented and enforced by the government. Similar steps are taken to
encourage the use of productive resources for encouraging the development of
backward areas of the country for removing specific shortages, and for
bringing about a balanced development of the economy as a whole.

1.7 ECONOMIC METHODOLOGY AND

ECONOMIC LAWS
Economic methodology investigates the nature of economics as a science. It
investigates the nature of assumptions, types of reasoning and forms of
explanations used in economic science. Various practices such as
classification, description, explanation, measurement, prediction, prescription
and testing are associated with economic methodology. Economic
methodology examines the basis and groups for the explanations. Economists
give answer why questions about the economy. For example, economists use
the shifting of demand and supply curves to answer the question of why prices
change.
Economics being a social science, economic laws are, therefore, a part of social
laws. In the words of Alfred Marshall, we should separate that part of
behaviour of members of the society where the main motive happens to be an
economic one, where the main motive can be expressed in terms of money
price. The corresponding activities are then economic activities. However, such
a dividing line between economic laws and other social laws is not always
clear. Very often an activity happens to be motivated by a combination of both
economic and non-economic considerations. As a result, it is often quite
difficult to formulate pure economic laws which have full validity also.

1.7.1 Inductive and Deductive Reasoning

Economists have followed two traditions in formulating economic laws.
According to one tradition, the causes (also called conditions or assumptions)
17
Introduction are specified and different economic units are expected to behave in a ‘rational’
manner. The outcome in this case is predictable, provided the assumptions
made are satisfied. The assumptions themselves may be totally unrealistic or
may be very close to reality but they are stated in a precise manner. In any
case, this type of reasoning is called deductive reasoning. In this method, the
generalisation or law is stated and the individual activities are expected to
conform to it. A typical example of deductive reasoning is the law of demand
which states that, other things being equal, the quantity of a product demanded
varies inversely with its price. When price falls, demand expands and when
price rises, demand contracts.
As against this deductive reasoning, some thinkers try to discover economic
laws the other way round. Instead of laying down causes or conditions on a
hypothetical basis, they collect the actual information regarding the behaviour
of economic units under different conditions. In other words, empirical
information is collected and generalisations regarding the behaviour of
economic units under different conditions are worked out. This is called the
method of inductive reasoning. A well-known example of the use of this
method is the Engel’s Law. Through a study of family budgets, Engel
concluded that as the income of a family increases, the proportion of its
expenditure on necessities decreases while that on comforts and luxuries goes
up. Most business firms prefer this line of approach.
In economics, both inductive and deductive methods of reasoning are used to
supplement our understanding of an economy and its working.

1.7.2 Equilibrium
The concept of equilibrium is an important tool of analysis in economics. It is
very frequently used and one should become familiar with it. Usually, an
economic variable (such as the price of a commodity) is subject to various
forces trying to pull it in different directions. When these forces are in balance,
the value of variable stops changing and it is said to be in equilibrium.
Concept of Equilibrium
Equilibrium means a state of rest, the attainment of a position from which there
is no incentive nor opportunity to move.

• A consumer is in equilibrium when his expenditure on different goods

and services yield maximum satisfaction. No move on his part can
increase his satisfaction but, rather, will decrease it.

• A business firm is in equilibrium when its resource purchases and its

output are such that it maximises its profits, if profit maximisation is its
objective, any change on its part will cause profits to decrease.

• A resource owner is in equilibrium when the resources which he owns are

placed in their highest paying employments and the income of the
resource owners is maximised. Any transfer of resource units from one
employment to another will cause his income to decrease.

• An economy is in equilibrium at the level of income (and employment)

where aggregate demand equals aggregate supply.
Equilibrium concepts are important, not because equilibrium is ever in fact
18 attained but because they show us the directions in which economic changes
proceed. Economic units in disequilibrium usually move toward equilibrium Introduction to
positions. Economics and
Economy
Equilibrium can be analysed in two forms:
1) Partial: In partial equilibrium analysis we concentrate on a single
market in isolation from the rest of the economy.
2) General: In general equilibrium analysis, we analyse simultaneously all
the markets in the economy on the basic premise that everything depends
on everything else.

1.8 POSITIVE VERSUS NORMATIVE

ECONOMICS
The term positive economics is concerned with only formulating economic
laws and describing reality. The economic laws may be derived from
theoretical assumptions or from recorded facts. Either way, they only tell us
what exists. They do not pass any judgement as to whether the findings of
economic analysis are desirable or need a modification.
As against this, normative economics realises the fact that an economy is
never perfect. The outcome of its working can always be improved upon. It
is quite normal to find an economy faced with many problems requiring
immediate attention. Such problems can be related to price changes,
employment, scarcity of certain inputs, inequalities of Income and wealth, and
so on. In normative economics, the knowledge gained is put to use for
improving the working of the economy. Targets of improvement are laid down
and policy measures are formulated by which the targets are to be achieved.
Thus, normative economics is concerned with what ought to be.

A positive statement:

“An increase in price of petrol leads to a fall in its quantity demanded.”

A normative statement:

Government should take steps to cut the consumption of Petrol.

More generally, normative statement uses the verb “should”.

1.9 MICROECONOMICS AND

MACROECONOMICS
The terms microeconomics and macroeconomics are used in connection with
the level of aggregation, that is the extent to which economic units and
variables are covered in economic analysis. At one end, the analysis may cover
the behaviour and responses of a single economic unit and at the other extreme
it may cover the entire economy. These two terms (micro and macro) are
derived from Greece words mikros and makros which mean small and large
respectively.

19
Introduction Microeconomics deals with the behaviour of individual elements in an
economy such as the determination of the price of a single product or the
behaviour of a single consumer or business firm.
As against this, macroeconomics covers large aggregates or collection of
economic units which may extend to the entire economy. In the words of
Kenneth Boulding, macroeconomics covers the great aggregates and
averages of the economic system rather than individual items. Here we
study collections of variables and economic units (i.e., macro variables) such
as national income, employment, level of prices in general, intersectoral flows
of goods and services, total savings and investment, and the like. While the
study of an individual firm or an industry lies within the scope of
microeconomics, an entire sector falls within the scope of macroeconomics.
To use a metaphor, macroeconomics studies elephant as one object;
microeconomics (like five blind men in a flok tale) studies individual parts of a
whole body. Each study leads to different results. Or, to use another metaphor,
one enjoys the macro-view of a cricket test match while one enjoys a ball-by-
ball description when sitting in before a TV.

1.10 STOCKS AND FLOWS

Economic variables are of two kinds: 1) stocks and 2) flows. A stock variable
is the one which can be measured only with reference to a point of time
and not over a period of time. As against this, a flow variable is the one
which can be measured only with reference to a period of time and not a
point of time. We come across numerous economic variables which belong to
one category or the other. Take the examples of the supply of money and
magnitude of wealth. They have reference to point of time. They are, therefore,
‘stock’ concepts. Correspondingly, examples of flow variables are production,
saving, expenditure, income, sales, purchases, etc. All these variables can be
measured only over a period of time. A factory can produce so much during,
say, a month and not at a given moment of time. A person does not have an
income at a point of time. But he has it only for a period of time. A flow
concept can assume some value only with the passage of time, not otherwise.
One should observe that stock and flow variables are often used together in
economic analysis.

1.11 STATICS AND DYNAMICS

Economic analysis can be conducted either by using a static framework or a
dynamic setting. Static and dynamic modes of analysis can be differentiated in
more than one ways. According to one definition, in a static model (theory)
the variables (cause effect) are not dated. The demand-supply model of market
behaviour is a static model. The model that demand depends on own price,
supply depends on own price, with an equilibrium condition that demand must
equal supply, time does not enter into the picture at all and the variables are all
undated. According to this definition, a dynamic model would be one where
the relevant variables are dated. If the demand-supply model is restructured as
follows, then the model would become dynamic according to this criterion.
Dt = f(Pt)
St = g(Pt)
20 Dt = St
where‘t’ is the relevant time unit. Introduction to
Economics and
However, according to some economists, even if the variables are dated the Economy
model does not become dynamic. A dynamic model according to this
definition would be one where the variables must be dated and a time lag must
exist in their relationships. According to this criterion the following would be
a dynamic model.
Dt = f(Pt)
St = g(Pt-1)
Dt = St
There is no lag in the demand relationship. Demand in period ‘t’ depends on
own price of the same period. However, in the supply relationship a gestation
lag exists which makes the model dynamic. Supply in period ‘t’ depends on
price prevailing in the previous period (t–1). The price level in previous period
(t–1) would have induced the producers to increase or decrease the supply, full
impact of such decisions are visible in time period ‘t’ only. For market to
attain equilibrium, demand in period ‘t’ must equal supply in period ‘t’.
Check Your Progress 3
1) State whether the following statements are True or False:
i) Positive economics is concerned with what ought to be.
ii) Normative economics requires a system of value judgement for
recommending policy steps.
iii) Every economist prescribes the same remedies for a particular
economic problem.
iv) Positive economies always depict reality.
v) We can always extend the conclusions of microeconomics to the
field of macroeconomics.
vi) Demand and supply are both stock variables.
vii) In comparative statics, a comparison of two equilibrium positions is
made.
2) Match the item in Column A with those in Column B.
Column A Column B
i) Study of individual firm and industry a) Barter
ii) A variable which can be measured at a point b) Macroeconomics
of time
iii) Study of an entire sector of an economy c) Marginal utility
iv) A variable which can be measured over a d) Ceteris paribus
period of time
v) Want satisfying capacity of a good e) Flow variable
vi) Satisfaction yielded from consuming one f) Microeconomics
additional unit
vii) Other things being equal g) Utility
viii) Exchange of apples with eggs h) Stock variable 21
Introduction 3) Which of the following will be the new production possibility frontier, if
new technology is developed that enables higher productivity in
agricultural (A) only? Industrial output (I) is not impacted.

Fig. 1.6

1.12 LET US SUM UP

Economics explains the behaviour of different economic units like consumer,
producer, households, firms, governments and the economy as a whole when
they are faced with the problem of scarcity. Scarcity is observed in terms of
unlimited wants in relation to available scarce resources. Scarcity gives birth
to three central problems: What to produce, how to produce and for whom to
produce. The other problems aligned with these three problems are the
problems growth, choice between public and private goods and the problem of
merit goods production. The central problem of an individual as well as for the
society is therefore the allocation of scarce means among competing ends. A
production possibility curve shows, given scarcity of resources and given
technology, the maximum output produced of one good, given the output of
other good. It shows how one good can be transformed into another good not
physically but via the transfer or shifting of the resources from one line of use
to another.
Economic methodology investigates the nature of economics as a science.
Economic laws enable us to provide explanation of an event or phenomena in
terms of cause and effect relationship. Two types of logics are followed in
formulation of economic laws – induction and deduction.
Equilibrium is an important tool of analysis in economics. When the different
forces pulling a variable in different directions are in balance, its value stops
changing and is said to be in equilibrium.
The term positive economics denotes that part of economic analysis which just
describes reality (or theoretical reasoning) without stating the desirability or
otherwise of the findings. Normative economics, on the other hand, is
concerned with what ought to be. It views reality in the light of chosen goals of
society and suggests ways and means of achieving them.
Microeconomics studies the economic activities and responses of individual
economic units and their small groups. Macroeconomics covers large
collections of economic units, their aggregates and averages and macro-
variables like national income, employment, and so on.

22
Economic variables can further be classified into stocks and flows. A stock Introduction to
variable is the one which can be measured only with reference to a point of Economics and
time. A flow variable, on the other hand, is measurable only over a period of Economy
time.
Static economic or comparative statics is a technique of analysis in which the
parameters of the economy are taken to be given. The assumption of ceteris
paribus is made and the initial and final equilibrium positions arc compared. In
dynamic-economics or dynamic analysis, parameters of the economy are
allowed to change.

1.13 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi,
2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

1.14 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Unlimited, ever increasing
2) Economy refers to the setup created for meeting the basic and permanent
problem of an imbalance between means and wants.
3) c)
Check Your Progress 2
1) The central problems of an economy are (i) what to produce, (ii) how to
produce, (iii) for whom to produce, (iv) the problems of growth, (v)
choice between public and private goods (vi) the problem of merit goods
production.
2) Addition in its stock of capital is capital formation.
3) Technique of production refers to exact proportion of factor inputs used
in the production of goods.
4) The goods whose consumption benefits both user and non-users are merit
goods.
5) Private goods are the goods whose availability is restricted to selected
individuals whereas in case of public goods nobody is excluded in the
availability of such goods.

23
Introduction Check Your Progress 3

1) i) False ii) True iii) False iv) False – It will depict reality only if its
assumptions are realistic. Otherwise it would have only correct reasoning
without applicable conclusions. v) False vi) False vii) True
2) i) f ii) h iii) b iv) e v) g vi) c vii) d viii) a
3) b

1.15 TERMINAL QUESTIONS

1) What is an economic system? Explain the central problems of an
economy.
2) What are the main characteristics of human wants?
3) Scarcity lies at the root of every economy. Explain.
4) What do you understand by factors of production? Briefly explain each of
the four main factors.
5) Write short notes on the following:
a) Public goods and private goods
b) Merit goods
c) Human wants
6) Explain how the solutions to the fundamental problems of an economy
are interlinked with each other.
7) Explain the concept of a production possibility curve. Enumerate its
assumptions. Illustrate it with the help of an example.
8) Briefly explain how resource allocation takes place in the following
systems:
a) Market economy
b) Socialist economy
c) Mixed economy
9) Giving reasons state which of the following statements are true or false:
i) All human wants cannot be satisfied. It is a universal truth. Why to
make a serious effort to satisfy them?
ii) Only a resource rich economy like Dubai is not faced with the
problem of choice.
iii) The difference between labour force and work force of an economy
indicates the size of unemployed persons.
iv) National Library at Kolkata is a right example of a public good.
v) MTNL/BSNL produce a private good.

24
10) Distinguish between positive and normative economics. Which one Introduction to
should be preferred and why? Economics and
Economy
11) Write short notes on the following :
a) Concept of Equilibrium
b) Limitations of Economic Laws
c) Ceteris Paribus
d) Tracing the Path of Change
12) Distinguish between :
a) Microeconomics and Macroeconomics
b) Static Economics and Dynamic Economics
13) State the reasons on account of which almost every modern economy is a
dynamic one.
14) In what forms opportunity costs manifest themselves for the consumer,
the producer, the investor, and a factor of production?

25
 UNIT 2 DEMAND AND SUPPLY
ANALYSIS
Structure
2.0 Objectives
2.1 Introduction
2.2 The Nature of Demand
2.3 Determinants of Demand
2.3.1 Determinants of Demand by a Consumer
2.3.2 Determinants of Market Demand

2.4 The Law of Demand

2.4.1 The Demand Schedule
2.4.2 The Demand Curve
2.4.3 Why does a Demand Curve Slope Downwards?

2.5 Change in Quantity Demanded versus Change in Demand

2.6 The Concept of Supply
2.6.1 Determinants of Supply

2.7 The Law of Supply

2.7.1 The Supply Schedule
2.7.2 The Supply Curve
2.7.3 Exceptions to the Law of Supply

2.8 Changes in Supply versus Changes in Quantity Supplied

2.8.1 Changes in Quantity Supplied
2.8.2 Change in Supply
2.8.3 Why the Supply Curve Shifts?

2.9 The Idea of Elasticity

2.9.1 Elasticity of Demand
2.9.2 Elasticity of Supply

2.10 Measurement of Price Elasticity of Demand

2.11 Determinants of Price Elasticity of Demand
2.12 Determinants of Elasticity of Supply
2.13 Let Us Sum Up
2.14 References
2.15 Answers or Hints to Check Your Progress Exercises
2.16 Terminal Questions

*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College
26 (University of Delhi), Delhi.
 Demand and
2.0 OBJECTIVES Supply Analysis
After studying this unit, you will be able to:
• distinguish between want and demand;
• explain the law of demand with the help of a demand schedule and a
demand curve;
• identify the movement along a demand curve and a shift of the demand
curve;
• state the concept of supply and its determinants;
• discuss the concept of elasticity of demand and supply and various
methods of their measurement; and
• explain the importance and determinants of elasticity of demand and
supply.

2.1 INTRODUCTION
Satisfaction of human needs is the basic end and goal of all production
activities in an economy. As we have learnt in Unit 1, human wants are
unlimited and recurring in nature, whereas means available to satisfy them are
limited. Therefore, a rational consumer has to make an optimal use of available
resources. The demand and supply analysis provides a framework within which
these decisions have to be made. Hence, in this unit we shall discuss the
various issues related to the theory of demand and supply analysis.

2.2 THE NATURE OF DEMAND

At first, let us understand the meaning of the terms like desire, want, and
demand. Desire is just a wish on the part of the consumer to possess a
commodity. If the desire to possess a commodity is backed by the purchasing
power and the consumer is also willing to buy that commodity, it becomes
want. The demand, on the other hand is the wish of the consumer to get a
definite quantity of a commodity at a given price in the market backed by a
sufficient purchasing power. There are three important points to remember
about the quantity demanded:
First, the quantity demanded is the quantity desired to be purchased. It is the
desired purchase. The quantity actually bought is referred to as actual purchase.
Secondly, quantity demanded is always considered as a flow measured over a
period of time, like if the quantity demanded of oranges is 10, it must be per
day or per week, etc.
Thirdly, the quantity demanded will have an economic meaning only at a
given price. For example, the demand for oranges equal to 10 units per week at
a price of Rs. 100 per dozen is a full and meaningful statement, as used in
micro-economic theory.

2.3 DETERMINANTS OF DEMAND

The demand of a product is determined by a number of factors. Let us discuss
them in detail.

27
Introduction 2.3.1 Determinants of Demand by a Consumer
The demand for commodity or the quantity demanded of a commodity on the
part of the consumer is dependent on a number of factors. These are mentioned
as follows:
i) Price of the commodity in question
ii) Prices of other related commodities
iii) Income of the consumers, and
iv) Taste of the consumers.
Demand function refers to the rule that shows how the quantity demanded
depends upon above factors. A demand function can be shown as:
Dx = f (Px, Py,Pz, M, T)
where, Dx is quantity demanded of X commodity, Px is the price of X
commodity, Py is the price of substitute commodity, Pz is price of a complement
good, M stands for income, T is the taste of the consumer.
If all the factors influencing the demand for a commodity X vary
simultaneously, the picture would be highly complicated. Therefore, normally
we allow only one of the factors to change, assuming that all other factors
remain unchanged (‘ceteris paribus’ other things remaining equal).
Demand Relationship: Relationship of quantity demanded of a commodity to
its various determinants can be stated as follows:
1) Price of the commodity: Normally, higher the price of the commodity,
the lower the demand of the commodity. This is the law of demand.
2) Size of the consumer’s income: When the increase in income leads to an
increase in the quantity demanded, the commodity is called a ‘normal
good’. If an increase in income leads to a fall in the quantity demanded,
we call that commodity an ‘inferior good’.
3) Prices of other commodities: A consumer’s demand for a commodity
may also be influenced by the prices of some other commodities. Some
are complementary goods, which are consumed along with the
commodity in question while others may be used in place of this
commodity. This category is called substitutes.
Demand bears inverse relationship with prices of complements and
direct relationship with prices of substitutes.
Tea and coffee are substitutes and a car and petrol are example of a pair
of complementary goods.
4) Tastes of consumer: If a consumer has developed a taste for a particular
commodity, he/she will demand more of that commodity. Similarly, if a
consumer has changed his taste against a particular commodity, less of it
will be demanded at any particular price. This development of tastes may
be related to seasons of the year as well. In summer months, you may
consume more cold drinks and ice creams, whereas in winters, the
preference may shift towards hot or warm drinks like tea and coffee etc.

28
2.3.2 Determinants of Market Demand Demand and
Supply Analysis
The factors determining the demand for a commodity in a market are the same
as those which determine the demand for the commodity on the part of a
consumer. Besides that two additional factors are also to be included. These
two factors are:
1) Size of the population: All other factors remaining unchanged, the
greater is the size of the population, more of a commodity will be
demanded.
2) Income distribution: People in different income groups show marked
differences in their preferences. So if larger share out of national income
goes to the rich, demand for the luxury goods may rise and a rise in
income share of the poor will increase demand for the wage goods.
A correct specification of the demand equation is a must for the estimated
function to predict demand accurately.
Check Your Progress 1
1) Distinguish between want and demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What are the determinants of demand of a commodity by an individual
consumer?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Explain the factors influencing the market demand of a commodity.
......................................................................................................................
......................................................................................................................
......................................................................................................................

2.4 THE LAW OF DEMAND

The inverse ralationship between the quantity of a commodity and its price,
given all other factors that influence the demand is called ‘law of demand’. It
gives us a demand curve that slopes downwards to the right. We can explain
this idea with help of a demand schedule, a table that records quantities
demanded at different prices. This schedule, on being recorded on a two
dimensional axes system, gives us a demand curve.

2.4.1 The Demand Schedule

Let us use imaginary figures to show the application of the law of demand.
Table 2.1 given below, showing the application of the law of demand, is called
the ‘Demand Schedule’.
29
Introduction Table 2.1 : The Demand Schedule of a Consumer for Apples
Quantity Demanded of
Price of Apple per Kg.
Apples
(in Rs.)
(in Kg. per week)
100 15
200 12
300 8
400 3

Four combinations of price and quantity demanded are shown in the Table 2.1.
We can easily infer that as price of an apple rises quantity demanded by the
consumer is falling.

2.4.2 The Demand Curve

The demand curve graphically shows the relationship between the quantity of a
good that consumers are willing to buy and the price of the good. Let us
understand the demand curve with the help of the Fig. 2.1. In this figure, on the
Y-axis, price of an apple in rupees in measured and on the X-axis the quantity
demanded of apples per week is measured. The first combination of Table 2.1
is shown by point a where at Rs. 100 per kg 15 units of apples are demanded.
Similarly points b, c, d represent combinations of Rs. 200 price – 12 quantity
demanded, Rs. 300 price – 8 quantity demanded and Rs. 400 price – 3 quantity
demanded, respectively. The joining together of points a, b, c, and d give us the
demand curve, DD.

Fig. 2.1

The most important feature of a demand curve is that it slopes downward from
left to right. In Fig. 2.1 the demand curve is a straight line. But it can also be in
the form of a curve as shown in Fig. 2.2.
Whether a demand curve is a straight line or a curve depends on how much
quantity demanded rises with the fall of its price or how much quantity
demanded falls with the rise in the price of the commodity. Whether we take
Fig. 2.1 or 2.2, in both the cases the law of demand is applicable.
30
 Demand and
Supply Analysis

Fig. 2.2

If we record demand schedules of two or more consumers of a commodity on

the same axes, we can get a number of demand curves. Horizontal summation
of those curves gives us the market demand curve. We are illustrating a two
consumer market demand curve for ice cream with help of the following
schedule and diagram:
Table 2.2

Price (Rs) Quantity Demanded by Market

Demand
Household A Household
B
3 4 + 5 =9
4 3 + 4 =7
5 2 + 3 =5
6 1 + 2 =3

Market demand curve is a horizontal summation of individual demand curves,

as illustrated below.

Fig. 2.3

31
Introduction 2.4.3 Why does a Demand Curve Slope Downwards?
Law of demand states that there is an inverse relationship between the price of
a commodity and its quantity demanded.
1) Substitution Effect
Substitution effect results from a change in the relative price of a commodity.
Suppose a Pepsi Can and a Coke Can both are priced at Rs. 90 and Rs. 20 each.
If the price of Coke is raised to Rs. 25, and the price of Pepsi is not changed,
Pepsi will become relatively cheaper to Coke, i.e. although the absolute price
of Pepsi has not changed, the relative price of Pepsi has gone down. The
change in the relative price of commodity causes substitution effect.
Similarly, if price of mango falls, the rest of the fruits will appear costlier, in
comparison with mango.
So in both the cases above, the quantity demanded of relatively costlier items
will register a decline.
2) Income Effect
This is the effect of a change in total purchasing power of the money income of
the consumer. As price of mango falls the purchasing power of the given
money income rises, or his real income rises. Thus, he can buy more of the
mangoes with the same money income. His demand for any other commodities
may also rise. This is called the ‘income effect’. A commodity with positive
income effect is called a ‘normal good’. It shows a positive or direct
relationship between the income and the quantity demanded.
When rise in income leads to a fall in the quantity demanded, we have a case of
negative income effect. Such goods are called the ‘inferior goods’.
3) Price Effect
Price Effect is the sum total of the substitution effect and income effect, i.e.
PE = SE + IE
Where PE = Price Effect.
SE = Substitution Effect
IE = Income Effect
It is important to note that substitution effect and income effect operate
simultaneously with the change in the price of the commodity. ‘Substitution
effect’, and ‘income effect’ taken together give ‘price effect.’ We can identify
three cases.
1) Substitution effect always operates in a manner such that as price falls,
quantity demanded of this commodity increases. If along with
substitution effect, we take income effect and if that happens to be
positive (a case of normal commodity) the law of demand will
necessarily apply.
2) Given substitution effect, if income effect is negative (a case of an
‘inferior commodity’) the law of demand can still apply provided the
substitution effect outweighs or is more powerful than the negative
income effect, and

32
3) Given substitution effect, if income effect is negative and it outweighs or Demand and
is more powerful than the substitution effect, the law of demand will not Supply Analysis
hold good.
GIFFEN GOOD
A case where negative income effect outweighs substitution effect is possible
when we have ‘Giffen good’ named after the Robert Giffen who first talked of
such paradox. Here a fall in the price of a commodity does not lead to a rise in
its demand, it may result in a fall in demand for this commodity.

2.5 CHANGE IN QUANTITY DEMANDED Vs.

CHANGE IN DEMAND
When the demand for a commodity changes because of the change in its price,
it is called ‘change in quantity demanded’. On the other hand, when the change
in demand is due to the factors other than its price cause a change it is called
‘change in demand’.
Expansion and Contraction in Demand
The change in quantity demanded of a commodity is called the expansion in
demand if a fall in the price causes the quantity demanded to rises. Conversely,
if with a rise in the price of a commodity, its quantity demand falls, we call it
contraction in demand. These can be represented in the form of a movement on
a demand curve, as shown in Fig. 2.4.

Fig. 2.4

DD is the demand curve. At point ‘a’ on the demand curve we find that at price
OPa, OQa of a commodity is demanded. As price falls to OPc, demand becomes
OQc. This movement from point a to point c on the demand curve DD is
referred to as ‘extension in demand’. Similarly when price of a commodity
rises to OPb, demand falls to OQb. Thus, the movement from a to b on the
demand curve DD is known as ‘contraction in demand’.
Change in Demand
Change in demand takes place when the whole demand scenario undergoes a
change. This change occurs due to a change in any determinant of demand
33
Introduction other than the price of that commodity.
Change in demand may take two forms:
i) Increase in demand, and (ii) Decrease in demand
Increase in demand takes place when;
a) at a given price, higher quantity is demanded, or
b) at a higher price, the same quantity is demanded
Decrease in demand takes place when:
a) at a given price, lower quantity is demanded, or
b) at a lower price, the same quantity is demanded
Graphically, increase in demand results in rightward shift of the whole demand
curve. Likewise, decrease in demand results in leftward shift of the demand
curve. This is shown in the Fig. 2.5.

Fig. 2.5

At price Pa, at point ‘a’ on DD, quantity demanded is OQa. At the same price,
quantity demanded rises to OQb at point b on the demand curve D'D'. This is
called ‘increase in demand’. Similarly, at price OPa the quantity demanded
comes down to OQc on point ‘c’ of demand curve D"D". This change in
quantity demanded is ‘decrease in demand’. The shift of the demand curve to
the right shows ‘increase in demand’ and a movement of the demand curve to
the left of the initial demand curve is a ‘decrease in demand’.
Many factors can shift a demand curve. Some of them are:
1) A rise in income of the consumer can enables him to demand more of a
commodity at a given price and a fall in income will generally force him
to curtail his demand.
2) A rightward shift in the demand curve can also take place because of
increase in price of a substitute. Similarly, a leftward shift in the demand
curve can be because of decrease in price of a substitute.
3) If the consumer develops a taste for a commodity, he may demand more
of it even if the price remains unchanged, shifting the demand curve to
the right. On the other hand, a leftward shift in the demand curve can
34 indicate that our consumer has started disliking the commodity.
Check Your Progress 2 Demand and
Supply Analysis
1) Given the demand function
q = 90 – 3P
i) at what price, no one will be willing to buy any commodity?
....................................................................................................................
....................................................................................................................
ii) what will be the quantity demanded, if the commodity is given free.
....................................................................................................................
....................................................................................................................
2) State the law of demand. Does it apply to all the goods?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) What is substitution effect?
....................................................................................................................
....................................................................................................................
....................................................................................................................
4) Substitution effect + Income effect = Price effect. Is it always true?
....................................................................................................................
....................................................................................................................
....................................................................................................................
5) Does a change in taste leads to a movement along the demand curve?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.6 THE CONCEPT OF SUPPLY

Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time. Just like demand, the word supply also has
some distinguishing features which are given below.
1) The supply of a commodity indicates the offered quantities. In fact,
current supply can be different from current production, the difference is
accounted for by the changes in the inventories or the stocks.
2) Like the demand, the supply is also with reference to the price at which
that quantity is supplied. If the price is not mentioned, our statement
would not carry any economic meaning.
35
Introduction 3) The supply is a flow. It has a time unit attached therewith. The supply has
to be per day/week or month.
Formally, supply of a commodity refers to the quantity that a producer is
willing to sell at different prices.

2.6.1 Determinants of Supply

Some of the important determinants of supply are as follows:
1) Price of the commodity supplied: The price is most immediate
determinant of supply. A person or firm will make quick check whether
the costs will be covered by the price. As the price goes up, a firm/person
will be willing to sell larger quantity.
2) The prices of factors of production or cost of production: These affect
the cost of production and possible profits of the firm. A rise in the prices
of factors of production discourages the production and supply of the
commodity.
3) Prices of other goods: As the prices of other commodities rise, they
become more attractive to produce for a profit maximising firm. Hence
supply of commodity whose price is unchanged will decline.
4) The state of technology: The improvement in the knowledge about the
means and the methods of production lead to lower costs of production
and helps increasing output.
5) Goals of the producer: The objective with which the producer
undertakes production also influences his production and supply
decisions.
A simultaneous change in all the determinants makes analysis difficult.
Therefore, we talk of a change in only one of the factors, others remaining
unchanged to work out effect of that factor on the quantity of the commodity
supplied by a firm.

2.7 THE LAW OF SUPPLY

A producer aims to maximise profits, the difference between total revenue and
total cost. Total revenue is the price of the product multiplied by its quantity
sold. Total cost is the cost of production.
Profit = TR – TC
TR = Total Revenue (q.p)
TC = Total Cost (q.AC)
where AC is average cost.
A higher price would mean more profits. The producer will supply more at a
higher price. Similarly, a producer will supply smaller quantity at a lower
price. This is a direct relationship between the price and the quantity supplied
of a commodity and is called the ‘Law of Supply’.
Here the change in price is the cause and change in supply is the effect. Thus,
the supply function is:
36
 S = f (P) Demand and
Supply Analysis
The supply of a commodity is a function of its price, the price of all other
commodities, the prices of factors of production, technology, the objectives of
producers and other factors remaining unchanged. So:
Qs = f(P1, P2, P3... Pn, F1… Fa, T, G, ….)
Where Qs stands for the quantity of the commodity supplied;
P1 is the price of that commodity, P2, P3...Pa are the prices of other
commodities;
F1 …… Fn are the prices of all factors of production;
T is the state of technology;
G is the goal of the producer.

2.7.1 The Supply Schedule

A supply schedule shows quantities of a commodity that a seller is willing to
supply, per unit of time, at each price, assuming other factors remaining
constant. A supply schedule of a product based on imaginary data is given in
Table 2.3 illustrating the relationship between price and quantity supplied as
given by the law of supply.
Table 2.3: Supply Schedule of a Pen Producer

Price (in Rs) per Pen Quantity Supplied (in

thousand)
per Month

2 25

3 40

4 50

5 60

6 70

The schedule presented in Table 2.3 shows that at Rs. 2 per pen, the producer
is willing to supply 25 thousand pens per month. At a higher price of Rs. 3 per
pen, he is willing to supply 40 thousand pens per month and so on. This
schedule depicts direct relationship between price per pen and quantity
supplied of pens per month.

2.7.2 The Supply Curve

Look at Fig. 2.6 where the data from Table 2.3 has been plotted. Here price is
plotted on the Y-axis and quantity supplied on X-axis.

37
Introduction

Fig. 2.6 : Supply Curve

Fig. 2.6 shows that point labelled a, for example, gives the same information
that is given on the first row of the table; when the price of pens is Rs. 2 per
pen, 25,000 pens per month are offered for sale. Similarly, points b, c, d, and e
on the graph correspond to row 3rd, 4th, 5th and 6th of Table 2.3 respectively.
The supply curve S is a smooth curve drawn through the five points a, b, c, d
and e. This curve shows the quantity of pens offered for sale at each price.
The supply curve (just like a demand curve) can be linear straight line, or in the
shape of an upward slopping curve convex downwards.
The upward slope of the supply curve indicates that higher the price, the
greater the quantity will be supplied. If the supply curve is extended to the Y-
axis, it may or may not pass through O. If it passes through O, it shows that the
quantity supplied is zero when the price is zero. If it does not pass through
zero, it shows that until the price rises up to a certain point, the quantity
supplied will remain zero. Re. 1 can be such a price. The producer will not
offer any quantity for sale if price is Re. 1 or less. The upward sloping supply
curve is just a diagrammatic representation of the law of supply.

2.7.3 Exceptions to the Law of Supply

Generally speaking, the law of supply indicates a direct relation between the
price and the quantity supplied. But there can be some exceptions to the law of
supply such as:
Non-maximisation of profits: In some cases the enterprise may not be
pursuing the goal of maximisation of profits. In that case, the quantity supplied
may increase even when price does not rise. For example, if the firm wants to
maximise sales, it may sell larger quantities even when the price remains
unchanged.
A multiproduct firm may aim at maximising total profits, rather than profit
from each of the line of production. So, the law of supply may not apply for
each product.
Factors other than price not remaining constant: We may notice that factors
other than the price of the product may not remain constant. For example, the
quantity supplied of a commodity may fall at a given price if prices of other
commodities show a tendency to rise. The change in technology can also bring
about a change in the quantity supplied of a commodity even if the price of that
38 commodity does not undergo a change.
Check Your Progress 3 Demand and
Supply Analysis
1) Producers supply more at a higher price. Why?
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Why does a supply curve usually slope upwards to the right?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.8 CHANGES IN SUPPLY VERSUS CHANGES IN

QUANTITY SUPPLIED
2.8.1 Changes in Quantity Supplied
Just as we saw for the demand, there can be changes in the quantity offered for
sale due to changes in the price of the commodity only, all other factors
remaining constant. This is termed as change in quantity supplied. The change
in quantity supplied can be of two types,
1) When the price of a commodity falls and its quantity supplied falls. It is
termed as ‘contraction of supply’.
2) When the price of a commodity rises and its quantity supplied rises,
provided the law of supply applies, it is termed as “extension of supply”.
The contraction, and ‘extension’ of supply has been shown in Fig. 2.7 below.

Fig. 2.7 : Supply Curve

Start with point b on the supply curve at which price per pen is Rs. 3 and
quantity supplied is 30,000 pens. As price per pen falls to Rs. 2, the quantity
supplied falls to 20,000. This is contraction of supply. When price of pen rises
to Rs. 4, the quantity supplied rises to 40,000. This is extension of supply.
39
Introduction On the graph it is the movement from b to a on the supply curve which
represents ‘contraction of supply’. Similarly, the movement from b to c on the
curve represents ‘extension of supply’.
2.8.2 Change in Supply
If supply of a commodity undergoes a change because of changes in factors
other than the price of the commodity, we call this change in supply. It is
usually shown by a shift in the position of the supply curve.
Change in supply can be of two types:
A decrease in supply: When the quantity of a commodity supplied declines, at
the same price it is referred to as a ‘decrease in supply’. It implies a leftward
shift of the supply curve.
An increase in supply: When the quantity of a commodity supplied increases,
at the same price, it is known as an increase in supply. This is shown by a
rightward shift in the supply curve.

Fig. 2.8: Shifts in Supply Curve

In short, a rise in supply implies a rightward shift of the supply curve showing
that producers are willing to supply more at each price. A fall in supply, on the
other hand, implies a leftward shift of the supply curve indicating that
producers are willing to supply less at each price.

2.8.3 Why the Supply Curve Shifts?

The reasons for the change in supply (both increase and decrease in supply)
are:
1) Change in the prices of other commodities: A decrease in the prices of
other commodities increases the supply of the commodity in question at
each price because relative profits from supplying other products fall. An
increase in the prices of other commodities decreases the supply of the
commodity in question at each price.
2) Change in the prices of factors of production: An increase in the prices
of factors of production used in producing the commodity tends to reduce
the supply of the commodity as the cost of production rises but the price
is given. Conversely, a decrease in the price of factors of production used
40
 in making a commodity leads to an increase in supply, at each price. Demand and
Supply Analysis
3) Change in technology: An improvement in technology normally leads to
a fall in cost of production and given the price of the product, a producer
tends to produce more of that commodity, at each price. Conversely, loss
in technical knowledge (the chances of which are meager) leads to a fall
in supply.
4) Change or expectation of change in other factors: Sometimes, supply
of a commodity may change because of the change in or expectation of a
change in government policies, taxes or rate of interest, fear of war,
inequalities of income and wealth which influence the demand pattern.
This will affect supply through expectations of the producer about the
profits.
Check Your Progress 4
1) How do you interpret a right shift of a supply curve?
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Effects of factors other than the own price are shown by a shift of entire
supply curve. Why?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) Distinguish between an ‘increase’ in supply and an ‘extension’ of supply.
....................................................................................................................
....................................................................................................................
....................................................................................................................
4) How does a contraction of supply differ from a decrease in supply?
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.9 THE IDEA OF ELASTICITY

In Sections 2.4 to 2.8, we have studied impact of changes in determinant
variables on the demand and supply. We examined, in particular, impact of
own price, prices of related goods and income of the consumer on demand for
a commodity. Likewise, we tried to explore impact of a change in own price,
prices of factors of production etc. on the supply of a commodity. The above
analysis underlined only one aspect: a change in a determinant leads to a
change in the determined variable. We still do not know how strong the impact
is. We still cannot say that how much change in, say, demand for oranges (or in
41
Introduction supply of) will be if their price increased by 10 per cent. This situation makes it
difficult to talk about the possible effects of the policy changes. In fact, an
assessment of relative strength of the impacts of different determinants is also
not possible. To this end, we use ‘the idea of elasticity’.
The elasticity of a variable X with respect to some other variable Y shows
responsiveness or sensitivity of X to changes in Y. the elasticity of X with
respect to Y is defined as the ratio of per cent change in X to per cent change in
Y. Symbolically:
Per cent change in X
E•• =
Per cent change in Y
We can also write it as:
∆ X!
E•• = X
∆Y!
Y
So the elasticity of demand for (or supply of ) oranges with respect to a change
in their price will be:
∆Q
!Q
E",# =
∆P!
P
Where Q represents quantity of oranges and P represents their price.
If we show two commodities by symbols X and Y, their respective quantities
and prices by Qx & Qy and Px & Py we can write down the expression for the
cross elasticity of demand for X with respect to a change in the price of
commodity Y:
∆ Q•
!Q
•
E•,• =
∆ P•!
P•

Similarly, We can write expression for income elasticity of demand:

∆ Q•
!Q
•
E•,$ =
∆M!
M
Where M shows the income of the consumer.

2.9.1 Elasticity of Demand

We can use different diagrams to depict the demand curves and their
elasticities.
The demand curve with Zero elasticity is depicted in Fig. 2.9. Here a change in
price has no impact on the quantity demanded. Such a commodity is,
sometimes, called an absolute necessity.

42
 Demand and
Supply Analysis

Fig. 2.9: Demand curve with zero elasticity

The Fig. 2.10 shows a demand curve which is infinitely elastic. In such a
situation, a very small fall in price can lead to an extremely large increase in
quantity demanded.

Fig. 2.10 : Infinite Elasticity of Demand

For a straight line demand curve falling to the right, elasticity of demand at
any point on the curve is given by the ratio of the lower segment to the upper
segment. Fig. 2.11, the elasticity will be:
E = (-) BE/EA

Fig. 2.11 43
Introduction A Proof: Initial price was OH and quantity demanded was OM. The price rises
to OA. At this price, the consumer does not demand any quantity of the good.
So, new demand is zero. Using this information in the formula for elasticity we
get:
E = (Change in quantity/ original quantity)/( change in price/ original price)
= (OM/OM ) / {( OA – OH) / OH} = 1/ (HA/OH) = OH/HA.
Now consider right angled triangle AOB. Line HE is parallel to base OB.
Therefore it divides perpendicular and the hypotenuse in equal proportions.
Therefore:
OH/HA = BE /EA
That means elasticity at point E on the demand curve AB equals ratio of lower
segment BE to the upper segment EA.
We can depict a special type of demand curve which has elasticity equal to
unity at every point. Such a demand function is shown using a rectangular
hyperbola, a curve which shows constant area under the curve at every point on
the curve. The Fig. 2.12 is such a demand curve.

Fig. 2.12: Demand curve with unitary elasticity

We can, likewise, show supply curves with zero, unitary, infinite and variable
elasticity.

2.9.2 Elasticity of Supply

A supply curve with zero elasticity is a vertical straight line, just like the
perfectly inelastic demand curve.
A straight line supply curve passing through the origin will have unitary
elasticity throughout.
A straight line supply curve running parallel to the quantity axis will have
infinite elasticity. This too is similar to the case of demand curve.
A straight line supply curve that intersects price axis will have elasticity greater
than one at all points in the 1st quadrant.
A straight line demand curve that intersects quantity axis in 1st quadrant has
elasticity less than one.
44
We can make a general observation about the supply curves involving the Demand and
above characteristics. For a straight line supply function shown in Fig. 2.13, Supply Analysis
elasticity of supply at a point E can be determined in this manner: drop a
perpendicular EM from E to the quantity axis. Extend the supply line to meet
the quantity axis in point K. Then:

Fig. 2.13: Elasticity of supply at point E

Es = KM/OM
If supply line passes through origin, point K will coincide with O. Therefore,
the ratio KM/OM will be equal to unity (KM = OM). If the supply line
intersects quantity axis in the 1st quadrant, elasticity will be less than one as
KM < OM. In the Fig. 2.13, the supply line cuts quantity axis in 2nd quadrant.
Therefore, KM> OM. Hence elasticity is greater than one.

2.10 MEASUREMENT OF PRICE ELASTICITY OF

DEMAND
There are a number of methods to measure price elasticity of demand. Some of
the important methods are as follows:
1) Point Method: Also known as the percentage method (as discussed
above), the main point to remember about this method is that it is
employed only when the changes in price and quantity demanded are
very small.
2) Total Expenditure Method: This total outlay method to measure price
elasticity of demand is used whenever the changes in price and demand
are not small. But it only helps us to distinguish three situations (i)
whether the price elasticity of demand is one or unity, (ii) whether the
price elasticity of demand is more than one, and (iii) whether the price
elasticity of demand is less than one. Here the elasticity is measured by
ratio P1Q1/P0Q0.
E = (P1Q1 ) / ( P0Q0 )
Where initial and after change price and quantity are indicated by subscript 0
and 1 respectively
3) Geometrical Method: According to this method, elasticity of demand is
different at different points on a given demand curve, and is measured as
follows on any point of a straight line curve.
Lower segment of the demand curve
E• =
Upper segment of the demand curve

45
Introduction
2.11 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND
The price elasticity of demand for a commodity depends on these important
factors:
1) Nature of the Commodity: The commodities are divided into three
categories (i) necessities, (ii) comforts, and (iii) luxuries. Price elasticity
of demand will be less for the necessities. We know a rise in the price of
salt will not be able to force people to reduce their consumption. As
luxuries are purchased by people with high income their demand also
does not change much with change in price.
2) Number of Substitutes: If a good’s substitutes are easily available, price
elasticity of demand will be high.
3) Number of uses of a commodity: The greater the number of possible
uses of a commodity, the greater its price elasticity of demand will be.
4) Price level of a commodity: The level of price will also have an impact
on price elasticity of demand. A commodity priced high will have higher
elasticity of demand and a low priced commodity will have lower
elasticity (This idea becomes clearer when you revisit Fig. 3.12).
Importance of Elasticity of Demand
The price elasticity of demand is very important in a number of policy
decisions regarding individual commodity markets. Some of the important
fields where price elasticity of demand is important are:
1) Price fixation by a monopolist: The monopolist is always interested in
charging a higher price. If he comes to know that the price elasticity for a
commodity is low, he would fix up a higher price for that commodity. He
would not be able to charge a very high price for a commodity whose
price elasticity of demand is relatively higher.
2) Price support programme of the government: A good harvest, because
of better monsoon can lead to a big fall in agricultural prices as elasticity
of demand is rather low. To protect the farmer’s interests, the government
announces a price support programme and the price of the commodity is
not allowed to fall below a particular level. Obviously, this creates a
situation of excess supply and the government has to lift the excess
supply from the market.
Similarly, a poor harvest can raise the price. Here to protect the interest of the
consumer, the government can announce a ‘price ceiling’ and releases stock
from its own warehouses or imports to meet the excess demand in the market.
Check Your Progress 5
1) Income elasticity is positive for normal goods only. Explain.
....................................................................................................................
....................................................................................................................
....................................................................................................................

46 ....................................................................................................................
2) Do you agree with the statement that ‘The sign of coefficient of cross Demand and
elasticity depends on whether the commodity is a complement or a Supply Analysis
substitute’. Give reasons.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.12 DETERMINANTS OF ELASTICITY OF

SUPPLY
Elasticity of supply depends on a number of factors and all these factors are to
be taken together before one can comment on the elasticity of supply of a
commodity. Some of the important determinants of elasticity of supply are
given as follows:
1) Behaviour of costs as output varies: As output of a commodity rises
total cost do rise, normally, at a falling rate in the beginning, then at a
constant rate and finally at a rising rate. If cost of production rises rapidly
as output rises, then a rise in price will not induce a big rise in supplies.
2) Nature of the commodity: Perishable products cannot be stored for long
and thus, their supply does not respond very much to the price changes.
Durable products can be stored and their supply responds to the price
changes.
3) Time: In the short-run, supply of a commodity is less elastic, but in the
long run, the size of the plant can be changed supply responds to the price
changes. Hence, supply can be more elastic.
4) Price expectations: If the producers expect that prices in the future will
be maintained above particular level, they may produce more. If they
expect prices to rise in the future, they may hold more stocks and may
supply lesser quantities in the market. Supply in such a case will be
inelastic. If the prices are expected to fall in the future, supply will be
more elastic.

2.13 LET US SUM UP

The demand refers to the wish on the part of the consumer to buy a commodity
in the market at a given price backed by the sufficient purchasing power. The
price of the commodity in question, prices of other related commodities,
income and taste of the consumers determine the demand for consumer.
Supply refers to the quantity a firm is willing to sell at a given price in every
time period. In addition to the own price, supply of a commodity depends on
prices of related goods and the factors of production as well. State of
technology is another important determinant of supply.
Elasticity is the responsiveness of quantity demanded (supplied) to given
changes in own price or prices of other related goods. In case of demand, it can
be with respect to income as well. Elasticity can be measured by way of point 47
Introduction method, outlay method or geometrical method. Nature of the commodity,
number of substitutes, number of uses of a commodity and price level of the
commodity are among important determinants of price elasticity. Elasticities of
demand and supply play an important role in price fixation by a monopolist,
price support programme of the government and in determination of incidence
of indirect tax.

2.14 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi,
2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

2.15 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 2.2
2) See Sub-section 2.3.1
3) Size of the population, Income distribution.
Check Your Progress 2
1) i) Rs. 30
ii) q = 90
2) See Section 2.4
3) See Section 2.4
4) Yes
5) No
Check Your Progress 3
1) See Section 2.6
2) See Sub-section 2.7.2
Check Your Progress 4
1) See Sub-section 2.8.2
2) See Sub-section 2.8.3
3) See Section 2.8
4) See Sub-section 2.8.1 & 2.8.2

48
Check Your Progress 5 Demand and
Supply Analysis
1) See Section 2.9
2) See Section 2.9

2.16 TERMINAL QUESTIONS

1) Explain the main determinants of demand for a commodity in the market.
2) Explain the law of demand with the help of a demand schedule and a
demand curve.
3) Explain the exceptions to the Law of demand using the distinction
between substitution and income effects.
4) Distinguish between an inferior good and a Giffen good.
5) What uses can be made by the government of the law of demand in
deciding about the price policy and tax cum subsidy policy.
6) What is law of supply? Explain with help of a suitable example.
7) Explain the circumstances where the law of supply may not hold.

49
 UNIT 3 DEMAND AND SUPPLY IN
PRACTICE
Structure
3.0 Objectives
3.1 Introduction
3.2 Determination of Equilibrium
3.3 Effects of Shift in Demand and Supply on Equilibrium
3.3.1 Determination of Equilibrium: A Mathematical Presentation
3.3.2 Uniqueness of Equilibrium and Multiple Equilibria

3.4 Applications
3.4.1 Rationing and the Allocation of Scarce Goods
3.4.2 Price Support Measures
3.4.3 Minimum Wage Legislation
3.4.4 Arbitrage
3.4.5 Sharing of Tax Burden

3.5 Let Us Sum UP

3.6 References
3.7 Answers or Hints to Check Your Progress Exercises
3.8 Terminal Questions

3.0 OBJECTIVES
After going through this unit, you will be able to :
• appreciate how market price and quantity are determined;

• evaluate the impact of price controls, minimum wages, price support and
arbitrage on price and quantity;

• determine how the taxes and subsidies affect consumers and producers;
and
• appreciate the usefulness of economic theory in our day to day life.

3.1 INTRODUCTION
Demand and supply curves are used to describe the market mechanisms. These
two market forces by way of equilibrium determine both the market price of a
good and the total quantity produced/supplied. The level of price and the
quantity depend on the particular characteristics of Demand and Supply.
Variations in price and quantity over time depend on the ways in which supply
and demand respond to other economic variables.
In this unit we will try to acquaint you with the usefulness of this analysis.
*Shri I.C. Dhingra, Rtd, Associate Professor, Shaheed Bhagat Singh College
50 (University of Delhi), Delhi.
 Demand and Supply
3.2 DETERMINATION OF EQUILIBRIUM in Practice
Equilibrium price is defined as the price at which the quantity demanded and
quantity supplied are equal. Quantity demanded is an inverse function of price,
while quantity supplied is a direct function of price. The two functions can be
stated as follows:

q• = 10 − 1P
and
q = 1P
Equilibrium price is the one at which the quantity demanded equals quantity
supplied, i.e.,

q! = q
or
10 − 1P = 1P
∴ P=5
Equilibrium price is Rs. 5. At this price q! = q and q! = 5 units. Thus, 5 units
would be sold and purchased in the market at price Rs. 5.
Similarly, if we graphically represent these two functions as in Fig. 3.1, we
find that the downward sloping demand curve intersects the upward sloping
supply curve at E, forming what is known as the Marshallian cross.

Fig. 3.1

In the equilibrium, OQ1 quantity is sold and purchased at OP1 price.

If, for any reason, the market price were to be less than the equilibrium price,
say at OP1, quantity demanded will be more than the quantity supplied,
resulting in excess demand in the market, TW in Fig. 3.2. This will push the
market price upwards, till the market price equals the equilibrium price.
Similarly, if the market price is more than the equilibrium price, the resultant
excess supply, RS, will push the price downwards to OP2. In short, we reach
the following conclusions:
• All demand curves have negative slopes throughout their entire range.
51
Introduction • All supply curves have positive slopes throughout their entire range.
• Prices change if and only if, there is excess demand or excess supply.
• Prices rise, if there is excess demand and fall if there is excess supply.
In short, market price has a tendency to be equal to the equilibrium price. This
is called stable equilibrium.

Fig. 3.2

The essential condition for stable equilibrium is that the demand curve should
have a negative slope and the supply curve a positive slope. Otherwise, it will
not be a stable equilibrium, this would be what can be called unstable
equilibrium.
Let us illustrate the situation of unstable equilibrium with the help of Fig. 3.3.

Fig. 3.3

We have plotted a negatively sloped demand curve and a negatively sloped

supply curve. Equilibrium is determined at point E. If the market price were to
fall to Op1 quantity supplied > quantity demanded, and therefore the market
52 price should fall further (rather than rise).
Similarly, if market price were to be Op3, quantity supplied < quantity Demand and Supply
demanded, and hence the price should still rise further (rather than fall to back in Practice
to equilibrium).
Thus, in this situation there is unstable equilibrium. The condition for stable
equilibrium is that above the equilibrium point surplus must exist (Qs > Qd) and
below the equilibrium point shortage must exist (Qd, > Qs). In case this
condition is not fulfilled, we get unstable equilibrium.
Can there be a stable equilibrium when supply curve is downward
sloping?
Yes, there can be a stable equilibrium even if supply curve is downward
sloping. This is illustrated with the help of Fig. 3.4. At price Op2, which is
more than the equilibrium price Op1 there exists surplus to the extent of SR,
which creates competition among sellers, as such price falls to Op1.

Fig. 3.4

At price Op3, which is less than equilibrium price Op1 there exists shortage to
the tune of WT, which creates competition among buyers, this causes the price
to increase to Op1 Thus, we get stable equilibrium.
This is also known as the Walrasian Equilibrium. The Walrasian stability
condition can be stated as follows:
Above the equilibrium price, the supply curve must be to the right of the
demand curve; and below the equilibrium price, the supply curve must be to
the left of the demand curve.
It would be seen that whereas the Marshallian adjustment process works
through a change in quantities, the Walrasian adjustment process works
through a change in price.

3.3 EFFECTS OF SHIFT IN DEMAND AND

SUPPLY ON EQUILIBRIUM
In the method of comparative statics we start from a position of equilibrium
and then introduce the change to be studied. The new equilibrium position is
determined and compared with the original one. The differences between the
53
Introduction two positions of equilibrium must result from the change that was introduced,
by keeping everything else as constant.
1) Shift in Demand Curve
A shift in demand curve (the supply curve remaining unchanged) will affect
the equilibrium price and equilibrium quantity, as shown in Fig. 3.5.

Fig. 3.5

An increase in demand would result in:

• an increase in the equilibrium price
• an increase in the equilibrium quantity.
Conversely, a decrease in demand would result in:
• a decrease in the equilibrium price
• a decrease in the equilibrium quantity.
2) Shift in Supply Curve
A shift in supply curve (the demand curve remaining unchanged) will also
affect both, the equilibrium price and equilibrium quantity, as shown in
Fig. 3.6.

Fig. 3.6
54
An increase in supply would result in: Demand and Supply
in Practice
• a fall in the equilibrium price
• an increase in the equilibrium quantity.
A decrease in supply would result in:
• a rise in the equilibrium price
• a fall in the equilibrium quantity.
3) Simultaneous Shift
We may also examine if both demand and supply curves shift simultaneously.
The combined result would be determined as we have analysed above.
The net result would depend upon the relative change in demand and supply.
The various results can be briefly summarised as follows:
When one of the demand or supply curves shifts, the effect on both the price
(P) and quantity (Q) can be determined:
• An increase in demand (a shift rightward in the demand curve) raises P
and increases Q.

• A decrease in demand (a shift leftward in the demand curve) lowers P

and decreases Q.

• An increase in supply (a shift rightward in the supply curve) lowers P and

increases Q.

When both the demand and supply curves shift the effect on the price or the
quantity can be determined but without information about the relativity of the
shifts, the effect on the other variable is ambiguous.
• If both the demand and supply curves increase (shift rightward), the
quantity increases but the price may rise, fall or remain the same.

• If the demand decreases (shifts leftward) and the supply increases (shifts
rightward) the price falls but the quantity may increase, decrease, or not
change.

3.3.1 Determination of Equilibrium: A Mathematical

Presentation
We begin with a simple numerical example:
qd = 100 – 2p (1)
qs = 3p (2)
qd = q s (3)
We solve the system by substituting (1) and (2) into (3):
100 – 2p = 3p = 100 = 3P + 2P
55
Introduction or 5p = 100
or p = 20
by putting P value in equation (1) we get,
qd = 100 – 2(20)
qd = 60
and qs = qd = 60
If we let the demand curve shift to the right so that 60 more units are bought at
each price, (I) becomes
qd = 160 – 2p (1')
Substituting (1') and (2) into (3) yields p = 32 and qd = qs = 96.
In this manner we could solve the equations every time.
Algebra allows us, however, to find the solution to any linear demand supply
system. To do this, we substitute letters, called parameters, for the numbers in
the above system:
qd = a + bp, a> 0, b < 0 (4)
qs = c + dp, c < a, d > 0 (5)
qd = q s (6)
The restrictions on the parameters ensure that a positive amount is demanded at
a zero price (a > 0), that the demand curve has a negative slope (b < 0), and the
supply curve has a positive slope (d > 0). The restriction on c is a little more
complex. If c is less than zero a positive price is required to call forth any
supply. If c exceeds zero, some amount is supplied at a zero price. In that case,
we need less to be supplied than demanded at a zero price (a >c) if we are to
get a positive equilibrium price. If c > a, supply exceeds demand at a zero price
and the linear model solves for a negative price.
To avoid this, we need the added condition that p = 0 whenever c > a.
Once again, we solve by substituting the equations (4) and (5) into (6). This
gives
a + bp = c + dp
Simple manipulation produces
•••
p= •••
(7)

Now, whenever we encounter a numerical example, we can substitute the

numbers directly into (7) and obtain the answer.

3.3.2 Uniqueness of Equilibrium and Multiple Equilibria

So far, we have examined the situations in which a unique equilibrium is
established, i.e., a single price (or single quantity) corresponding to a single
quantity (or single price).
56
We can also conceive of a situation in which there is no such unique price or Demand and Supply
unique quantity. This is illustrated with the help of Fig. 3.7 and Fig. 3.8. in Practice

Fig. 3.7 Fig. 3.8

In Fig. 3.7, both the demand curve and the supply curve have horizontal
segments.
As a result of this, though the equilibrium price is uniquely determined, there is
no unique quantity. It lies in the range TW.
In Fig. 3.8 similarly, both the demand curve and the supply curve have vertical
segments. Though a unique quantity is determined, there is no unique price.
The equilibrium price lies in the range TW.
This is also known as multiple equilibria.
Check Your Progress 1

1) Given the following demand and supply functions, find the equilibrium
price and quantity in the market

qs = – 5 + 3P, qd = 10 – 2P

2) From the following equation find the equilibrium price and output qd =
6 – P, qs = 3P – 2

3) State whether following statements are true or false:

i) All demand curves have positive slopes
ii) Prices change if and only if there is excess demand or excess supply
iii) Prices fall if there is excess demand
iv) The Walrasian equilibrium adjustment process works through
change in quantity
v) The quantity increases in case of both demand and supply curve
shift rightwards.

4) There are 1000 identical individuals in the market for commodity X

given the individual demand function qd = 12 – 2P and 100 identical
producers of commodity given the individual producer supply
function qs = 20P. Find the equilibrium price and quantity.
57
Introduction
3.4 APPLICATIONS
3.4.1 Rationing and the Allocation of Scarce Goods
Rationing implies fixation of price controls. Price control means that a ceiling
has been imposed on the prices of such commodities as are covered under the
price-control measures. Fixation of ceiling on prices means that the free
operation of the forces of demand and supply is not being permitted.
Let us see what will happen in such a situation. This can be illustrated with the
help of Fig. 3.9. DD and SS are the original demand and supply curves
respectively for a commodity. R is the equilibrium point, corresponding to
which OQ quantity is being demanded and supplied at the price OP per unit.
Suppose the Government decides to interfere with the free operation of the
market forces, i.e., it decides to impose price controls. Price controls, as
already stated, take the form of ceiling on prices. Ceiling could be fixed at a
price (a) higher than the equilibrium price, say at OK, (b) equal to the
equilibrium price, i.e., OP, and (c) less than the equilibrium price, say at OH.

Fig. 3.9

• Ceiling price more than the equilibrium price will have no effect on the
market. At a higher price say OK, OT quantity of the commodity will be
demanded. The suppliers, on the other hand, would be waiting in their
wings to supply more than the quantity being presently demanded. There
will be a tendency for the price to fall down to the equilibrium level.

• If ceiling price equals the equilibrium price, OP, it will leave the market
unaffected.

• If ceiling price is less than the equilibrium price, it will create conditions
which need our further attention. Suppose, in Fig. 3.9, the Government
imposes ceiling at OH per unit. The equilibrium price, OP, would no
longer be legally obtainable. Prices must be reduced from OP to OH. At
the lower price, OH, quantity demanded will expand to HN or OW. But
at this reduced price, suppliers will be ready to supply only HL or OT
quantity of goods. As a result, a shortage of this commodity (equal to
quantity demanded minus quantity supplied) will emerge. This shortage
58 is being represented by the line segment LN.
We reach the following conclusion about the effect of price control in free Demand and Supply
market: The setting of minimum prices will either have no effect (maximum in Practice
price set at or below the equilibrium) or it will cause a shortage of the
commodity and reduce both the price and the quantity actually bought and sold
below their equilibrium values.
Consequences of Price Controls (ceiling below the equilibrium price).
Imposition of ceiling below the equilibrium price will have the following major
implications:
1) Shortages: The quantity actually sold and bought in the market will
shrink. As a result, a large chunk of consumer’s demand will go
unsatisfied. The situation, as it arises, has been explained in Fig. 3.9.
2) Problem of allocation of limited supplies among large number of
consumers: As already observed, shortage of a commodity means that all
those consumers who demand the commodity at the ruling price cannot
be satisfied. In other words, a large number of potential consumers of the
commodity will be denied its use.
Here question arises how to allocate the limited supplies among large numbers
of consumers?
One general way is that it is left at the retail shops to arrange for the
distribution of the scarce product. For example, in our country, we have often
witnessed such products as kerosene, edible oils, sugar, onions, etc., going
scarce in the market. More generally, the consumer is left at the mercy of the
local retailer, who more often than not chooses I: serve his regular customers in
preference to others.
Among all others, the scarce product may be distributed on the basis of first-
come-first-served. The latter situation often develops in the formation of long
unmanageable queues at the retail centres, so that the persons lining up at the
tail of the queue have only a little chance of getting the desired good. To avoid
these problems which may often arise from the free marketing of the scarce
product, Governments generally couple price controls with distribution
controls. The most effective form of distribution control is rationing.
Rationing implies that a ceiling is imposed on the quantity which can be
bought and consumed by a consumer. A consumer with less utility may choose
not to purchase the rationed product. But those consumers for whom the
rationed product has fairly large marginal utility are assured of some quantity
at least, which possibly might not have been available to them in free
marketing conditions. Rationing thus will increase the aggregate utility derived
by the community from the consumption of the commodity. In such a situation,
in all probabilities, rationing will replace first-come-first-served method of
distribution.
We reach the conclusion:
Where there is a feeling against allocation on the basis of first-come-first-
served and seller’s preferences, effective price ceiling will give rise to strong
pressure for a central (administered) system of rationing.

59
Introduction 3) Black Marketing: It is a direct consequence of price controls. Black
marketing implies a situation in which the controlled commodity is sold
unlawfully, below the desk, at a price higher than the lawfully enforced
ceiling price.
This situation arises largely because of the fact that (i) the number of potential
consumers of the commodity is more than what can be served by the available
supplies of the commodity, and, (ii) there are consumers who are willing to pay
more than the ceiling price. This latter phenomenon is more important in
creating black market and sustaining it.
In Fig. 3.9, OH is the ceiling price. At this price only OT quantity is being
supplied and therefore actually bought in the market. We can see from DD
curve in Fig. 3.9 that OT quantity would be demanded even at the price TZ or
OK, which is substantially higher than the ceiling and the equilibrium price.
Those buyers, who are willing to pay more than the ceiling price, will prefer to
indulge in underhand transactions rather than go without the commodity since
none of the free market methods of distribution can assure these consumers
that the desired supplies would be coming.
Thus, we reach the interesting conclusion:
Black marketing in a commodity whose price has been controlled by the
authorities will invariably arise since there are consumers who are willing to
pay more than the controlled price.
3.4.2 Price Support Measures
Price support means a floor has been fixed on the prices of such commodities
as are covered under the price-support measures.
Producers of these commodities need not sell at prices lower than the floor
prices (i.e., the minimum prices) fixed by the Government. Fixation of floor on
prices means that the free operation of the forces of demand and supply is
being interfered with. Let us see what will happen in such a situation.
In Fig. 3.10; R is the equilibrium point determined by the intersection of
demand and supply curves, OQ quantity is being supplied and demanded at OP
price. Suppose, the Government decides to impose price supports. Price
supports mean that the Government imposes a floor on prices. Floors could be
fixed at a price (a) lower than the equilibrium price, say at OH; (b) equal to the
equilibrium price, OP; and (c) more than the equilibrium price, say at OK.

Fig. 3.10
60
Floor Price Lower than the Equilibrium Price: If floor price is less than the Demand and Supply
equilibrium, it will have no effect on the market. At a lower price, say OH, HZ in Practice
quantity will be supplied. The consumers, on the other hand, would be willing
to pay a higher price. The price will move upwards towards the equilibrium
level.
Floor Price Equal to the Equilibrium Price: If floor price equals the
equilibrium price, OP, it will leave the market unaffected.
Floor Price Higher than the Equilibrium Price: If floor price is more than the
equilibrium price, it will need our further attention. Suppose, in Fig. 3.10, the
Government imposes the price floor at OK per unit. The equilibrium price OP
would no longer be legally obtainable. Price must be raised to OK. At the
higher price, OK, quantity demanded will contract to KL. But at this price
suppliers will be ready to supply KN quantity. As a result, a surplus will
emerge; surplus is shown by the line segment LN.
We reach the following conclusion about the effect of price support in a free
market:
The setting of minimum prices will either have no effect (minimum price set
below the equilibrium) or it will cause surplus of the commodity to develop
with the actual price being above its equilibrium level but the actual quantity
bought and sold being below its equilibrium level.
Consequences of Price Support (Floor above equilibrium price): Imposition of
floor prices above equilibrium price will have the following major
implications:
1) Surpluses: The quantity actually bought and supplied will shrink as a
direct consequence of price support. As a result, large chunk of
producer’s stocks will remain unutilised. The situation, as it arises, has
been explained in Fig. 3.10 where the surplus has been shown equal to
LN.
2) Buffer Stocks: In order to maintain the support price, the Government
would have to design some such programme as to enable producers to
dispose of their surplus stocks. One such programme can take the form of
buffer stocks. The Government purchases the surplus stocks available
with the producers, these stocks are released if and when the production
of the supported commodity suffers. The buffer stock operations benefit
the producers as a group. But who bears this cost? First, consumer who
has to pay higher prices for the product. Second, the people in general
who have to pay taxes to support this programme.
3) Subsidies: To offset the loss to the consumers, the Government may
undertake to subsidise the product. By subsidy we mean that the
Government purchases the product at the support price and sells the
product to consumers below its cost of procurement. The difference
between cost and price is borne by the Government.
Before we leave this discussion of price floors and ceilings, the reader should
note that such terms as surplus and shortage are defined with reference to a
specific price.

61
Introduction 3.4.3 Minimum Wage Legislation
Minimum wage legislation is similar to fixing of floor prices. Governments, at
times, are known to have interfered in the factor markets also. Legislation may
be enacted whereby in the market, employers may be prohibited from paying
less than the minimum wage fixed by the Government. The effect of fixing the
minimum wage would be the same as that of fixing the minimum price of a
commodity. Let us illustrate this effect diagrammatically, as in Fig. 3.11.

Fig. 3.11

In Fig. 3.11, OQ quantity of labour is being demanded and supplied at the

equilibrium wage rate OP. If the wage rate is fixed at OZ by Government
legislation, or by trade union agreement, the following consequences will
follow:
1) Where the law or the agreement is effective, it will raise the wages of that
labour which remains in employment, from OP to OZ.
2) Minimum wage will lower the actual amount of employment; at the new
minimum wage rate only ZT or OW labour would be demanded, whereas
at the equilibrium wage OQ labour was being supplied and demanded.
Employment will fall by WQ.
3) Minimum wage will create a surplus of labour which would like to work,
but cannot find a job. The surplus labour would equal TJ.
4) Some of the unemployed workers may be tempted or forced to offer
themselves for work at the wage rate below the floor rate. Some sort of
clandestine transaction in the labour market will begin to take place.

3.4.4 Arbitrage
Arbitrage is an operation involving simultaneous purchase and sale of a
commodity in two or more markets between which there are price differentials
or discrepancies. The arbitrageur aims to profit from the price difference; the
effect of his action is to lessen or eliminate it.
Suppose fresh mushrooms are being sold in New Delhi and Noida.
Geographically separate markets are illustrated in Fig. 3.12.
62
 Demand and Supply
in Practice

Fig. 3.12

New Delhi (ND) and Noida (NA) are separate markets with separate demand
curves. The vertical supply curve in each city represents the quantity of
mushrooms now available in each place. The equilibrium price in New Delhi is
labelled PND and in Noida, PNA.
If the equilibrium price in New Delhi is much less than that in Noida, a trucker
might buy a load in New Delhi and sell them in Noida. As long as the price
differential is greater than the cost of transporting the mushrooms, it will pay
truckers to buy and sell in this way. As mushrooms are bought in New Delhi
for sale in Noida, the price in New Delhi will increase, while that in Noida will
fall. Thus the transport of mushrooms from New Delhi to Noida tends to
narrow the price gap between the two cities. This process is called arbitrage.
Arbitrage will stop when the price differential becomes equal to or less than the
cost of transportation between the two points. If transportation costs are small
relative to the price of the good, the price differentials between cities will
remain small.
Arbitrage narrows the dispersion of prices. If commodities are easily
transported, geographic variations in price are small. If a commodity is easily
stored, seasonal variations in price are insignificant. When markets are well-
organised, with information about prices in different places and times readily
available, arbitrage works easily. Any dealer can act as an arbitrageur by
deciding when and where to buy. If, however, information about prices in
different times and places is expensive to get, the dispersion of prices will then
be greater.
Case Study
A few years ago The New York Times carried a dramatic front page picture of
the President of Kenya setting fire to a large pile of elephant tusks that had
been confiscated from poachers. The accompanying statement explained that
the burning was intended as a symbolic act to persuade the world to halt the
ivory trade. One may well doubt whether the burning really touched the hearts
of criminal poachers. However, one economic effect was clear. By reducing the
supply of ivory in the world markets, the burning of tusks forced up the price
of ivory which raised the illicit rewards reaped by those who slaughter
elephants. They could only encourage more poaching – precisely the opposite
of what the Kenyan government sought to accomplish!

63
Introduction 3.4.5 Sharing of Tax Burden
Who bears the tax burden under following situations:
a) When demand is perfectly elastic and supply is of normal shape.
b) When demand is perfectly inelastic and supply is of normal shape.
c) When supply is perfectly elastic and demand is of normal shape.
d) When supply is perfectly inelastic and demand is of normal shape.
a) When demand is perfectly elastic, the whole tax burden is borne by the
producer himself as is illustrated in the Fig. 3.13. Before imposition of
tax, equilibrium point is E which gives equilibrium price as OP. After the
imposition of per unit tax, the equilibrium point shifts to giving
equilibrium price as OP which is same as before the imposition of tax.
Hence the whole tax burden is borne by the producer.

Fig. 3.13

b) When demand is perfectly inelastic, the whole tax burden is borne by the
consumer because in this case the price rises by the full amount of tax as
shown in the Fig. 3.14. The equilibrium point before imposition of tax is
E which gives the equilibrium price as OP. After the imposition of tax per
unit, the equilibrium point shifts to E1 which gives equilibrium price as
OP1 Thus, price rises by the full amount of tax.

64 Fig. 3.14
c) When supply is perfectly elastic, the whole tax burden is borne by the Demand and Supply
consumer as illustrated in the Fig. 3.15. Before imposition of tax, the in Practice
equilibrium point is E giving equilibrium price as OP. After the
imposition of tax, the equilibrium point shifts to E1 showing equilibrium
price as OP1. Thus the whole tax burden is borne by the consumer.

Fig. 3.15

d) When supply is perfectly inelastic, the whole tax burden is borne by the
seller as the pre-tax equilibrium position and post-tax equilibrium
remains unchanged, as shown in Fig. 6.16. Since supply is perfectly
inelastic, with the imposition of tax the supply curve remains unchanged
as such equilibrium price remains unchanged. So the tax burden falls on
producer.

Fig. 3.16
65
Introduction • Show that as the demand curve becomes steep (arid hence inelastic) as
greater amount of the tax is passed on to the consumer.

We take three different demand curves with different elasticities as shown in

Fig. 3.17.

Fig. 3.17

All the three curves are drawn through the point E in order to facilitate
comparison. Let the imposition of tax shift the supply curve to S1S1. The post-
tax equilibrium position is shown by three points, A, B or C depending upon
whether the relevant demand curve is D1D1, D2D2 or D3D3 respectively. The
length of vertical line segment from points A, B or C to the line PE shows the
amount of increase in the consumer price that will occur, given the respective
demand curves. Examining the relationship between the amount of the price
increase and the slope of the demand curve, we note that as the demand curve
becomes steep (and hence elastic) a greater amount of the tax is passed onward
to the consumer.
Check Your Progress 2
1) The price of a personal computer has continued to fall in the face of
increasing demand. Explain.
2) New cars are normal goods. Suppose that the economy enters a period of
strong economic expansion so that people’s incomes increase
substantially. Determine what happens to the equilibrium price and
quantity of new cars.
3) State whether following statements are true or false:
i) If ceiling price equals the equilibrium price, it will affect the
market.
ii) The minimum wage Act lowers the actual employment of workers.
iii) Arbitrage widens the dispersion of prices.
iv) When the demand is perfectly elastic, the whole burden is born by
66 the consumer.
4) Suppose that the policy makers decide that the price of a pizza is too high Demand and Supply
and that not enough people can afford to buy pizza. As a result, they in Practice
impose a price ceiling on pizza that is below the current equilibrium
price. Are consumers able to buy more pizza: before the price ceiling or
after?
5) Suppose that demand for a good is subject to unpredictable fluctuations.
Explain how speculators help reduce the price variability of the good.

3.5 LET US SUM UP

Basics of demand and supply enables us to appreciate the relevance of
economics in day to day life. Market price is determined at a point where
quantity demanded is equal to quantity supplied. The characteristics of demand
and supply may differ from one situation to another and from one market to
another. These market forces influence the prices and quantity over a period of
time. Marshalian equilibrium is attained through the process of change in
quantity whereas Walrasian adjustment process works through a change in
price.
Imposition of ceiling below the equilibrium price have implications of shortage
of supply, black marketing and hence the need for central administered system
of rationing. The imposition of floor prices may cause the surpluses of the
commodity, hence need for buffer stocks and selling of the product to the
consumers at subsidised prices.
The impact of minimum wage legislative is similar to fixing of floor prices.
The Arbitrage narrows the dispersion of prices.

3.6 REFERENCES
1) Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson
Education, New Delhi, 2015.
2) Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi, 2014.
3) Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th
edition, W.W.Norton and Company/ Affiliated East-West Press (India),
2010.

3.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) P = 3, qd = 4
2) p = 2, q = 4
3) (i) False (ii) True (iii) False (iv) false (v) True
4) P = 3, q = 6000

67
Introduction Check Your Progress 2
1) Personal computers have fallen in price although the demand for them
has increased because the supply has increased more rapidly.
2) Because new cars are a normal good, an increase in income increases the
demand for them. Hence the demand curve shifts rightward. As a result,
the equilibrium price rises and the equilibrium quantity also rises.
3) (i) False (ii) True (iii) False (iv) False
4) As a result of a price ceiling, the sellers would offer less quantity for sale
in the market. The consumers would end up consuming less of the pizzas.
There would be a large unmet demand.
5) Speculators buy the product to exploit any potential profit opportunities.
In particular, speculator- aim to sell the good from their inventories if the
current price is higher than the expected future price and they strive to
buy the good to be added to their inventories if the current price is below
the expected future price.
The first profit opportunity – selling when the current price is higher than the
expected future price – reduces the current price. The second profit opportunity
– buying when the current price is lower than the expected future price – raises
the current price.
Selling, if the price is higher than, or buying, if the price is lower than the
expected future price, means that the price will not deviate much from the
expected future price.
Thus, speculators help reduce price fluctuations and make the price less
variable.

3.8 TERMINAL QUESTIONS

1) Given the following supply and demand equations
Qu – 100 – 5P
Qs – 10 + 5P
a) Determine the equilibrium price and quantity.
b) If the government sets a minimum price of Rs. 10 per unit, how
many units would be supplied and how many would be demanded?
c) If the government sets a maximum price of Rs. 5 per unit, how
many units would be supplied and how many would be demanded?
d) If demand increases to
Qd1 = 200 – 5P
determine the new equilibrium price and quantity.
2) Discuss the likely effects of the following:
a) Rent ceilings on the market for apartments.

68
 b) Floors under wheat prices on the market for wheat. Demand and Supply
in Practice
Use supply-demand diagrams to show what may happen in each case.
3) The demand and supply curves for T-shirts in the tourist town,
Bengaluru, are given by the following equations:
Qd = 24,000 – 500 P
Qs = 6,000 + 1,000 P
a) Find the equilibrium price and quantity algebraically.
b) If tourists decide they do not really like T-shirts that much,
which of the following might be then demand curve?
Qd = 21,000 – 500 P
Qd = 27,000 – 500 P
Find the equilibrium price and quantity after the shift of the demand
curve.
c) If, instead, two more new stores that sell T-shirts open up in town,
which of the following might be the new supply curve?
Qs = 3,000 + 1,000 P
Q = 9,000 + 1,000 P
Find the equilibrium price and quantity after the shift of the supply curve.
4) Under which condition will a shift in the demand curve result mainly in a
change in quantity? In price?
5) Under which condition will a shift in the supply curve result mainly in a
change in price? In quantity?
6) Suppose the market demand for pizza is given by Qd = 300 – 20 P and the
market supply for pizza is given by Qs = 20 P – 100, where P = price (per
pizza).
a) Graph the supply and demand schedules for pizza using Rs. 5
through Rs. 15 as the value of P.
b) In equilibrium, how many pizzas would be sold and at what price?
c) What would happen if suppliers set the price of pizza at Rs 15?
Explain the market adjustment process.
d) Suppose the price of hamburgers, a substitute for pizza, doubles.
This leads to a doubling of the demand for pizza (at each price
consumers demand twice as much pizza as before). Write the
equation for the new market demand for pizza.
e) Find the new equilibrium price and quantity of pizza.

69
UNIT 4 CONSUMER BEHAVIOUR:
CARDINAL APPROACH
Structure
4.0 Objectives
4.1 Introduction
4.2 Concept of Utility
4.2.1 What is Utility?
4.2.2 Relationship between Want, Utility, Consumption and Satisfaction
4.2.3 Measurement of Utility

4.3 Some Basic Assumptions about Preferences

4.3.1 Assumptions about Consumer Preferences

4.4 Cardinal Utility Analysis

4.5 Law of Diminishing Marginal Utility
4.5.1 Exceptions to the Law/Limitations of the Law
4.5.2 Criticism of the Law

4.6 Consumer Equilibrium through Utility Analysis

4.6.1 Determination of Consumer Equilibrium

4.7 Derivation of Demand Curve with the Help of Law of Diminishing

Marginal Utility
4.8 Consumer Surplus
4.9 Critical Evaluation of Cardinal Utility Analysis
4.10 Let Us Sum Up
4.11 References
4.12 Answers or Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After completion of this unit, you will be able to:
• explain the concept of utility;
• analyse and use cardinal utility approach for measurement of utility;
• explain Law of Diminishing Marginal utility;
• describe consumer equilibrium with the help of law of equi-marginal
utility;
• distinguish between cardinal and ordinal utility approaches; and
• list the assumptions of consumer preferences.

*Dr. Vijeta Banwari, Assistant Professor in Economics, Maharaja Surajmal Institute, New Delhi. 73
Theory of
Consumer
4.1 INTRODUCTION
Behaviour
In previous units, we have understood the concept of demand and supply, their
determinants, and elasticity of demand and supply etc. We have also applied
the concepts of demand and supply in practice i.e. equilibrium, determination
of price and quantity, rationing and allocation of scarce goods, minimum wage
legislation and arbitrage etc. In this and subsequent unit, we shall examine the
theory of consumer behaviour. Consumer behaviour has always been a subject
of curiosity and research. Researchers have been trying to understand and
predict consumer behaviour ever since the commencement of trade. However,
relevance of this subject has increased over the time. With global markets and
more informed customers today, success of business is entirely dependent on
its understanding of consumer behaviour. Traditional businesses are getting
obsolete every day and new businesses based on needs of consumers (or
utility) are evolving. Increased internet penetration has changed the concept of
market. Businesses are increasingly talking about value creation rather than
mere product creation.
The concept of value creation is based on the concept of utility. Consumer
values a product only if it has ‘utility’ for him. Thus, the concept of utility has
become extremely relevant today. It is guiding marketing team across the globe
in designing business and marketing the company in a way that is likely to
attract the maximum number of customers and maximise sales revenues.
Let us begin to state the concept of utility and how has it evolved.

4.2 CONCEPT OF UTILITY

Utility is the basis of consumer demand. The consumers demand a commodity
because they desire or expect to derive utility from that commodity. As
discussed above, the concept of market, interaction between consumer and
producer has evolved in present times. Today, a consumer is more informed
about the choices available to him and someone somewhere is trying to
produce a good/service in order to provide utility to the customer. New
businesses, like an app to book a cab, maid, grocery, medicine, beauty service
etc. which have evolved in present time are successful because they provide
high utility to their customers.

4.2.1 What is Utility?

Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure
or well-being experienced by the consumer from the consumption or
possession of the commodity or availing of a service. In this sense, it is a
subjective or relative concept i.e. level of utility derived from a product differs
from person to person. For example, meat has no utility for vegetarians.
Utility of a product can be ‘absolute’ in the sense that the want satisfying
power is ingrained or embeded in it. For example, pen has its own utility
whether a person can write or not. However, utility is considered as
‘subjective’ in consumer analysis because a consumer will demand a good only
if that good holds utility for her. Utility not only varies from person to person
but also from time to time, at different level of consumption and at different
moods of a consumer. The most basic example to understand this concept is
food. If a person is not hungry, even her favourite food will not have any utility
74 for her at that point of time.
Based on this understanding, marketing concepts have also evolved over the Consumer Behaviour :
time. Advertisers target now consumers on the basis of their past purchases, Cardinal Approach
interests, likes/dislikes, sites they visit. Customers are often offered customised
coupons for the product/service that might hold ‘utility’ for them.

4.2.2 Relationship between Want, Utility, Consumption and

Satisfaction
Want of the consumer is the basis of understanding her behaviour. A consumer
selects a commodity based on its want satisfying power. Consumption of the
commodity leads to satisfaction of wants. Thus want, utility, consumption and
satisfaction are related in following manner:
Want Selection of Consumption of Getting utility in the sense
commodity the commodity of satisfaction of the want

Following points can be noted about utility:

a) Utility is a want satisfying power of a commodity
b) Utility varies from person to person
c) It varies from time to time, at different level of consumption and at
different moods of a consumer.
There are three concepts related to utility:
1) Initial Utility- The utility derived from the first unit of a commodity is
called initial utility. For example: utility obtained from consumption of
first roti is called initial utility.
2) Total Utility- The utility derived by a person from the total number of
units of a commodity consumed by her is called total utility.
i.e. TUn= U1+ U2=U3=….Un
3) Marginal Utility- It means addition made to total utility by consuming
an additional unit.
It can be measured with the help of following formula:
MUn= TUn –TUn-1
Where: MUn = Marginal utility of nth unit
TUn = Total utility of n units
TUn-1 = Total utility of n – 1 units or one unit less than the total no. of
units
Let us understand the concept with the help of Table 4.1 and Fig. 4.1.

75
Theory of Table 4.1: Relationship between Total utility (TU) and Marginal utility
Consumer (MU)
Behaviour
Units of a Good Total Utility Marginal Utility
Consumed (TU) (MU)
1 6 6
2 10 4
3 12 2
4 12 0
5 10 -2
6 6 -4

14 12 12
12
Marginal utility and Total Utility

10 10
10
8 6 6
6
4
2
0
-2 0 1 2 3 4 5 6 7
-4
-6
Units of commodity

Marginal utility (MU) Total utility (TU)

Fig. 4.1: Relationship between Total utility (TU) and Marginal utility (MU)

In Fig. 4.1, units of commodity are measured along x axis and utility is
measured along y axis. Upto 3rd unit the total utility is increasing but marginal
utility is diminishing but is positive. When a consumer consumes 4th roti, the
total utility is maximum and the marginal utility is zero. Consumer is getting
maximum satisfaction at this point. If a consumer consumes more than 4 units,
total utility will diminish and the marginal utility will be negative. This is also
called Law of diminishing Marginal Utility, which is discussed in detail in
Section 4.4.

4.2.3 Measurement of Utility

The concept of measurement of utility has evolved over the time. The classical
economists viz Jeremy Bentham, Menger, Walras etc. and neoclassical
economists like Marshall believed that utility is cardinally or quantitatively
measurable like height, weight etc. The belief resulted in Cardinal Utility
Approach. The exponents of cardinal utility analysis regard utility to be a
cardinal concept. According to them, a person can express utility or satisfaction
he derives from the goods in the quantitative cardinal terms. Jeremy Bentham
(1748–1832), the founder of Utilitarian school of ethics coined a psychological
unit of measurement called ‘utils’. Thus, a person can say that he derives utility
equal to 10 utils from the consumption of a unit of good A, and 20 utils from
the consumption of a unit of good B. Moreover, the cardinal measurement of
utility implies that a person can compare utilities derived from goods in respect
76
of size, that is, how much one level of utility is greater than another. Consumer Behaviour :
According to Marshall, marginal utility is actually measurable in terms of Cardinal Approach
money and money is the measuring rod of utility. This approach will be
discussed in detail in Section 4.4. The modern economists like J.R Hicks, Allen
are of view that utility is not quantitatively measurable but can be compared or
ranked. This is known as Ordinal concept of utility. Modern Economists hold
that utility being a psychological phenomenon, cannot be measured
quantitatively, theoretically and conceptually. However, a person can
introspectively express whether a good or service provides more, less or equal
satisfaction when compared to one another. In this way, the measurement of
utility is ordinal, i.e. qualitative, based on the ranking of preferences for
commodities. For example, Suppose a person prefers tea to coffee and coffee
to milk. Hence, he or she can tell subjectively, his/her preferences, i.e. tea >
coffee > milk. Ordinal Utility approach of measurement of utility is discussed
in detail in the next unit.
Check Your Progress 1
1) Explain the relationship between total utility and marginal utility.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Calculate Marginal utility in following table:

Ice Creams Consumed Total Utility Marginal Utility

1 20
2 36
3 46
4 50
5 50
6 44

4.3 SOME BASIC ASSUMPTIONS ABOUT

PREFERENCES
One of the basic questions addressed in microeconomics is how a consumer
with limited income takes decision about which good/service to buy. As
discussed above, consumer behaviour has gained great relevance today and
companies are spending huge amount to understand consumer preferences.
Success of business has always been dependent on its understanding of
consumer behaviour. But now since the world is more connected than ever
through internet, consumers have large number of options. It has become
imperative for companies to analyse consumer choices, preferences and design
their goods/services accordingly.
Economists have identified three basic steps to understand consumer
behaviour:

77
Theory of 1) Consumer Preferences: First step is to identify consumer preferences.
Consumer This can be done graphically or algebraically also. Behaviour is based on
Behaviour preferences i.e. likes, dislikes of the consumers. Thus, it is important to
identify ‘what gives value to the consumer’. We live in an information
age and today. Companies follow their customers online, keep a track of
sites they visit, products they buy etc. in order to identify their
preferences. Social networking sites have become popular data source to
identify preferences.
2) Budget Constraints: This is next important aspect. Prices of goods and
paying capacity of consumer has strong influence on his behaviour.
Through online tracking, companies today are not only able to identify
consumer preferences alone, but also their paying capacity and budget
constraints. Additional discounts, cash back schemes, EMI options etc.
are offered to the customer these days in order to ease their budget
constraint.
3) Consumer choices: Final step to understand consumer behaviour is
consumer choices. Given preferences and limited income, consumer
chooses the combination of goods which maximise their satisfaction.
With markets becoming global, consumers have large number of choices
available these days. But final demand for a good will be dependent on
combination of factors: their preferences, value offered by the product
and budget constraint.
4.3.1 Assumptions about Consumer Preferences
As discussed above, the theory of consumer behaviour is based on consumer
preferences. For better understanding of consumer behaviour with the help of
consumer preferences, economists usually make following assumptions about
consumer preferences:
a) Completeness: Preferences are assumed to be complete i.e. any two
different bundles of goods can be compared. A consumer either prefers
one basket over other or is indifferent between two baskets.
Mathematically, (a1, a2) ≥ (b1, b2) or
(a1, a2) ≤ (b1, b2) or
Both
b) Transitivity: Transitivity means that if a consumer prefers X over Y and
Y over Z then the consumer also prefers X over Z. Transitivity is a
necessary assumption to ensure consumer consistency.
c) More is always preferred over less: Consumer is rational and knows
that greater utility can be derived by consuming more quantity of a
commodity. Thus, he always prefers more quantity over less.
Check Your Progress 2
1) What are the basic assumptions about consumer preferences?
.....................................................................................................................
.....................................................................................................................

78 .....................................................................................................................
2) How does consumer preferences affect consumer behaviour? Consumer Behaviour :
Cardinal Approach
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.4 CARDINAL UTILITY ANALYSIS

Cardinal utility Analysis was mainly given by neoclassical economists like
Jevons, Dupuit, Menger, Walras and Pigou etc. The exponents of this approach
regards utility as cardinal concept. In other words, they hold that utility is a
measurable and quantifiable entity. For example, According to cardinal utility
approach, if a person is drinking a glass of water, it will be possible for him to
assign some numerical value say 10 utils or 20 utils to the utility derived from
it.
This approach is based on following assumptions:
1) The cardinal measurement of utility- Utility of any commodity can be
measured in units called ‘utils’.
2) Utilities are additive i.e. total utility can be calculated by measuring
utility derived from all the units of a commodity consumed.
3) Utility is independent i.e. not related to the amounts of other commodities
purchased by the consumer. Further, it is also assumed that it is not
affected by utilities of other individuals.
4) Marginal utility of money remains constant: When a person purchases
more of a good, the amount of money diminishes and marginal utility of
remaining money may increase. But in this approach, marginal utility of
money is treated constant. This assumption is important as cardinalists
have used money as a measure of utility and it is necessary to keep the
measuring rod of utility as fixed.

4.5 LAW OF DIMINISHING MARGINAL UTILITY

Law of Diminishing Marginal Utility is one of the most fundamental law of
utility analysis. It explains the relationship between utility and quantity of a
commodity. This law states that after sufficient quantity of a commodity is
consumed, the utility derived from each successive unit decreases,
consumption of all other commodities remaining same. Let us take an example
to illustrate this law. For example, If a person is hungry, the first roti he
consumes will have high utility for him as it will give him high level of
satisfaction. As he keeps on consuming more and more roties, utility derived
from each successive unit will go on decreasing. After a point of time, when
person is satisfied, he will not be able to eat more. The utility will drop to zero
here. If the consumption of roti is continued further, a person would get
negative utility or disutility. This can be illustrated with the help of following
table:

79
Theory of Table 4.2: Diminishing Marginal Utility
Consumer
Behaviour
No. of Roti Marginal Utility (MU)
1 10
2 8
3 5
4 3
5 0
6 -2

Fig. 4.2: Diminishing Marginal Utility

It can be noted from the above table and diagram, that the utility of first roti is
very high i.e. 10 utils. The utilities of 2nd, 3rd, 4th roti falls to 8, 5 and 3 utils
respectively. 5th roti gives zero utility, after which each successive roties starts
giving negative utility.

4.5.1 Exceptions to the Law/ Limitations of the Law

The law of Diminishing Marginal utility does not apply in following cases:
1) Small initial unit: The law is not applicable when the initial units of
commodity are of very small size. For example, drinking water with a
spoon. In such cases, initially utility derived from additional units will go
on increasing and the law may not operate for sometime. It is only after a
stage in consumption is reached that marginal utility begins to diminish.
2) Rare and curious things like rare paintings, gold and diamond
jewellery: The law does not apply in such cases because collection of
more and more units usually give more satisfaction to the
collector/consumer.

4.5.2 Criticism of the Law

Law of Diminishing Marginal utility has been criticised by modern economists
on following grounds:
1) Measurement of utility is not possible: The major criticism of this
80 approach is that it is not possible to measure utility in cardinal numbers.
 Utility is a psychological phenomenon and thus it is not possible to Consumer Behaviour :
measure it in quantifiable terms. In real life, we can only describe utility Cardinal Approach
of a product in words.
2) Marginal utility of money does not remain constant: Cardinal
economists believe that marginal utility of money remains constant
throughout. However, when a person uses money, stock of money
reduces leading to increase in utility of remaining stock.
3) Utility is not always independent: Sometimes utility of one commodity
is affected by other commodities. Many times, consumer prefers to
consume series of related goods. For example, A consumer may prefer to
consume biscuits or pakoda along with tea.
4) Unrealistic assumptions: The law is based on various unrealistic
assumptions. It assumes no change in fashion, taste, income, preferences
of a customer. But in real life, environment is extremely dynamic and so
are taste, fashion etc. With new products having advanced features being
launched so frequently, taste and preferences of customers are also
changing frequently. Thus, this law may not operate in present dynamic
times, at least not in the same form it was believed to operate, say one
century ago.
Check Your Progress 3
1) Why does marginal utility diminished?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) What does happen to marginal utility at a point when total utility is
maximum?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.6 CONSUMER EQUILIBRIUM THROUGH

UTILITY ANALYSIS
Consumer Equilibrium is a situation wherein a consumer gets maximum
satisfaction out of his limited income and has no tendency to change his
existing expenditure pattern. A consumer is considered to be extremely
satisfied when he allocates his income in such a way that the last rupee spent
on each commodity yields the same level of utility. The concept of consumer
equilibrium can be examined under one-commodity model and multi-
commodity model.
Consumer equilibrium through utility analysis is based on following set of
assumptions:

81
Theory of 1) Consumer is rational: This is one of the basic assumption of the law.
Consumer Consumer is rational i.e. he measures, compares and chooses the best
Behaviour option in order to maximise his utility.
2) Cardinal measurement of utility: Utility can be measured in
quantifiable terms.
3) Marginal utility of money is constant: It is assumed that utility is
measured in terms of money and utility of money does not change.
4) Fixed income and prices: It is assumed that income of the consumer and
prices of goods remain constant.
5) Constant tastes and preferences: It is assumed that taste and
preferences of the consumer remain same.

4.6.1 Determination of Consumer Equilibrium

As discussed above, Consumer equilibrium can be examined under two cases:
1) Consumer equilibrium-One commodity case
Suppose a consumer with fixed income consumes a single commodity x. He
will continue his consumption till a point where marginal utility that he
derived from consumption of a unit of commodity is greater than marginal
utility of money spent on purchasing that unit. If the marginal utility of
commodity x (MUx) is greater than the marginal utility of money (MUm), then
a consumer will exchange his money for a commodity. Consumer will keep
on consuming and spending his money so long as (MUx)>Px(MUm) where Px
is the Price of commodity x and MUm is 1(constant), Thus a utility
maximising consumer will be in equilibrium where
MUx=Px

Fig. 4.3: Consumer equilibrium in case of single commodity

Let us understand the concept with the help of an example. Suppose, the
consumer wants to buy a good x costing Rs. 10 per unit. Marginal utility
derived from each successive unit (in utils is determined and is given in Table
4.3 (It is assumed that 1 util = Re. 1, i.e. MUm = Re. 1).

82
 Table 4.3: Consumer Equilibrium in case of Single Commodity Consumer Behaviour :
Cardinal Approach
Unit of Price of Marginal Difference Remarks
‘x’ ‘x’ Utility (MU) between
MU and
(Px) in Utils Px
1 10 18 8 Since MUx>Px
Consumer will
2 10 16 6 increase
3 10 12 2 consumption

4 10 10 0 Consumer
equilibrium
MUx=Px
5 10 8 -2 Since MUx<Px
Consumer will
6 10 0 -10 not buy any
7 10 -2 -12 more units

2) Consumer equilibrium in Multi-commodity case:

Consumer equilibrium in single commodity is unrealistic model in the sense
that in real life, consumer consumes a large number of commodities. This
model deals with the equilibrium in case of many commodities. This model
works under the assumption of limited income of the consumer and
diminishing marginal utility of commodities. Thus, utility maximising
consumer will first spend money on commodity which yield highest utility,
then the second highest and so on. Finally, a consumer will reach equilibrium
when the last rupee he spent on different commodities will yield equal level of
utility.
This case of multi-commodities is known as Law of Equi-Marginal Utility, a
consumer having choices of multiple goods distribute their limited income in
such a way that the last rupee spent on each commodity yields equal marginal
utility. Suppose a customer consumes only two goods x (with price Px) and y
(with price Py). Thus he will try to maximise his utility by equating his
marginal utility and prices.
MUx=Px (MUm)
MUy=Py (MUm)
Given these conditions, a consumer will be in equilibrium when:
MUx/ Px (MUm) = MUy/ Py (MUm)
Or
MUx/ Px = MUy/Py (because MU of each unit of money is assumed to be
constant at 1)
Two commodity case can be generalised for multi-commodity case. Suppose a
customer consumes various goods, he will be in equilibrium when:
MUx/ Px = MUy/ Py= MUc/ Pc= ……MUz/ Pz 83
Theory of Diagrammatically, equilibrium is achieved at a point when MUx/Px= MUy/Py
Consumer
Behaviour

Fig. 4.4: Consumer equilibrium in multi commodity case

Let us understand the law with the help of an example: Suppose, total money
income of a consumer is 5 which he wants to spend on two goods ‘x’ and ‘y’.
Both these commodities are priced at Re. 1 per unit. Table 4.4 presents
marginal utility which consumer derives from various units of the two
commodities.
Table 4.4: Consumer Equilibrium in case of multi-commodity
Unit MU Derived from Good X MU Derived from Good Y
(in Utils) (in Utils)
1 12 9
2 10 8
3 8 6
4 6 4
5 4 2

It can be noted from Table 4.4 that the consumer will spend first and second
rupee on commodity ‘x’, which will provide him utility of 12 and 10 utils
respectively. The third rupee will be spent on commodity ‘y’ to get utility of 9
utils. Fourth and fifth rupee will be spent on X and Y respectively. To reach the
equilibrium, consumer should purchase that combination of both the goods,
when:
a) MU of last rupee spent on each commodity is same; and

84 b) MU falls as consumption increases.

It happens when consumer buys 3 units of ‘x’ and 2 units of ‘y’ because: Consumer Behaviour :
Cardinal Approach
a) MU from last rupee (i.e. 5th rupee) spent on commodity y gives the same
satisfaction of 8 utils as given by last rupee (i.e. 4th rupee) spent on
commodity x; and
b) MU of each commodity falls as consumption increases.
The total satisfaction of 47 utils will be obtained when consumer buys 3 units
of ‘x’ and 2 units of ‘y’. It reflects the state of consumer’s equilibrium. If the
consumer spends his income in any other order, total satisfaction will be less
than 47 utils.
Check Your Progress 4
1) Given the price of good, how will a consumer decide as to how much
quantity of the good to buy? Use utility analysis.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) A consumer consumes only two goods – x and y. State and explain the
conditions of consumer equilibrium using utility analysis.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.7 DERIVATION OF DEMAND CURVE WITH

THE HELP OF LAW OF DIMINISHING
MARGINAL UTILITY
We have learned in Unit 2 that the demand curve or law of demand shows the
relationship between price of a good and its quantity demanded. Marshall
derived the demand curves for goods from their utility functions.
Marshall assumed the utility functions of different goods to be independent of
each other. In other words, Marshallian technique of deriving demand curves
for goods from their utility functions rests on the hypothesis of additive utility
functions.
Dr. Alfred Marshall derived the demand curve with the help of law of
diminishing marginal utility. The law of diminishing marginal utility states that
as the consumer purchases more and more units of a commodity, utility that he
derives from successive units goes on decreasing.
A rational consumer, while purchasing a commodity compares the price of the
commodity which he has to pay with the utility he receives from it. So long as
the marginal utility of a commodity is higher than its price (MUx >Px), the
consumer would demand more and more units of it till its marginal utility is
equal to its price MUx = Px or the equilibrium condition is established.

85
Theory of In other words, as the consumer consumes more and more units of a
Consumer commodity, its marginal utility goes on diminishing. So it is only at a
Behaviour diminishing price at which the consumer would like to demand more and more
units of a commodity. Derivation of demand curve with the help of law of
diminishing marginal utility is presented in Fig. 4.5.

Fig. 4.5: Derivation of demand curve with the help of law of diminishing marginal utility
In Fig. 4.5, the MUx is negatively slopped. It shows that as the consumer
acquires larger quantities of good X, its marginal utility diminishes.
Consequently at diminishing price, the quantity demanded of the good X
increases as is shown in the second Fig. of 4.5.
At X1, quantity of the marginal utility of a good is MU1. This is equal to P1 by
definition. Thus, consumer demands OX1 quantity of the commodity at
P1 price. In the same way X2 quantity of the good is equal to P2. Here at
P2 price, the consumer will buy OX2 quantity of commodity. At X3 quantity the
marginal utility is MU3, which is equal to P3. At P3, the consumer will buy
OX3 quantity and so on.
It can be concluded that as the purchase of the units of commodity X are
increased, its marginal utility diminishes. So at diminishing price, the quantity
demanded of good X increases. The rational supports the notion of down
slopping demand curve that when price falls, other things remaining the same,
the quantity demanded of a good increases and vice versa.

4.8 CONSUMER SURPLUS

The concept of consumer surplus was first formulated by Dupuit in 1844 to
measure social benefits of public goods such as canals, bridges, national
highways. Marshall further refined and played a significant role in providing it
a theoretical structure in his book ‘Principles of Economics’ published in 1890.
Marshall’s concept of consumer’s surplus was based on the cardinal
measurability and interpersonal comparisons of utility. According to him,
consumer’s surplus is the difference between what ‘one is willing to pay’ and
‘what one actually pays’ to acquire a particular good. Concept of consumer’s
surplus is a very important concept in economic theory, especially in theory of
demand and welfare economics. It is also very useful in formulation of
economic policies such as taxation by the Government.
The quintessence of the concept of consumer’s surplus is that people generally
86 get more utility from the consumption of goods than the price they actually pay
for them. This extra satisfaction, which the consumers obtain, from buying a Consumer Behaviour :
good has been called consumer’s surplus. Cardinal Approach

The concept of consumer’s surplus is derived from the law of diminishing

marginal utility. As we purchase more units of a good, its marginal utility goes
on diminishing. It is because of the diminishing marginal utility that
consumer’s willingness to pay for additional units of a commodity declines as
he has more units of the commodity.
The measurement of consumer surplus from a commodity from the demand or
marginal utility curve is illustrated in Fig. 4.6. In the figure, quantity of a
commodity is measured along the X-axis, the marginal utility (or willingness to
pay for the commodity) and the price of the commodity are measured on the Y-
axis.
DD' is the demand or marginal utility curve which is sloping downward,
indicating that as the consumer buys more units of the commodity, marginal
utility derived from the additional units of the commodity falls.
If OP is the price that prevails in the market, then the consumer will be in
equilibrium when he buys OM units of the commodity, since at OM units,
marginal utility from a unit of the commodity is equal to the given price OP.
The Mth unit of the commodity does not yield any consumer’s surplus to the
consumer since this is the last unit purchased and for this price paid is equal to
the marginal utility which indicates the price that he is prepared to pay rather
than go without it. But for the units before Mth unit, marginal utility is greater
than the price and therefore, these units yield consumer’s surplus to the
consumer. The total utility of a certain quantity of a commodity to a consumer
can be known by summing up the marginal utilities of the various units
purchased.

Fig. 4.6: Consumer Surplus

In Fig. 4.6, the total utility derived by the consumer from OM units of the
commodity will be equal to the area under the demand or marginal utility curve
up to point M. That is, the total utility of OM units in Fig. 4.6 is equal to
ODSM.
In other words, for OM units of the good the consumer will be prepared to pay
the sum equal to Rs. ODSM. But given the price equal to OP, the consumer
will actually pay the sum equal to Rs. OPSM for OM units of the good. It is
thus clear that the consumer derives extra utility equal to ODSM minus OPSM 87
Theory of = DPS, which has been shaded in Fig. 4.6. If market price of the commodity
Consumer rises above OP, the consumer will buy fewer units of the commodity than OM.
Behaviour As a result, consumer’s surplus obtained by him from his purchase will
decline. On the other hand, if price falls below OP, the consumer will be in
equilibrium when he is purchasing more units of the commodity than OM. As a
result of this, the consumer’s surplus will increase. Thus, given the marginal
utility curve of the consumer, the higher the price, the smaller the consumer’s
surplus and the lower the price, the greater the consumer’s surplus.

4.9 CRITICAL EVALUATION OF CARDINAL

UTILITY ANALYSIS
Cardinal utility analysis of demand has been criticised by modern economists
on following grounds:
1) Cardinal measurability of utility is impractical:
Cardinal utility analysis of demand is based on the assumption that utility can
be measured in absolute, objective and quantitative terms. But in actual
practice utility cannot be measured in such quantitative or cardinal terms. Since
utility is a psychological phenomenon and subjective feeling, it cannot be
measured in quantitative terms. In reality, consumers are only able to compare
the satisfactions derived from various goods or various combinations of the
goods. In other words, in the real life consumer can state only whether a good
or a combination of goods gives him more or less, or equal satisfaction as
compared to another. Thus, economists like J.R. Hicks are of the opinion that
the assumption of cardinal measurability of utility is unrealistic and therefore it
should be given up.
2) Wrong assumption of independent utilities:
Cardinal Utility analysis also assumes that utilities derived from various goods
are independent. This means that the utility which a consumer derives from a
good is the function of the quantity of that good only. In other words, the
assumption of independent utilities implies that the utility which a consumer
obtains from a good does not depend upon the quantity consumed of other
goods. On this assumption, the total utility which a person gets from the whole
collection of goods purchased by him can be calculated as sum of the separate
utilities of various goods. In other words, utility functions are additive. But in
the real life this is not so. In actual life the utility or satisfaction derived from a
good depends upon the availability of some other goods which may be either
substitutes for or complementary with each other. For example, the utility
derived from a pen depends upon whether ink is available or not. Similarly,
utility of tea may increase if accompanied by biscuits. It is, thus, clear that the
utilities derived from various goods are interdependent, that is, they depend
upon each other.
3) Assumption of constant marginal utility of money is not true:
An important assumption of cardinal utility analysis is that when a consumer
spends varying amount on a good or various goods or when the price of a good
changes, marginal utility of money remains constant. But in actual practice,
this is not correct. As a consumer spends his money income on the goods,
money income left with him declines.
88
With the decline in money available to the consumer, the marginal utility of Consumer Behaviour :
remaining money rises. Further, when price of a commodity changes, the real Cardinal Approach
income of the consumer also changes. With this change in real income,
marginal utility of money will change and this would have an effect on the
demand for the good in question, even though the total money income
available with the consumer remains the same.
Cardinal utility analysis ignores the changes in real income and its effect on
demand for goods following the change in price of a good. Further, it is
because of the constant marginal utility of money and therefore the neglect of
the income effect by Marshall that he could not explain Giffen Paradox.
Marginal utility of money also varies from a poor man to a rich one. For
example, a person having just Rs. 80/- with him will place much higher
valuation as each of these 10 rupees. But, someone who has thousands of
rupees with him may not place that much value on a Rs. 10 note.
4) Cardinal utility analysis does not split up the Price effect into
Substitution and Income effects:
Another shortcoming of the cardinal utility analysis is that it does not
distinguish between the income effect and the substitution effect of the price
change. Marshall and other exponents of cardinal utility analysis ignored
income effect of the price change by assuming the constancy of marginal
utility of money.
In real life, when the price of a good falls, the consumer becomes better off
than before, that is, a fall in price of a good brings about an increase in the real
income of the consumer. With this income he would be in a position to
purchase more of this good as well as other goods. This is the income effect of
the fall in price on the quantity demanded of a good. Besides, when the price of
a good falls, it becomes relatively cheaper than other goods and as a result the
consumer is induced to substitute that good for others. This results is increase
in quantity demanded of that good. This is the substitution effect of the price
change on the quantity demanded of the good. Thus total effect of price can be
decomposed into substitution effect and income effect.
5) Marshall could not explain Giffen Paradox:
By not visualising the price effect as a combination of substitution and income
effects and ignoring the income effect of the price change, Marshall could not
explain the Giffen Paradox. He treated it merely as an exception to his law of
demand. In contrast to it, indifference curve analysis has been able to explain
satisfactorily the Giffen good case.
According to indifference curve analysis, in case of a Giffen Paradox or the
Giffen good, negative income effect of the price change is more powerful than
substitution effect so that when the price of a Giffen good falls, the negative
income effect outweighs the substitution effect with the result that quantity
demanded of it falls.
Check Your Progress 5
1) If price of good is Rs. 10 and marginal utility of a consumer is Rs. 12,
how much will be the consumer surplus? Use utility analysis.
.....................................................................................................................
89
Theory of .....................................................................................................................
Consumer
Behaviour .....................................................................................................................
2) Critically examine Cardinal utility approach.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

4.10 LET US SUM UP

Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure
or well-being experienced by the consumer from the consumption or
possession of the commodity or a service. In this sense, it is a subjective or
relative concept i.e. level of utility derived from a product differs from person
to person. We also examined the relationship between want, utility,
consumption and satisfaction i.e. how want leads to selection of commodity
having utility which in turn leads to consumption and finally satisfaction of
want. We further analysed the relationship between Marginal utility and Total
utility and the law of diminishing marginal utility. We also explained consumer
equilibrium using utility approach in case of single commodity and multiple
commodity. We also discussed the basic assumptions of consumer preferences.

4.11 REFERENCES
1) Dwivedi, D.N.(2008). Managerial Economics, 7th edition, Vikas
Publishing House.
2) Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th
edition, 2010.
3) Hal R. Varian, Intermediate Microeconomics, a Modern Approach, 8th
edition, W.W. Norton and Company/Affiliated East-West Press (India),
2010.
4) Kumar, Raj and Gupta, Kuldip (2011). Modern Micro Economics: Analysis
and Applications, UDH Publishing House.
5) Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill
education.
6) Salvatore, D. (8th rd. 2014) Managerial Economics in a Global economy,
Oxford University Press.
7) http://www.learncbse.in/important-questions-for-class-12-economics-
consumers-equilibrium-through-utility-approach/
8) https://www.meritnation.com/ask-answer/question/explain-the-conditions-
of-consumer-s-equilibrium-in-case-of/theory-of-consumer-behaviour/
2323428
9) http://economicsconcepts.com/derivation of the demand curve.htm
10) http://www.vourarticlelibrary.com/economics/consumer-surplus-meaning-
measurement-critical-evaluation-uses-and-application/36842
90
 Consumer Behaviour :
4.12 ANSWERS OR HINTS TO CHECK YOUR Cardinal Approach
PROGRESS EXERCISES
Check Your Progress 1
1) Study Section 4.2 and answer
2) 1. 20 2. 16 3. 10 4. 4 5. 0 6. -6
Check Your Progress 2
1) Completeness, Transitivity and more is preferred to less.
2) Consumer preference are the first step for determining consumer
behaviour. Consumer behaves according to his preferences and budget
constraint.
Check Your Progress 3
1) Study Section 4.5 and answer
Marginal utility is zero when total utility is maximum
Check Your Progress 4
1) A consumer buys a quantity of commodity when Marginal utility is equal
to price of that good.
2) Study Sub-section 4.6.1 and answer
Check Your Progress 5
1) Consumer Equilibrium is the difference between what customer is willing
to pay and what he actually pays. So consumer surplus is Rs. 2
2) Study Section 4.9 and answer

91
 UNIT 5 CONSUMER BEHAVIOUR:
ORDINAL APPROACH
Structure
5.0 Objectives
5.1 Introduction
5.2 Ordinal Utility Approach
5.3 Indifference Curve Analysis
5.3.1 Indifference Schedule
5.3.2 Indifference Curve
5.3.3 Indifference Map
5.3.4 Law of Diminishing Marginal Rate of Substitution
5.3.5 Properties of Indifference Curve

5.4 Some Exceptional Shapes of Indifference Curve

5.5 Budget Line
5.6 Shift in Budget Line
5.7 Consumer Equilibrium through Indifference Curve Analysis
5.8 Some Exceptional Shapes of Indifference Curve and Corner Equilibrium
5.9 Price Effect as Combination of Income Effect and Substitution Effect
5.9.1 Income Effect
5.9.2 Substitution Effect
5.9.3 Price Effect

5.10 Measuring Income and Substitution Effects of Price Change

5.11 Derivation of Demand Curve from Indifference Curves
5.12 Let Us Sum Up
5.13 References
5.14 Answers or Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After completion of this unit, you will be able to:
• state ordinal utility approach for measurement of utility;
• use Indifference curve analysis to explain consumer behaviour;
• identify shape of Indifference curve in case of perfect substitutes and
complementary goods;
• explain the concept of Budget line;

*Dr. Vijeta Banwari, Assistant Professor in Economics, Maharaja Surajmal Institute, New Delhi.
92
• identify the factors causing shift in Budget line; Consumer Behaviour :
Ordinal Approach
• describe consumer equilibrium through Indifference curve approach;

• decompose price effect into income effect and substitution effect using
Hicksian and Slutsky approach; and
• derive demand curve from Price Consumption curve (PCC).

5.1 INTRODUCTION
In Unit 4, we have learnt the concept of cardinal and ordinal utility in order to
understand the concept of consumer preferences. We also examined consumer
equilibrium through cardinal utility analysis. As discussed in previous unit,
study of consumer behaviour has been a focus point for researchers as well as
business houses. Consumer behaviour directly affects the sales and thus profits
of the companies. In order to understand consumer’s buying pattern, it is also
important to understand how consumer equilibrium is attained. A rational
consumer wants to maximise his satisfaction derived from consumption of
various goods but is subject to his budget constraint. In this unit, we will
examine the concept of consumer equilibrium using ordinal utility approach.

5.2 ORDINAL UTILITY APPROACH

Cardinal Utility approach was criticised for being restrictive in nature. English
economist Edgeworth criticised cardinal approach for its Unrealistic
assumptions. He was of opinion that measurement of utility in quantitative
scale is neither possible nor necessary. This idea gave birth to ordinal
approach. Edgeworth also believed that all consumer behaviour can be
measured in terms of preferences and rankings and can be understood using
Indifference curve approach. Though this approach was originally propounded
by Edgeworth, it became popular because of Vilfred Pareto (1906), Slutsky
(1915) and finally because of RGD Allen and J.R Hicks. However, this
approach is also based on some assumptions.
Assumptions of Ordinal Utility Approach

1) Rationality: The basic assumption is that consumer is a rational being,

i.e., he prefers more to less and tries to maximise his satisfaction.

2) Indifference curve analysis assumes that utility is only ordinally

expressible i.e. utility derived from two goods can be compared, as more,
less, or equal, but not how much more or less.

3) Transitivity: Consumer choices are assumed to be transitive. Transitivity

of choices means that if a consumer prefers A to B and B to C, then he
prefers A to C, or if she treats A>B and B>C, then she also treats A>C.

4) Consistency: Consistency of choice means that if a person prefers A over

B in one period, he/she will not prefer B over A in another period.

5) Non satiety: This assumption means that a consumer prefers a larger

quantity of all the goods over smaller quantities of the same.

6) Diminishing Marginal Rate of Substitution (MRS): MRS is that rate at

which a consumer is willing to substitute one commodity (say X) for 93
Theory of another (say Y) while maintaining the same utility or level of satisfaction
Consumer to the consumer. The concept of diminishing MRS will be discussed in
Behaviour greater detail in next section.

5.3 INDIFFERENCE CURVE ANALYSIS

J.R Hicks used the concept of Indifference curve to analyse consumer
behaviour. A consumer facing choice between large number of bundles of two
goods tries to maximise his satisfaction by choosing a combination which gives
him maximum utility. In the course of decision making, consumer finds out
that goods can be substituted for each other and identifies various combinations
of commodities that give him equal level of satisfaction. When all these
combinations are plotted graphically, it produces a curve called Indifference
curve.

5.3.1 Indifference Schedule

An indifference schedule is a table which represents various combinations of
two goods, which yield equal satisfaction to consumer. Since all the
combinations give equal level of satisfaction, consumer is indifferent between
them.
Table 5.1 presents an imaginary indifference schedule representing the various
combinations of two goods X and Y.
Table 5.1: Indifference schedule of two commodities ‘X’ and ‘Y’

Combinations Units of ‘X’ Goods Units of ‘Y’ Satisfaction

(Cup of Tea) Goods (Biscuits)
A 1+ 12 K
B 2+ 8 K
C 3+ 5 K
D 4+ 3 K
E 5+ 2 K

In above table, five different combinations of Tea and Biscuits are depicted.
All these combinations give equal level of satisfaction i.e. K. The consumer is
indifferent whether he buys 1 cup of tea and 12 biscuits or 2 cups of tea and 8
biscuits. Different schedules can be formed showing different levels of
satisfaction.

5.3.2 Indifference Curve

The graphical presentation of Indifference schedule is known as Indifference
curve. The indifference curve is locus of all the combinations of two
commodities which give same level of satisfaction to the consumer.
Fig. 5.1 is graphical representation of Table 5.1. It shows all the combinations
of good X and good Y i.e. A, B, C, D and E which yield equal level of
satisfaction to the consumer. The curve is downward sloping, convex to the
point of origin.

94
 Consumer Behaviour :
Ordinal Approach

Fig. 5.1: Indifference curve

5.3.3 Indifference Map

The combinations of two commodities X and Y given in the Indifference
schedule are not the only possible combinations for these commodities. The
consumer may make any other combinations with less of one or both of the
goods, each yielding the same level of satisfaction but less than the one shown
in schedule. IC curve of this schedule will be above IC1. Similarly, the
consumer may make other combinations with more of one or both of the
goods, each combination yielding the same satisfaction but greater than the
satisfaction indicated.
A diagram showing different indifference curves corresponding to different
indifference schedules of the consumer is indifference map. In other words, a
set or family of indifference curves is an indifference map.

Fig. 5.2: Indifference map

Fig. 5.2 shows four indifference curves: IC1, IC2, IC3 and IC4. All the points on
IC2 will yield higher satisfaction than the points on IC1 and all the points on
IC3 will yield lesser satisfaction than the points on IC4.

95
Theory of 5.3.4 Law of Diminishing Marginal Rate of Substitution
Consumer
Behaviour What is Marginal Rate of Substitution?
Marginal rate of substitution may be defined as the rate at which a consumer
will exchange successive units of a commodity for another. In other words,
Marginal rate of substitution is the rate at which, in order to get the additional
units of a commodity, the consumer is willing to sacrifice or give up to get one
additional unit of another commodity.
The Marginal Rate of Substitution can symbolically be represented as under:
MRSxy= ΔY/ΔX
Where MRSxy= Marginal rate of substitution of X for Y
ΔY= Change in ‘Y’ commodity
ΔX= Change in ‘X’ commodity.
Diminishing Marginal rate of Substitution
One of the basic postulates of ordinal utility theory is that Marginal rate of
substitution (MRSxy or MRSyx) decreases. It means that the quantity of a
commodity that a consumer is willing to sacrifice for an additional unit of
another commodity goes on decreasing. Law of diminishing Marginal rate of
substitution is an extensive form of the law of diminishing Marginal Utility. As
discussed in previous section, Law of diminishing marginal Utility states that
as a consumer increases the consumption of a good, his marginal utility goes
on diminishing. Similarly as consumer gets more and more unit of good X, he
is willing to sacrifice less and less units of good Y for each extra unit of X. The
significance of good X in terms of good Y goes on diminishing with each
addition of good X. The law can be understood with the help of following
Table 5.2.
Table 5.2: Marginal rate of Substitution

Units of ‘X’ Units of ‘Y’ MRS of ‘X’ for

Good Good ‘Y’
1 10 -
2 7 3:1
3 5 2:1
4 4 1:1

To have the second combination and yet to be at the same level of satisfaction,
the consumer is ready to forgo 3 units of Y for obtaining an extra unit of X.
The marginal rate of substitution of X for Y is 3:1. The rate of substitution is
units of Y for which one unit of X is a substitute. As the consumer desires to
have additional unit of X, he is willing to give away less and less units of Y so
that the marginal rate of substitution falls from 3:1 to 1:1 in the fourth
combination.
In Fig. 5.3 given below at point M on the Indifference curve I, the consumer is
willing to give up 3 units of Y to get an additional unit of X. Hence, MRSxy =3.
As he moves along the curve from M to N, MRSxy, = 2. When the consumer
96 moves downwards along the indifference curve, he acquires more of X and less
of Y. The amount of Y he is prepared to give up to get additional units of X Consumer Behaviour :
becomes smaller and smaller. Ordinal Approach

Fig. 5.3: Indifference curve and Marginal rate of Substitution

The marginal rate of substitution of X for Y (MRSxy) is, in fact, the slope of the
curve at a point on the indifference curve, such as points M, N or P in Fig. 5.3.
Thus MRSxy = ∆Y/∆X

5.3.5 Properties of Indifference Curve

1) Indifference curve slopes downwards from left to right: It implies that
Indifference curve has a negative slope. This attribute is based on the
assumption that if a consumer uses more quantity of one good, he has to
reduce the consumption of the other good in order to stay at the same
level of satisfaction.
2) Indifference curves are generally convex to the origin ‘O’: This
property is based on the principle of Diminishing Marginal Rate of
Substitution. It means that as the units of ‘X’ are increased by equal
amounts, the ‘Y’ diminishes by smaller and smaller amounts. This
happens because as a consumer gets more and more units of ‘X’ good, he
is willing to give up less and less units of good Y for each extra unit of X.
3) Indifference curves cannot intersect each other: This is because of the
fact that each indifference curve represents different level of satisfaction.
If two indifference curves intersect, it will lead to self-contradictory
result. In Fig. 5.4, two Indifference curve IC1 and IC2 are shown
intersecting each other at point C. But this is not possible.
Point ‘A’ and point ‘C’ on Indifference curve IC1 represents combination
yielding equal satisfaction. That is satisfaction from A combination = the
satisfaction from C combination, therefore,
i) Pt. A = Pt. C ( Because both lie on same IC curve IC1)
ii) Pt. B = Pt. C ( Because both lie on same IC curve IC2)
Thus Pt. B = Pt. A in terms of satisfaction. But this is impossible because at
combination ‘B’ quantities of both X and Y are more than in combination ‘A’,
hence this is self-contradictory.

97
Theory of
Consumer
Behaviour

Fig. 5.4: Two Indifference curves cannot intersect

Thus, two Indifference curves cannot intersect with each other. The
Indifference curves cannot be tangent to each other.
4) Higher Indifference curve represents higher level of satisfaction: In
Fig. 5.5, the indifference curve IC2 lies above and to the right of the IC1.
Point C on IC2 represents more units of ‘x’ than point A on IC1.
Similarly, Point B on IC2 represents more units of ‘y’ than point A on
IC1. It is thus evident that higher the indifference curve, the higher the
satisfaction it represents because our consumer prefers more of a good to
less of it. Also note that all the points between B and C on IC2 show
larger amounts of both X and Y compared to point A on IC1.

Fig. 5.5: Higher Indifference curve means higher level of satisfaction

5) Indifference curves do not touch either of the axes X or Y . This is

because of the assumption that the consumer purchases combination of
different commodities. In case, an indifference curve touches either axis,
it means the consumer wants only one commodity and his demand for the
98 second commodity is zero. Purchasing one commodity means
 monomania, i.e. consumer’s lack of interest in the other commodity. This Consumer Behaviour :
is against the assumption of Indifference curve which is a two good Ordinal Approach
model.
6) No Indifference curve cuts either of axes: If it were to happen, the
consumer will be consuming negative quantity of that commodity which
makes no sense.

5.4 SOME EXCEPTIONAL SHAPES OF

INDIFFERENCE CURVE
Indifference curve may take a different shape in case of perfect substitutes and
perfect complements. Some exceptional shapes of Indifference curve are
discussed as follows:
Perfect Substitutes
We have examined the concept of perfect substitutes in previous units. Two
goods are perfect substitutes if the utility consumers get from one good is the
same as another.
When two goods are perfect substitutes of each other, their indifference curve
will be a straight diagonal line sloping downwards from left to right. It is
because of the fact that MRS in such cases is constant i.e. 1.
For example: Suppose good A and good B are perfect substitutes, consumer
will be indifferent between them and will be ready to sacrifice equal quantity
of good A to achieve good B. But, even here, the ICs will not cross the axes.

Fig. 5.6: Indifference curve in case of Perfect Substitutes

Perfect Complements
Two goods may be perfect complementary to each other. Just as left and right
shoes, cups and saucers of a tea set etc. In such case, the indifference curve
will be parallel to each other and bent at 90 degree angle or L shaped. Perfect
complementary goods are those goods which are used in fixed ratio i.e. 1:1or
2:2. They cannot be substituted for each other, thus putting MRS as zero. This
99
Theory of case is shown in Fig. 5.7. It is clear that IC1 and IC2 are right angled curves,
Consumer meaning thereby that the consumer buys piece of each right shoe. This will be
Behaviour useless. The consumer will be no better off and he will remain at point ‘A’ on
IC1. In case, he buys 2 pieces of left shoe and only one piece of right shoe, it
will be useless, the consumer will be no better off and he will remain at point C
of IC1. It means that having one more pair of shoe will not add to his
satisfaction. But if he buys one more shoe, his satisfaction will immensely
increase and he will move to point B on higher Indifference curve IC2.

IC3
IC2

IC1

Fig. 5.7: Indifference curve in case of Perfect Complements

Check Your Progress 1
1) Suppose that goods A and B are perfect compliments. Draw a set of
indifference curves for perfect compliments, and explain why the curves
look the way they do. Do the same for perfect substitutes?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain the concept of Marginal Rate of Substitution (MRS). What
happens to MRS when consumer moves downward along the
Indifference curve?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Why is Indifference curve convex to origin?
......................................................................................................................
......................................................................................................................
......................................................................................................................

5.5 BUDGET LINE

As discussed above, a rational consumer always acts according to his budget
constraint and tries to maximise his level of satisfaction. Thus, the knowledge
of the concept of budget line or what is also called budget constraint is
100
essential for understanding the theory of consumer’s equilibrium.
A consumer in his attempt to maximise his satisfaction will try to reach the Consumer Behaviour :
highest possible indifference curve. But in his pursuit of maximising Ordinal Approach
satisfaction by buying more and more goods, he has to consider two
constraints: first, he has to pay the prices for the goods and, secondly, he has a
limited money income to purchase the goods. Thus, how much a person is
capable to buy, depends upon the prices of the goods and the money income
which he has at his disposal.
Price line or budget line represents all possible combinations of two goods that
a consumer can purchase with his given income and the given prices of two
goods. Let us try to understand the concept with the help of an example:
Suppose a consumer has an income of Rs. 100 to spend on Oranges and Apples
which cost Rs. 10 each. He can either spend his limited income only on one
good or both the goods. All the possible alternative combinations of two goods
are presented in Table 5.3.
Table 5.3: Alternative consumption possibilities

Income Apples (Rs. 10/piece) Oranges (Rs. 10/piece)

Rs. 100 10 0
Rs. 100 9 1
Rs. 100 8 2
Rs. 100 7 3
Rs. 100 6 4
Rs. 100 5 5
Rs. 100 4 6
Rs. 100 3 7
Rs. 100 2 8
Rs. 100 1 9
Rs. 100 0 10

It can be observed from the above table that if the consumer spends his total
income of Rs. 100 on Apples, he is able to buy 10 Apples. On the other hand, if
he buys Oranges alone, he can get 10 Oranges by spending his total income.
Further, a consumer can also buy both the goods in different combinations.
The budget line can be written algebraically as follows:
Algebraic Expression for Budget Set: The consumer can buy any bundle (A,
B), such that:
M ≥ (PX * QX) + (PY * QY)
Where PX and PY denote prices of goods X and Y respectively and M stands
for money income
We can rewrite the budget line as: PYQY = M – PXQX
• ••
dividing both sides by PY yields: QY = • − ••
Q
•

This is the budget line plotted in Fig. 5.8.

101
Theory of SLOPE OF BUDGET LINE
Consumer
Behaviour As we know that the slope of a curve is calculated as a change in variable on
the Y-axis divided by change in variable on the X-axis, slope of the budget line
in given example will be number of units of Oranges, that the consumer is
willing to sacrifice for an additional unit of Apple.
Slope of Budget Line = Units of Oranges (Y) willing to Sacrifice/ Units of
Apples (X) willing to Gain = ∆Y/∆X
In above example, 1 Apple need to be sacrificed each time to gain 1 Orange.
So, Slope of Budget Line = –1/1 = –1
This slope of budget line is equal to ‘Price Ratio’ of two goods.
Price Ratio = Price of X (PX)/Price of Y (PY) = –PX /PY
Budget line is presented in Fig. 5.8.

Fig. 5.8: Budget Line

5.6 SHIFT IN BUDGET LINE

Budget line is drawn on the basis of assumption of constant prices of the goods
and constant income of the consumer. Thus, if there is any change in either of
the two variables, budget line shifts.
Thus, there are two variables that causes shift in Budget Line:
1) Change in Income of the consumer
2) Change in equal proportion of Prices of both the goods.
Change in Income of the consumer
If income changes while the prices of goods remain the same, Budget line will
shift rightwards or leftwards. Since the prices of two goods are constant, slope
102
of budget line will remain constant. The effect of changes in income on the Consumer Behaviour :
budget line is shown in Fig. 5.9. If consumer’s income increases while prices Ordinal Approach
of both goods X and Y remain unaltered, the price line shifts upward and is
parallel to the original budget line.

Fig. 5.9: Effect of change in Income on Budget Line

This is because with the increased income the consumer is able to purchase
proportionately larger quantity of both goods than before.
On the other hand, if income of the consumer decreases, prices of both goods
X and Y remaining unchanged, the budget line shifts downward but remains
parallel to the original price line. This is because a lower income will leave the
consumer in a position to buy proportionately smaller quantities of both goods.
Changes in Price of either of the two goods:
Budget Line also shifts when there is change in price of either of the two
goods. Increase in price of any commodity reduces the purchasing power of the
consumer, in turn reducing the quantity demanded. Shift of Budget line due to
change in prices of either good x or good y is presented below:
Changes in Budget Line as a Result of Changes in Price of Good X
Suppose, price of good X rises, the price of good Y and income remaining
unaltered. With higher price of good X, the consumer can purchase smaller
quantity of X.
In Fig. 5.10, original price line is AB. With increase in Price of good X, budget
line will shift to AB2 i.e. consumer will be able to buy less quantity of good X,
quantity of good Y remaining same. Similarly when there is fall in price of
good X, keeping prices of good Y constant, budget line shifts from AB to AB1
i.e. consumer will be able to buy more quantity of good X, quantity of good Y
remaining same.

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Theory of
Consumer
Behaviour

Fig. 5.10: Shift in Budget line due to change in price of good X

Change in Price of good Y
Fig. 5.11 shows the changes in the budget line when price of good Y falls or
rises, with the price of X and income remaining the same. It can be observed
from Fig. 5.11 that the initial budget line is AB. With fall in price of good Y,
other things remaining unchanged, the consumer could buy more of Y with the
given money income and therefore budget line will shift above to EB.
Similarly, with the rise in price of Y, other things being constant, and the
budget line will shift below to DB.

Fig. 5.11: Shift in Budget line due to change in price of good Y

104
Check Your Progress 2 Consumer Behaviour :
Ordinal Approach
1) What is budget line? Calculate slope of Budget line if prices of good X
and good Y are 8 and 10 respectively?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What will happen to budget line if:
Case A: Price of good X increases
......................................................................................................................
......................................................................................................................
Case B: Price of good Y decreases
......................................................................................................................
......................................................................................................................
Case C: Income of consumer increases
......................................................................................................................
......................................................................................................................

5.7 CONSUMER EQUILIBRIUM THROUGH

INDIFFERENCE CURVE ANALYSIS
Assumptions
As discussed above, consumer equilibrium is a point of maximum satisfaction
for the consumer. It is a state of rest for the consumer. Study of Consumer
equilibrium requires some assumptions to be made about the consumer
behaviour. These are:
i) Rationality: The consumer is rational. He wants to obtain maximum
satisfaction given his income and prices.
ii) Consumer has an indifference map, showing his scale of preference for
various combinations of good x and y.
iii) Utility is ordinal: It is assumed that the consumer can rank his preference
according to the satisfaction of each combination of goods.
iv) Consistency of choice: It is also assumed that the consumer is consistent
in the choice of combination of goods.
v) Consumer has a given and fixed amount of money income to spend on
the goods. Thus, consumer has to choose to spend his income on either of
the two goods or a combination thereof.
vi) All the units of the goods are homogeneous.
vii) The goods are divisible i.e. they can be divided into small units.
105
Theory of viii) Total utility: The total utility of the consumer depends on the quantities
Consumer of the good consumed.
Behaviour
Conditions of Consumer’s Equilibrium
There are two fundamental conditions of consumer’s equilibrium through
Indifference curve approach:
1) The price line should be tangent to the Indifference curve. It means that at
the point of equilibrium the slope of the indifference curve and of the
price line should be same. The slope of Indifference curve indicates
MRSxy i.e. –ΔY/ΔX. The slope of the price line indicates the ratio
between price of two goods X and Y i.e. Px/Py.
2) Indifference curve should be convex to the point of origin: Marginal rate
of substitution of X for Y (MRSxy i.e. Δy/Δx) is equal to the slope of the
price line that indicates the ratio between prices of two goods.
Condition 1: MRSXY = Ratio of prices or PX/PY
Let the two goods be X and Y. The first condition for consumer’s equilibrium
is that
MRSxy = Px/Py
• If MRSxy> Px/Py, it means that the consumer is willing to pay more for X
than the price prevailing in the market. As a result, the consumer buys
more of X. As a result, MRS falls till it becomes equal to the ratio of
prices and the equilibrium is established.

• If MRSxy< Px/Py, it means that the consumer is willing to pay less for X
than the price prevailing in the market. It induces the consumer to buys
less of X and more of Y. As a result, MRS rises till it becomes equal to
the ratio of prices and the equilibrium is established.

Condition 2: MRS continuously falls

The second condition for consumer’s equilibrium is that MRS must be
diminishing at the point of equilibrium, i.e. the indifference curve must be
convex to the origin at the point of equilibrium. Unless MRS continuously
falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in
equilibrium.
Let us now understand this with the help of a diagram:
In Fig. 5.12, IC1, IC2 and IC3 are the three indifference curves and MM is the
budget line. With the constraint of budget line, the highest indifference curve,
which a consumer can reach, is IC2. The budget line is tangent to indifference
curve IC2 at point ‘P’. This is the point of consumer equilibrium.

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 Consumer Behaviour :
Ordinal Approach

Fig. 5.12: Consumer equilibrium through indifference curve

All other points on the budget line to the left or right of point ‘P’ will lie on
lower indifference curves and thus indicate a lower level of satisfaction. As
budget line can be tangent to one and only one indifference curve, consumer
maximises his satisfaction at point P, when both the conditions of consumer’s
equilibrium are satisfied:
i) MRS = Ratio of prices or PX/PY:
At tangency point P, the absolute value of the slope of the indifference curve
(MRS between X and Y) and that of the budget line (price ratio) are same.
Equilibrium cannot be established at any other point such as MRSXY> PX/PY at
all points to the left of point P or MRSXY< PX/PY at all points to the right of
point P. So, equilibrium is established at point P, when MRSXY = PX/PY.
ii) MRS continuously falls:
The second condition is also satisfied at point P as MRS is diminishing at point
P, i.e. IC2 is convex to the origin at point P.

5.8 SOME EXCEPTIONAL SHAPES OF

INDIFFERENCE CURVE AND CORNER
EQUILIBRIUM
As hinted earlier, indifference curve may take different shape in exceptional
cases like perfect complements, perfect substitutes. Also if an assumption of
‘two goods’ is dropped, indifference curve may touch X axis or Y axis also. In
case of an exceptional shape of an indifference curve, equilibrium may be
called as corner solution. This section deals with such cases.
Normally, an equilibrium is achieved at the point of tangency between the
budget line and his indifference curve. At this point, consumer’s preferences
are such that he likes to consume some amount of both the goods. This
equilibrium position at the point of tangency which lies within commodity
space between the two axes is often called interior solution. Interior solution
implies that consumers’ pattern of consumption is diversified and they prefer
basket or bundle of several different goods instead of spending their entire
income on a single commodity.
107
Theory of However, this may not be true in real life scenario and a customer may prefer
Consumer small number of goods and service rather than buying all goods and services
Behaviour available. There may be various reasons for such behaviour – price, taste and
preference etc.
Corner solution when only Commodity Y is purchased
Fig. 5.13 presents a case where indifference map between two goods X and Y
and budget line BL are such that the interior solution is not possible and
consumer in its equilibrium position at point B will not consume any quantity
of commodity X. The reason behind such indifference map is high price of
commodity X. As we already know that the slope of budget line is ratio of
price of two goods, high price of good X makes the budget curve is steeper
than the indifference curves between the two commodities i.e. price or
opportunity cost of commodity X in the market is greater than the marginal rate
of substitution of X for Y which indicates willingness to pay for the
commodity X (Px/Py >MRSxy). The price of good X is so high that the
consumer does not purchase even one unit of the commodity X. Thus the
consumer maximises his satisfaction or is in equilibrium at the corner point B
where he buys only commodity Y. Thus, consumer’s equilibrium in this case is
a corner solution.

Fig. 5.13: Corner solution when only Commodity Y is bought

Corner solution when only Commodity X is purchased
On the other hand, when the indifference map between the two goods is such
that the budget line BL is less steep than the indifference curves between the
two goods so that the MRSxy > Px/Py for all levels of consumption along the
budget line BL. Therefore, he maximises his satisfaction at the corner point L
where he buys only commodity X and none of Y. In this case price of
commodity Y and willingness to pay (i.e. MRS) for it are low that he does not
consider it worthwhile to purchase even one unit of it. Fig. 5.14 presents the
corner solution when only commodity X is purchased.

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 Consumer Behaviour :
Ordinal Approach

Fig. 5.14: Corner solution when only Commodity X is purchased

Corner Equilibrium and Concave Indifference Curves:
The indifference curves are usually convex to the origin. Convexity of
indifference curves is due to the reason that marginal rate of substitution of X
for Y falls as more of X is substituted for Y. However, indifference curves are
concave to the origin in some exceptional cases. Concavity of the indifference
curves implies that the marginal rate of substitution of X for Y increases when
more of X is substituted for Y. Thus, in case of concave indifference curve,
consumer will choose or buy only one good. It implies that the customer
prefers to buy only one good and does not prefer diversification in his buying
pattern.
In case of concave indifference curves, the consumer will not be in equilibrium
at the point of tangency between budget line and indifference curve, that is, in
this case interior solution will not exist. Instead, we would have corner solution
for consumer’s equilibrium. Corner solution in case of concave indifference
curve is presented in Fig. 5.15.

Fig. 5.15: Consumer equilibrium in case of concave indifference curves

It can be observed from Fig. 5.15 that the given budget line BL is tangent to
the indifference curve IC2 at point Q. However, consumer cannot be in
equilibrium at Q since by moving along the given budget line BL he can get on
109
Theory of to higher indifference curves and obtain greater satisfaction than at Q. Thus, by
Consumer moving on higher indifference curve he will reach at extreme point B or point
Behaviour L. In Fig. 5.15, point B is on higher indifference curve. Thus, consumer will be
satisfied at point B where he will buy OB units of commodity Y. It should be
noted that at B the budget line is not tangent to the indifference curve IC5, even
though the consumer is here in equilibrium. It is clear that when a consumer
has concave indifference curves, he will consume only one good.
Corner solution in case of Perfect Substitutes and Perfect Complements:
Another case of corner solution to the consumer’s equilibrium occurs in case of
perfect substitutes. As seen above, indifference curves for perfect substitutes
are linear. In their case tangency or interior solution for consumer’s
equilibrium is not possible since the budget line cannot be tangent to a point of
the straight-line indifference curve of substitutes.
In this case budget line would cut the straight-line indifference curves. Fig.
5.16A presents a case where slope of the budget line BL is greater than the
slope of indifference curves. If the slope of the budget line is greater than the
slope of indifference curves, B would lie on a higher indifference curve than L
and the consumer will buy only Y.

Fig. 5.16 A: Corner equilibrium in case of Perfect Substitutes

Fig. 5.16 B presents a case the slope of the budget line can be less than the
slope of indifference curve. If the slope of the budget line is less than the slope
of indifference curves, L would lie on a higher indifference curve than B and
the consumer will buy only X.

Fig. 5.16 B: Corner equilibrium in case of Perfect Substitutes

Perfect complements
Another exceptional case of perfect complementary goods is presented in Fig.
110 5.17. Indifference curves of perfect complementary goods have a right-angled
shape. In such a case the equilibrium of the consumer will be determined at the Consumer Behaviour :
corner of indifference curve which just touches the budget line. It can be noted Ordinal Approach
from Fig. 5.17 that in case of perfect complements equilibrium point will be
point C and will be consuming OM of X and ON of Y.

Fig. 5.17: Corner solution in case of Perfect Complements

5.9 PRICE EFFECT AS COMBINATION OF

INCOME EFFECT AND SUBSTITUTION
EFFECT
As discussed above, a consumer’s equilibrium position is affected by the
changes in his income, prices of substitute and changes in the price of goods
consumed. These effects are known as:
1) Income effect,
2) Substitution effect, and
3) Price effect

5.9.1 Income Effect

In the analysis of the consumer’s equilibrium it is assumed that the income of
the consumer remains constant, and the prices of the goods X and Y are given.
Thus, given the tastes and preferences of the consumer and the prices of the
two goods, if the income of the consumer changes, the effect it will have on his
purchases is known as the Income effect.
The Income effect may be defined as the effect on the purchases of consumer
caused by the changes in income, if the prices of goods remain constant. If the
income of the consumer increases his budget line will shift upward to the right,
parallel to the original budget line. On the contrary, a fall in his income will
shift the budget line inward to the left. The budget lines are parallel to each
other because relative prices remain unchanged.
Assumptions of Income Effect
1) The prices of both the commodities X and Y remain constant
2) Taste and preferences remain constant
111
Theory of 3) There is no change in fashion and market condition
Consumer
Behaviour Kinds of Income Effect
Income effect may be of three types:
1) Positive Income effect
2) Negative Income effect
3) Zero Income effect
1) Positive Income effect: When an increase in income leads to an increase
in demand for a commodity or for both the commodities the income
effect is positive. In case of Normal goods, income effect is positive and
Income consumption curve slopes upwards to the right.
2) Negative Income effect: Income effect is negative, when with the
increase in his income, the consumer reduces his consumption of the
good. Income effect is negative in case of inferior goods.
3) Zero Income effect: If with the change in income, there is no change in
the quantity purchased of a commodity, than the income effect is said to
be zero. Zero income effect is in case of goods like medicines, necessities
like salt etc.
All the three effects are explained diagrammatically.
In Fig. 5.18, when the budget line is B1, the equilibrium point is X* where it
touches the indifference curve I1. If now the income of the consumer increases,
B1 will move to the right as the budget line B2, I1, and the new equilibrium
point is X1 where it touches the indifference curve I2. As income increases
further, B3 becomes the budget line with X2 as its equilibrium point.
The locus of these equilibrium points X*, X1 and X2 traces out a curve which is
called the income-consumption curve (ICC). The ICC curve shows the income
effect of changes in consumer’s income on the purchases of the two goods,
given their relative prices.
Normally, when the income of the consumer increases, he purchases larger
quantities of two goods. Usually, the income consumption curve slopes
upwards to the right as shown in Fig. 5.18. Here the income effect is also
positive and both X and Y are normal goods.

Fig. 5.18: Income Consumption curve-Normal goods

112
But an Income-consumption curve can have any shape provided it does not Consumer Behaviour :
intersect an Indifference curve more than once. Ordinal Approach

The second type of ICC curve may have a positive slope in the beginning but
become and stay horizontal beyond a certain point when the income of the
consumer continues to increase. In case where X is a superior good and Y is a
necessity, shape of ICC curve will be as shown in Fig. 5.19.
In Fig. 5.19, the ICC curve slopes upwards with the increase in income up to
the equilibrium point R at the budget line P1Q1 on the indifference cure I2.
Beyond this point it becomes horizontal which means that the consumer has
reached the saturation point regarding consumption of good Y. He buys the
same amount of Y (RA) as before despite further increases in his income. It
often happens in the case of a necessity (like salt) whose demand remains the
same even when the income of the consumer continues to increase further.
Here Y is a necessity.

Fig. 5.19: Income Consumption curve (X is a superior good and Y is a necessity)

Further, the demand of inferior goods falls, when the income of the consumer
increases beyond a certain level, and he replaces them by superior substitutes.
For example, he may replace coarse grains by wheat or rice, and coarse cloth
by a fine variety. In Fig. 5.20, good X is inferior and Y is a normal good.
It can be observed from the Fig. 5.20, that up to point R the ICC curve has a
positive slope and beyond that it is negatively inclined. The consumer’s
purchases of X fall with the increase in his income.

Fig. 5.20: Income Consumption curve (Y is normal good and X is inferior)

113
Theory of The different types of income-consumption curves are also shown in Fig. 5.21
Consumer where: (1) ICC1, has a positive slope and relates to normal goods; (2) IСС2 is
Behaviour horizontal from point A, X is a normal good while Y is a necessity of which
the consumer does not want to have more than the usual quantity as his income
increases further: (3) IСС3 is vertical from A, y is a normal good here and X is
satiated necessity; (4) ICC4 is negatively inclined downwards, Y becomes an
inferior good form A onwards and X is a superior good; and (5) ICC5 shows X
as an inferior good.

Fig. 5.21: Possible shapes of Income Consumption curve (ICC)

5.9.2 Substitution Effect

The substitution effect relates to the change in the quantity demanded resulting
from a change in the price of one good it prompts the substitution of relatively
cheaper good for a dearer one, while keeping the price of the other good, real
income and tastes of the consumer as constant. Prof. Hicks has explained the
substitution effect independent of the income effect through compensating
variation in income. “The substitution effect is the increase in the quantity
bought as the price of a commodity falls, after adjusting income so as to keep
the real purchasing power of the consumer the same as before. This adjustment
in income is called compensating variations and is shown graphically by a
parallel shift of the new budget line until it become tangent to the initial
indifference curve.”
Thus, on the basis of the methods of compensating variation, the substitution
effect measures the effect of change in the relative price of a good. The
increase in the real income of the consumer as a result of fall in the price of,
say good X, is so withdrawn that he is neither better off nor worse off than
before.
The substitution effect is explained in Fig. 5.22 where the original budget line
is PQ with equilibrium at point R on the indifference curve I1. At R, the
consumer is buying OB of X and BR of Y. Suppose the price of X falls so that
his new budget line is PQ1. With the fall in the price of X, the real income of
the consumer increases. To make the compensating variation in income or to
keep the consumer’s real income constant, take away the increase in his
income equal to PM of good Y or Q1N of good X so that his budget line
PQ1 shifts to the left as MN and is parallel to it so that new budget line tangent
to I1 at point H.
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 Consumer Behaviour :
Ordinal Approach

Fig. 5.22: Substitution effect (Hicksian Analysis)

As MN is tangent to the original indifference curve I1, at point H, the consumer

buys OD of X and DH of Y. Thus PM of Y or Q1N of X represents the
compensating variation in income, as shown by the line MN being tangent to
the curve I1 at point H. Now the consumer substitutes X for Y and moves from
point R to H or the horizontal distance from В to D. This movement is called
the substitution effect. The substitution affect is always negative because when
the price of a good falls (or rises), more (or less) of it would be purchased, the
real income of the consumer and price of the other good remaining constant. In
other words, the relation between price and quantity demanded being inverse,
the substitution effect is negative.

5.9.3 Price Effect

The price effect indicates the way the consumer’s purchases of good X change,
when its price changes, given his income, tastes and preferences and the price
of good Y. This is shown in Fig. 5.23. Suppose the price of X falls. The budget
line PQ will extend further out to the right as PQ1, showing that the consumer
will buy more X than before as X has become cheaper. The budget line
PQ2 shows a further fall in the price of X. Any rise in the price of X will be
represented by the budget line being drawn inward to the left of the original
budget line towards the origin.
If we regard PQ2, as the original budget line, a two time rise in the price of X
will lead to the shifting of the budget line to PQ1, and PQ2 – PQ. Each of the
budget lines fanning out from P is a tangent to an indifference curve I1, I2, and
I3 at R, S and T respectively. The curve PCC connecting the locus of these
equilibrium points is called the price-consumption curve (PCC). The price-
consumption curve indicates the price effect of a change in the price of X on
the consumer’s purchases of the two goods X and Y, given his income, tastes,
preferences and the price of good Y.

115
Theory of
Consumer
Behaviour

Fig. 5.23: Price effect through Indifference curve analysis

Check Your Progress 3

1) Differentiate between Income effect, price effect and substitution effect.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) What will be the shape of Income consumption curve (ICC):
Case A: X is an inferior good, Y is superior good
......................................................................................................................
......................................................................................................................
Case B: Y is an inferior good, X is superior good
......................................................................................................................
......................................................................................................................

5.10 MEASURING INCOME AND SUBSTITUTION

EFFECTS OF PRICE CHANGE
As noted above, the change in consumption basket due to change in the prices
of consumer goods is called price effect. Price effects combines two effects:
Income effect and substitution effect. Income effect is the result of increase in
real income due to decrease in price of a commodity. Substitution effect arises
due to substitution of costly good by cheaper good. This section presents the
decomposition of Income and substitution effect from the price effect. There
are two approaches for the decomposition: a) Hicksian approach, and b)
Slutsky approach.
Hicksian approach uses two methods of splitting the price effect, namely
i) Compensating variation in income

116 ii) Equivalent variation in income.

Slutsky uses cost-difference method to decompose price effect into its two Consumer Behaviour :
component parts. Ordinal Approach

Hicksian or Compensating Variation approach

In this method of decomposition of price effect into income and substitution
effects by compensating variation, income of the consumer is adjusted so as to
offset the change in satisfaction and bring the consumer back to his original
indifference curve, that is, his initial level of satisfaction before the change in
price.
For instance, with the fall in price of a commodity, a consumer moves to a new
equilibrium position at a higher indifference curve i.e. at a higher level of
satisfaction. To offset this increase in satisfaction resulting from a fall in price
of the good, one part of income is taken back to force him to come back at his
original indifference curve. This requires reduction in income (say, through
levying a lump sum tax) to cancel out the gain in satisfaction or welfare on
account of by reduction in price of a good. It is called compensating variation
in income.
The effect is called compensating variation in income because it compensates
(in a negative way) for the gain in satisfaction resulting from a price reduction
of the commodity. Process of decomposition of price effect into substitution
effect and income effect through the method of compensating variation in
income is presented in Fig. 5.24.

Fig. 5.24: Decomposition of price effect into income effect and substitution effect through
Compensating variation in Income

It can be observed from Fig. 5.24, that when price of good X falls, budget line
shifts to PL2 i.e. real income of the consumer i.e. he can buy more of both the
goods with his increased income. With the new budget line PL2, consumer is in
equilibrium at point R on a higher indifference curve IC2 and enjoy increased
satisfaction as a result of fall in price of good X.
Suppose, money income of the consumer is reduced by the compensating
variation in income so that he is forced to come back to the original
indifference curve IC1 he would buy more of X since X has now become
117
Theory of relatively cheaper than before. In Fig. 5.24, with the reduction in income by
Consumer compensating variation, budget line will shift to AB which has been drawn
Behaviour parallel to PL2 so that it just touches the indifference curve IC1 on which he
was before the fall in price of X.
Since the price line AB has got the same slope as PL2, it represents the changed
relative prices with X being relatively cheaper than before. Now, X being
relatively cheaper than before, the consumer, in order to maximise his
satisfaction, in the new price income situation substitutes X for Y.
Thus, when the consumer’s money income is reduced by the compensating
variation in income (which is equal to PA in terms of Y or L2B in terms of X),
the consumer moves along the same indifference curve IC1 and substitutes X
for Y. At price line AB, consumer is in equilibrium at S at indifference curve
IC1 and is buying MK more of X in place of Y. This movement from Q to S on
the same indifference curve IC1 represents the substitution effect since it occurs
due to the change in relative prices alone, real income remaining constant.
If the amount of money income which was taken away from him is now given
back to him, he would move from S at indifference curve IC1 to R on a higher
indifference curve IC2. The movement from S at lower indifference curve to R
on a higher in difference curve is the result of income effect. Thus the
movement from Q to R due to price effect can be regarded as having taken
place into two steps first from Q to S as a result of substitution effect and
second from S to R as a result of income effect. Thus, price effect is the
combined result of a substitution effect and an income effect.
In Fig. 5.24 the various effects on the purchases of good X are:
• Price effect = MN
• Substitution effect = MK
• Income effect = KN
• MN = MK+KN or
Price effect = Substitution effect + Income effect
Slusky’s Cost difference approach
In Slutsky’s approach, when the price of good changes and consumer’s real
income or purchasing power increases, the income of the consumer is changed
by the amount equal to the change in its purchasing power which occurs as a
result of the price change. His purchasing power changes by the amount equal
to the change in the price multiplied by the number of units of the good which
the individual used to buy at the old price.
In other words, in Slutsky’s approach, income is reduced or increased (as the
case may be), by the amount which leaves the consumer to be just able to
purchase the same combination of goods, if he so desires, which he was having
at the old price.
That is, the income is changed by the difference between the cost of the
amount of good X purchased at the old price and the cost of purchasing the
same quantity of X at the new price. Income is then said to be changed by the
cost difference. Thus, in Slutsky substitution effect, income is reduced or
118
increased not by compensating variation as in case of the Hicksian substitution Consumer Behaviour :
effect, but, by the cost difference. Ordinal Approach

Slutsky substitution effect is explained in Fig. 5.25.

Fig. 5.25: Slutsky’s Substitution Effect (For a Fall in Price)

Initially, with a given money income and the given prices of two goods as
represented by the price line PL, the consumer is in equilibrium at point Q on
the indifference curve IC1 where consumer is buying OM units of good X and
ON units of good Y. Suppose that price of X falls, price of Y and money
income of the consumer remaining constant. As a result of this fall in price of
X, the price line will shift to PL' and the real income or the purchasing power
of the consumer will increase.
In order to identify Slutsky’s substitution effect, consumer’s money income
must be reduced by the cost difference or, in other words, by the amount which
will leave him to be just able to purchase the old combination Q, if he so
desires.
For this, a price line GH parallel to PL' has been drawn which passes through
the point Q. It means that income equal to PG in terms of Y or LH in terms of
X has been taken away from the consumer and as a result he can buy the
combination Q, if he so desires, since Q also lies on the price line GH.
Consumer will not now buy the combination Q since X has now become
relatively cheaper and Y has become relatively dearer than before. The change
in relative prices will induce the consumer to rearrange his purchases of X and
Y. He will substitute X for Y. But in this Slutsky substitution effect, he will not
move along the same indifference curve IC1, since the price line GH, on which
the consumer has to remain due to the new price-income circumstances is
nowhere tangent to the indifference curve IC1.
The price line GH is tangent to the indifference curve IC2 at point S. Therefore,
the consumer will now be in equilibrium at a point S on a higher indifference
curve IC2. This movement from Q to S represents Slutsky substitution effect
according to which the consumer moves not on the same indifference curve,
but from one indifference curve to another.
It is important to note that movement from Q to S as a result of Slutsky
substitution effect is due to the change in relative prices alone, since the effect
119
Theory of due to the gain in the purchasing power has been eliminated by making a
Consumer reduction in money income equal to the cost-difference.
Behaviour
At S, the consumer is buying OK of X and OW of Y; MK of X has been
substituted for NW of Y. Therefore, Slutsky substitution effect on X is the
increase in its quantity purchased by MK and Slutsky substitution effect on Y
is the decrease in its quantity purchased by NW.

5.11 DERIVATION OF DEMAND CURVE FROM

INDIFFERENCE CURVES
A demand curve shows quantity of a good purchased or demanded at various
prices, assuming that tastes and preferences of a consumer, his income, and
prices of all related goods remain constant. Demand curve showing
relationship between price and quantity demanded can be derived from price
consumption curve (PCC) of indifference curve analysis.
In Marshallian utility analysis, demand curve was derived on the assumptions
that utility was cardinally measurable and marginal utility of money remained
constant with the change in price of the good. In the indifference curve
analysis, demand curve is derived without making such assumptions.
Let us suppose that a consumer has got income of Rs. 300 to spend on goods.
In Fig. 5.26 money is measured on the Y-axis, while the quantity of the good X
whose demand curve is to be derived is measured on the X-axis. An
indifference map of a consumer is drawn along with the various budget lines
showing different prices of the good X. Budget line PL1 shows that price of the
good X is Rs. 15 per unit.
As price of good X falls from Rs. 15 to Rs. 10, the budget line shifts to PL2.
Budget line PL2 shows that price of good X is Rs. 10. With a further fall in
price to Rs. 7.5 the budget line takes the position PL3. Thus PL3 shows that
price of good X is Rs. 7.5. When price of good X falls to Rs. 6, PL4 is the
relevant budget line.
Tangency points between the various budget lines and indifference curves,
which when joined together by a line constitute the price consumption curve
shows the amounts of good X purchased or demanded at various prices. With
the budget line PL1 the consumer is in equilibrium at point Q1 on the price
consumption curve (PCC) at which the budget line PL1 is tangent to
indifference curve IC1. In his equilibrium position at Q1 the consumer is buying
OA units of the good X. In other words, it means that the consumer demands
OA units of good X at price Rs. 15. When price falls to Rs. 10 and thereby the
budget line shifts to PL2, the consumer comes to be in equilibrium at point Q2
the price-consumption curve PCC where the budget line PL2 is tangent to
indifference curve IC2. At Q2, the consumer is buying OB units of good X.
In other words, the consumer demands OB units of the good X at price Rs. 10.
Likewise, with budget lines PL3 and PL4, the consumer is in equilibrium at
points Q3 and Q4 of price consumption curve and is demanding OC units and
OD units of good X at price Rs. 7.5 and Rs. 6 respectively. Thus, price
consumption curve shows the quantity demanded of the good X against various
prices.

120
 Consumer Behaviour :
Ordinal Approach

Money

Fig. 5.26: Derivation of demand curve from indifference curve

In most cases, the demand curve of individuals will slope downward to the
right, because as the price of a good falls both the substitution effect and
income effect pull together in increasing the quantity demanded of the good.
Even when the income effect is negative, the demanded curve will slope
downward to the right if the substitution effect is strong enough to overcome
the negative income effect. Only when the negative income effect is powerful
enough to outweigh the substitution effect can the demand curve slope upward
to the right instead of sloping downward to the left.
Deriving Demand Curve for a Giffen Good:
Giffen good is a good where higher price causes an increase in demand
(reversing the usual law of demand). The increase in demand is due to the
income effect of the higher price outweighing the substitution effect. In this
section we will derive the demand curve of a Giffen good.
In Fig. 5.26, demand curve DD in case of a normal good is downward sloping.
There are two reasons behind downward slope: a) income effect b) substitution
effect.
Both the income effect and substitution effect usually work towards increasing
the quantity demanded of the good when its price falls and this makes the
demand curve slope downward. But in case of Giffen good, the demand curve
slopes upward from left to right. This is because in case of a Giffen good,
income effect, which is negative and works in opposite direction to the
substitution effect, outweighs the substitution effect. This results in the fall in
121
Theory of quantity demanded of the Giffen good when its price falls and therefore the
Consumer demand curve of a Giffen good slopes upward from left to right. Fig. 5.27
Behaviour presents the Indifference curves of a Giffen good along with the various budget
lines showing various prices of the good. Price consumption curve of a Giffen
good slopes backward.

Fig. 5.27: Upward Sloping Demand Curve for a Giffen Good

It is evident from Fig. 5.27 (the upper portion) that with budget line PL1 (or
price P1) the consumer is in equilibrium at Q1 on the price consumption curve
PCC and is purchasing OM) amount of the good. With the fall in price from P1
to P2 and shifting of budget line from PL1 to PL2, the consumer goes to the
equilibrium position Q3 at which he buys OM2 amount of the good. OM2 is less
than OM1.
Thus, with the fall in price from P1 to P2 the quantity demanded of the good
falls. Likewise, the consumer is in equilibrium at Q3 with price line PL3 and is
purchasing OM at price P3. With this information we can draw the demand
curve, as is done in the lower portion of Fig. 5.26. It can be seen from Fig. 5.27
(lower part) that the demand curve of a Giffen good slopes upward to the right
indicating that the quantity demanded varies directly with the changes in price.
With the rise in price, quantity demanded increases and with the fall in price
quantity demanded decreases.
Check Your Progress 4
1) Differentiate between Hicksian or Compensating Variation approach and
Slutsky Cost difference approach.
......................................................................................................................
......................................................................................................................
......................................................................................................................
122
2) How can demand curve be derived from Indifference curve? Consumer Behaviour :
Ordinal Approach
......................................................................................................................
......................................................................................................................
......................................................................................................................

5.12 LET US SUM UP

In this unit, we have learnt consumer equilibrium through Indifference curve
analysis. Consumer equilibrium is a situation, in which a consumer derives
maximum satisfaction, with no intention to change it and subject to given
prices and his given income. In indifference curve analysis, the point of
maximum satisfaction is achieved by studying indifference map and budget
line together. We have discussed the concept of budget line to identify
consumer equilibrium. Price line or budget line represents all possible
combinations of two goods that a consumer can purchase with his given
income and the given prices of two goods. Budget line may shift due to change
in income or change in prices of either of the two commodities. We further
examined the two conditions of consumer equilibrium i.e. MRSXY = Ratio of
prices or PX/PY and continuous fall of MRS. We have also learnt how is Price
effect combination of income effect and substitution effect using Hicksian and
Slutsky’s analysis. Demand curve has been derived from price consumption
curve.

5.13 REFERENCES
1) Dwivedi, D.N.(2008) Managerial Economics, 7th edition, Vikas Publishing
House.
2) Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th
edition, 2010.
3) Hal R. Varian, Intermediate Microeconomics, a Modern Approach, 8th
edition, W.W. Norton and Company/Affiliated East-West Press (India),
2010.
4) Kumar, Raj and Gupta, Kuldip (2011) Modern Micro Economics: Analysis
and Applications, UDH Publishing House.
5) Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill
education.
6) Salvatore, D. (8th rd. 2014) Managerial Economics in a Global economy,
Oxford University Press.
7) http://www.learncbse.in/important-questions-for-class-12-economics-
indifference-curve-indifference-map-and-properties-of-indifference-curve/
8) https://www.businesstopia.net/economics/micro/indifference-curve-
analysis-concept-assumption-and-properties
9) https://www.transtutors.com/homework-help/business-
economics/consumer-theory/satisfaction.aspx
10) http://www.statisticalconsultants.co.nz/blog/utility-functions.html
11) https://businessjargons.com/budget-line.html
123
Theory of 12) http://www.shareyouressays.com/knowledge/8-most-important-properties-
Consumer of-a-budget-line/115699
Behaviour
13) {http://www.econmentor.com/microeconomics-hs/consumers/price-
change-and-the-budget-line/text/772.html#Price change and the budget
line}
14) http://www.learncbse.in/important-questions-for-class-12-economics-
budget-setbudget-line-and-consumer-equilibrium-through-indifference-
curve-analysis-or-ordinal-approach/
15) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/notes-on-
convex-indifference-curves-and-corner-equilibrium/1018
16) https://en.wikipedia.org/wiki/lncome%E2%80%93consumption curve
17) http://www.vourarticlelibrarv.com/economics/income-effect-substitution-
effect-and-price-effect-on-goods-economics/10757
18) http://www.economicsdiscussion.net/indifference-curves/measuring-the-
substitution-effect-top-2-methods-with-diagram/18290
19) http://www.vourarticlelibrarv.com/economics/income-effect-substitution-
effect-and-price-effect-on-goods-economics/10757
20) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/price-
demand-relationship-normal-inferior-and-giffen-goods/1069
21) http://www.vourarticlelibrary.com/economics/the-slutskv-substitution-
effect-explained/36663
22) http://www.economicsdiscussion.net/cardinal-utilitv-analysis/how-to-
derive-individuals-demand-curve-from-indifference-curve-analysis-with-
diagram/1076

5.14 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Study Section 5.4 and answer
2) Study Sub-section 5.3.4 and answer
3) Indifference curve is convex to origin because of diminishing marginal
rate of substitution.
Check Your Progress 2
1) Study Section 5.5 and answer
2) Study Section 5.6 and answer
Check Your Progress 3
1) Study Section 5.9 and answer
2) Study Section 5.9 and answer
Check Your Progress 4
1) Study Section 5.10 and answer
2) Study Section 5.11 and answer
124
UNIT 6 PRODUCTION WITH ONE
VARIABLE INPUT
Structure
6.0 Objectives
6.1 Introduction
6.2 Total, Average and Marginal Products
6.3 Total, Average and Marginal Product Curves
6.4 The Law of Variable Proportions: Returns to a Factor
6.4.1 The Three Stages of Production
6.4.2 Explanation of Increasing Returns
6.4.3 Explanation of Constant Returns
6.4.4 Explanation of Diminishing Returns

6.5 Let Us Sum Up

6.6 References
6.7 Answers or Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit, you will be able to :
• state the concept of total product, average product and marginal product;

• explain the nature and relationship of total, average and marginal product
curves;
• analyse the operation of the law of variable proportions; and
• identify the three stages of production.

6.1 INTRODUCTION
For the purpose of production, we require a combination of various inputs or
factors of productions. It is only with the joint efforts of these inputs (like
labour, machines, land, raw materials etc.) that output is produced. Normally,
production is carried out under conditions of variable proportions which
implies that the rate of input quantities may vary. Fixed proportions production
means that there is only one ratio of inputs that can be used to produce a good.
For example, only one driver can work one truck. In this case, the ratio of
driver and truck is technologically determined and is fixed. It is beyond the
capabilities of the producer to change it. However, the ratio of land and labour
in agriculture can be changed and is thus regarded as variable. In the short run,
not all inputs are variable. In the long run, however, all inputs are variable and
the ratio of inputs may also vary. This is the case of technological Progress. In
this unit, we shall focus only on short run production. In the short run, for the

*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi. 127
Production purpose of analysis, it is often assumed that only one input is variable and all
and Costs other inputs are fixed. We shall follow this convention.

6.2 TOTAL, AVERAGE AND MARGINAL

PRODUCTS
At the outset we shall explain the concept of total, average and marginal
products. The short run production function, whether it is shown as a table, a
graph or as a mathematical equation, gives the total output obtainable from
different quantities of the variable inputs given a specified amount of the fixed
input. Let us now consider the case in which capital is fixed, but labour is
variable, so that the firm can produce more output by increasing the labour
input. For example, consider a firm manufacturing garments. It has a fixed
amount of equipment, but it can hire more or less labour to operate the
machines. For decision making, the firm’s manager (or owner) must know how
the amount of total output or product (Q) increases (if at all) as the labour input
(L) increases. Table 6.1 provides this information about the production
function.
Table 6.1 shows the output that can be produced with different amounts of
labour and with capital fixed at 5 units. The first column shows the fixed
amount of capital, the second shows the amounts of labour from zero to 10
units and the third shows total product or output. From the table, it is clear that
when labour input is zero, output is zero because capital alone cannot produce
anything. Then, upto a labour input of seven units output increases first at an
increasing rate and then at a decreasing rate in response to increased use of
labour. The eighth unit of labour input does not raise output. Whether firm
applies 7 or 8 units of labour input to a fixed amount of capital input, total
output remains 224 units. Beyond this point using more units of labour input is
counter productive because output declines as use of labour is increased.
Table 6.1: Production with One Variable Input

Amount Amount of Total Average Marginal

of Capital Labour Product or Product Product
(K) (L) Output (Q) (Q/L) (∆Q/∆L)
5 0 0 -- --
5 1 20 20 20
5 2 60 30 40
5 3 120 40 60
5 4 160 40 40
5 5 190 38 30
5 6 216 36 26
5 7 224 32 8
5 8 224 28 0
5 9 216 24 -8
5 10 200 20 -16
Although the figures provided in Table 6.1 are hypothetical, the general
relationship they indicate is common. To examine the relationship further, we
128 introduce the concepts of average product and marginal product of an input.
The average product (or average physical product) of an input can be Production with One
defined as total output (or total product) divided by the amount of input Variable Input
used to produce that output. For example, 4 units of labour input produce
160 units of output, so the average product of labour is 40 units of output per
worker at that level of employment. In a more general way, we may express
•
APL =
•

where, APL = average product of labour

Q = total output or total product
L = amount of labour
The fourth column in Table 6.1 shows the average product of labour (APL).
The average product for each quantity of labour is derived by dividing total
output shown in column 3 by corresponding amount of labour in column 2 that
produces each output level. In our illustration, the average product of labour
increases initially but when labour input exceeds 4 units, it tends to fall.
The marginal product (or marginal physical product) of an input is
defined as the change in total output due to a unit change in the use of an
input while quantities of other inputs are held constant. For example, with
capital fixed at 5 units when the amount of labour increase from 3 to 4 units,
total output rises from 120 to 160 units or by 40 units. So the marginal product
of labour, when fourth unit of labour input is employed, is 40 units of output.
We may thus generalise,
•
MPL= •

where, MPL = Marginal product of labour

∆Q = Change in output
∆L = Change in labour input
In Table 6.1, the fifth column shows the marginal product of labour. It may be
noted that like the average product, the marginal product increases initially and
then falls and finally becomes negative. In the present example, the marginal
product of labour becomes negative when labour input exceeds 8 units. This
happens when the variable input is used too intensively with the fixed input.
The marginal product is greater than average product when average
product is rising, equals average product when average product is at
maximum, and is less than average product when average product is
falling.

This proposition is, in fact, true of all marginal and average relationships.

6.3 TOTAL, AVERAGE AND MARGINAL

PRODUCT CURVES
Fig. 6.1 plots the information provided in Table 6.1 (it has been assumed in
drawing the graphs that both labour input and the product are divisible into
smaller units and thus the relationships are smooth curves rather than discrete
points). The total product curve shown in Fig. 6.1 indicates how the total
129
Production product varies with the quantity of labour input used. As indicated in Table 6.1,
and Costs Fig. 6.1 a also shows that first the total output increases at an increasing rate
upto point E as more labour is used. The point E where total product stops
increasing at an increasing rate and begins increasing at a decreasing rate is
called the point of inflexion. Total product reaches a maximum at 224 units
when 7 units of labour input are used. The use of an additional unit of labour
input at this stage does not lead to any increase in total product. Beyond this
point, further use of labour input results in a fall in total product.
That portion of total product curve (TP) is shown by dashed segment which
indicates a decline in output as a result of increased employment of labour. In
Fig. 6.1 a when labour input is expanded beyond eighth unit, output falls which
means that production is not technically efficient and is thus not a part of the
production function.
Fig. 6.1 b shows the average and marginal product curves for labour. (The
units of the vertical axis have been changed from output per period of time to
output per unit of labour). Hence, average product and marginal product curves
measure the output per unit of labour. It may be noted that as the use of labour
input increases, initially the marginal product of labour increases, reaches a
maximum at 3 units of labour, and then declines. The marginal product of
labour in our example becomes zero at 8 units of labour and thereafter turns
negative. However, technical efficiency rules out the possibility of negative
marginal products and is, therefore, not a part of the production function. The
average product of labour also increases initially, reaches a maximum at 4 units
of labour input, and then declines.
Relationship between MP and AP Curves:
Let us now consider the relationship between the marginal and average product
curves. As is true of all marginal and average curves, there are definite
relationships between the marginal and average product curves.
i) When marginal product increases, average product also increases though
at a rate lower than that of the marginal product. It is important to note in
this context that even when marginal product starts declining but remains
greater than the average product, the latter shows a tendency to increase.
ii) When the average product is maximum, the marginal product is equal to
it. This is the reason why the marginal product curve intersects the
average product curve at its highest point.
iii) Beyond this point, when the marginal product declines, it also pulls down
the average product. However, the rate of decline in the average product
is less than that of the marginal product.
Relationship between TP and MP Curves
The relationship between the total product curve and the marginal product
curve can be stated as under:
i) As long as marginal product is positive, total product curve will continue
to rise.

130
 Production with One
Variable Input

Fig 6.1: Production with one variable input (labour). In the upper part of the figure, the
total product curve (TP) of labour is shown. The lower part of the figure shows how
average product curve (AP) of labour and marginal product curve (MP) of labour are
obtained with the help of information contained in the upper part

ii) When marginal product is zero, total product curve reaches its highest
point. It may be noted that when eighth unit of labour input is employed,
marginal product of labour becomes zero and total product is at the
maximum.
iii) Thereafter, marginal product of labour is negative and total product curve
has a downward slope which means that total product falls.
Check Your Progress 1
1) Indicate the following statement as true (T) or false (F):
i) The marginal product is greater than average product when average
product is falling.
ii) As long as marginal product is rising, total product curve will
continue to rise.
2) Discuss the relationship between the marginal and average product
curves.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
131
Production
and Costs
6.4 THE LAW OF VARIABLE PROPORTIONS:
RETURNS TO A FACTOR
Knowledge regarding the conditions of production reveals that as more and
more of some input is employed, all other input quantities being held constant,
normally marginal and average product (of the variable input) increase upto a
point. Thereafter, marginal product starts declining and this pulls down the
average product also. In the production process generally land, capital
equipment and buildings remain fixed in the short run while quantities of
labour and raw materials can be conveniently varied. However, we may
consider a case where amount of capital is fixed and the quantity of labour is
increased.
i) In this case, initially the marginal product of labour will increase as its
amount is increased and the marginal product will also pull up average
product with it. In this situation, total product increases at an increasing
rate.
ii) If the variable input, say, labour is further increased, marginal product
stops increasing after a point. Therefore, the rate of increase of total
product also shows a tendency to fall.
iii) Ultimately marginal product turns negative and this causes a fall in total
product itself.
Since in the short run, changes in technology are ruled out, the tendency of
marginal product to decline after a point is inevitable. This statement of trends
in marginal product in response to changes in the quantities of a variable factor
applied to a given quantity of a fixed factor is called the law of diminishing
returns. It is also called the law of variable proportions because it predicts the
consequences of varying the proportions in which factors of production are
used. we can sum up the law of variable proportions as follows:
“As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point the
resulting increments of product will decrease, i.e, the marginal product
will diminish.”
The law of variable proportions can be easily followed with the help of Table
6.1 and Fig. 6.1 which has been drawn on the basis of illustration given in
Table 6.1. In Table 6.1, it has been assumed that capital is a fixed factor and its
quantity remains unchanged at 5 units. Labour is the variable factor and its
quantity increases from 1 to 10. It can be seen from Table 6.1.
i) As the amount of labour employed increases, the total output also
increases until the seventh unit of labour is employed. Initially the
increase in output takes place at an increasing rate because marginal
product rises. This tendency is observed upto the point E where marginal
product reaches a maximum. At point E, which is the point of inflexion,
the rate of increase in total product switches from increasing to
decreasing because marginal product begins to diminish. However,
average product continues to increase until it reaches a maximum at point
F on total product curve (point J on average product curve).
ii) When the amount of labour is further expanded, total product continues
to increase though at a diminishing rate. Both marginal product and
132
 average product remain positive, but both continue to diminish. Production with One
Eventually, total product reaches a maximum at point G and the marginal Variable Input
product becomes zero (note point K in Fig. 6.1 b). The average product,
however, remains positive but continues to diminish.
iii) Any attempt to increase output beyond this point by employing more
units of labour will not be fruitful. In fact, it will be counter-productive
because marginal product is negative which implies that total product
diminishes.
Product curves such as the one shown in Fig. 6.1 are general representations of
production function with fixed and variable inputs. To illustrate particular
instances, similar product curves could be drawn, though each different from
others in some way. The stage of increasing marginal product may be long or
brief or can be totally absent. Moreover, when marginal product diminishes,
the rate at which it happens may be different in each case. Table 6.2 sums up
the law of variable proportions.
Table 6.2: Properties of Product Curves

Marginal Average
Total Product Figure 6.1
Product Product
Stage I
first increases at Increases Increases to point E
increasing rate

then rate of reaches a continues at points E and H

increase changes maximum, and increasing
from increasing then starts
to diminishing diminishing
Stage II
continues to continues reaches a at points F and J
increase at diminishing maximum where
diminishing rate it equals MP and
then starts
diminishing

reaches a
maximum and continues
diminishing at points G and
then starts
becomes zero K
diminishing
Stage III
diminishes is negative continues to right of points
diminishing J and K

6.4.1 The Three Stages of Production

Normally when the amount of a variable input is expanded, the marginal
product first rises and then falls and the product curves have the shapes shown
in Fig. 6.1. Conventionally, these product curves are partitioned into three
regions, shown as Stages I, II and III in Fig. 6.1.

133
Production Stage I is characterised particularly by the rising average product. In our
and Costs example, Stage I occurs when labour is employed from 1 to 4 units. In Stage 1,
total product first increases at an increasing rate and thus marginal product
rises. It reaches a maximum at labour input of 3 units. When fourth unit of
labour input is employed, diminishing returns set in implying that total product
increases at a diminishing rate and the marginal product falls.
In Stage II, total product increases at a diminishing rate and thus both marginal
product and average product decline. Marginal product being below the
average product, pulls the latter down. The right-hand boundary of Stage II is
at maximum total product where marginal product reaches zero. In our
example, Stage II ranges from 4 to 8 units of labour.
In Stage III, total product falls and marginal product is negative. In our
example, stage III occurs when labour is employed in excess of 8 units.
Actual Stage of Operation
The rational producer will operate in Stage II. It is not difficult to follow why
production will not be done in Stage III. In Stage III, less output is produced by
using more of the variable input which means that production costs would be
higher in Stage III than they were in Stage II. Obviously, any rational producer
will always avoid such inefficiencies in the use of production inputs.
In Stage I, average product of the variable input is increasing. Therefore, if the
amount of variable input is doubled, the output more than doubles and the unit
cost of producing output decreases. If a firm is operating in a competitive
market, it would avoid producing in this stage because by expanding output it
reduces the unit costs while the price it receives remains same for each
additional unit sold. This means that total profits increase if production is
expanded beyond the region of rising average product.
To sum up we can say: Initially, the variable factor-labour is not able to use all
the capacities of the fixed factor, hence MP and AP remain low. For instance,
one worker may not be able to make full use of the potential of a one hectare
plot of land. But two workers, together are is a better position to work on that
field. Hence rise in MP as Labour increases from 1 to 2.
Thus, any rational producer will operate in the second stage only when the law
of diminishing marginal return operates. This is why the law of variable
proportions is also called the Law of Diminishing Marginal Returns to a factor.

6.4.2 Explanation of Increasing Returns

According to modern economists, when in the initial stage of production
quantity of the variable factor is increased, the tendency of increasing returns
in production operates. The classical economists had also observed this
tendency and had termed it as the Law of Increasing Returns. However, they
felt that this law operated only in manufacturing industries. As against this, the
modern economists believe that this law can operate in any area of economic
activity. Below we give the views of Marshall (representing the former
position) and Joan Robinson (representing the latter position) in this regard.
Marshall opined that the tendency of increasing returns operates only in the
manufacturing industries. He believed that when the quantity of labour and
capital employed in the manufacturing industries is increased, the scale of
134
production expands and this leads to a better organisation of production. In Production with One
Marshall’s own words: Variable Input

“An increase in labour and capital leads generally to improved

organisation, which increases the efficiency of the work of labour and
capital... Therefore, in those industries which are not engaged in raising
raw produce, an increase in labour and capital generally gives a return
increased more than in proportion.”

Joan Robinson’s explanation of the tendency of increasing returns is more

scientific. She states:

“When an increased amount of any factor of production is devoted to a

certain use, it is often the case that improvements in organisation can be
introduced which will make natural units of the factor (men, acres or
money capital) more efficient, so that an increase in output does not
require a proportionate increase in the physical amount of the factors.”
From the above statement of Joan Robinson, it is clear that:
1) The tendency of increasing returns operates not only in manufacturing
industries but in all productive activities. Limiting the application of this
tendency to manufacturing industries alone is wrong.
2) The tendency of increasing returns comes into operation because the
efficiency of the factors of production is improved.
Let us now examine in detail why the tendency of increasing returns operates.
1) Optimum combination of factors of production: According to Joan
Robinson, full exploitation of some indivisible factors of production is
not possible until increased quantities of some other factors of production
are employed. Therefore, when the producer engages a small quantity of
different factors of production, an optimum proportion among them is not
established and the level of production remains low. When he increases
the quantities of those factors of production, which were employed less
(in relation to the requirements of optimum production), marginal product
increases till the point is reached where the factors are combined in
optimum proportion. Naturally, at this point, output level is the
maximum.
2) Large size of fixed factors: When the size of the fixed factors used for
producing a given good is very large while the quantity of the variable
factor used is very small, the level of efficiency remains very low. As
more and more quantities of the variable factors are employed, marginal
productivity increases (since the level of efficiency increases). For
example, if only one person is working on a ten hectare plot of land, his
productivity will be very low. As the number of workers increases,
division of labour and specialisation will lead to increasing returns as
marginal product will rise rapidly.

6.4.3 Explanation of Constant Returns

If even on continuously increasing the quantity of variable factors of
production in a firm, the marginal product neither increases nor decreases but
135
Production remains constant, the tendency of constant returns is in operation. In fact, there
and Costs is no industry in which increase in the quantity of variable factors of
production yields constant returns permanently. According to Marshall, “if the
actions of the law of increasing and diminishing returns are balanced, we have
the law of constant returns.”
Marshall feels that the operation of the law of constant returns is very limited.
According to him, this law can operate only when there is a balance between
the tendencies of increasing returns and diminishing returns. However, modern
economists regard the area of operation of constant returns as fairly large.
According to them, tendency of constant returns is generally found to operate
before the tendency of diminishing returns sets in. In no field of productive
activity increasing returns are obtained forever. Whether it is agriculture,
manufacturing, industry or any other productive activity, the tendency of
increasing returns can operate only up to a certain limit. After this limit is
reached, constant returns operate for some time. From the point of view of the
producer, this is an important stage because it exhibits an optimum
combination of the factors of production. In this stage, marginal cost is the
minimum. This is due to two reasons. First, the stage of constant returns is
reached only when the tendency of increasing returns comes to an end so that
there is no possibility of a further decline in marginal cost. Second, after the
stage of constant returns, the stage of diminishing returns sets in. Therefore, the
stage of constant returns is very significant from the point of view of the
producers.

6.4.4 Explanation of Diminishing Returns

The diminishing returns stage is the most important of the three stages of the
law of variable proportions. In Economics, the explanation of the law of
diminishing returns is presented in two ways. The classical economists
believed that this law applies only to agriculture. Basically accepting this
position of the classical economists, the neo-classical economist Marshall had
stated, “We say broadly that while the part which nature plays in production
shows a tendency of diminishing returns, that part which man plays shows a
tendency of increasing returns.”
Modern economists like Joan Robinson, Stigler, etc. constitute the second
category of economists. These economists regard the law of diminishing
returns of far greater applicability than the classical economists. According to
them, this law operates in all areas of productive activity.
Marshall had argued that this law operated only in agriculture. Therefore, he
discussed it only in reference to agriculture. According to him,
“An increase in the capital and labour applied in the cultivation of land
causes in general a less than proportionate increase in the amount of
produce raised unless it happens to coincide with an improvement in
the arts of agriculture.”
The implication is that when land is kept fixed in agriculture while the quantity
of labour and capital applied on that land is increased, total production
increases but not in the same proportion as the factors of production are
increased. It increases by a lesser proportion. For example, if an agriculturist
doubles the amount of labour and capital employed on a fixed plot of land, the
total production will undoubtedly increase but it will not double itself. Due to
136
this reason agriculturists do not consider it profitable to continuously increase Production with One
the application of other factors of production on their fixed plots of land. They Variable Input
know from their experience that unless there is some improvement in
agricultural techniques, increased application of labour and capital on a fixed
quantity of land leads to a situation of continuously declining marginal
product.
Marshall has accepted two limitations of the law of diminishing returns as
applied to agriculture:
1) The law generally operates in agriculture: Marshall was aware of the
fact that the law of diminishing returns does not always operate in
agriculture (hence the qualification that it generally operates in
agriculture). In some cases when the agriculturist applies the first unit of
labour and capital on his fixed plot of land, the fertility of the soil is not
properly exploited. Accordingly, the level of production remains low.
When the second unit of labour and capital is applied, output increases in
a greater proportion. However, this tendency does not remain for long
because the agriculturist soon finds that additional units of labour and
capital start yielding a lower and lower marginal product. On account of
the above reasons, Marshall was careful in pointing out that the law of
diminishing returns operates generally in agriculture. However, in certain
exceptional cases, it may not operate.
2) There should be no improvement in agricultural techniques: The
law of diminishing returns operates only if there is no improvement in
agricultural techniques. It is a law of static agriculture. If the agriculturist
is able to expand irrigation facilities on his land, or make use of better
seeds, better agricultural implements, more fertilisers, etc. or use new
scientific methods in production, he can stall the operation of this law.
Generally, an improvement in agricultural techniques leads to a more
than proportionate increase in output corresponding to an increase in
labour and capital.
As against the view of Marshall, modern economists like Joan Robinson,
Stigler and Boulding regard the law of diminishing returns as more pervasive
and universal. According to these economists, this law operates in all branches
of productive activity. Accordingly, they have presented this law in a general
fashion as would be clear from the definition of this law presented by Joan
Robinson:

“The Law of Diminishing Returns, as it is usually formulated, states

that, with fixed amount of any one factor of production, successive
increases in the amount of other factors will after a point yield a
diminishing increment of the product.”
From the above definition of the law by Joan Robinson, it is clear that she
regards this law as of universal value and does not restrict its application to
agriculture alone. According to her, this law operates in all branches of
productive activity and the principal reason behind the operation of this law is
that the optimum proportion between different factors of production breaks
down sooner or later.
The law of diminishing returns is a logical necessity. When in any productive
activity, the quantity of the variable factors of production employed with given
137
Production quantity of fixed factor of production is increased, the law of diminishing
and Costs returns sets in after the point of optimum proportion has been reached.
Initially, application of variable factors was sub-optional, given the size of
fixed factor. Later, the expansion in use of variable factors leads to sub-
optimality of a different kind: each doze or unit of variable factors have sub-
optional quantity of fixed factor to work on.
Another important reason for the operation of the law of diminishing returns is
that one factor of production (out of the various factors of production) is used
in a fixed quantity. Had all the factors of production been available in
abundance and had it been possible to increase their use in production to all
conceivable limits, the law of diminishing returns would not operate. However,
all factors of production land, labour, capital, enterprise, organisation, etc. are
scarce and often the supply of one of these is taken to be fixed. It is this factor
that results in diminishing returns.
Check Your Progress 2
1) Indicate the following statement as true (T) or false (F):
i) In statge II of production, both marginal product and average
product decline.
ii) In stage III of production, marginal product is negative.
iii) The law of diminishing returns operates only in agriculture.
2) State the law of diminishing marginal returns. There is a provision to the
law that other things be held constant. What are these things?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Explain the three stages of production. Why should a rational producer
under competitive conditions produce in stage II?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the (i) law of increasing returns, (ii) law of constant returns.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

6.5 LET US SUM UP

In this unit we have focused on short run production assuming that only one
input is variable and all other inputs are fixed. We then define total product,
138 average product of an input and the marginal product of an input. We note that
total product in the case of production with one variable input first increases at Production with One
an increasing rate as the amount of variable input expands and then switches to Variable Input
increasing with decreasing rate. Having reached a maximum, it eventually
declines. We then explain the law of variable proportions. Conventionally the
product curves drawn to depict the law of variable proportion are partitioned
into three stages. In stage I, average product increase throughout, in stage II
marginal product from the point where it equals average product falls
throughout but remains positive; and in stage III total product fall and marginal
product is negative. The diminishing returns stage is the most important of the
three stages of the law of variable proportions.

6.6 REFERENCES
1) Robert S.P rindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh edition, 2009), Chapter 5,
Section 5.1.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth edition, 2010), Chapter 7, Section 6.2.
3) A.Kontsoyianmis, Modern Microeconomics (The Macmillan Press Ltd.,
Second Edition, 1982/, Chapter 3.
4) John P Gould and Edward P Lazar, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 6.

6.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (i) (F); (ii) (T)
2) See Section 6.3
Check Your Progress 2
1) (i) F; (ii) (T); (iii) (F)
2) See Sub-section 6.4.4
3) See Sub-section 6.4.1
4) See Sub-section 6.4.2. for law of increasing returns and Sub-section 6.4.3
for law of constant returns.

139
 UNIT 7 PRODUCTION WITH TWO
AND MORE VARIABLE
INPUTS
Structure
7.0 Objectives
7.1 Introduction
7.2 Production Function: The Concept
7.3 Production Function with two Variable Inputs
7.3.1 Definition of Isoquants
7.3.2 Types of Isoquants
7.3.3 Assumptions of Isoquants
7.3.4 Properties of Isoquants

7.4 Economic Region of Production and Ridge Lines

7.5 The Optimal Combination of Factors and Producer’s Equilibrium
7.5.1 Input Prices and Isocost Lines
7.5.2 Maximisation of Output for a Given Cost
7.5.3 Minimisation of Cost for a Given Level of Output

7.6 The Expansion Path

7.6.1 Optimal Expansion Path in the Long Run
7.6.2 Optimal Expansion Path in the Short Run

7.7 Production Function with Several Variable Inputs

7.7.1 Increasing Returns to Scale
7.7.2 Constant Returns to Scale
7.7.3 Diminishing Returns to Scale

7.8 Economies and Diseconomies of Scale

7.8.1 Internal Economics of Scale
7.8.2 Internal Diseconomies of Scale
7.8.3 External Economics of Scale
7.8.4 External Diseconomies of Scale

7.9 Let Us Sum Up

7.10 References
7.11 Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you should be able to:
• know the meaning and nature of isoquants;
• identify the economic region in which production is bound to take place;

140 *Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi.
• find out the level at which output will be maximised subject to a given Production with
cost; Two and More
Variable Inputs
• for a given level of output, find the point on the isoquant where cost will
be minimised;
• describe the nature of optimal expansion path both in long run and short
run;
• state to concept of returns to scale; and
• discuss the concept of economies and diseconomies of the scale.

7.1 INTRODUCTION
How do firms combine inputs such as capital, labour and raw materials to
produce goods and services in a way that minimises the cost of production is
an important issue in the principles of microeconomics. Firms can turn inputs
into outputs in a variety of ways using various combinations of labour, capital
and materials. Broadly there can be three ways:
1) by making change in one input or factor of production.
2) by making change in two factors of production.
3) by making change in more than two or more inputs /factor of production.
The nature and characteristics of production function of a firm under the
assumption that firm makes variation in one input has been discussed in
previous unit. Here we would like to discuss the nature, forms and
characteristics of production function if firm decides to make variation in two
or more inputs.
Let us begin to recapitulate the concept of production function.

7.2 PRODUCTION FUNCTION: THE CONCEPT

The theory of production begins with some prior knowledge of the technical
and/or engineering information. For instance, if a firm has a given quantity of
labour, land and machinery, the level of production will be determined by the
technical and engineering conditions and cannot be predicted by the economist.
The level of production depends on technical conditions. If there is an
improvement in the technique of production, increased output can be obtained
even with the same (fixed) quantity of factors. However, at a given point of
time, there is only one maximum level of output that can be obtained with a
given combination of factors of production. This technical law which expresses
the relationship between factor inputs is termed as production function.
The production function thus describes the laws of production, that is, the
transformation of factor inputs into products (outputs) at any particular period
of time. Further, the production function includes only the technically efficient
methods of production. This is because no rational entrepreneur will use
inefficient methods.
Take the case of a production process which uses two variable inputs say,
labour (L) and capital (K). We can write the production function of this case as
Q = F (L, K)
141
Production This equation relates the quantity of output Q to the quantities of the two
and Costs inputs, labour and capital. A popular production function of such a case in
economics is Cobb Douglas production function which is given as
Q=••• • •
A special class of this production functions is linear homogenous production
function which states that when all inputs are expanded in the same
proportion, output expands in that proportion. The form of Cobb-Douglas
production function becomes
Q=••• • !•

i.e. β= 1 – α
Here we can see that when labour and capital are increased λ times, output Q
also increased λ times as
•( !)" ( #)$%" =A[ "&($%") "
! # $%" ]=λ[•!" # $%" ]=λQ

7.3 PRODUCTION FUNCITON WITH TWO

VARIABLE INPUTS
The behaviour of the production function of a firm which makes use of two
variable inputs or factors of production is analysed by using the concept of
isoquants or iso product curves. Hence, let us understand the concept of
isoquants.
7.3.1 Definition of Isoquants
An isoquant is the locus of all the combinations of two factors of production
that yield the same level of output.
Let us understand the concept of an isoquant with the help of an example.
Suppose a firm wants to produce 100 units of commodity X and for that
purpose can use any one of the six processes indicated in Table 7.1.
Table 7.1: Isoquant Table showing combinations of Labour and Capital
producing 100 Units of X
Process Units of Labour Units of Capital
1 1 10
2 2 7
3 3 5
4 4 4
5 6 3
6 9 2
From Table 7.1, it is clear that all the six processes yield the same level of
output, that is, 100 units of X. The first process is clearly capital-intensive.
Since we assume possibilities of factor substitution, we find that there are five
more processes available to the firm and in each of them factor intensities
differ. The sixth process is the most labour-intensive or the least capital-
intensive. Graphically, we can construct an isoquant conveniently for two
factors of production, say labour and capital. One such isoquant is shown in
Fig. 7.1.
142
 Production with
Two and More
Variable Inputs

Fig. 7.1: This figure shows that at point A, B and C same level of output (=100 units) is
obtained by using different combinations of labour and capital.
Curve p is known as isoquant

7.3.2 Types of Isoquants

Depending upon the degree of substitutability of the factors, Isoquants can
assume three shapes categorised as:
1) Convex isoquant
2) Linear isoquant
3) Input-output isoquant
1) Convex Isoquants: This isoquant take the shape of curve sloping
downward from left to right as shown in Fig. 7.1. The explanation for
assumption of this shape has been given in next section.
2) Linear Isoquant: In case of perfect substitutability of the factors of
production, the isoquant will assume the shape of a straight line sloping
downwards from left to right as shown in Fig. 7.2. In Fig. 7.2 it is shown
that when quantity of labour is increased by RS, the quantity of capital
can be reduced by JK to produce a constant output level, i.e., 50 units of
X. Likewise, on increasing the quantity of labour by ST, it is possible to
reduce the quantity of capital by KL, and on increasing the quantity of
labour by TU, quantity of capital can be reduced by LM for producing 50
units of X. Since in respect of labour RS = ST = TU and in respect of
capital JK = KL = LM, it is clear that a constant quantity of labour
substitutes a constant quantity of capital. It implies that a given
commodity can be produced by using only labour or only capital or by
infinite combinations of labour and capital. In the real world of
production, this seldom happens. Therefore, a linear downward sloping
isoquant can be taken only as an exception.

143
Production
and Costs

Fig. 7.2: In the case of perfect substitutability of factors of production, the isoquant
becomes a straight line and is, therefore, known as linear isoquant

3) Input-Output Isoquant: When factors of production are not substitutes

but complementary, technical coefficients are fixed. This means that
optimum output is obtained only when the factors of production are used
in a fixed proportion. In this situation if a producer uses one factor of
production in excess of what is required by fixed proportion, there will be
no increase in output. In the case of complementarily of factors of
production, the shape of the isoquant is right angled or like the letter ‘L’
as shown in Fig. 7.3. As would be clear from the figure, the isoquant is
formed by two straight lines, one vertical and the other horizontal, and
these two lines are perpendicular to each other. The common point of
these lines is convex to the origin.
This type of isoquant is also called Leontief isoquant after Wassily
Leontief who did pioneer work in the field of input-output analysis.
Input-output isoquant does not imply that by increasing the quantities of
the two factors of production, viz., labour and capital the output will
increase proportionately; it implies only that for producing any quantity
of a commodity, capital and labour must be used in a fixed proportion. In
Fig. 7.3, the slope of isoquant P1 and P2 indicates the capital-labour ratio
has to be maintained for ensuring efficiency in production.
lsoquant Map
The production function shows how output varies as the factor inputs change.
Therefore, there are always a number of isoquants for a producer depicting
levels of production (one isoquant depicting one particular level of production).
Isoquants nearer the point of origin represent relatively lower level of
production. The level of production increases as one moves away from the
origin and goes to higher isoquants. A complete set of isoquants for the
producer is called an isoquant map. One such isoquant map showing four
isoquants is shown in Fig. 7.4.
144
 Production with
Two and More
Variable Inputs

Fig. 7.3: If factors of production can be used only in a fixed proportion, the isoquant is
‘L’ shaped and is known as an input-output isoquant

Fig. 7.4: When a number of isoquants are depicted together, we get an isoquant map

In Fig. 7.4, P• is the highest isoquant and it represents the highest level of
output, i.e., 400 units. P , P! and P" represent lower output levels in that order.
It may, however, be noted that the distance between two isoquants on an
isoquant map does not measure the absolute difference between output levels.
7.3.3 Assumptions of lsoquants
Isoquant analysis is normally based on the following assumptions:
1) There are only two factors or inputs of production. This makes the
geometric exhibition of the concept easy since we can easily draw a
diagram.
2) The factors of production are divisible into small units and can be used in
various proportions.
3) Technical conditions of production are given and it is not possible to
change them at any point of time.
145
Production 4) Given the technical conditions of production, different factors of
and Costs production are used in the most efficient way. If this assumption is
abandoned, then any one combination of the factors of production will
yield a number of different levels of production of which the highest level
obtained would be efficient (and all lower levels of production
inefficient).
7.3.4 Properties of Isoquants
A smooth continuous isoquant that has been adopted in the traditional
economic theory possesses the following characteristics:
1) lsoquants are negatively sloped
2) A higher isoquant represents a larger output
3) No two isoquants intersect or touch each other
4) lsoquants are convex to the origin.
1) lsoquants are negatively sloped
Normally, isoquants slope downwards from left to right implying that they are
negatively sloped. The reason for this characteristic of the isoquant is that
when the quantity of one factor is reduced, the same level of output can be
achieved only when the quantity of the other is increased. This characteristic of
the isoquant, however, assumes that in no case marginal productivity of a
factor will be negative. In a more realistic case when this assumption is
dropped, one may find an isoquant which bends back upon itself or has a
positively sloped segment. in Fig. 7.5, such an isoquant is shown. AB and CD
segments of this isoquant are positively sloped.

Fig. 7.5: Isoquant having positively sloped segments

2) A higher isoquant represents a larger output

A higher isoquant is one that is farther from the point of origin. It represents a
larger output that is obtained by using either the same amount of one factor and
the greater amount of the other factor or the greater amounts of both the
factors. Two isoquants P" and P! have been shown in Fig. 7.6. They depict
output levels of 100 units and 200 units. Obviously, the output level
represented by isoquant P! can be reached only by using more of factor inputs
as compared to the amount of factor inputs required to reach output level
146 represented by isoquant P" .
 Production with
Two and More
Variable Inputs

Fig. 7.6: Two isoquants representing different output levels. A higher isoquant depicts a
higher amount of output
3) No two isoquants intersect or touch each other
Isoquants do not intersect or touch each other because they represent different
levels of output. If, for example, isoquants P" and P! (Fig. 7.7) represent output
levels of 100 and 200 units respectively, their intersection at some point, say A
would mean that two output levels (i.e., 100 and 200 units) will be reached by
using the same amount of capital and labour which is not likely to happen. For
the same reason, no two isoquants will touch each other.

Fig. 7.7: No two isoquants intersect each other because each isoquant depicts a different
level of output

4) lsoquants are convex to the origin

In most production processes the factors of production have substitutability.
Often, labour can be substituted for capital and vice versa. However, the rate at
which one factor of production is substituted for the other in a production
process, that is, the marginal rate of technical substitution (MRTS) often tends
to fall.

147
Production
Marginal rate of technical substitution of factor L for factor K
and Costs
(MRTSL,K) is the quantity of K that is to be reduced on increasing the
quantity of L by one unit for keeping the output level unchanged.

The isoquants are convex to the origin precisely because the marginal rate of
technical substitution tends to fall. Let us explain why this happens with the
help of Fig. 7.8. Here, the isoquant is curve P. Let us suppose that the producer
is at point ‘a’ of the curve. The meaning of this is that he uses OJ units of
capital and OR units of labour to produce 100 units of output. We shall assume
that one unit of labour is OR = RS = ST = TU = UV. Now, if he wants to
increase the amount of labour by RS, and keep the output at 100 units, he must
reduce the use of capital by JK. Similarly, when he increases the amount of
labour by ST, TU and UV, he must reduce the application of capital by KL,
LM and MN respectively if output has to be kept at the same level (i.e., 100
units). It is clear from the figure that JK > KL > LM > MV. In other words, as
additional units of labour are employed it becomes progressively more and
more difficult to substitute labour in place of capital so that lesser and lesser
units of capital can be replaced by additional units of labour. This means that
the marginal rate of technical substitution tends to fall. This is due to the reason
that factors of production are not perfect substitutes for one another. When the
quantity of one factor is reduced, it becomes necessary to increase the quantity
of the other at an increasing rate. For example, let us suppose that in a
particular productive activity two factors of production – labour and capital –
are employed. When the quantity of labour employed is reduced by one unit, it
is possible to undertake the activity by employing one more unit of capital
initially. However, when one more unit of labour is reduced, it might become
necessary to compensate this by employing, say, two units of capital. As the
quantity of labour employed is reduced successively at each stage, we would
require more and more units of capital to compensate for the loss of each
additional unit of labour.

Fig. 7.8: An isoquant is covex from below because the marginal rates of technical
substitution tends to fall

If the factors of production are perfect substitutes, the marginal rate of

technical substitution between them would be constant and the isoquant will be
148 linear and sloping downwards from left, to right as in Fig. 7.2. In the case of
strict complementarity, that is, zero substitutability of the factors of production Production with
the isoquant will be right angled or we may say that it will assume the shape of Two and More
‘L’ as in Fig. 7.3. However, the linear and right angled isoquants are the Variable Inputs
limiting cases in the production processes.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) In case of perfect substitability of the factors of production,
the isoquant is convex from below. ( )
ii) Isoquants are positively sloped. ( )
iii) A higher isoquant represents a larger output. ( )
iv) No two isoquants intersect each other. ( )
2) Define isoquant. Discuss its properties.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Draw the possible shapes which the isoquants may assume depending on
the degree of substitutability.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

7.4 ECONOMIC REGION OF PRODUCTION AND

RIDGE LINES
Generally, production functions generate isoquants which are convex to the
origin, negatively sloped throughout, do not intersect each other and the higher
the isoquants, greater the level of output. However, there are some production
functions which yield isoquants having all the properties of a normal isoquant
except that they are not negatively sloped throughout. In other words, they
have positively sloped segments. In Fig. 7.9, the production function is
depicted in the form of a set of isoquants which have positively sloped
segments.
Let us consider isoquant P• . AB segment of this isoquant has a negative slope.
Beyond points A and B, this isoquant is positively sloped. Similarly, other
isoquants have the points where they bend back upon themselves implying that
they become positively sloped. The lines OK and OL joining these points are
called ridge lines. They form the boundaries for the economic region of
production. A careful interpretation of any of the isquants in Fig. 7.9 will make
this point clear.
Suppose the output represented by isoquant P• is to be produced. For producing
this quantity, a minimum of OK amount of capital is required because any
smaller amount will not allow the producer to attain the P• level of output.
With OK amount of capital, OL amount of labour must be employed. In case
the producer uses an amount of labour less than OL together with OK amount 149
Production of capital, his output level would be lower than the one represented by isoquant
and Costs P• . This is quite normal, because use of inputs in smaller amounts would yield
a smaller output. But combining labour input in an amount larger than OL
with OK amount of capital would also result in output smaller than that is
represented by the isoquant P• . In order to maintain the P• level of output with
a larger labour input, capital input also in a larger amount has to be used.
Obviously, this is something which no rational producer would attempt
because it involves uneconomic use of resources.

Fig. 7.9: Area enclosed within the upper side line OK and the lower side lint OL indicates
the economic region of production

Point B on isoquant P• represents the intensive margin for labour because an

increase in the amount of labour input beyond OL with a fixed amount of
capital input OK results in a fall in the output level. At this point, marginal
product of labour is zero and thus the marginal rate of technical substitution of
labour for capital (MRTS!" ) is zero. This implies that at point B labour has
been substituted for capital to the maximum extent. Thus, to the right of ridge
line OL in Fig. 7.9, we have Stage III for labour.
Similarly, for producing P• level of output, a minimum of OL# amount of
labour input is required. A smaller amount of labour input will not allow the
producer to attain P• level of output. With OL# amount of labour, OK# amount
of capital must be used and any additions to capital input beyond OK# would
result in smaller output. Therefore, the marginal product of capital is zero at
point A. This point represents intensive margin for capital because an increase
in the amount of capital input beyond OK# with a fixed labour input of OL#
will reduce rather than augment output. At point A on P• , capital has been
substituted for labour to the maximum extent. Thus, above ridge line OK in
Fig. 7.9, we have Stage III for capital. The marginal rate of technical
substitution of capital for labour (MRTSKL) is zero, which means that the
marginal rate of technical substitution of labour for capital (MRTSKL) is
infinite or undefined.
The line OK in Fig. 7.9 connects the point of zero marginal product of capital.
We have designated it as the upper ridge line. Similarly, the line OL
designated as the lower ridge line joins the points of zero marginal product of
150 labour.
 Production with
The combinations of labour and capital inputs comprising the area Two and More
between ridge lines OK and OL constitute the generalised Stage II of Variable Inputs
production for both resources. These are the combinations that are
relevant for production decisions.

7.5 THE OPTIMAL COMBINATION OF FACTORS

AND PRODUCER’S EQUILIBRIUM
So far, we have explained as to how different combinations of inputs allow a
producer to attain a certain level of output. The producer is free to choose any
of these input combinations. However, his choice cannot be arbitrary if he
wishes to minimise cost of producing a stipulated output. Our task now is to
explain how the producer selects a particular input combination.

7.5.1 Input Prices and Isocost Lines

A producer may attempt maximisation of output subject to a given cost or
alternatively, he may seek to minimise cost subject to a given level of output.
In both cases, for choosing optimum quantities of two inputs, viz., labour and
capital, he must consider their physical productivities as well as their prices.
While isoquants represent the productivities of the inputs, their prices are
shown by isocost lines.

An isocost line represents various combinations of inputs that may be

purchased for a given amount of expenditure; that is, the producer’s
budget.

The firm or the producer has to purchase factors or inputs from the market.
How the prices of labour and capital are determined in the market is not our
present concern. Moreover, the firm is in no position to influesence the input
prices unless it is a monopsonist or oligopsonist. In other words, prices of
labour and capital have to be taken as given by the firm operating in a
competitive factor market. Let us now suppose that the firm’s total cost outlay
on labour and capital is Rs. 1000. The firm is free to spend this entire amount
on labour or capital or it may spend it on a combination of both labour and
capital. In Fig. 7.10, we have shown that if the firm chooses to spent the entire
amount of Rs. 1,000 on labour input, it can employ OL• amount of labour, and
if the entire amount is to be spent on capital, it can get OK • amount of capital.
The straight line K • L• is an isocost line representing all the combinations of
capital and labour which the firm can obtain for Rs. 1,000. In the figure, the
length of OL• is twice the length of OK • which means that the price of a unit of
labour is half that of a unit of capital. The slope of the line K • L• shows the
ratio of input prices. Hence, the slope of an isocost line is (w/r), which is the
ratio of the price of labour (w) to the price of capital (r) when X-axis denotes
labour input and Y-axis denotes capital input. We can thus generalise that for
any isocost line which is always linear because the firm has no control over the
prices of inputs, and the prices remain the same, no matter how much quantity
of these inputs the firm buys,

∆! ! #$%&'()*%+ ,'&-.) #$%&'()*%+ ,'&-.) /

Slope = ∆"
="= $
/ /
= $

151
Production
and Costs

Fig. 7.10: Isocost Lines- A higher cost line indicates a higher cost

This property of an isocost line is similar to that of the budget line of the
consumer. However, there is an important difference between the two lines.
Since the consumer’s budget is invariably fixed, he has a single budget line.
The firm generally has no such constraint and thus has more than one isocost
lines. In Fig. 7.10, we have shown three isocost lines. There can be many more
of them corresponding to firm’s cost outlay plans to attain various output
levels.
An isocost line farther to the right reflects higher costs; the one closer
to the origin reflects lower costs.

7.5.2 Maximisation of Output for a Given Cost

A rational producer is expected to maximise output for a given cost.

Alternatively, he may attempt to minimise cost subject to a given level
of output.

In this section, we shall explain how a producer maximises his output for a
given cost. Suppose the producer’s cost outlay is C and the prices of capital
and labour are r and w respectively. Subject to these cost conditions, the
producer would attempt to attain the maximum output level.
Let KL isocost line in Fig. 7.11 represents the given cost outlay at input prices
r and w. P0 , P• and P1 , are isoquants representing three different levels of
output. It may be noted that P3 level of output is not attainable because the
available factor resources (various labour-capital combinations represented by
isocost line KL) are insufficient to reach that output level. In fact, any output
level beyond isocost line KL is not attainable. The producer, however, can
attain any output level in the region OKL, but that would not require all the
resources (labour and capital inputs) that are available to the producer for his
cost outlay. Therefore, in the case of a given cost, the producer’s attempt
would be to reach the isoquant which represents the maximum output level.
The producer can operate at points such as R and T. At these two points, the
combinations of labour and capital to produce P0 level of output are available
for a given cost represented by isocost line KL. In contrast, at point S, the
combination of labour and capital available for the same cost (as it is also on
isocost line KL) enables the producer to reach isoquant P• which represents an
152
output level higher than that represented by P0 . Since at point S on isoquant P• Production with
is jus tangent to isocost line, a greater output than P• is not obtainable for the Two and More
given level of cost. A lesser output is not efficient because production can be Variable Inputs
raised without incurring additional cost. Hence, the optimal combination of
factors of production, viz., capital and labour is OK • of capital plus OL• labour
as it enables the producer to reach the highest level of production possible
given the cost conditions.

Fig. 7.11: With the given cost line KL, the highest isoquant that a producer can reach is
P2. Point S on this isoquant, therefore, indicates producer’s equilibrium

The above proposition should be obvious to those who have studied the theory
of consumer behaviour. At the same time, the reason that lies behind it must be
followed carefully. Let us suppose that the producer wishes to produce at point
T. The marginal rate of technical substitution of labour for capital indicated by
the slope of tangent AB at point T is relatively high. Suppose ∆K is equal to 3
and ∆L is equal to 1. Thus, the slope of tangent AB is 3:1 which implies that at
point T one unit of labour can replace 3 units of capital. However, the relative
factor price indicated by the slope of KL is less, say, 0.7:1 which means that
the cost of 1 unit of labour is the same as the cost of 0.7 unit of capital.
Therefore, it would be rational on the part of the producer that he substitutes
labour for capital so long as the marginal rate of substitution of labour for
capital is not equal to the factor price ratio, that is, the ratio of the price of
labour to the price of capital. At point R, the opposite situation prevails
because the marginal rate of technical substitution is less than the factor price
ratio.

The producer maximises output for a given cost (reaches equilibrium)

only when the marginal rate of technical substitution of labour for
capital is equal to the ratio of the price of labour to the price of capital.

Thus,
4 678
MRTS23 = 5
=
679

153
Production 7.5.3 Minimisation of Cost for a Given Level of Output
and Costs
If a producer seeks to minimise the cost of producing a given amount of
output rather than maximising output for a stipulated cost, the
condition of his equilibrium remains formally the same. That is, the
marginal rate of technical substitution must be equal to the factor price
ratio.

This can be easily followed graphically. In Fig. 7.12, we have a single isoquant
P which denotes the desired level of output, but there is a set of isocost lines
representing various levels of total cost outlay. An isocost line closer to origin
indicates a lower total cost outlay. The isocost lines are parallel and thus have
the same slope w/r because they have been drawn on the assumption of
constant prices of factors.

Fig. 7.12: To obtain a level of production indicated by isoquant P, the minimum cost that
must be incurred is given by point E on the isocost line K2L2. Therefore, point E indicates
the point of producer’s equilibrium

It may be noted that isocost line K0 L0 is just not relevant because the output
level represented by the isoquant P is not producible by any factor combination
available on this isocost line. However, the P level output can be produced by
the factor combinations represented by the points F and G which are on isocost
line K 1 L1 . Alternatively, the producer can attain the P level output by the
factor combination represented by the point E which is on isocost line K • L• .
Since the isocost line K • L• is closer to the origin as compared to the isocost
line K 1 L1 , it represents relatively lower cost. Therefore, by moving either from
F to E or from G to E, the producer attains the same output level at a lower
cost. The producer thus minimises his costs by employing OB amount of
capital plus OA amount of labour determined by the tangency of the isoquant P
with the isocost line K • L2. Points representing factor combinations below E
are certainly preferable because they represent lower costs but they cannot be
considered as they cannot help in producing the output level represented by the
isoquant P. Points above E represent higher costs. Hence, point E denotes the
least cost combination of the factors, viz., labour and capital for producing
output shown by isoquant P. This discussion thus leads us to the principle that
in the case of producer’s equilibrium, the marginal rate of technical
substitution of labour for capital must be equal to the ratio of the price of
154
labour to the price of capital. We can now sum up the whole discussion as Production with
follows: Two and More
Variable Inputs

1) The optimal combination of factors, whether the producer seeks to

maximise output for a given cost or he wishes to minimise cost for a
stipulated output, is that where marginal rate of technical
substitution and the factor price ratio are equal.
2) The producer is in equilibrium when there is optimal combination
of factors.

7.6 THE EXPANSION PATH

Producers expand their outputs both in the long run and in the short run. In the
long run, output expands with all factors variable, while in the short run,
expansion of output is possible with some factor(s) constant and some others
variable. We shall consider both cases.
7.6.1 Optimal Expansion Path in the Long Run
In the long run, there is no limitation to the expansion of output as all the
factors of production are variable. The firm’s goal being maximisation of its
profits, it seeks to expand outputs in the optimal way. With given factor prices,
the optimal expansion path is the locus of the points of tangency of successive
isocost lines and successive isoquants.
Consider now Fig. 7.13. Given the factor prices, the output corresponding to
isoquant P0 is producible at the lowest cost at point A where isocost line K0 L0
is tangent to the isoquant P0 . This is the initial position of producer
equilibrium. Assuming that factor prices remain constant, suppose the producer
desires to expand output to the level indicated by the isoquant P• . This will
cause a shift in the isocost line from K0 L0 to K • L• . The new equilibrium is
found at point B where isocost line K • L• is tangent to the isoquant P• . Further
expansion in output to the level corresponding to the isoquant P1 will shift
equilibrium to point C where isocost line K 1 L1 is tangent to the isoquant P1 .

Fig. 7.13: Expansion path in the case of non-linear production function

On connecting all points of producer equilibrium, such as A, B and C, we get
the curve OE which is called the expansion path. Since every point of the
expansion path denotes an equilibrium point of the producer, it indicates
155
Production the optimum combination of factors of production of some particular level
and Costs of output. It may be recalled that each point of producer equilibrium is defined
by equality between the marginal rate of technical substitution and the factor
price ratio. Since the latter has been assumed to remain constant, the former
also remains constant. Hence, OE is an isocline along which output expands
when factor prices remain constant.
In the case of linear homogeneous production function, the isoclines are
straight lines through the origin. Therefore, the expansion path will also be a
straight line as shown in Fig. 7.14. This means that given the prices of the
factors of production, the optimal proportion of the inputs of the firm will not
change with the size of the firm’s output or input budget.

Fig. 7.14: Expansion path in the case of linear homogeneous production function is a
straight line

The line formed by connecting the points determined by the tangency

between the successive isoquants and the successive isocost lines is the
firm’s expansion path. It identifies the least costly input combination
for each level of output and will slope upward in the long-run setting.
This means that the firm will expand use of both inputs as it expands its
output.

7.6.2 Optimal Expansion Path in the Short Run

In the short run, capital is a fixed factor and thus its amount remains constant.
Labour is, however, variable and the producer can expand his output by
increasing the amount of labour along a straight line parallel to the axis on
which this factor is measured. In Fig. 7.15, the straight line AB indicates the
expansion path as the total amount of capital is fixed at OA in the short run.
With the prices of the factors of production remaining constant, the firm
cannot maximise its profits while it expands its output in the short run, on
account of the constraint of the fixed amount of capital. This can be
followed from Fig. 7.15. The firm’s initial equilibrium is at point E where
isocost line K0 L0 is tangent to the isoquant P0 . If the firm wishes to raise its
output level corresponding to the isoquant P• , it reaches the point F which,
given the factor prices, is not the least cost situation. Further expansion of
output to the level corresponding to the isoquant P1 leads the firm to reach the
156
point G which again does not represent the least cost situation. The optimal Production with
expansion path would be OR, were it possible for the firm to increase the Two and More
quantity of capital. However, given the amount of capital, the firm has no Variable Inputs
choice but to expand along the straight line AB in the short run.

Fig. 7.15: Expansion path in the short run in the case of linear
homogeneous production function
Check Your Progress 2
1) Indicate the following statements as True (T) or False (F):
i) The condition for optimal combination is that marginal rate of
technical substitution is greater than factor price ratio. ( )
ii) The area between ridge lines constitutes the Stage II of production
for both resources. ( )
iii) An isocost line represents various combinations of input that may
be purchased for a given amount of expenditure. ( )
iv) An isocost line farther to the right reflects higher cost. ( )
v) Every point on the expansion path denotes an equilibrium point of
the producer. ( )
vi) The line formed by connecting the points determined by the
tangancy between the successive isoquants and the successive
iocost lines is the firm’s expansion path. ( )
2) Explain the condition of a producer’s equilibrium.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Suppose that P• = Rs. 10, P = Rs. 20 and TO (total outlay) = Rs. 160.
i) What is the slope of the isocost ?
ii) Write the equation of the isocost?
......................................................................................................................
......................................................................................................................
......................................................................................................................
157
Production
and Costs
7.7 PRODUCITON FUNCTION WITH SEVERAL
VARIBALE INPUTS
When all the factors of production (labour, capital, etc.) are increased in the
conditions of constant techniques, three possibilities arise:
1) Output increases in a greater proportion as compared to the increase in
the factors of production. This is the case of increasing returns to scale.
2) Output increases in the same proportion as the increase in the amount of
the factors of production. This is the case of constant returns to scale.
3) Output increases in a smaller proportion as compared to the increase in
the amounts of the factors of production. This is the case of diminishing
returns to scale.
The concept of returns to scale is associated with the tendency of production
that is observed when the ratio between the factors is kept constant but the
scale is expanded, i.e. use of all the factors is changed in same proportion.

7.7.1 Increasing Returns to Scale

When the ratio between the factors of production is kept fixed and the scale is
expanded, initially output increases in a greater proportion than the increase in
the factors of production.

Fig. 7.16: Increasing Returns to scale output increases in a greater proportion than the
increase in the factors of production

There are main factors which account for increasing returns to scale are given
below:
1) Indivisibility: The most important reason of increasing returns to scale is
the ‘technical and managerial indivisibilities’. The meaning of an
indivisible factor of production is that there is a certain minimum size of
the factor and even if it is large in relation to the size of the output, it has
to be used (i.e., it cannot be divided). For example, even if only 10-15
letters are to be despatched from an office, it would be necessary to keep
158
 a typewriter. It is not possible to purchase only half the typewriter since Production with
only a small number of letters have to be typed daily. We would, Two and More
therefore, say that typewriter is not divisible. In a similar way, plants and Variable Inputs
managerial services in modern factories are not divisible. Accordingly,
when the scale of production is enlarged initially there is no equi-
proportionate increase in the demand for the factors of the production.
2) Specialisation: Chamberlin does not regard indivisibility as an important
cause of ‘increasing returns to scale’. According to him, the main reason
of increasing returns to scale is specialisation. When due to division of
labour, workers are given jobs according to their ability, their
productivity increases while cost declines. According to Donald S.
Watson, acknowledgement of this fact contradicts the assumption that the
ratio of different factors of production remains constant. Accordingly, he
casts doubts whether specialisation can be regarded as leading to
increasing returns to scale. The importance of specialisation can be
accepted only if we assume that although an increase by an equal amount
in quantity of labour and capital employed is necessary for an expansion
in scale, this increase does not mean the doubling or trebling their units
employed but it does mean an increase in their fixed money cost. But this
can lead to technical changes and it is very much possible that increasing
returns emerge not due to an expansion in scale but due to technical
reasons.

7.7.2 Constant Returns to Scale

Increasing returns to scale can be obtained only upto a point. After this point is
reached, expansion of scale only leads to equal proportionate change in output.
Empirical evidence suggests that the phase of constant returns is a fairly long
one and is observed in the case of a number of commodities. In a scientific
sense, constant returns to scale implies that when the quantity of the factors of
production is increased in such a way that the ratio of the factors remains
unchanged, output increases in the same proportion in which the factors are
increased. Such a production function is often called linear homogeneous
production function or homogeneous production function of the first degree.
The phase of constant returns to scale can be understood with the help of Fig.
7.17.

Fig. 7.17: Constant Returns to Scale-output increases in the same proportion in which
inputs are increased
159
Production The question that now arises is what are the reasons which account for constant
and Costs returns to scale. Generally when inefficiencies of production on a small scale
are overcome and no problems regarding technical and managerial
indivisibilities remain, expansion in scale leads to a situation where returns
increase in the same proportion as the factors of production. Some economists
are of the view that when benefits of specialisation of a factor in the unit of
production are small or when such benefits have already been reaped at a small
level of production, then for a considerable period of time, production
increases according to the law of constant returns to scale.
Further if the factors of production are perfectly divisible, the production
function must exhibit constant returns to scale.

7.7.3 Diminishing Returns to Scale

Diminishing returns to scale ensure that the size of the productive firms cannot
be infinitely large. Generally after a limit when the quantity of the factors of
production is increased in such a way that the proportion of the factors remains
unchanged, output increases in a smaller proportion as compared to increases
in the amounts of the factors of production. For example, it may happen that an
increase in amount of labour and capital by 100 per cent leads to an increase in
output by only 75 per cent. In other words, if output has to be doubled, the
factors of production will have to be more than doubled. We can understand
this phenomenon with the help of Fig. 7.18.

Fig. 7.18: Diminishing Returns to Scale – output increases proportionally less than inputs
Economists do not agree on the causes which leads to operation of diminishing
returns to scale. Nevertheless, the two causes that are often mentioned are as
follows:
1) Enterprise: Some economists emphasise that enterprise is a constant and
indivisible factor of production and its supply cannot be increased even in
the long run. Accordingly, when the quantity of other factors is increased
and the scale of production expanded in a bid to boost up production, the
proportion of other factors in relation to enterprise increases. Beyond a
certain point, this results in diminishing returns as enterprise becomes
scarce in relation to other factors.
160
2) Managerial difficulties: According to some other economists, the main Production with
reason for the operation of diminishing returns to scale is managerial Two and More
difficulties. When the scale of production expands, the co-ordination and Variable Inputs
control of different factors of production tends to become weak and
therefore output fails to increase in the same proportion as the factors of
production increase. This results in diminishing returns to scale.

7.8 ECONOMIES AND DISECONOMIES OF

SCALE
Expansion of the scale confers a number of economies on the firm. Some of
these are in ‘real terms’ while others are in ‘pecuniary terms’. Economies that
are obtained in production work, marketing, management, transport, etc. are in
real terms, while economies that are obtained in terms of, say, purchase of
inputs at wholesale rate, availability of finance at lower rate of interest, saving
on advertisement costs, etc. are in money terms. Then, there are certain
economies that do not accrue to the firm whose scale of operation is large but
accrue to certain other firms which benefit from the large scale of this firm.

In Economics, those economies which accrue to a firm on expansion of

its own size are known as internal economies. As against this, those
economies which accrue to a firm not due to its own operations but due
to the operations of other firms are termed external economies.

7.8.1 Internal Economies of Scale

Generally, when the scale of production is sought to be enlarged, the firm
replaces its small plant by a larger plant. This increases the efficiency of
production. However, it is not always necessary to change the plant for
expanding the scale of production. The firm can keep the old plant in a running
condition and either establish a new plant of the same type or a new plant of
some new type. In all these alternatives, the firm obtains many different kinds
of economies. These economics that determine the nature of the long-run
average cost curve are listed below:
1) Real Internal Economies of Scale: When expansion in the scale of
production takes place, the firm obtains some real internal economies.
These economies accrue in the form of saving in the physical quantities
of raw materials, labour, fixed and variable capital, and other inputs.
Broadly speaking, real internal economies are of the following four types:
(1) production economies, (ii) selling or marketing economies, (iii)
managerial economies, and (iv) economies in transport and storage.
2) Pecuniary Internal Economies: Some pure pecuniary economies accrue
to a firm as its scale of operation expands. The more important ones are
the following:
1) A large sized firm can ask the suppliers of raw materials to give
specific concessions and discounts. No raw material supplier
usually ignores such requests (or pressures) of the large firm.
2) Perfect competition generally does not prevail in the capital market.
Since the large companies have greater goodwill in the capital
market, they are in a position to obtain loans on lower rates of
interest from the banks and financial institutions. 161
Production 3) Transport companies are also willing to provide discounts and
and Costs concessions if the cargo is substantially large. This enables the firm
to obtain monetary economies in transport costs by expanding its
scale of operations.
4) When production is large, the firm is required to spend a large
amount on advertising as well. However, advertising on a large
scale attracts discounts and concessions from the media in which
the advertisements appear.

7.8.2 Internal Diseconomies of Scale

If the scale of production is continuously expanded, is it possible that after a
certain point, increase in production is less proportionate than increase in the
factors of production? Many economists believe that such a situation can and
does arise if production is pushed beyond the point of optimum scale. The
reasons that they advance are as follows:
1) Limitations on the availability of factors of production: The factors of
production are always available in limited supply at the place of
production. When the scale of production is increased beyond a certain
point, it no longer remains possible to meet the requirements of some
factors from local sources and, accordingly, factors have to be transported
from other regions. This is generally possible only at higher prices.
2) Problems in management: When the scale of production is very large,
the task of management at the top level becomes increasingly more and
more burdensome and some inefficiency is bound to creep in. At times,
information vital for taking a decision does not reach the top managers of
the company in time. This delay, in turn, leads to a delay in decision
making and increases the per unit cost.
3) Technical factors: When the scale of production is expanded, per unit
cost increases due to a number of technical reasons. The establishment
cost of large and sophisticated plants and machinery is generally high.
The buildings of large factories should also have stronger foundations
and the factory itself must be equipped with coolers, air-conditioners, etc.
All these factors lead to an increase in per unit cost.
7.8.3 External Economies of Scale
External economies were discussed first of all by Alfred Marshall. According
to him, when a firm enters production, it obtains a number of economies for
which the firm’s own production strategy, managerial arrangements, etc. are
not responsible. In fact, these are economies external to the firm. For example,
let us suppose that a firm is established at a place where transport, advertising
facilities, etc. are not available. If the size of the firm remains small, it is
possible that these facilities are not locally available in the future as well.
However, if the size of the firm increases significantly, these facilities will
themselves start coming to the firm. These are, in fact, external economies.
When a firm expands its scale of production, other firms also earn many
economies. For example, when a large factory attracts various factors of
production fairly regularly, many other factories set up in the neighbourhood,
that could not have attracted these factors on their own, also stand to gain.
They obtain these factors at practically the same prices at which the large
factory obtained them.
162
Because of external economies of large-scale production, there is a gap Production with
between private and social returns. When a firm expands its scale of Two and More
production, it becomes possible for the other firms to reduce their cost of Variable Inputs
production. However, there is no method available in the prevalent price
mechanism to the firm expanding its scale of operations to charge for the
benefits it confers on the other firms.

7.8.4 External Diseconomies of Scale

When the scale of operations is expanded, many such diseconomies emerge
that have no particular ill-effect on the firm itself. In fact, their burden falls on
the other firms. On account of this reason, they are termed external
diseconomies. The smoke rising from the chimney of a factory pollutes the
atmosphere. When the firm is of a small size, the pollution is less and its ill-
effects on the people living in colony nearby is limited. However, if the scale
of the firm is large, the smoke will be very dense and can cause serious health
hazard to the people. Similarly, as the scale of production of the factories
increases, employment rises sharply. This creates problems of traffic
congestion and overcrowding in the city where these factories are located.
Check Your Progress 3
1) Indicate the following statements as true (T) or false (F):
i) When output increases in a greater proportion as compared to the
increase in the amount of the factors of productions, we have the
stage of increasing returns to scale.
ii) Those economies which accrue to a firm an account of the other
firms are known as external economies.
iii) Production economies are a part of pecuniary internal economies.
iv) In the case of linear homogenous production function, we have
constant returns to scale.
2) Discuss the factors which account for increasing returns to scale.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by external economies and external diseconomies?
......................................................................................................................
......................................................................................................................
......................................................................................................................

7.9 LET US SUM UP

The unit begins with the concept of production function which referes to
functional relationship between inputs and output. This is followed by the
definition of an isoquant and the explanation of three types of isoquant– (i)
convex isoquant, (ii) linear isoquant, and (iii) input-output isoquant. The
properties of isoquants are: (i) isoquant are negatively sloped (ii) a higher
isoquant represents a larger output, (iii) no two isoquants intersect or touch
163
Production each other, and (iv) isoquants are convex to the origin. From here we proceed
and Costs to a discussion of the concept of the economic region of production and ridge
lines. The next section is devoted to a discussion of the optimum combination
of factors and producer’s equilibrium. In this section, we first consider the
concept of isocost lines and then consider (i) maxmisation of output for a given
cost, and (ii) minimisaton of cost for a given level of output. When the ratio
between the factors is kept constant and several variable inputs are used this
give rise to three possibilities– increasing returns to scale, constant returns to
scale and diminishing returns to scale. Economics of scale are decided into two
parts- internal economies of scale and external economies of scale. Similarly
diseconomies of scale are both internal and external.

7.10 REFERENCES
1) Robert S Pindyck, Daniel L. Rubinfld and Prem L Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2009), Chapter 5,
Section 5.1 and Section 5.3.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth Edition, 2010), Chapter 7, Section 7.1, Section 7.3 and
Section 7.4.
3) A.Koutsoyiannis, Modern Microeconomics (The Macmillan Ltd., Second
edition, 1982). Chapter 3.
4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 7.

7.11 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) i) F) ii) F iii) T iv) T
2) See Sub-section 7.3.1 and 7.3.4
3) See Sub-section 7.3.2
Check Your Progress 2
1) i) F ii) T iii) T iv) T v) T vi) T
2) See-section 7.5.3
3) (i) Slope of isocost is –P• /P• = –2 and the eqution is 160 = 10K + 20L or
16 = K + 2L or K = 16 – 2L
Check Your Progress 3
1) i) T ii) T iii) F iv) T
2) See Sub-section 7.7.1 and answer
3) See Sub-section 7.8.3 and 7.8.4

164
UNIT 8 THE COST OF PORDUCTION
Structure
8.0 Objectives
8.1 Introduction
8.2 The Concept of Costs
8.2.1 Private Costs and Social Costs
8.2.2 Money Cost: Explicit and Implicit Costs
8.2.3 Real Costs
8.2.4 Sunk Cost and Incremental Cost
8.2.5 Economic Cost and Accounting Cost
8.2.6 Historical Cost and Replacement Cost

8.3 Cost Functions: Short-Run and Long-Run

8.3.1 Cost Function and the Time Element
8.3.2 Long-Run Cost Function
8.3.3 Short-Run Cost Function

8.4 Theory of Cost in the Short-Run

8.4.1 Fixed Cost
8.4.2 Variable Cost
8.4.3 Total Fixed Cost
8.4.4 Total Variable Cost
8.4.5 Total Cost
8.5 Short-Run Cost Curves
8.5.1 Average Fixed Cost
8.5.2 Average Variable Cost
8.5.3 Average Total Cost
8.5.4 Marginal Cost
8.5.5 Relationship between Marginal Cost and Average Cost

8.6 Long-Run Cost Curves

8.6.1 Long Period Economic Efficiency
8.6.2 The Long-Run Average Cost Curve
8.6.3 Long-Run Marginal Cost Curve
8.6.4 Relationship between Long-Run Marginal Cost and Short-Run Marginal
Cost

8.7 Let Us Sum Up

8.8 References
8.9 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you should be able to:

• state the various concepts of costs like private cost, social cost, money
cost, sunk cost, economic cost, accounting cost etc.;
*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi. 165
Production • differentiate between short-run and long-run cost functions;
and Costs
• know the difference between fixed cost and variable cost and the nature
of total cost curve;
• explain the concept of average fixed cost, average variable cost, average
total cost and marginal cost and nature of these curves;

• discuss the relationship between marginal cost curve and average cost
curve;
• appreciate the difference between short-run and long-run cost curves; and

• describe the relationship between long-run marginal cost and short-run

marginal cost.

8.1 INTRODUCTION
The decision of a firm regarding production of a good depends on two factors:
First, the demand for the good, and second, the cost of production of the good.
Accordingly, the concept of cost of production is basic to the understanding of
the price theory and requires a thorough discussion. A price taker firm wishes
to maximise its profits will be able to do so if it is able to minimise its costs.
Obviously a firm is interested in minimising what economists call the private
cost. The concept of social cost that is being often referred to in the context of
social welfare is not relevant for the theory of firm. However, it is necessary to
understand the distinction between the concepts of the private cost and the
social cost. In economic analysis, we often distinguish between money cost and
the opportunity cost. From analytical point of view both the concepts are
relevant and thus must be understood carefully. The concept of money cost
may be interpreted from the point of view of an accountant or an economist.
The two approaches differ on the treatment of implicit costs.
After settling these conceptual issues in the theory of costs, one has to analyse
the nature of costs in both the short-run and the long-run. In the short-run since
we have some fixed inputs and some other inputs are variable, one has to draw
the distinction between the fixed costs and the variable costs. However, in the
long-run because the amounts of all the inputs can be varied, all costs are
considered together. Finally, the theory of costs attempts to explain as to how
cost changes occur in response to changes in the size of production. In the last
two units we have discussed the theory of production at some length. This
discussion should help us to understand that the cost changes depend largely on
how changes in production take place as a result of changes in the amounts of
inputs.

8.2 THE CONCEPTS OF COSTS

8.2.1 Private Costs and Social Costs
In microeconomic theory, the concepts of both private cost and social cost are
used. The firm, in its attempt to attain the goal of profit maximisation, is
guided entirely by the private cost considerations. In its decision making, it
ignores all those costs which it may be imposing on others while carrying out
its production programme. However, in welfare studies, together with the
166
firm’s both explicit and implicit costs, all such costs are taken into account The Cost of
which are external to the ‘narrow economy’ of the firm. Production

Private costs: Every firm requires various inputs to produce a good. In order
to secure a command over these inputs, the firm has to pay some price for each
of these inputs. In common parlance, the amount of money so paid is known as
cost. Economists, however, include in the private cost not only the expenditure
incurred by the producer on purchasing (or hiring) of factors of production (or
inputs) from the market, but also the imputed cost of all those services which
the producer himself provides. The private cost of production of any output
may thus be defined as either the purchase or the imputed value of all
productive services used in producing the output and is equivalent to the total
monetary sacrifice of the firm made to secure it.
Generally, economists include the following expenditures in the cost: (i) cost
of the raw materials, (ii) wages of the labourers, (iii) interest payments on
capital loans, (iv) rent of the land and the buildings, (v) repairing costs of
machines and depreciation, (vi) tax payments to the government and local
bodies, (vii) imputed wage payment to the producer for the work performed by
him, (viii) imputed interest payment for the capital invested by the producer
himself, (ix) rent of land and buildings owned by the producer himself and (x)
normal profits of the firm.

This shows that three types of expenditures are included in the private
cost: (i) the purchase price of the factors of production employed in the
production process, (ii) imputed price of the resources provided by the
producer himself, and (iii) normal profits.
Social costs: Social costs differ from private costs on account of two reasons:
First, externalities are not included in private costs. For example, a factory
located in the residential area by polluting the atmosphere will expose the
residents of the colony to various ailments and will thereby raise their medical
expenditures. Though these costs are quite relevant from the point of view of
the society, they will never be considered by the firm as part of its costs.
Secondly, market prices of goods may not reflect their social value and
thus there may be divergence between private and social costs. The
imposition of government taxes, subsidies, and controls of various kinds distort
free market prices. Further, prices of factors of production may overstate or
understate the opportunity cost of using those factors. In heavily populated
countries where widespread disguised unemployment is to be found in the
agricultural sector, the industrial wage often exceeds the opportunity cost of
the labour which is drawn from the agricultural sector. In computing the social
costs, adjusted market prices for goods and factors of production are used.
While the adjusted prices for factors of production are called shadow prices,
the adjusted prices for goods are termed as social prices.

8.2.2 Money Cost: Explicit and Implicit Costs

The concept of the money cost in contrast to the concept of opportunity cost is
simple.

The money cost of production of any output is considered to be

equivalent to the total monetary sacrifice made to obtain that output.
167
Production Thus, costs are not sacrificed alternatives but monetary payments. This
and Costs conception of money cost is rather narrow and is used for accounting purposes.
From the point of view of the economists, this concept of cost is not very
relevant. Since economists wish to study as to how costs affect output choices,
employment decisions, and the like, costs should include imputed value of all
the inputs provided by the producer himself in addition to outright money
expenses. Hence, costs can be classified as explicit costs and implicit costs.
Explicit costs arise from transactions between the firm and other parties in
which the former purchases inputs or services of inputs for carrying out the
production. These costs are usually the costs shown in the accounting
statements and include wage payments, raw materials costs, interest on loans,
payments for insurance, electricity and so on. Implicit costs are the costs
associated with the use of the firm’s own resources. Since these resources will
bring return if employed elsewhere, their imputed values constitute the implicit
costs. Implicit costs are however difficult to measure. Economists nonetheless
assert that they must be taken into account in analysing the activities of a firm.

8.2.3 Real Costs

The concept of real cost was developed by Alfred Marshall. In his opinion, a
worker suffers discomfort while he renders his services for productive
purposes. Similarly, a person makes some sacrifice when he saves his income
and lends it to investors who use it for carrying out production. These
discomforts and sacrifices are in the nature of real costs of production. In
Marshall’s own words, “The exertions of all the different kinds of labour that
are directly or indirectly involved in making it; together with the abstinences or
rather the waitings required, for saving the capital used in making it; all these
efforts and sacrifices together will be called the real costs of the production of
the commodity.”
The concept of real cost is, however, based on subjectivity and cannot be used
for precise measurement of production cost. It is this reason why modern
economists do not consider it to be of much relevance in the price theory. They
admit that most of the labour involves hard work and is definitely unpleasant.
It, therefore, has a heavy real cost. In contrast, the real cost of simple and less
arduous work is generally low. But this fact is not at all relevant from the point
of view of price determination in a free enterprise economy. Moreover, to
modern economists, savings do not involve any sacrifice. Hence, these
economists regard the concept of real cost as inappropriate.

8.2.4 Sunk Cost and Incremental Cost

In economics and business decision-making, a sunk cost is a cost that has
already been incurred and cannot be recovered. Sunk costs (also known as
retrospective costs) are sometimes contrasted with prospective costs, which are
future costs that may be incurred or changed if an action is taken. In traditional
microeconomic theory, only prospective (future) costs are relevant for decision
making. Since sunk costs have already been incurred and cannot be recovered,
therefore they should not influence the rational decision-maker’s choices.
An incremental cost is the increase in total costs resulting from an increase in
production or other activity. For instance, if a company’s total costs increase
from Rs. 5.6 lakh to Rs. 6.0 lakh as a result of increasing its machine hours
from 7,000 to 8,000, the incremental cost of the 1,000 machine hours is Rs.
168 40,000.
8.2.5 Economic Cost and Accounting Cost The Cost of
Production
Economists and accountants view costs from different angles. Accountants are
concerned with the firm’s financial statement and tend to take a retrospective
look at the firm’s finances because they have to keep track of assets and
liabilities and evaluate past performance. Accounting cost includes
depreciation expenses for capital equipment at rates allowed by the tax
authorities.
Economists, on the other hand, are concerned with what cost is expected to be
in the future, and with how the firm might be able to rearrange its resources to
lower its cost and improve its profitability. Thus, they take a forward looking
view and must therefore be concerned with opportunity costs.
As stated earlier, there is a difference regarding the treatment of explicit and
implicit costs as well. Both, the economists and the accountants consider
explicit costs (like payment of wages and salaries, cost of raw material,
property rentals, etc.) because these involve direct payments by a company to
other firms and individuals that it does business with. However, while
economists also take into account the implicit costs, accountants ignore them.
For example, consider the owner of a retail store who manages his own retail
store but does not pay any salary to himself. Since no monetary transaction has
taken place, accountant will not include it in the accounting cost. However, the
economist will include this implicit cost in total cost as the retail store owner
could have earned a competitive salary by working elsewhere (that is, the
implicit cost of the owner will be his opportunity cost).
The treatment of depreciation is also different. When estimating the future
profitability of a business, an economist is concerned with the capital cost of
plant and machinery. This involves not only the explicit cost of buying and the
running of the machinery, but also the cost associated with wear and tear. On
the other hand, accountants use depreciation rates on different assets as
allowed under the tax laws in their cost and profit calculations. These
depreciation rates need not reflect the actual wear and tear of the equipment,
which is likely to vary asset by asset.
The above discussion shows that there are some important differences in the
methods of calculating costs as used by the economists and the accountants.
Accordingly, the calculation of profit will also differ. To illustrate, consider a
retail store owner who has invested Rs. 1,00,000 as equity in a store and
inventory. His monthly sales revenue is Rs. 2,60,000. After deduction of cost
of goods sold, salaries of hired labour, and depreciation of equipment and
buildings, the accounting profit to the store owner is Rs. 25,000 (see Table
8.1).
Table 8.1: Accounting income statement for the Retail-Store Owner
Sales Rs. 2,60,000
Cost of goods sold Rs. 1,80,000
Salaries 30,000
Depreciation expense 25,000 Rs. 2,35,000

Accounting profit Rs. 25,000

169
Production In Table 8.2 we consider the economic statement of profit of the same store.
and Costs The cost of goods sold and salaries remain the same. Let us suppose that the
market values of the equipment and building in fact declined by Rs. 25,000
over the current year and that the depreciation charge, therefore, reflects the
opportunity costs of these resources. Thus, depreciation expense is taken to be
Rs. 25,000 as in Table 8.1. However, the economist will add two items relating
to the implicit cost in the cost of production. Suppose that the owner-manager
could earn Rs. 25,000 per month as a departmental manager in a large store
and that this is his best opportunity for salary. Then we would add
Rs. 25,000 as the imputed salary of the owner-manager to the cost of
production. Similarly, the owner-manager has Rs.1,00,000 equity in the store
and inventory – a sum he could have easily invested elsewhere. Let us suppose
that he could have earned 10 per cent interest on this amount had he invested it
elsewhere. Thus, imputed interest cost on equity will be Rs. 10,000. Thus, as
can be seen from Table 8.2, the total economic costs, or the opportunity costs
of all resources used in the production process will add up to Rs. 2,70,000.
This implies an economic loss of Rs.11,000 to the owner-manager of the store
against the accounting profit of Rs. 25,000 depicted in Table 8.1.
Table 8.2: Economic statement of profit to the Retail-Store Owner
Rs. Rs.
Sale 2,60,000
Cost of goods sold 1, 80,000
Salaries 30,000
Depreciation expense 25,000
Imputed salary to owner-manager 25,000
Imputed interest cost on equity 10,000 2,70,000

Economic Profit -10,0000

In addition to the above differences in the calculation of profits by the

economists and the accountants, it is also important to point out that while for
economists, profits and losses are the driving force, business accounting does
not stop here. Business accounts also include the balance sheet, which is a
picture of financial conditions on a particular date. This statement records what
a firm is worth at a given point of time. On one side of the balance sheet are
recorded the ‘assets’ and on the other side are recorded the ‘liabilities’ and ‘net
worth’. A balance sheet must always balance because net worth is a residual
defined as assets minus liabilities.
The business accounting concepts can be summarised as follows:

1) The income statement shows the flow of sales, cost, and revenue
over the year or accounting period. It measures the flow of money
into and out of the firm over a specified period of time.
2) The balance sheet indicates an instantaneous financial picture or
snapshot. It is like a measure of the stock of water in a lake. The
major items are assets, liabilities and net worth.

170
8.2.6 Historical Cost and Replacement Cost The Cost of
Production
The historical cost is the cost that was actually incurred at the time of
the purchase of an asset. As against this, replacement cost is the cost
that will have to be incurred now to replace that asset (i.e., replacement
cost is the current cost of the new asset of the same type).
These two costs differ because of changes in prices over a period of time.
Naturally, if prices remain unchanged over time, both the costs will be the
same. But this seldom happens. Accordingly, historical cost and replacement
cost of an asset always differ. If the price rises over a period of time,
replacement cost will be higher than the historical cost. On the other hand, if
the price of the asset declines over a period of time, replacement cost will be
lower than the historical cost.
Because of the requirements of tax laws and the laws governing financial
reporting to shareholders, accountants generally express many costs in terms of
the actual or historic costs paid for the resources used in the production process
in accordance with the convention of financial accounts. However, both
economists and accountants agree on the fact that for decision making
purposes, it is not the historical cost that is relevant but the replacement cost.
This is due to the reason that for all decision making purposes, it is the
‘current’ (or the replacement) cost that is important and not the cost that was
incurred some years earlier at the time of the purchase of the asset.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) Externalities are not a part of private cost ( )
ii) Implicit costs are the costs associated with the use of firm’s own
resource ( )
iii) Retrospective costs are relevant for decision making ( )
iv) Accountants tend to take a retrospective look at the firm’s finances
( )
v) Economists are concerned with opportunity costs ( )
vi) The historical cost is the current cost of the new asset of the same
type ( )
2) Explain the difference between explicit cost and implicit cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Distinguish between private cost and social cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
171
Production 4) What is the difference between sunk cost and incremental cost?
and Costs
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Explain the difference between economic cost and accounting cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

8.3 COST FUNCTIONS: SHORT-RUN AND

LONG-RUN
The relationship between product and costs is known as the cost function.
There are two elements in determining the cost function of a firm. First, the
production of the firm, and second, the prices paid by the firm for the factors
used.
In practice, production functions can be of various types. At times, one factor
of production is variable and other factors fixed. It is also possible for some
factors to be variable. On account of this reason, cost function can also be of
various types. In economics, generally two types of cost functions are
considered under the price theory:
i) The short-run cost function, and
ii) The long-run cost function.
Cost functions can be illustrated in diagrammatic forms as cost curves.

8.3.1 Cost Function and the Time Element

To understand the theory of cost, it is necessary to be clear about the meaning
of short-run and long-run. In common usage, these terms may be used for
weeks, months and years but for the economist they indicate conditions of
production and have no reference to the calendar year. Even then, the concept
of time does creep in indirectly when the terms short-run and long-run are
discussed.
Generally, economists regard that period of time as short-run in which some
factors of production are fixed (at least one factor is fixed) and the firm
depends only on the variable factors of production to increase the level of
output. If the firm does not employ the variable factors at all, the output will be
zero in the short-run. However, the maximum quantity of output that can be
produced depends upon the quantity of the fixed factors of production. In the
long-run, all factors are variable and the quantity of the output can be increased
to any limit. For example, in a manufacturing industry the plants, machinery,
building of the factory, etc. are fixed resources in the short-run while the raw
materials, labour, power, etc. are variable. Therefore, to increase the amount of
output in this period, it will become necessary to employ more units of the
172 variable resources in conjunction with the fixed resources. Obviously, the
maximum output that can be obtained in this period will depend to a great The Cost of
extent upon the total quantity of the fixed resources of production. Production

8.3.2 Long-Run Cost Function

In the long-run, total cost is a multivariable function which implies that total
cost is determined by many factors. The long-run cost function may be written
as
C = f(Q, T, Pf)
Where, C = total cost of production
Q = output
T = technology
Pf = prices of the relevant factors of production.
Graphically, the long-run cost function is shown on two dimensional diagram
as C=f(Q), ceteris paribus. With the assumption that the technology and the
prices of relevant factors of production remain constant, the long-run cost
function may be written as
C = f(Q, T̅, P̅f or C = f(Q)
However, the technology and the factor prices need not remain constant. When
these factors change, their effect on cost is shown by a shift of the cost curve. It
is this reason why the factors other than output are known as shift factors.
Theoretically there is no difference between the various factors which
determine the costs, and the distinction we have drawn above between the
output level and other factors determining costs can sometimes be misleading.
However, for showing costs on two dimensional diagrams this distinction has
to be made.

8.3.3 Short-Run Cost Function

In the short-run, in addition to output level, technology and factor prices, the
fixed factors such as capital equipment, land, etc. also determine costs of
production. Therefore, the short-run cost function is written as
C = f (Q, T̅, P̅f, K̅)
Where, K̅ indicates fixed factors. In the discussion on the production function,
it has been stated that in the short-run certain factors like capital equipment,
land, factory building and top managerial staff remain constant. K̅ underlines
the fact of the constancy of the fixed factors. Since the amount of fixed factors
does not change in the short-run under any circumstances, K̅ is not a shift
factor like technology and factor prices.

8.4 THEORY OF COST IN THE SHORT-RUN

The short-run costs of a firm are divided into fixed and variable costs.
Therefore,
TC = TFC + TVC
where, TC = total cost
173
Production TFC = total fixed cost
and Costs
TVC = total variable cost

8.4.1 Fixed Cost

Fixed cost is also known as supplementary cost. While engaging in

productive activity, the producer always has to incur some expenditure
which remains fixed whatever the level of production, so much so that
even if the producer stops production altogether, these costs have to be
incurred.
This is known as fixed cost of production. Interest paid by the producer on the
capital borrowed for purchasing plant and machinery, rent of the factory
building, depreciation of the machinery, the wages of foremen and organisers,
etc. are all fixed costs. These costs remain fixed even when the level of output
is varied. Even if the producer decides to close down production, he has to bear
these costs since the factory rent, wages of managers, interest on capital, etc.
have to be paid. This discussion makes it clear that larger the level of
production in a firm, the lower will be the per unit fixed cost (or average fixed
cost).

8.4.2 Variable Cost

The cost which keeps on changing with the changes in the quantity of
output produced is known as variable cost.

For instance, raw material has to be used in the process of production in a

manufacturing industry, labour has to be employed for running machines, and
energy (electricity) has to be arranged. Generally expenditure on these inputs
increases or decreases due to changes in the level of production. It is important
to remember in this context that when the producer abandons production in the
short run, these costs also vanish completely. In fact, it is due to this direct
relationship between expenditure on such inputs and the level of production
that these expenditures are known as variable costs.
The concepts of total cost, total variable cost and total fixed cost in the short-
run can be easily followed with the help of Table 8.3.
Table 8.3 : Short-Run Costs of a Hypothetical Firm

Output Total Fixed Cost Total Variable Total Cost

(Unit) (Rupees) Cost (Rupees)
(Rupees)
0 240 0 240
1 240 120 360
2 240 160 400
3 240 180 420
4 240 212 452
5 240 280 520
6 240 420 660
174
8.4.3 Total Fixed Cost The Cost of
Production

Total fixed cost is the total expenditure by the firm on fixed inputs.

From Table 8.3, it is clear that the total fixed cost of the firm remains constant
at Rs. 240 irrespective of the level of output. In our illustration, output varies
from 1 unit to 6 units, but the total fixed cost remains 240 in each case. Even
when the firm stops production altogether, implying that output is at zero level,
the total fixed cost remains unchanged. The firm’s total fixed cost function is
shown in Fig. 8.1.

Fig. 8.1 : Total Fixed Cost curve is parallel to X axis as total fixed cost remains the same
for all levels of output

8.4.4 Total Variable Cost

Total variable cost is firm’s total expenditure on variable inputs used to

carry out production.

Since higher output levels require greater utilisation of variable inputs, they
mean higher total variable cost. Table 8.3 shows that the total variable cost of
the firm increases as its output increases. However, when the firm stops its
production altogether, it does not require any variable input and, therefore, its
total variable cost is zero. Fig. 8.2 shows the firm’s total variable cost function.
Notice one peculiar feature of TVC – initially it rises sharply, then, there is a
moderation in its rate of rise and ultimately it resumes rising at a faster pace.

175
Production
and Costs

Fig. 8.2 : Total Variable Cost Curve rises from left to right

8.4.5 Total Cost

Total cost is the sum of total fixed cost and total variable cost.
Thus, to obtain the firm’s total cost at a given output, we have only to add its
total fixed cost and its total variable cost at that output. The result is shown in
Table 8.3 and the total cost function is shown in Fig. 8.3. Since the total cost
function and the total variable cost function differ by only the amount of total
fixed cost which is constant, they have the same shape.

Fig. 8.3: Total Cost curve is obtained by adding the total fixed cost to total variable cost

176
In Fig. 8.4, all the three cost functions discussed above (total fixed cost The Cost of
function, total variable cost function and total cost function) have been shown Production
together. Cost functions, when depicted graphically, are often called cost
curves.

Fig. 8.4 : Total Fixed Cost, Total Variable Cost and Total Cost

In Fig. 8.4, TFC is the total fixed cost curve. Since it is parallel to X-axis, it
indicates that whatever be the level of output the total fixed cost remains the
same (i.e., it does not change in response to a change in the level of
production). TC is total cost curve. It indicates the sum of total fixed cost and
total variable cost for the various output levels. If the level of production is to
be raised, the use of variable inputs will have to be increased and this will push
up the costs. The rising total cost curve TC from left to right (the positive slope
of TC curve) indicates this fact. The vertical distance between the total cost
curve TC and the total fixed cost curve TFC indicates total variable cost. For
example, if the firm wishes to produce OQ units of output, the total variable
cost will be GQ – MQ = GM and if the level of output is OR, the total variable
cost will be HR – NR = HN. The total variable cost has been depicted by the
curve TVC in Fig. 8.4. This is parallel to the total cost curve TC and the
vertical distance between the two curves (TC and TVC) indicates total fixed
cost.
Check Your Progress 2
1) Indicate the following statements as true (T) or false (F):
i) Cost function explains the relationship between product and costs
( )
ii) In the long run all factors are variable ( )
iii) Fixed cost is also known as supplementary cost ( )
iv) Total variable cost is the total expenditure by the firm for fixed
input ( )
2) Define and distinguish between long run cost function and short run cost
function.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
177
Production 3) Distinguish between fixed cost and variable cost.
and Costs
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Define total fixed cost and total variable cost and trace the nature of the
total cost curve.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

8.5 SHORT-RUN COST CURVES

To find out the per unit profit, the firm has to compare the per unit cost (or
average cost) with per unit price. Therefore, it is necessary for us to understand
the concepts of average fixed cost, average variable cost and average total cost.

8.5.1 Average Fixed Cost

Generally, all those firms whose total costs of production include a significant
proportion of fixed costs try to increase the level of production to such an
extent that per unit fixed cost which is often known as average fixed cost, is
reduced substantially. To find out the average fixed cost, total fixed cost has to
be divided by the output.
In the form of a formula,
•••
AFC =
•

where, AFC is the average fixed cost

TFC is the total fixed cost
Q is the output
Table 8.4: Average Fixed Cost, Average Variable Cost and Average Total
Cost of the Firm

Output Average Fixed Average Variable Average Total

(Units) Cost Cost Cost
TFC ÷ Q TVC ÷ Q TC ÷ Q
1 240 ÷ 1=240 120 ÷ 1=120 360 ÷ 1=360
2 240 ÷ 2=120 160 ÷ 2=80 400 ÷ 2=200
3 240 ÷ 3=80 180 ÷ 3=60 420 ÷ 3=140
4 240 ÷ 4=60 212 ÷ 4=53 452 ÷ 4=113
5 240 ÷ 5=48 280 ÷ 5=56 520 ÷ 5=104
6 240 ÷ 6=40 420 ÷ 6=70 660 ÷ 6=110

178
A mere look at Table 8.4 will show how the average fixed cost declines with a The Cost of
rise in the level of output. When the firm produces only 1 unit, average fixed Production
cost is Rs. 240. As the ouput is expanded, there is a sharp decline in average
fixed cost and it is as low as Rs. 40 when 6 units of the commodity are
produced.

Fig. 8.5: Average Fixed Cost curve is a rectangular hyperbole

The fact that average fixed cost must decline with increases in output can be
easily understood with the help of average fixed cost curve in Fig. 8.5. In this
figure, when output is 1 unit, the average fixed cost is Rs. 240. When the
output is increased to 3 units and then to 6 units, average fixed cost declines
first to Rs. 80 and then to Rs. 40.
The average fixed cost curve (AFC) is a rectangular hyperbole because
multiplication of average fixed cost with the quantity of output produced
always yields a fixed value (the area under the curve is always same and
is equal to the total fixed cost).

8.5.2 Average Variable Cost

To obtain the average variable cost, we divide the total variable cost by the
output. In the form of formula:
•••
AVC=
•

where, AVC = the average variable cost

TVC = the total variable cost
and Q = the output.

In fact, the average variable cost curve (AVC) gives us the same
information in money terms that we obtain from the average product
curve of the variable factor in physical terms.

With an increase in the amount of variable factor, the efficiency in production

increases (resulting in an increase in average product) and the average variable
179
Production cost declines. If average productivity remains constant, average variable cost
and Costs will also remain constant. If it declines, average variable cost increases.

Thus, average variable cost curve is the reciprocal of the average

variable (factor) product curve.

After having understood the relationship between average variable factor

productivity and average cost, it is easy to understand the nature of the AVC
curve. While discussing the laws of production, we had stated that if other
factors are kept constant and only the quantity of one factor is increased, then
initially the tendency of increasing returns is observed. Later on, it is followed
by constant returns and diminishing returns in that order. This means that in the
initial stages, average variable cost declines and, after reaching a minimum
point, starts increasing. This increase is due to the operation of the law of
diminishing returns. From Table 8.4 we learn that at the output level of 1 unit
the firm’s average variable cost is Rs. 120. It declines when output is increased
and is Rs. 53 when 4 units of the commodity are produced. Thereafter, it
increases and is Rs. 70 when output level is raised to 6 units. The average
variable cost curve is thus U-shaped as in Fig. 8.6.

Fig. 8.6: Average variable cost curve is a U-shaped curve

8.5.3 Average Total Cost
The average total cost is also known as average cost. To find out average cost,
we divide total cost (which is the sum of total fixed cost and total variable cost)
by the output. In the form of a formula:
•• • • ••
AC or ATC= = +
• • •
The modern economists are generally agreed that in all areas of economic
activity, average total cost declines initially. The reasons are the same which
lead to increasing returns in the initial stages. Average cost declines initially
because some of the resources are indivisible and there are possibilities of
specialisation in the production process. As long as the indivisible factors are
not fully utilised, the average total cost falls and when expansion in output
leads to a stage where the indivisible resources are fully utilised, an optimum
proportion is established between the factors of production. Output obtained at
this point is the optimum output. Here, the average total cost is minimum. If
the output is expanded beyond this point (which denotes an optimum
combination of resources) by increasing the amount of variable inputs, then
180 total production increases at a diminishing rate. This leads to a rise in average
total cost. This shows why the average total cost curve is U-shaped as shown in The Cost of
Fig. 8.7. The illustration given in Table 8.4 also makes this point abundantly Production
clear.

Fig. 8.7: Average Total Cost curve is obtained by dividing total cost by the output

We can understand the shape of average total cost curve ATC better with the
help of average variable cost curve AVC and average fixed cost curve AFC
drawn in Fig. 8.8. Since the ATC curve is obtained by vertically summing up
the AVC and AFC curves, when both AVC and AFC curves slope downward,
the ATC curve also slopes downwards. The point R on the AVC curve shows
the minimum average variable cost. After this point, the average variable cost
starts increasing and thus the AVC curve is sloping upward. However, the fall
in the average fixed cost more than compensates for the rise in average variable
cost. Hence, the ATC curve slopes downward. Since at point T on the AVC
curve the rate of increase of the average variable cost is the same as the rate at
which the average fixed cost falls corresponding to this level of output, average
total cost is minimum at this output level. As the level of output increases
beyond this point, the average variable cost rises far more rapidly than the rate
at which average fixed cost falls. Therefore, the ATC curve slopes upward.

Fig. 8.8: Average total cost is the vertical sum of AFC and AVC

8.5.4 Marginal Cost

The marginal cost is the increase in the total cost owing to a small increase in
output.
181
Production In symbols,
and Costs
!•• !•••
MC = !•
or
!•

where, MC is marginal cost

∆TC is change in total cost associated with a small change in output
∆TVC is change in total variable cost associated with a small change in
output
∆Q is small change in output
The concept of marginal cost can be understood with the help of an example.
In Table 8.5, the total cost of producing 2 units of output is Rs. 400 and the
total cost of producing 2 + l or 3 units of output is Rs. 420. Therefore, marginal
cost is Rs. 20 which is Rs. 420 – Rs. 400.

Table 8.5: Calculation of Marginal Cost

Output Total Cost Total Variable Marginal Cost

Units (Rs. ) Cost ( Rs.)
(Rs. )

0 240 0 -
1 360 120 120
2 400 160 40
3 420 180 20
4 452 212 32
5 520 280 68
6 660 420 140

Since fixed cost remains unchanged in the short run, marginal cost can also be
defined as the increase in total variable cost consequent upon a small increase
in output. From Table 8.5, we learn that the variable cost of producing 2 units
is Rs. 160 and that of 3 units Rs. 180. The marginal cost, thus, will be
Rs. 180 – Rs. 160 = Rs. 20.
The marginal cost (MC) curve as it would be clear from Fig. 8.9 is U-shaped.
This implies that the marginal cost curve MC first slopes downward and then at
the point where marginal cost is minimum, it starts sloping upward because
marginal cost after decreasing with increases in output at low output levels,
increases with further increases in output. The shape of marginal cost curve is
in fact attributable to the law of variable proportions. According to the law of
variable proportions, the marginal product of the variable input rises at low
output levels and then falls with the expansion in output. Hence, the marginal
cost curve will first fall and then rise. There are two important points to
remember about the marginal cost curve:
i) The MC curve reaches its minimum point before the ATC and the AVC
curves reach their minimum points; and
182
ii) When the MC curves rises, it cuts the AVC and the ATC curves at their The Cost of
minimum points. Production

Fig. 8.9 : Marginal Cost Curve is a U-shaped Curve

8.5.5 Relationship between Marginal Cost and Average Cost

There is a close relationship between the marginal cost (MC) curve and the
average total cost (ATC) and average variable cost (AVC) curves. We shall
explain the relationship only between the MC curve and the ATC curve, but
the relationship between the MC curve and the AVC curve can be explained
along the same lines of reasoning.
Fig. 8.10 shows the MC curve together with the ATC curve and the AVC
curve. The relationship between the ATC curve and the MC curve is as
follows:

1) When the MC curve is below the AC curve (which means

marginal cost is less than average cost), the latter falls.
2) When the MC curve is above the AC curve (which means
marginal cost is more than average cost), the latter rises.
3) The MC curve intersects the AC curve at its minimum point.

Fig. 8.10 : MC curve intersects both AVC curve and ATC curve at their minimum points
183
Production The reason for the above stated relationship between the MC curve and the
and Costs ATC curve is simple. So long as the MC curve lies below the ATC curve, it
pulls the latter downwards; when the MC curve rises above the ATC curve, it
pulls the latter upwards. Consequently, marginal cost and average total cost are
equal where the MC curve intersects the ATC curve. Further when output is
small, marginal cost remains lower than average total cost; but when output is
expanded, marginal cost exceeds average total cost. Thus, it is natural that the
MC curve intersects the ATC curve at its minimum point.
Another important feature of the relationship between MC and AC curves is
that MC is affected only by variable costs. Fixed costs do not affect marginal
costs. This can be proved algebraically as follows:
MCN = TCN – TCN-1
= (TFCN + TVCN) – (TFCN-1 + TVCN-1)
Since, TFCN will always be equal to TFCN-1 we can also state as follows:
MCN = TFCN + TVCN – TFCN-1 – TVCN-1
= TVCN – TVCN-1
This proves that MC is affected only by TVC and not by TFC.
Check Your Progress 3
1) Indicate the following statement as true (T) or false (F):
i) Average fixed cost curve is a rectangular hyperbole ( )
ii) Average variable cost curve is the reciprocal of the average variable
factor productivity curve ( )
iii) The average total cost curve has inverted U shape ( )
iv) When the MC curve is below the AC curve, the latter rises ( )
2) What is average cost? What is the nature of the average total cost curve?
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Define and distinguish between average cost and marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) Explain the relation between the average cost and the marginal cost. How
is it possible that the marginal cost continues to rise while average cost
declines?
..................................................................................................................
..................................................................................................................
..................................................................................................................

184
5) The following table gives information on total cost, total fixed cost and The Cost of
total variable cost for a firm for different levels of output: Production

Output 0 1 2 3 4 5 6

TFC (Rs.) 120 120 120 120 120 120 120

TVC Rs.) 0 60 80 90 105 140 210
TC (Rs.) 120 180 200 210 225 260 330

Find (i) AFC (ii) AVC (iii) AC and (iv) MC.

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

8.6 LONG-RUN COST CURVES

In the long-run, all factors are variable. Due to the absence of fixed factors in
the production function, all costs of production are variable in the long-run and
therefore there is no need to distinguish between fixed and variable costs as is
done in the short-run. In the long-run, to increase the level of production, all
factors have to be increased and this results in an expansion of scale.
In the short-run, the production capacity of the firm depends upon the size of
the plant. Generally, there are many options before a firm. According to the
circumstance, it can choose any plant out of the large and small plants
available to it. Let us suppose that a firm has three options and corresponding
to them, the short-run average total cost (SATC) curves are as given in Fig.
8.11. We shall call the smallest plant as A, the medium size plant as B, and the
large size plant as C. The short-run average total cost curves corresponding to
these plants are designated SATCa, SATCb and SATCc.
The firm decides about the size of plant keeping the market considerations in
view. If the demand is small, the firm will use plant A for purposes of
production but in doing so it will have to incur a higher average total cost. If
the firm has to produce OQ2 quantity of output, it has two options open before
it: firstly, it can employ plant A. The optimum level of output that can be
produced with the help of this plant is itself OQ2. Secondly, it can opt for plant
B. If it does so, the capacity of plant B will not be fully utilised nevertheless
per unit cost of production will be lower than the cost of production the firm
will have to incur if it opts for producing OQ2 amount of output with the help
of plant A (even though OQ2 is the optimum level of output that can be
produced on plant A). This is due to the tendency of ‘increasing returns to
scale’. Not that plant C is larger in size than plant B yet, the curve SATCc is
higher than the SATCb curve. If the firm opts for plant C in this case, the
average total cost will increase due to the operation of ‘diminishing returns to
scale’.

185
Production
and Costs

Fig. 8.11 : Long-run average cost curve envelopes short-run average total cost curves

Theoretically speaking, the long-run average cost (LAC) curve touches the
short-run average total cost (SATC) curves on their minimum points.
Geometrically this is possible only under those circumstances when the
tendency of constant returns to scale prevails. It is due to the fact that initially
increasing returns to scale and after some time diminishing returns to scale
prevail in the production process that the LAC curve touches the lowest SATC
curve at its minimum point. In the phase of increasing returns to scale when
average total cost is falling, the LAC curve touches the SATC curves to the left
of the minimum points of the SATC curves and in the phase of diminishing
returns towards the right of minimum points of these curves. In Fig. 8.11, the
curve LAC touches the SATCb curve at its minimum point K, the SATCa curve
towards the left of its minimum point (at L) and the SAT Cc curve towards the
right of its minimum point (at M).

In Economics, we say that the long-run average cost curve (LAC)

‘envelopes’ the short-run average total cost (SATC) curves.

8.6.1 Long Period Economic Efficiency

The behaviour of the firm which seems to be efficient in the short-run may be
found to be inefficient in the long-run. To understand this let us consider Fig.
8.12. Let us suppose that the firm is producing OQ1 quantity of output. If, due
to an increase in demand, the firm wishes to increase output by Q1Q2, plant
cannot be changed in the short-run and only variable factors will be increased.
Thus, the firm will advance on the curve SATC1. As a result, the efficiency of
the variable resources will improve and per unit production cost will decline
from BQ1 to JQ2. In the short-run the level of efficiency cannot improve further
because this is the optimum level of production that can be achieved with the
help of the plant available to the firm. However, in the long-run to produce the
level of output OQ2, the use of plant of such a small size is inefficient. If the
firm uses a plant of a larger size, it will benefit from the increasing returns that
would thus become available. As a result, the per unit cost will fall and come
down to the level KQ2. Though the full capacity of this plant will not be fully
utilised, even then it would be more efficient as compared to the earlier plant.

186
 The Cost of
Production

Fig. 8.12: Explanation of long-run economic efficiency

In a similar way when an expansion in scale leads to diseconomies or

diminishing returns to scale emerge, it will be in the interest of the firm to
reduce the level of production. If the firm is producing the output OQ4 in Fig.
8.12, it will not be a right strategy from the point of view of maximising
profits. The firm can cut down production by Q3 Q4 in the short-run and this
will enable it to reduce the average total cost from DQ4 to MQ3. This will
result in optimum use of the plant. However, in the long-run, this position will
not be satisfactory as the firm can reduce the average cost to the level NQ3 by
reducing the size of the plant. Since NQ3 < MQ3, the position which was
optimum for the firm in the short-run becomes inefficient in the long-run. It is
clear that when the firm uses plant of a relatively small size, it produces output
much larger than is technologically optimum yet the cost remains low because
it becomes possible to reduce the diseconomies of the large plant.

8.6.2 The Long-Run Average Cost Curve

We have explained in detail above that the short-run average total cost curve is
U-shaped. Let us now discuss the shape of long-run average cost curve. There
is general agreement that the long-run average cost falls initially due to
economies of scale. But whether it falls to a certain point and then becomes
constant or rises again, cannot be conclusively said.
In traditional analysis, the long-run average cost (LAC) curve is assumed to be
U-shaped (as in Fig. 8.12). The shape of the long-run average cost curve is
based on the assumption that ultimately the tendency of diminishing returns
operates in the production process. If this belief of the economists is correct
that every producer wishes to maximise profits and conditions of production
are perfectly competitive, then it is true that the LAC curve must ultimately
rise to the right.

187
Production 8.6.3 Long-Run Marginal Cost Curve
and Costs
After having understood the meaning of short-run marginal cost, it is not
difficult to understand what long-run marginal cost is. Long-run marginal cost
designates the change in total cost consequent upon a small change in total
output when the firm has ample time to accomplish the output changes by
making the appropriate adjustments in the quantities of all resources used,
including those that constitute its plant. As can be seen, this definition of long-
run marginal cost is practically the same as the definition of short-run marginal
cost given by us earlier. The only difference between the two is that whereas in
the short-run the existing plant will continue to be used for affecting an
increase in output, in the long-run the plant itself will be changed.
As far as the relationship between the long-run marginal cost curve and long-
run average cost curve is concerned, it is precisely the same as exists between
the short-run marginal cost curve and the short-run average total cost curve.
This would be clear from a mere glance at Fig. 8.13.

Fig. 8.13: Long-run marginal and average cost curves

8.6.4 Relationship between Long-Run Marginal Cost and

Short-Run Marginal Cost
When to produce a certain given level of output, a firm sets up the most
efficient plant, its short-run marginal cost (SMC) becomes equal to its long-run
marginal cost (LMC). Let us explain this with the help of Fig. 8.14. In this
figure, the given quantity of output is OQ1. This output can be produced at
lowest unit cost with the help of plant A. The short-run average cost curve of
the firm when it produces with the help of plant A is given by SAC. Short-run
average cost curves corresponding to other plants have not been drawn in Fig.
8.14. It is clear from the figure that at OQ1 level of output, SMC and LMC are
equal. However, we must see why they should be equal.
188
 The Cost of
Production

Fig. 8.14: Equality of SMC and LMC on use of an optimum size plant

To find out why SMC and LMC must be equal at the level of output OQ1, let
us consider the implications of a small change in the output by a small amount.
For instance, let us take the level of output OQ2. At this output level, short-run
average cost will be greater than long-run average cost (SAC > LAC). In other
words, short-run total cost is greater than long-run total cost (STC > LTC).
When output rises from the level OQ2 to the level OQ1 the short run total cost
becomes equal to the long-run total cost. If the level of output is raised to OQ3
then since SAC is greater than LAC at this output, STC will also be greater
than LTC. In other words, when output level is raised beyond OQ1, we find
that SMC exceeds LMC. Actually as we move from OQ2 to OQ1, we find that
rate of decline in SMC is declining. In fact, beyond OQ1, it stands rising. On
the other hand, LMC keeps falling over the entire range. Therefore, between
OQ1 and OQ3 SAC is rising and LAC is falling.
On practical considerations, the equality of short-run marginal cost and the
long-run marginal cost is very significant for a firm. If the firm has to increase
the level of output only by a very small amount whether it continues to employ
the existing plant and changes only the quantity of the variable resources or
makes a small change in the size of the plant, the results are the same.
Therefore, from the point of view of the firm, both the methods are equally
correct.
Check Your Progress 4
1) Indicate the following statements as True (T) or False (F):
i) There is no need to distinguish between fixed costs and variable
costs in the long-run. ( )
ii) Long-run average cost curve envelopes the short-run average total
cost curves. ( )
iii) Long-run marginal cost curve cuts the long-run average cost curve
from below at the latter’s lowest point. ( )
189
Production 2) Discuss the nature of the long-run average cost curve.
and Costs
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Discuss the concept of long period economic efficiency.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) What is the relationship between long-run marginal cost curve and long-
run average cost curve.
..................................................................................................................
..................................................................................................................
..................................................................................................................
5) Discuss the relationship between long-run marginal cost and short-run
marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................

8.7 LET US SUM UP

In this unit, we start with a discussion of the various concepts of cost like
private cost, social cost, and economic cost and accounting cost. This is
followed by a discussion of short-run and long-run cost functions. We then
proceed to define the distinction between fixed cost and variable cost. We note
that total fixed cost curve is a straight line while the total variable cost curve
and the total cost curve rise upwards to the right. We then turn to a discussion
of short-run cost curves .We note that the nature of the average fixed cost curve
is that of a rectangular hyperbola. When average variable cost curve is added to
the average fixed cost curve, we get the average cost curve. This is followed by
a discussion of the marginal cost and the nature of the marginal cost curve. The
marginal cost curve cuts the average cost curve from below at the latter’s
minimum point.

8.8 REFERENCES
1) Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2010). Chapter 6,
Section 6.1, 6.2, 6.3 and 6.4.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Presss, Fifth Edition, 2010). Chapter 8, Section 8.1, 8.2, 8.3, 8.4 and 8.5.

190
3) A. Kountsoyiannis, Modern Microeconomics (The Macmillion Press The Cost of
Ltd., Second edition, 1982), Chapter 4. Production

4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India

Traveller Bookseller, Sixth edition, 1996). Chapter 8.
5) Ahuja H.L., Advanced Economc Theory (S.Chand & Company Ltd., New
Delhi 2001), Chapter 20 Page 396-439.

8.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (T) ; ii) (T) ; iii) (F) ; iv) (T) ; v) (T) ; vi) (F) .
2) See Sub-section 8.2.2 of Section 8.2.
3) See Sub-section 8.2.1 of Section 8.2.
4) See Sub-section 8.2.4 of Section 8.2.
5) See Sub-section 8.2.5 of Section 8.2.
Check Your Progress 2
1) (T) ; ii) (T) ; iii) (T) ; iv) (F)
2) See Section 8.3
3) See Sub-section 8.4.1 and 8.4.2 of Section 8.4
4) See Sub-section 8.4.3, 8.4.4 and 8.4.5 of Section 8.4
Check Your Progress 3
1) (T) ; ii) (T) ; iii) (F) ; iv) (F)
2) See Sub-section 8.5.3 of Section 8.5
3) See Sub-sections 8.5 .3 and 8.5.4 of Section 8.5
4) See Sub-section 8.5.5 of Section 8.5
••• ••• •• ∆(••)
5) (I )AFC = •
(ii) AVC = •
(iii) AC = • (iv) MC = ∆•

Check Your Progress 4

1) (i) T (ii) T (iii) T
2) See section 8.6
3) See Sub-section 8.6.1 of Section 8.6
4) See Sub-sections 8.6.2 and 8.6.3 of Section 8.6
5) See Sub-section 8.6.4 of Section 8.6

191
UNIT 10 MONOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
10.0 Objectives
10.1 Introduction
10.1.1 Meaning of Monopoly
10.1.2 Some Definitions
10.1.3 Characteristics of Monopoly
10.1.4 Causes of Monopoly

10.2 Demand and Revenue Curves under Monopoly

10.2.1 Relationship between AR, MR, and Price Elasticity under Monopoly

10.3 Equilibrium of the Monopoly Firm: Price and Output Decision

10.3.1 Total Revenue and Total Cost Approach
10.3.2 Marginal Revenue and Marginal Cost Approach
10.3.3 Long Run Equilibrium under Monopoly

10.4 Comparison of Monopoly with Perfect Competition

10.5 Efficiency and Deadweight Loss under Monopoly
10.6 Price Discrimination under Monopoly: Types and Degrees
10.6.1 Types of Price Discrimination
10.6.2 Degrees of Price Discrimination

10.7 Pricing in Public Monopoly

10.7.1 Marginal Cost Pricing
10.7.2 Average Cost Pricing
10.7.3 Mark-up Pricing

10.8 Let Us Sum Up

10.9 References
10.10 Answers or Hints to Check Your Progress Exercises

10.0 OBJECTIVES
We have learned in Unit 9 that there are different forms of market. Broadly
speaking market can either be perfectly competitive or imperfectly
competitive. In Unit 9 we have already discussed price and output decisions of
a firm and industry under perfectly competitive market. There are various
forms of market under imperfect competition. These include monopoly,
oligopoly, and monopolistic competition. Some of them are extreme forms. In
this unit we will discuss an extreme form of market, that is monopoly, where,
there is only one seller.
After going through this unit, you will be able to:
• state the meaning, causes and characteristics of monopoly;
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 213
Market • explain pricing and output decision under monopoly;
Structure
• discuss the concept of deadweight loss under monopoly;

• explain price discrimination under monopoly; and

• illustrate pricing in a public monopoly.

10.1 INTRODUCTION
10.1.1 Meaning of Monopoly
The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control. In this
way, monopoly refers to a market situation in which there is only one seller of
a commodity.
There are no close substitutes for the commodity that monopoly firm produces
and there are barriers to entry. The single producer may be in the form of
individual owner or a simple partnership or a joint stock company. In other
words, under monopoly there is no difference between firm and industry.
Monopolist has full control over the supply of commodity. Having control over
the supply of the commodity, it exercises the market power to set the price.
Thus, as a single seller/producer monopolist may be a king without a crown. If
there is to be an effective monopoly, the cross elasticity of demand between the
product of the monopolist and the product of any other seller must be very
small.

10.1.2 Definitions
“Pure monopoly is represented by a market situation in which there is a single
seller of a product for which there are no substitutes; this single seller is
unaffected by and does not affect the prices and outputs of other products sold
in the economy.” -Bilas
“Monopoly is a market situation in which there is a single seller. There are no
close substitutes of the commodity it produces, and there are barriers to entry”.
-Koutsoyiannis
“Under pure monopoly there is a single seller in the market. The monopolist’s
demand is market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation”. -A. J. Braff
“A pure monopoly exists when there is only one producer in the market. There
are no dire competitors.” -Ferguson

10.1.3 Characteristics of Monopoly

1) Single Seller: There is only one seller; he can control supply of his
product. But he cannot control demand for the product, as there are
many buyers.
2) No close Substitutes: There are no close substitutes for the product.
Either they have to buy the product or go without it.
3) Control over price: The monopolist has control over the supply and
thereby on price. Sometimes he may adopt price discrimination. He may
214
 fix different prices for different sets of consumers. A monopolist can Monopoly: Price
either fix the price or quantity of output; but he cannot do both, at the and Output
same time. Decisions

4) No Entry: There is no freedom to other producers to enter the market as

the monopolist is enjoying monopoly power. Barriers for new firms to
enter are strong. There are legal, technological, economic and natural
obstacles, which may block the entry of new producers.
5) No difference between Firm and Industry: Under monopoly, there is
no difference between a firm and an industry. As there is only one firm,
that single firm constitutes the whole industry.
10.1.4 Causes of Monopoly
1) Natural: A monopoly may arise on account of some natural
causes. Some minerals are available only in certain regions. For example,
South Africa has the monopoly of diamonds; nickel in the world is
mostly available in Canada and oil in Middle East. This monopoly is
caused by natural availability of resources.
2) Technical: Monopoly power may be enjoyed due to technical reasons. A
firm may have control over raw materials, technical knowledge, special
know-how, scientific secrets and formula that enable a monopolist to
produce a commodity, e.g., Coco Cola.
3) Legal: Monopoly power is achieved through patent rights, copyrights and
trade marks by the producers. This is called legal monopoly.
4) Large Amount of Capital: The manufacture of some goods requires a
large amount of capital or lumpiness of capital. All firms cannot enter the
field because they cannot afford to invest such a large amount of capital.
This may give rise to monopoly. For example, iron and steel industry,
railways, etc.
5) State: Government will have the sole right of producing and selling some
goods. They are State monopolies. For example, in India we have public
utilities like electricity, railways, water supply. These public utilities are
generally run by the State.

10.2 DEMAND AND REVENUE CURVES UNDER

MONOPOLY
It is important to understand the nature of the demand curve facing a
monopolist. The demand curve facing an industrial firm under perfect
competition, is a horizontal straight line, but the demand curve facing the
whole industry under perfect competition is sloping downward.
This is so because the demand is made by all the consumers and the demand
curve of total consumers for a product usually slopes downward. The
downward-sloping demand curve of the consumers faces the whole
competitive industry. An individual firm under perfect competition does not
face a downward-sloping demand curve. But in the case of monopoly one firm
constitutes the whole industry. Therefore, the entire demand of the consumers
for a product faces the monopolist. Since the demand curve of the consumers
for a product slopes downward, the monopolist faces a downward sloping
demand curve.
215
Market A perfectly competitive firm merely adjusts the quantity of output it has to
Structure produce, price being a given and constant datum for him. But the monopolist
encounters a more complicated problem. He cannot merely adjust quantity at a
given price because each quantity change by him will bring about a change in
the price at which the product can be sold.
Consider Fig. 10.1. DD is the demand curve facing a monopolist. At price OP
the quantity demanded is OM, therefore he would be able to sell OM quantity
at price OP. If he wants to sell a greater quantity ON, then he has to price it
OL. If he restricts his quantity to OG, the price will rise to OH.
Thus, every quantity change by him entails a change in price at which the
product can be sold. The problem faced by a monopolist is to choose a price-
quantity combination which is optimum for him, that is, which yields him
maximum possible profits.
Demand curve facing the monopolist will be his average revenue curve. Thus,
the average revenue curve of the monopolist slopes downward throughout its
length. Since average revenue curve slopes downward, marginal revenue curve
will lie below it. This follows from usual average-marginal relationship. The
implication of marginal revenue curve lying below average revenue curve is
that the marginal revenue will be less than the price or average revenue.

Fig. 10.1: Demand Curve of Monopolist slopes downward

Fig. 10.2: Marginal and Average revenue curves under monopoly

216
When monopolist sells more, the price of his product falls; marginal revenue Monopoly: Price
therefore must be less than the price. In Fig. 10.2, AR is the average revenue and Output
curve of the monopolist and slopes downward. MR is the marginal revenue Decisions
curve and lies below AR curve. At quantity OM, average revenue (or price) is
MP and marginal revenue is MQ which is less than MP. The same can be
shown by a numerical example in the Table 10.1 below:
Table 10.1 : Computation of MR for given AR

Price P=AR Quantity (q) TR= P*Q MR= TR/ q

11 0 0 -
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
10.2.1 Relationship between Average Revenue, Marginal
Revenue and Price Elasticity under Monopoly
Average and marginal revenue at a quantity are related to each other through
price elasticity of demand and in this connection, we had derived the following
formula in:
(•••)
MR = AR , where e stands for price elasticity
•

Since, AR is the same thing as price

(•••)
Therefore, MR = price
•
•
or price = MR
(•••)

Since the expression (e–1)/e will be less than unity, MR will be less than price,
or price will be greater than MR. The extent to which MR curve lies below AR
curve depends upon the value of the fraction (e – 1)/e.
The monopolist has a clearly distinguished demand curve for his product,
which is identical with the consumers’ demand curve for the product in
question. It is also worth mentioning that, unlike oligopolist or a firm under
monopolistic competition, monopolist does not consider the repercussions of
the price change by him upon those of other firms.
Monopoly, as defined here, requires that the gap between the monopoly
product and those of other firms is so sharp that change — in the price policies
of the monopolist will not affect other firms and will therefore not evoke any
readjustments of the policies by these firms.
The first thing to understand is that, apart from the special case of constant
elasticity where the demand curve is of the form Q = aP-b, the elasticity will
217
Market vary along different points of the demand curve. This is true even when the
Structure gradient of the demand curve is constant (i.e. the demand curve is linear). This
is a point that sometimes confuses you about elasticity, you think “constant
gradient = constant elasticity”…no it doesn’t.
Here is an example, this is a simple demand function Q = 20 – 0.5P.

Fig. 10.3

We can calculate the elasticity at different points, a, b, c, d and e.

••
With this demand function, ••
= −0.5, so the elasticity at different points will
•
be e = × −0.5
•

So at point a, the elasticity is 36/2 × –0.5 = –9

At point b, the elasticity is 24/8 × –0.5 = –1.5
At point c, the elasticity is 20/10 × –0.5 = –1
At point d, the elasticity is 18/11 × –0.5 = –0.818
At point e, the elasticity is 4/18 × –0.5 = –0.111
Notice that at point c, the midpoint of the curve, the elasticity is –1, this is
where the curve is unit elastic. Above point c, the curve is elastic. It gets more
elastic at higher level of price and lower the quantity. At the point where the
price is 40 and the quantity is 0, the elasticity will be infinity. Below point c,
the curve is inelastic and gets less elastic at lower the price and higher the
quantity. At the point where the price is 0 and the quantity is 20, the elasticity
will be 0.
•(!")
We can now think of this situation with marginal revenue. MR = and TR
••
•(••)
= PQ so MR = .
••
218
Here the inverse demand function is P = 40 – 2Q so PQ = 40Q – 2Q2 Monopoly: Price
•(••)
and •• = 40 − 4Q. So we can draw the marginal revenue curve MR = 40 –
and Output
Decisions
4Q:

Fig. 10.4

Notice how the marginal revenue is positive when the demand curve is
elastic, it is zero when the demand curve is unit elastic and it
becomes negative when the demand curve is inelastic.
This is the answer to the question. Given that the marginal revenue is the
amount of revenue gained by selling an extra unit, nobody is going to sell an
extra unit if the marginal revenue is negative (i.e. they lose money by selling
it).
•(••)
You can also think of this in an algebraic way. Given that MR = , we can
••
•(••) •• •• ••
use the product rule to say =P + Q so MR = P + Q
•• •• •• ••

Now multiply both top and bottom parts of the right hand side of that equation
••
by P so you get MR = P + PQ . We can factorise the P out of this to
•••
••
get MR = P #1 + Q $ which can be rewritten slightly differently as MR =
•••
• ••
P #1 + $.
• ••
%
The right hand side of that equation is the inverse of the elasticity, , so MR =
&
P •1 + ". This is a useful equation to remember.
!

Elastic demand is where e< –1 and inelastic demand is where –1 < e < 0. So
now we can think of why a monopolist won't produce in the inelastic part of its
demand curve. When demand is inelastic then –1 < e < 0 so •1 + " < 0 . And
!
219
Market
given that the price, P, is positive, it also follows that P •1 + !" < 0. So the
Structure
marginal revenue will be negative, and no firm will produce an extra unit if it
means it loses money.

10.3 EQUILIBRIUM OF THE MONOPOLY FIRM:

PRICE AND OUTPUT DECISION
Under monopoly, for the equilibrium and price determination, two different
conditions need to be satisfied:
1) Marginal revenue must be equal to marginal cost.
2) MC must cut MR from below.
However, there are two approaches to determine equilibrium price under
monopoly viz.;
1) Total Revenue and Total Cost Approach.
2) Marginal Revenue and Marginal Cost Approach.

10.3.1 Total Revenue and Total Cost Approach

Monopolist can earn maximum profits when difference between TR and TC is
maximum. By fixing different prices, a monopolist tries to find out the level of
output where the difference between TR and TC is maximum. The level of
output where monopolist earns maximum profits is called the equilibrium
situation. This can be explained with the help of Fig. 10.5.

Fig. 10.5

In Fig. 10.5, TC is the total cost curve. TR is the total revenue curve. TR curve
starts from the origin. It indicates that at zero level of output, TR will also be
zero. TC curve starts from P. It reflects that even if the firm discontinues its
production, it will have to suffer the loss of fixed costs.
Total profits of the firm are represented by TP curve. It starts from point R
showing that initially firm is faced with negative profits. Now as the firm
increases its production, TR also increases. But in the initial stage, the rate of
increase in TR is less than that of TC.
Therefore, RC part of TP curve reflects that firm is incurring losses. At point
M, total revenue is equal to total cost. It shows that firm is working under no
profit, no loss basis. Point M is called the breakeven point. When firm
220
produces more, beyond point M, TR will be more than TC. TP curve also Monopoly: Price
slopes upward. It shows that firm is earning profit. Now as the TP curve and Output
reaches point E then the firm will be earning maximum profits. This amount of Decisions
output will be termed as equilibrium output.

10.3.2 Marginal Revenue and Marginal Cost Approach

According to marginal revenue and marginal cost approach, a monopolist will
be in equilibrium when two conditions are fulfilled i.e., (i) MC = MR and (ii)
MC must cut MR from below. The study of equilibrium price according to this
analysis can be conducted in two time periods.
1) The Short Run
2) The Long Run
1) Short Run Equilibrium under Monopoly
Short period refers to that period in which the monopolist has to work with a
given existing plant. In other words, the monopolist cannot change the fixed
factors like, plant, machinery etc. in the short period. Monopolist can increase
his output by changing the variable factors. In this period, the monopolist can
enjoy super-normal profits, normal profits and sustain losses.
These three possibilities are described as follows:
Super Normal Profits
If the price determined by the monopolist in more than AC, he will get super
normal profits. The monopolist will produce up to the level where MC=MR.
This limit will indicate equilibrium output. In Fig. 10.6 output is measured on
X-axis and price on Y-axis. SAC and SMC are the short run average cost and
marginal cost curves respectively while AR and MR are the average revenue
and marginal revenue curves respectively.

Fig. 10.6
The monopolist is in equilibrium at point E because at point E both the
conditions of equilibrium are fulfilled i.e., MR = MC and MC intersects the
MR curve from below. At this level of equilibrium the monopolist will produce
OQ1 level of output and sells it at CQ1 price which is more than average cost
DQ1 by CD per unit. Therefore, in this case total profits of the monopolist will
be equal to shaded area ABDC.

221
Market Normal Profits
Structure
A monopolist in the short run would enjoy normal profits when average
revenue is just equal to average cost. We know that average cost of production
is inclusive of normal profits. This situation can be illustrated with the help of
Fig 10.7.

Fig. 10.7

In Fig. 10.7 above the firm is in equilibrium at point E. Here marginal cost is
equal to marginal revenue. The firm is producing OM level of output. At OM
level of output average cost curve touches the average revenue curve at point
P. Therefore, at point ‘P’ price MR is equal to average cost of the total product.
In this way, monopoly firm enjoys the normal profits.
Minimum Losses
In the short run, the monopolist may have to incur losses. This situation occurs
if in the short run price falls below the variable cost. In other words, if price
falls due to depression and fall in demand, the monopolist will continue to
produce as long as price covers the average variable cost. Once the price falls
below the average variable cost, monopolist will stop production. Thus, a
monopolist in the short run equilibrium may bear the minimum loss, equal to
fixed costs. Therefore, equilibrium price will be equal to average variable cost.
This situation can also be explained with the help of Fig. 10.8.

Fig. 10.8

In Fig. 10.8 above monopolist is in equilibrium at point E. At point E marginal

cost is equal to marginal revenue and he produces OM level of output. At OM
level of output, equilibrium price fixed by the monopolist is OP1. At OP1 price,
AVC touches the AR curve at point A.
222
It signifies that the firm will cover only average variable cost from the Monopoly: Price
prevailing price. At OP1 price, firm will bear loss of fixed cost i.e., A per unit. and Output
The firm will bear the total loss equal to the shaded area PP1 AN. Now if the Decisions
price falls below OP1, the monopolist will stop production. It is so, because, if
he continues production, he will have to bear the loss of variable costs along
with fixed costs.
Illustration 1: Let the cost of production of monopoly firm be given as : C =40
+ Q2 and demand be P = 20 – Q.
Find the profit maximising level of output and price.
Solution: Since cost is given as:
C = 40 + Q2
ƥ
MC = ƥ = 2Q

and
Since demand is given as:
P = 20 – Q
Total Revenue = P . Q = (20 – Q) Q = 20 Q – Q2
∆••
MR = = 20 − 2Q
ƥ

and
Profit maximisation occurs where:
MR = MC
20 – 2Q = 2Q
Q=5
Thus profit maximising level of output is 5 units and profit maximising price is
P = 20 – Q = 20 – 5 = 15
Illustration 2. Only one firm produces and sells soccer balls in the country of
Wiknam, and as the story begins, international trade in soccer balls is
prohibited. The following equations describe the monopolist’s demand,
marginal revenue, total cost, and marginal cost:
Demand : P = 10 – Q
Marginal Revenue : MR = 10 – 2Q
Total Cost : TC = 3 + Q + 0.5 Q2
Marginal Cost : MC = 1 + Q
Where Q is quantity and P is the price.
(a) How many units does the monopolist produce? At what price are they
sold? What is the monopolist’s profit?
Solution:
P = 10 – Q
223
Market MR = 10 – 2Q
Structure
TC = 3 + Q + 0.5Q2
MC = 1 + Q
Monopolist will produce where:
MR = MC
10 – 2Q = 1 + Q
3Q = 9
Q=3
Quantity are sold at price given by:
P = 10 – Q
= 10 – 3
䴞 P = $7

Monopolist profit (Rupees) is given by:

Profit = TR–TC
= [7 × 3] – [3 + 3 + 0.5 × 33 ]
• •
= 21 – [6 + •] = [21 – ••] = 10.5

Profit = $10.5

10.3.3 Long Run Equilibrium under Monopoly

Long-run is the period in which output can be changed by changing the factors
of production. In other words, all variable factors can be changed and
monopolist would choose that plant size which is most appropriate for specific
level of demand. Here, equilibrium would be attained at that level of output
where the long-run marginal cost cuts marginal revenue curve from below.
This can be shown with the help of Fig. 10.9.

Fig. 10.9
224
In Fig. 10.9 above monopolist is in equilibrium at OM level of output. At OM Monopoly: Price
level of output marginal revenue is equal to long run marginal cost and the and Output
monopolist fixes OP price. HM is the long run average cost. Price OP being Decisions
more than LAC i.e., HM which fetch the monopolist super normal profits.
Accordingly, the monopolist earns JM – HM = JH super normal profit per unit.
His total super normal profits will be equal to shaded area PJHP1.
Check Your Progress 1
1) How does the monopolist determine his price and output in the short
period?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Based on market research, a film production company in Mumbai obtains
the following information about the demand and production costs of its
new DVD:
Demand: P = 1,000 – 10Q
Total Revenue TR = P × Q = 1000Q – 10Q2
Marginal Revenue: MR = 1,000 – 20Q
Marginal Cost MC = 100 + 10Q
Where Q indicates the number of copies sold and P is the price in dollars.
Find the price and quantity that maximises the company’s profit.
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.4 COMPARISON OF MONOPOLY WITH

PERFECT COMPETITION
Following points make clear difference between both the monopoly and perfect
competition:
1) Output and Price
Under perfect competition, price is equal to average cost which is equal to
marginal cost at the equilibrium output. Under monopoly, the price is always
greater than marginal cost, it may be less than, equal to or greater than average
cost.
2) Equilibrium
Both under perfect competition and monopoly equilibrium is possible only
when MR = MC and MC cuts the MR curve from below.

225
Market 3) Entry
Structure
Under perfect competition, there exists no restrictions on the entry or exit of
firms into the industry. Under simple monopoly, there are strong barriers on
the entry and exit of firms.
4) Discrimination
Under monopoly, a monopolist can charge different prices from the different
groups of buyers. But, in the perfectly competitive market, it is absent by
definition. We shall discuss the price discriminations by a monopolist in
Sections 10.6 below.
5) Profits
The difference between price and average cost under monopoly results in
super-normal profits to the monopolist. Under perfect competition, a firm in
the long run enjoys only normal profits.
6) Supply Curve of Firm
Under perfect competition, supply curve can be known. It is so because all
firms can sell desired quantity at the prevailing price. Moreover, there is no
price discrimination. Under monopoly, supply curve cannot be known. MC
curve is not the supply curve of the monopolist.
7) Slope of Demand Curve
Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the
industry and each firm has to accept that price. On the other hand, under
monopoly, average revenue curve slopes downward. AR and MR curves are
separate from each other. Price is determined by the monopolist.

Fig. 10.10

8) Goals of Firms
Under perfect competition and monopoly the firm aims at to maximise its
profits. The firm which aims at to maximise its profits is known as rational
firm.
9) Comparison of Price
Monopoly price is higher than perfect competition price. In long period, under
perfect competition, price is equal to average cost. In monopoly, price is higher
as is shown in Fig. 10.11 below. The perfect competition price is OP1, whereas
monopoly price is OP. In equilibrium, monopoly sells ON output at OP price
226 but a perfectly competitive firm sells higher output ON1 at lower price OP1.
 Monopoly: Price
and Output
Decisions

Fig. 10.11

10) Comparison of Output

Perfect competition output is higher than monopoly output. Under perfect
competition the firm is in equilibrium at point M1 where AR = MR = AC = MC
are equal. The equilibrium output is ON1. On the other hand monopoly firm is
in equilibrium at point M where MC=MR. The equilibrium output is ON. The
monopoly output is lower than perfectly competitive firm output.
Summary of Comparison:
A general comparison between monopoly and perfect competition for easy
understanding has been depicted as under:

S. No. Features Monopoly Perfect Competition

1 Description Extreme market A fair, direct
situation, where there is competition between
only one seller. He has buyers and buyers, seller
no competition and so and sellers, and finally
controls supply and between buyers and
price. sellers.
2 Buyers and Only one seller and Large number of buyers
Sellers practically all buyers and sellers. Hence no
depend on him. Hence sellers or buyers can
he has absolute control alter the price in the
over the market. market.
3 Supply Supply from only one i) Supply comes from
seller, hence absolute large number of sellers
control over the supply. ii) Individual supply is
negligible, compared to
market supply.
4 Demand Demand is not perfectly. Demand is perfectly
Demand curve slopes elastic. Demand curve
downward. faced by a seller is a
horizontal straight line.
5 Product Homogeneous product. Homogenous product.
6 Nature of No competition at all. No Pure and perfect
Competition price or product competition in price.
competition.
227
Market
7 Price Higher price, higher than Normal Price P = MR =
Structure
all competitive price. P MC
> MR = MC
8 Output Small output fixed by the Large output fixed by
sole seller. MR = MC
9 Profit Excess profit monopoly Normal profit realised
gain. by price competition.
10 Application Pure Monopoly is rare Quite unreal.
but elements of
monopoly are there in
markets.

10.5 EFFICIENCY AND DEADWEIGHT LOSS

UNDER MONOPOLY
The outcome of a competitive market has a very important property. In
equilibrium, all gains from production activities are realised. This means that
there is no additional surplus to obtain from further trades between buyers and
sellers. In this situation, we say that the allocation of goods and services in the
economy is efficient. However, markets sometimes fail to operate properly and
not all gains from trade are exhausted. In this case, some buyer surplus, seller
surplus, or both are lost. Economists call this a deadweight loss.
The deadweight loss from a monopoly is illustrated in the Fig. 10.12 below.
The monopolist produces a quantity such that marginal revenue equals
marginal cost. The price is determined by the demand curve at this quantity. A
monopoly makes a profit equal to total revenue minus total cost. When the
total output is less than socially optimal, there is a deadweight loss, which is
indicated in the figure.
Deadweight loss arises in other situations, such as when there are quantity or
price restrictions. It also arises when taxes or subsidies are imposed in a
market. Tax incidence is the way in which the burden of a tax falls on buyers
and sellers — that is, who suffers most of the deadweight loss. In general, the
incidence of a tax depends on the elasticities of supply and demand.
Price

Quantity
228 Fig. 10.12
 Monopoly: Price
10.6 PRICE DISCRIMINATION UNDER and Output
MONOPOLY: TYPES AND DEGREES Decisions

In monopoly, there is a single seller of a product called monopolist. The

monopolist has control over pricing, demand, and supply decisions, thus, sets
prices in a way, so that maximum profit can be earned.
The monopolist often charges different prices from different consumers for the
same product. This practice of charging different prices for identical product is
called price discrimination.
According to Robinson, “Price discrimination is charging different prices for
the same product or same price for the differentiated product.”

10.6.1 Types of Price Discrimination

Price discrimination is a common pricing strategy used by a monopolist having
discretionary pricing power. This strategy is practiced by the monopolist to
gain market advantage or to capture market position.
There are three types of price discrimination, which are shown below:

i) Personal
Personal price discrimination refers to a situation when different prices are
charged from different individuals. The different prices are charged according
to the level of income of consumers as well as their willingness to purchase a
product. For example, a doctor charges different fees from poor and rich
patients.
ii) Geographical
This type of price discrimination occurs when the monopolist charges different
prices at different places for the same product. This type of discrimination is
possible if those who buy at lower price cannot sell to those being charged a
higher price by the firm.
iii) On the basis of use
This kind of price discrimination occurs when different prices are charged
according to the use of a product. For instance, an electricity supply board
charges lower rates for domestic consumption of electricity and higher rates for
commercial consumption. Similar discrimination occurs when buyers are
charged different prices at different hours of the day – it is referred to as peak-
load pricing.

229
Market 10.6.2 Degrees of Price Discrimination
Structure
i) First-degree Price Discrimination
Refers to a price discrimination in which a monopolist charges the maximum
price that each buyer is willing to pay. This is also known as perfect price
discrimination as it involves maximum exploitation of consumers. In this price
discrimination, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.
ii) Second-degree Price Discrimination
Refers to a price discrimination in which buyers are divided into different
groups and different prices are charged from these groups depending upon
what they are willing to pay. Railways and airlines practice this type of price
discrimination.
iii) Third-degree Price Discrimination
Refers to a price discrimination in which the monopolist divides the entire
market into submarkets and different prices are charged in each submarket.
Therefore, third-degree price discrimination is also termed as market
segmentation.
In this type of price discrimination, the monopolist is required to segment
market in a manner, so that products sold in one market cannot be resold in
another market. Moreover, he/she should identify the price elasticity of
demand of different submarkets. The groups are divided according to age, sex,
and location. For instance, railways charge lower fares from senior citizens.
Students get discount in cinemas, museums, and historical monuments. We are
explaining it with help of Fig. 10.13, which has three segments (a), (b) and (c).

Fig. 10.13

Segments (a) and (b) depict markets with inelastic and elastic demand curves
respectively. The segment (c) has horizontal sum of the AR and MR curves of
(a) and (b), denoted as AR t and MR t. The firm has a single Average Total Cost
curve and corresponding Marginal Cost Curve. Inter-section of this MC with
MR t gives us equilibrium output OQ for the firm. It also shows the MR for the
firm, which maximises its profits. The firm will like to realise the same MR
from each of the units sold in either of those two market segments. So,
wherever the extended line EM cuts MRa and MRb (points Ea and Eb
respectively) will be used to determine equilibrium outputs Q aO and Q bO for
the two market segments. The prices will be what the consumers are ready to
pay for the respective quantities, that is, Pa and P b.
230
Note two points: The monopolist offers larger quantities in market with Monopoly: Price
relatively elastic demand curve and smaller in market with inelastic demand. and Output
We find that Q b > Q a. However, the price change in the segment (a)with Decisions
inelastic demand, P a is greater than price in segment (b) P b. So we can say
that buyers with inelastic demand will face a double disadvantage at the hands
of a monopolist: They end up buying smaller quantities and have to pay higher
prices.
Check Your Progress 2
1) What is Price Discrimination?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain the degrees of Price Discrimination.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) How Monopolist firm faces efficiency loss?
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) How is price determination under Monopoly is different from Perfect
Competition?
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.7 PRICING IN PUBLIC MONOPOLY

So far we have discussed the behaviour of a private monopolist whose
objective is to maximise her profits, given the economic and technical
constraints. In this section, we analyse the behaviour of a public monopoly — a
firm owned and controlled by the government. The objective of a public
monopoly is to provide more output and charge lower price so as to increase
the welfare of people. The optimal pricing and output decisions by such an
undertaking is not based on profit or sales maximisation principles but on
maximisation of welfare.
Average-cost-pricing and marginal-cost-pricing are the two possible options
for the determination of output and price by a public utility firm. In fact, these
two options can become policy guidelines for the government for price
regulation of a private monopoly firm as well.
There is a need to regulate monopoly because monopolists have ability to
restrict output and raise prices of their product and this way earn super normal
231
Market profits. Such behaviour increases inequalities in the distribution of income and
Structure wealth leading to exploitation of the consumers and also causes inefficiency in
allocation of resource. A net result of all these actions is reduction of consumer
welfare in the society. Therefore, the main objective behind regulation of
monopoly is the maximisation of welfare. A monopoly may be regulated either
through fixation of a maximum price that a monopolist may charge or
appropriate taxation policy. Here, we are concerned with price regulation of
monopoly only. The issue involved in average and marginal cost pricing
discussed here are useful in fixing of prices in a public utility as well.

10.7.1 Marginal Cost Pricing

As discussed above, a monopolist sets price of its product higher than marginal
cost. Monopolist maximise profit at the level of output where MR=MC and
charges price according to equilibrium condition. The government may decide
to regulate a monopoly by fixing maximum price that equals marginal cost of
production. The monopolist will be forced to raise the output higher then the
equilibrium level and charges price, which would have prevailed had the
market been perfectly competitive. Such a price would ensure efficiency in
allocation of resources as well, since it is equal to marginal cost. It also
enhances welfare of the consumers, as they get larger output al lower price.
The consumer’s surplus under regulated monopoly is more then it was in non-
regulated monopoly.
It may be noted that given the conditions of demand and cost ‘Marginal cost’
pricing may still allow a monopolist to earn super normal profits as the price
may still be higher than the average cost. This is a case of ‘capacity-
constrained situation’, that is the demand for the product is quite high as
compared to the production capacity. But, in a different situation, when there is
excess capacity, marginal cost pricing results in direct loss to the firm as its
average cost is higher than marginal cost. Thus, the firm will produce marginal
cost price output only if it is compensated by the government for the direct loss
at this level of production.

10.7.2 Average Cost Pricing

The aim of the public policy is to regulate monopoly in such a manner that is
possible to provide maximum output at minimum price. One policy option is to
fix price according to the average cost, i.e, at a point where AR = AC. This
allows the firm to earn normal profit. In case of capacity-constrained situation,
average cost pricing leads to higher output and lower price. This means there
will be higher level of consumer’s surplus compared to marginal cost pricing.
However, in excess capacity situation, there shall be a somewhat higher price
with average cost pricing but there shall be no direct loss to the producer as
P = AC. Marginal cost pricing adopted to reach full economic efficiency or
maximum social welfare. But in case of excess capacity, where AC > MC,
marginal cost pricing necessitates state subsidies to induce the monopolist to
stay in the market.

10.7.3 Mark-up Pricing

It is observed that in real life, prices are not fixed by marginal analysis, viz, by
the use of marginal revenue and marginal cost concepts. An alternative
approach is to set the prices in accordance with the average cost principle.

232
The firm sets a price equal to its average cost which includes some profit Monopoly: Price
margin, that is. and Output
Decisions
P = AVC + GPM
where P is the price, AVC is the average variable cost, and GPM is the gross
profit margin which include average fixed cost and net profit margin.
The purpose of this note is to show that average cost principle and marginal
analysis would give the same long-run profit maximisation solution. The
setting of the price on the basis of the average cost principles incorporates as
estimation of the elastic of demand in the long run equilibrium. Recall that the
necessary condition for profit maximisation is MC=MR. It has already been
proved that MR=P(e–1/e). Given that MC >0. MR must be positive for profit
maximisation. This implies e>1, provided that AVC is constant over the
relevant range of output, that is, AVC=MC. For equilibrium, AVC=MR, that
is, AVC=P(1–1/e)=P{(e–1)/e}. In other words P = AVC {e/(e–1)}. Given that
e>1, we may write {e/(e–1)}=(1+k), where k>0. Therefore, P=AVC(1+k),
where k is the gross profit margin. For example, if the firm sets a 20 per cent of
•
AVC as its profit margin, we have (1+k) = [1 + 0.20] = ••• . Thus, the
elasticity of demand is 6. Setting a gross profit margin is equivalent to
estimating the price elasticity of demand and applying marginalist analysis.
Check Your Progress 3
1) How a public monopoly is different from a private monopolist firm?
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2) How does the public monopoly firm make price and output decisions?
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3) What do you mean by Mark up pricing?
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10.8 LET US SUM UP

Monopoly is a market structure in which there is a single seller with large
number of buyers. Assumptions of monopoly are: Single firm, No close
substitutes, Barriers to entry, Goal is profit maximisation, Perfect knowledge.
In monopoly, market Firm’s demand curve is industry’s demand curve. The
demand curve is downward sloping because monopolist is a price maker and
not a price taker. The demand curve of monopolist is the AR curve or the price
line. According to the marginal principle, equilibrium takes place where: MR =
MC and slope of MC should be greater then Slope of MC. In the long-run, the
firm will either continue to earn profit or may breakeven. Two market 233
Market structures, i.e. Perfect Competition and Monopoly are extreme situations.
Structure Monopolist charges higher price and sells lesser output as compared to
perfectly competitive firm. Price discrimination is the practice of charging
different prices from different consumers for the same good. AC and MC
pricing are undertaken by a public monopoly for social or public welfare.

10.9 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

10.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 10.3.2 and answer
2) Q = 30 units
P = Rs. 700
Check Your Progress 2
1) Read Section 10.6 and answer
2) Read Sub-section 10.6.2 and answer
3) Read Section 10.5 and answer
4) Read Section 10.4 and answer
Check Your Progress 3
1) Read Section 10.7 and answer
2) Read Sub-section 10.7.1 and answer
3) Read Sub-section 10.7.2 and answer

234
UNIT 11 MONOPOLISTIC
COMPETITION: PRICE AND
OUTPUT DECISIONS
Structure
11.0 Objectives
11.1 Introduction
11.2 Concept and Features of Monopolistic Competition
11.3 Demand Curve under Monopolistic Competition
11.4 Equilibrium under Monopolistic Competition
11.4.1 Individual Firm’s Equilibrium in Short-Run Period
11.4.2 Individual Firm’s Equilibrium in Long Run
11.4.3 Group Equilibrium in Monopolistic Competition
11.4.4 Equilibirium with Selling Costs

11.5 Perfect Competition, Monopoly and Monopolistic Competition:

Comparison
11.6 Theory of Excess Capacity under Monopolistic Competition
11.7 Let Us Sum Up
11.8 References
11.9 Answers or Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After studying this unit, you will be able to:
• define the term monopolistic competition;
• explain the demand curve under monopolistic competition;
• state the equilibrium conditions of monopolistic competition;
• make comparison under perfect competition, monopoly and monopolistic
competition; and
• explain the theory of excess capacity under monopolistic competition.

11.1 INTRODUCTION
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 235
Market firms which sell closely related but differentiated products. Markets of
Structure products like soap, toothpaste AC, etc. are examples of monopolistic
competition.

11.2 CONCEPT AND FEATURES OF

MONOPOLISTIC COMPETITION
Monopolistic competition is a market in which firms can enter freely each
producing its own brand or a differentiated product. Thus, a firm under
monopolistic competition
a) Enjoys ‘monopoly position’ as far as a particular brand is concerned.
b) Since the various brands are close substitutes, its monopoly position is
influenced by the stiff ‘competition’ from other firms.
Examples of Monopolistic Competition:
1) When you walk into a departmental store to buy toothpaste, you will find
a number of brands, like Pepsodent, Colgate, Neem, Babool, etc.
i) On one hand, the market for toothpaste seems to be full of
competition, with thousands of competing brands and freedom of
entry;
ii) On the other hand, its market seems to be monopolistic, due to
uniqueness of each toothpaste and power to charge different price.
Such a market for toothpaste is a monopolistic competitive market.
2) A firm supplies branded good ‘Lux Soap’ in the market. There are many
other firms in the market which sell similar soaps (not identical) with
different brand names like Rexona, Palm Rose, etc., etc. Some times we
can find one company manufacturing and selling similar products with
several brand names at different prices. Their idea is to place each of
their products in ‘niches’ or slots which capture attention of a different
set of consumers. The firm supplying ‘Lux Soap’ enjoys a monopoly in
the sale of its own product. It also faces competition from firms selling
similar products. Same is the case with many other firms in the market
like plywood manufacturing, jewellery making, wood furniture, book
stores, departmental stores, repair services of all kinds, professional
services of doctors, technicians, etc. These firms and others which have
an element of monopoly power and also face competition over the sale of
product or service in the market are called monopolistically competitive
firm.
The following are the features or characteristics of monopolistic competition:-
1) Large Number of Sellers
There are large number of sellers producing differentiated products. So,
competition among them is very keen. Since number of sellers is large, each
seller produces a very small part of market supply. Every firm is limited in its
size.

236
In other words, there are large numbers of firms selling closely related, but not Monopolistic
homogeneous products. Each firm acts independently and has a limited share Competition: Price
of the market. So, an individual firm has limited control over the market price. and Output Decisions
Large number of firms leads to competition in the market.
2) Product Differentiation
It is one of the most important features of monopolistic competition. In perfect
competition, products are homogeneous in nature. On the contrary, here, every
producer tries to keep his product dissimilar than his rival’s product in order to
maintain his separate identity. This boosts up the competition in market and at
the same time every firm acquires some monopoly power. Hence, each firm is
in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are
also willing to pay different prices for the same product produced by different
firms. This gives some monopoly power to an individual firm to influence
market price of its product. Following points provide insight about the product
differentiation:
a) The product of each individual firm is identified and distinguished from
the products of other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on
either ‘real’ or ‘imaginary’ differences.
i) Real Differences may be due to differences in shape, flavour,
colour, packing, after sale service, warranty period, etc.
ii) Imaginary Differences mean differences which are not really
obvious but buyers are made to believe that such differences exist
through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes
demand for the product less elastic and enables the firm to charge a price
higher than its competitor’s products. For example, Pepsodent is costlier
than Babool.
f) Some more examples of Product Differentiation: i) Toothpaste:
Pepsodent, Colgate, Neem, Babool, etc., ii) Cycles: Atlas, Hero, Avon,
etc., iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
3) Freedom of Entry and Exit
This feature leads to stiff competition in market. Free entry into the market
enables new firms to come with close substitutes. Free entry or exit maintains
normal profit in the market for a longer span of time.
4) Selling Cost
It is a unique feature of monopolistic competition. In such type of market, due
to product differentiation, every firm has to incur some additional expenditure
in the form of selling cost. This cost includes sales promotion expenses,
advertisement expenses, salaries of marketing staff, etc. 237
Market But on account of homogeneous product in perfect competition and zero
Structure competition in monopoly, selling cost does not exist there.
5) Absence of Interdependence
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All
are independent.
6) Two Dimensional Competition
Monopolistic competition has two types or aspects of competition aspects viz.
Price competition i.e. firms compete with each other on the basis of price. Non-
price competition i.e. firms compete on the basis of brand, product quality
advertisement.
7) Concept of Group
In place of Marshallian concept of industry, Chamberlin introduced the concept
of Group under monopolistic competition. An industry means a number of
firms producing identical product. A group means a number of firms producing
differentiated products which are closely related.
8) Falling Demand Curve
In monopolistic competition, a firm is facing downward sloping demand curve.
It means one can sell more at lower price and vice versa.
9) Lack of Perfect Knowledge
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it
becomes very difficult for a consumer to evaluate different products available
in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same
quality.
Check Your Progress 1
1) What is monopolistic competition? Explain with few examples.
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.....................................................................................................................
2) Identify the features that shows the presence of monopolistic competition
in market.
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3) A market with few entry barriers and with many firms that sell
differentiated products is
A) purely competitive.
B) a monopoly.
C) monopolistically competitive.
D) oligopolistic.

238
 Monopolistic
11.3 DEMAND CURVE UNDER MONOPOLISTIC Competition: Price
COMPETITION and Output Decisions

Under monopolistic competition, large number of firms selling closely related

but differentiated products make the demand curve downward sloping. It
implies that a firm can sell more output only by reducing the price of its
product.
As seen in Fig. 11.1, output is measured along the X-axis and price and
revenue along the Y-axis. At OP price, a seller can sell OQ quantity. Demand
rises to OQ1, when price is reduced to OP1. So, demand curve under
monopolistic competition is negatively sloped as more quantity can be sold
only at a lower price.

Fig. 11.1

MR < AR under Monopolistic Competition: Like monopoly, MR is also less

than AR under monopolistic competition due to negatively sloped demand
curve.
Demand Curve: Monopolistic Competition Vs. Monopoly:
At first glance, the demand curve of monopolistic competition looks exactly
like the demand curve under monopoly as both faces downward sloping
demand curves. However, demand curve under monopolistic competition is
more elastic as compared to demand curve under monopoly. This happens
because differentiated products under monopolistic competition have close
substitutes, whereas there are no close substitutes in case of monopoly.
Let us prove this with the help of Fig. 11.2.

239
Market
Structure

Fig. 11.2

We know, price elasticity of demand (by geometric method) at a point on the

demand curve is given by: Ed = Lower segment of demand curve / Upper
segment of demand curve.
At price ‘OP’, price elasticity of demand under monopolistic competition is
BC/AB and under monopoly is EF/DE. Fig. 11.2 reveals that BC > EF and DE
> AB. So, BC/AB > EF/DE.
It means, demand curve in case of monopolistic competition is more elastic as
compared to demand curve under monopoly.

11.4 EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
A firm under monopolistic competition has to face various problems which are
absent under perfect competition. Since the market of an individual firm under
perfect competition is completely merged with the general one, it can sell any
amount of the good at the ruling market price.
But, under monopolistic competition, individual firm’s market is isolated to a
certain degree from those of its rivals with the result that its sales are limited
and depend upon:
1) Its price,
2) The nature of its product, and
3) The advertising outlay it makes.
Thus, the firm under monopolistic competition has to confront a more
complicated problem than the perfectly competitive firm. Equilibrium of an
individual firm under monopolistic competition involves equilibrium in three
respects, that is, in regard to the price, the nature of the product, and the
amount of advertising outlay it should make.
Equilibrium of the firm in respect of three variables simultaneously – price,
nature of product, selling outlay – is difficult to discuss. Therefore, the method
of explaining equilibrium in respect of each of them separately is adopted,
keeping the other two variables given and constant.
Moreover, as noted above, the equilibrium under monopolistic competition
involves “individual equilibrium” of the firms as well as “group equilibrium”.
We shall discuss these two types of equilibrium first in respect of price and
240 output and then in respects of product and advertising expenditure adjustments.
11.4.1 Individual Firm’s Equilibrium in Short-Run Period Monopolistic
Competition: Price
The demand curve for the product of an individual firm, as noted above, is and Output Decisions
downward sloping. Since the various firms under monopolistic competition
produce products which are close substitutes to each other, the position and
elasticity of the demand curve for the product of any of them depend upon the
availability of the competitive substitutes and their prices.
Therefore, the equilibrium adjustment of an individual firm cannot be defined
in isolation from the general field of which it is a part. However, for the sake of
simplicity in analysis, conditions regarding the availability of substitute
products produced by the rival firms and prices charged for them are held
constant while the equilibrium adjustment of an individual firm is considered
in isolation.
Since close substitutes for its product are available in the market, the demand
curve for the product of an individual firm working under conditions of
monopolistic competition is fairly elastic. Thus, although a firm under
monopolistic competition has a monopolistic control over its variety of the
product but its control is tempered by the fact that there are close substitutes
available in the market and that if it sets too high a price for its product, many
of its customers will shift to the rival products.

Fig. 11.3

Assuming the conditions with respect to all substitutes such as their nature and
prices being constant, the demand curve for the product of a firm will be given.
We further suppose that only variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic competition is graphically
shown in Fig. 11.3. DD is the demand curve for the product of an individual
firm, the nature and prices of all substitutes being given. This demand curve
DD is also the average revenue (AR) curve of the firm.
AC represents the average cost curve of the firm, while MC is the marginal
cost curve corresponding to it. It may be recalled that average cost curve first
falls due to internal economies and then rises due to internal diseconomies.
241
Market Given these demand and cost conditions a firm will adjust its price and output,
Structure at the level which gives it maximum total profits. Theory of value under
monopolistic competition is also based upon the profit maximisation principle,
as is the theory of value under perfect competition.
Thus a firm, in order to maximise profits, will equate marginal cost with
marginal revenue. In Fig. 11.3, the firm will fix its level of output at OM, for at
OM output marginal cost is equal to marginal revenue. The demand curve DD
facing the firm in question indicates that output OM can be sold at price MQ =
OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and output at OM, the
firm is making profits equal to the area RSQP which is maximum. It may be
recalled that profits RSQP are in excess of normal profits because the normal
profits which represent the minimum profits necessary to secure the
entrepreneur’s services are included in average cost curve AC. Thus, the area
RSQP indicates the amount of supernormal or economic profits made by the
firm.
In the short-run, the firm, in equilibrium, may make supernormal profits, as
shown in Fig. 11.3 above, but it may make losses too if the demand conditions
for its product are not so favourable relative to cost conditions. Fig. 11.4
depicts the case of a firm whose demand or average revenue curve DD for the
product lies below the average cost curve, indicating thereby, that no output of
the product can be produced at positive profits.

Fig. 11.4

However, the firm is in equilibrium at output ON and setting price NK or OT.

By adjusting price at OT and output at ON, it is able to minimise its losses. In
such an unfavourable situation, there is no alternative for the firm except to
make the best of the bad bargain.
We thus see that a firm in equilibrium under monopolistic competition, as
under pure or perfect competition, may be making supernormal profits or
losses depending upon the position of the demand curve relative to the position
of the average cost curve. Further, a firm may be making only normal profits
even in the short run if the demand curve happens to be tangent to the average
242 cost curve.
It should be carefully noted that in individual equilibrium of the firm in Fig. Monopolistic
11.3 and 11.4, the firm having once adjusted price at OP and (respectively will Competition: Price
have no tendency to vary the price any more. If it varies its price upward, the and Output Decisions
loss due to fall in quantity demanded will be more than possible gain owing to
the higher price. If it cuts down its price, the gain due to the increase in
quantity demanded will be less than the loss due to the lower price. Hence,
price will remain stable at OP and OT in the two cases respectively.

11.4.2 Individual Firm’s Equilibrium in Long Run

In the preceding sections, we have discussed that in the short run, firms can
earn supernormal profits. However, in the long run, there is a gradual decrease
in the profits of the firms. This is because in the long run, several new firms
enter the market due to freedom of entry.
When these new firms start production the market supply would increase and
the price would fall. This would automatically increase the level of competition
in the market. Consequently, AR curve shifts from right to left and
supernormal profits are eliminated. The firms will be able to earn normal
profits only.
In the long run, the AR curve is more elastic than that of in the short run. This
is because of an increase in the number of substitute products in the long-run.
The long-run equilibrium of monopolistically competitive firms is achieved
when average revenue is equal to average cost. In such a case, the firms receive
normal profits.

Fig. 11.5: Shows the long-run equilibrium position under monopolistic competition

In Fig. 11.5, P is the point at which AR curve touches the average cost curve
(LAC) as a tangent. P is regarded as the equilibrium point at which the price
level is MP (which is also equal to OP') and output is OM.
In the present case average cost is equal to average revenue that is MP.
Therefore, in long run, the profit is normal. In the short run, equilibrium is
attained when marginal revenue is equal to marginal cost. However, in the long
run, both the conditions (MR=MC and AR=AC) must hold to attain
equilibrium.

11.4.3 Group Equilibrium in Monopolistic Competition

The concept of group equilibrium was introduced by Chamberlin. The price-
output equilibrium of all firms is known as group equilibrium. Group
equilibrium represents the price and output of firms having close substitutes.
243
Market However, due to product differentiation, it is difficult to form market demand
Structure schedules and supply.

For overcoming the problem Chamberlin gave a concept called product group,
which includes products that are technological and economic substitute of each
other. Technological substitutes are the products having technical similarity,
while economic substitutes are the products that have same prices and fulfill
the same want of consumers.

A product group refers to a group in which the demand for each product is
highly elastic. Here, the demand for a product changes with the changes in the
prices of other products within the group, and, the price and cross elasticity of
demand for products forming the group is high.

In an industry, different types of groups exist automatically. In automobile

industry makers of cars and trucks are two different product groups.

The main competition would be among those organisations manufacturing

similar products (cars or trucks) which are close substitutes of each other. Due
to product differentiation, there is a large variation in the demand and cost
curves of firms. Their price, output, and profits also differ.

Therefore, to simplify product group analysis, Chamberlin has given two

assumptions, which are as follows:

i) The demand and cost curves of all products in the group are the same or
uniform. The uniformity assumption. The preferences of consumers are
evenly distributed and the difference in preferences does not lead to
variation in cost.

ii) In monopolistic competition, a large number of sellers are not able to

influence each other’s decisions. The changes in prices or level of output,
of firm would have insignificant influence on its competitors. This is
termed as the symmetry assumption.

These two assumptions form the basis for group equilibrium analysis. If an
organisation within the group has established a popular brand, it is more likely
to earn supernormal profits. However, in the long run, other organisations
would strive to emulate the product design and features. In such a case,
supernormal profits would vanish. This is a general case of all monopolistically
competitive organisations.

On the other hand, if the entire group is earning supernormal profits, then
external organisations would get attracted towards the group, until the legal or
economic barriers are imposed.
In Fig. 11.6, P is the equilibrium point at which output is OM, price is MP, and
average cost is MT. In such a case, marginal cost is equal to marginal revenue.
Therefore, firms are earning supernormal profits (P'PTT'). However, these
supernormal profits disappear in the long run.

244
 Monopolistic
Competition: Price
and Output Decisions

Fig. 11.6: The short-run group equilibrium

Fig.11.7: The long-run group equilibrium

In Fig. 11.7, it can be seen that the supernormal profits have disappeared. It
also depicts that average revenue (AR) is tangent to LAC, which implies that
price is equal to average revenue. Marginal revenue gets equal to marginal cost
at the output level of OM. This shows that in the long run, all firms in the
industry are making normal profits.

11.4.4 Equilibrium with Selling Costs

Selling Costs: Concept
“Selling costs are costs incurred in order to alter the position or shape of the
demand curve for the product.” E.H. Chamberlin
Selling costs play the key role in monopolistic competition and oligopoly.
Under these market forms, the firms have to compete to promote their sale by
spending on advertisements and publicity.
Moreover, producer has not to decide about price and output only. He also
keeps in view how to maximise the profit.
Thus, cost on advertisement, publicity and salesmanship add to the cost or
supply curve of the product while also contributing to rise in its demand. The
Selling costs is a broader concept than the advertisement expenditures.
Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, incentives to retailers
to display the products, besides the advertisements. It was Chamberlin who
introduced the analysis of selling costs and distinguished it from the production 245
Market costs. The production costs include all those expenses which are spent on the
Structure manufacturing of the commodity, its transportation cost of handling, storing
and delivering of the commodity to actual customers because these add utilities
to a commodity.
On the other hand, all selling costs include expenditures in order to raise
demand for a commodity. In short, selling costs are those which are made to
‘create’ the demand for the product. Transport costs should not be included in
selling costs; rather these should be included in the production costs. Transport
costs actually do not increase the demand; it only helps in meeting the demand
of the consumers.
In general, “those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of
selling.”
The concept of selling cost is based on the following two assumptions:
1) Buyers do not have any perfect knowledge about the different types of
product.
2) Buyers’ demand and tastes can be changed.
While production costs include outlays incurred on services engaged in the
manufacturing of the product like land, labour and capital etc, the selling costs
include all the costs incurred to change the consumer’s preference from one
product to another. These raise the demand of a product at any given price.
“Production costs create utilities in order that demands may be satisfied while
selling costs create and shift the demand curves themselves.”
Selling costs influence equilibrium price-output adjustment of a firm under
monopolistic competition. In the Fig. 11.8 APC is the initial average
production cost. AR1 is the initial average revenue curve or initial demand
curve. The initial price is OP and the firm earns profits shown by the first
shaded rectangle PQRS.

Fig. 11.8: Equilibrium with selling costs

246
ACC1 is the average composite costs curve, which includes the average selling Monopolistic
cost (ASC). Average selling cost is equal to the vertical distance between APC Competition: Price
and ACC1. The new demand curve is AR2. It is obtained after incurring selling and Output Decisions
costs or after making advertisements.
It is, obvious, that the demand for the product has increased as a result of
selling costs. The profits have also increased as a result of selling costs. The
profits after incurring selling costs at OM1 level of output become equal to the
shaded area P1Q1R1S1. Note that these profits are greater than the initial level
of profits when no selling cost was incurred, i.e., P1 Q1 R1 S1 > PQRS.
ACC2 is the average composite cost when more additional selling cost is
incurred, as a result of which the demand for the product further increases. The
new demand curve is AR3 which indicates a higher demand for the product.
The profits are also greater than before since the shaded area P2Q2R2S2 >
P1Q1R1S.
It is, thus, obvious that the demand for the product is increasing as a result of
the selling costs. Since selling costs are included in the cost of production,
therefore price of the product is also increasing as a result of selling costs.
Profits are also increasing as a result of higher selling costs and increased
demand.
Here, question arises, how long a firm may go on incurring expenditure on
selling costs? It will continue to make expenditure on selling costs as long as
any addition to the revenue is greater than the addition to the selling costs. The
firm will stop incurring expenditure on selling costs when the total profits are
at the highest possible level.
This would be the point at which the additional revenue due to advertising
expenditure equals the extra expenditure on advertisement. It should, however,
be noted clearly that the effects of advertisement on prices and output are
uncertain. Advertisement by a firm may be considered successful if the
elasticity of demand for its product falls.
Check Your Progress 2
1) Will the demand curve for a firm under monopolistic competiton be
horizontal or downward sloping?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) On which factors equilibrium of individual firm depend under
monopolistic condition?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Construct the diagram showing long run equilibrium of firm in
monopolistic competition.
.....................................................................................................................
.....................................................................................................................
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247
Market
Structure
11.5 PERFECT COMPETITION, MONOPOLY,
AND MONOPOLISTIC COMPETITION:
COMPARISON
The upcoming discussion will help you to make a comparison between perfect
competition, monopoly and monopolistic competition.
1) Structural Differences
Under perfect competition, there are innumerable numbers of firms who
produce homogeneous goods. Each firm in the market is so small that it cannot
exert any influence on price and output. Each firm, thus, behaves as a price-
taker.
Under monopolistic competition, there is quite a large number of sellers who
sell slightly different products. Product differentiation enables a firm to
exercise some power over price and output. This means that sellers behave
as ‘price-makers’. However, a monopoly seller has full control over its price-
output decision.
There is complete freedom of entry and exit of firms — both in perfect
competition and in monopolistic competition. This condition is true during the
long period only. In the short run, entry or exit is ruled out in both these market
forms. But a monopoly business is characterised by the absence of a rival
seller. Entry of new firms is either legally prohibited in monopoly, or may not
be financially feasible.
2) Behavioural Differences
A firm behaves as a price-taker under perfect competition, and the demand
curve faced by it is a horizontal one. Since price is fixed, AR curve coincides
with the MR curve. A monopoly firm, however, faces a negatively sloped
demand curve because it can have perceptible influence over price and output.
Consequently, MR curve is also negative sloping and lies below the AR curve.
This is also true under monopolistic competition. The only difference between
monopoly and monopolistic competition is that the demand curve faced by a
monopolistically competitive seller is relatively more elastic.
Since price is fixed for a competitive firm, it has only to undertake output
decisions. Further, products sold by competitive firms are perfect substitutes.
Because of complete product homogeneity, no firm finds any incentive to
spend money on any kind of sales promotional activity.
A monopoly firm also does not find any urgency to spend money on
advertisement since there is no rival seller. But a monopolistically competitive
seller has to incur some sort of “selling costs” just to provide information
about its product or rivals’ products. In fact, in order to attract more and more
customers, additional expenditure on selling cost is a necessity.
In every market, sellers adopt independent price-output policy. But all sellers
of all market forms follow one basic principle. The basic behavioural rule is
the equality between MC and MR. Under perfect competition, since AR = MR,
MC = MR = AR = P. But, in monopoly and in monopolistic competition, this
behavioural rule is slightly altered to MC = MR < AR = P, since in these two
markets, AR > MR.
248
A monopoly firm or a monopolistically competitive firm produces in that Monopolistic
region of its demand curve where the coefficient of elasticity of demand is Competition: Price
greater than one. But, under perfect competition, coefficient of elasticity of and Output Decisions
demand is infinite.
3) Optimum Capacity and Sub-Optimal Capacity of Production
A competitive firm always produces at the minimum point of its AC curve.
This means that a firm utilises its plant optimally. Since AR curve is a
horizontal one, a competitive firm will always produce at the lowest point of its
AC curve. It is then said that perfect competition leads to optimum economic
efficiency.
But, under monopoly, or under monopolistic competition, the demand curve is
negative sloping. It is due to the nature of this demand curve that a firm fails to
operate at the minimum point of its AC curve. It operates somewhere to the left
of the lowest point of the AC curve.
The implication of this is that resources are not utilised optimally under
imperfect competition. Imperfect competition leads to economic inefficiency.
As a result, a higher price for the product is charged and lower output is
produced. In this sense, perfect competition is an ideal market where social
welfare gets maximised. But social welfare gets reduced in monopoly or in
monopolistic competition.
4) Supply Curve
Under perfect competition, MC curve above the shut-down point is the short
run supply curve. But, under monopoly, or monopolistic competition, the
supply curve remains indeterminate. In other words, in these market forms,
MC curve is not the supply curve.

11.6 THEORY OF EXCESS CAPACITY UNDER

MONOPOLISTIC COMPETITION
The doctrine of excess (or unutilised) capacity is associated with monopolistic
competition in the long-run and is defined as “the difference between ideal
(optimum) output and the output actually attained in the long-run.”

Fig. 11.6
We know that under perfect competition, the demand curve (AR) is tangential
to the long-run average cost curve (LAC) at its minimum point and conditions
of full equilibrium are fulfilled: LMC = MR and AR (price) = Minimum LAC.
This means that in the long-run, the entry of new firms forces the existing firms
to make the best use of their resources to produce at the lowest point of average
total costs. At point E in Fig. 11.6, abnormal profits will be competed away 249
Market because MR = LMC = AR = LAC at its minimum point E and OQ will be the
Structure most efficient output which the society will be enjoying. This is the ideal or
optimum output which firms produce in the long-run.
Under monopolistic competition, the demand curve facing the individual firm
is not horizontal as under perfect competition, but it is downward sloping. A
downward sloping demand curve cannot be tangent to the LAC curve at its
minimum point.
The double condition of equilibrium LMC = MR = AR (P) = Minimum LAC
will not be fulfilled. The firms will, therefore, producing at less than the
optimum level even when they are earning normal profits. No firm will have
the incentive to produce the ideal output, since any effort to produce more than
the equilibrium output would involve a higher long-run marginal cost than
marginal revenue.
Thus each firm under monopolistic competition will be producing at less than
the optimum level and work under excess capacity. This is illustrated in Fig.
11.7 where the monopolistic competitive firm’s demand curve is d and MR1 is
its corresponding marginal revenue curve. LAC and LMC are the long-run
average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1curve from
below and OQ1 output is set at the price Q1 A1. OQ1 is the equilibrium output
but not the ideal output because d is tangent to the LAC curve at A1 to the left
of the minimum point E. Any effort on the part of the firm to produce beyond
OQ1 will mean losses as beyond the equilibrium point E1, LMC > MR1. Thus
the firm has negative excess capacity measured by OQ1 which it cannot utilise
working under monopolistic competition.
A comparison of the equilibrium positions under monopolistic competition and
perfect competition with the help of Fig. 11.7 reveals that the output of a firm
under monopolistic competition is smaller and the price of its product is higher
than under perfect competition. The monopolistic competition output OQ1 is
less than the perfectly competitive output OQ, and the monopolistic
competitive price Q1A1 is higher than the competitive equilibrium price QE.
This is because of the existence of excess capacity under monopolistic
competition.

Fig. 11.7
250
Check Your Progress 3 Monopolistic
Competition: Price
1) In what respects monopolistic competition is different from other two and Output Decisions
extreme forms of market structure.

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

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

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

2) What do you understand by the term ‘excess capacity’?

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

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

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

11.7 LET US SUM UP

Monopolistic competition is a market structure in which there are many firms
selling closely related commodities. Its assumptions are: Large number of
buyers and sellers, Differentiated products, Free entry and exit, aim of the firm
is profit maximisation. Product differentiation exist which can be real or
artificial. Its effect is that the firm has some degree of price-making power.
Under monopolistic competition in the short-run, firm maximises profit where
MR=MC and the MC curve intersects MR curve from below. In the long-run,
due to free entry and exit of firms, firm earns normal profit. Economic profits
are zero.
Excess Capacity Theory states that it is a long-run concept and is the difference
between least cost output and profit maximising output. While, under perfect
competition, there is no excess capacity and under monopolistic competition,
excess capacity always exists.

11.8 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

11.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 11.1 and answer
2) Read Section 11.2 and answer
3) (c) 251
Market Check Your Progress 2
Structure
1) Read Section 11.3 and answer
2) Read Section 11.4 and answer
3) Read Sub-section 11.4.1 and answer
Check Your Progress 3
1) Read Section 11.5 and answer
2) Read Section 11.6 and answer

252
UNIT 12 OLIGOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
12.0 Objectives
12.1 Introduction
12.1.1 Definition of Oligopoly
12.1.2 Features of Oligopoly Market
12.1.3 Causes for the Existence of Oligopoly

12.2 Price and Output Determination under Oligopoly

12.2.1 Cournot’s Model
12.2.2 Stackelberg’s Model
12.2.3 Paul Sweezy’s Model: Kinked Demand Curve Analysis
12.2.3.1 Why the Kink in the Demand Curve?
12.2.3.2 Analysis of the Kinked Demand Curve Model

12.3 Co-operative vs. Non-cooperative Behaviour

12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
12.3.2 Types of Co-operative Behaviour
12.3.3 Types of Non-Cooperative Behaviour

12.4 Cartel Theory of Oligopoly

12.5 Let Us Sum Up
12.6 References
12.7 Answers or Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After studying this unit, you shall be able to:
• state the meaning and features of oligopoly;
• discuss the causes of existence of oligopoly;
• throw light on different models that explain the oligopoly price and
output determination;
• explain the co-operative and non-cooperative behaviour of oligopolistic
firms; and
• appreciate cartel theory of oligopolist.

12.1 INTRODUCTION
Oligopoly refers to a market wherein only a few firms account for most or all
of total production.

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi.
253
Market 12.1.1 Definition of Oligopoly
Structure
Oligopoly referes to the presence of few sellers in the market selling the
homogeneous or differentiated products. In other words, the Oligopoly market
structure lies between the pure monopoly and monopolistic competition, where
few sellers dominate the market and have control over the price of the product.
Under the Oligopoly market, a firm either produces homogeneous or
heterogeneous products:
• Homogeneous Product: The firms producing the homogeneous products
are called as Pure or Perfect Oligopoly. It is found in the case of
industrial products such as aluminum, copper, steel, zinc, iron, etc.

• Heterogeneous Product: The firms producing the heterogeneous

products are called as Imperfect or Differentiated Oligopoly. Such type of
Oligopoly is found in the production of consumer goods such as
automobiles, soaps, detergents, television, refrigerators, etc.

12.1.2 Features of Oligopoly Market

1) Few Sellers: Under the Oligopoly market, the sellers are few, and the
customers are many. Few firms dominating the market enjoy a
considerable control over the price of the product.
2) Interdependence: It is one of the most important features of an
Oligopoly market, wherein, the seller has to be cautious with respect to
any action taken by the competing firms. Since there are few sellers in the
market, if any firm makes a change in the price or promotional scheme,
all other firms in the industry have to comply with it to remain in the
competition.
Thus, every firm remains alert to the actions of others and plan their
counterattack beforehand to escape the turmoil. Hence, there is a
complete interdependence among the sellers with respect to their price-
output policies.
3) Advertising: Under Oligopoly market, every firm advertises their
products on a frequent basis with the intention to reach more and more
customers and increase their customer base. This advertising makes the
competition intense.
If any firm does a lot of advertisement while the other remained silent,
then you will observe that his customers are going to the firm which is
continuously promoting its product. Thus, in order to be in the race, each
firm spends lots of money on advertisement activities.
4) Competition: It is genuine that with a few players in the market, there
will be an intense competition among the sellers. Any move by one firm
will have a considerable impact on its rivals. Thus, every seller keeps an
eye over its rivals and be ready with the counterattack.
5) Entry and Exit Barriers: The firms can easily exit the industry
whenever they want, but has to face certain barriers to enter into it. These
barriers could be Government license, Patent, large firm’s economies of
scale, high capital requirement, complex technology, etc. Also,
sometimes the government regulations favour the existing large firms,
thereby acting as a barrier for the new entrants.
254
6) Lack of Uniformity: There is a lack of uniformity among the firms in Oligopoly: Price and
terms of their size, some are big, and some are small. Since there are less Output Decisions
number of firms, any action taken by one firm has a considerable effect
on the other. Thus, every firm must keep a close eye on its counterpart
and plan the promotional activities accordingly.
12.1.3 Causes for the Existence of Oligopoly
There are certain reasons which have led to the emergence of oligopoly. These
are:
1) Large Investment of Capital
The number of firms in an industry may be small due to the large requirements
of capital. No entrepreneur will like to venture into investing large sums in an
industry in which addition to output to the existing level may depress prices.
Further, the new entrant may also fear of provoking a price-war by the
established firms in the industry. This is always true that in the midst of
differentiated products, it is difficult to introduce a new product.
2) Control of Indispensable Resources
A few firms may control some indispensable resources which may enable them
to secure several advantages in costs over all others. This enables them to
operate profitably at a price at which others cannot survive.
3) Legal Restriction and Patents
In public utility sector, the entry of new firms is closely regulated through the
grant of certificate by the State. This policy of exclusion of rivals may be due
to diseconomies of small scale or of duplication of services. Another factor for
the emergence of oligopoly is the patent right which a few firms acquire in
matter of some goods. Patents have led to many important industrial
monopolies in America and elsewhere.
4) Economies of Scale
Another factor responsible for emergence of oligopoly is the operations at large
scale. In some industries, a few firms can meet the entire demand for the
product. It is possible that the demand may be satisfied by a large number of
firms, but small firms cannot secure the economies of large scale production.
In the industries where there is a lot of mechanisation and where economies of
large scale are considerable, only a few firms will survive.
The firms attain such a huge size that just a few of them can satisfy the entire
demand. For example, automobiles, steel industry, petroleum etc. Oligopolies
are also found in local markets. In small towns, a few firms may be sufficient
to satisfy the demand, e.g., petrol, banks, building material suppliers etc. The
market is small and therefore can be satisfied by a few firms.
5) Superior Entrepreneurs
In some industries there may be some superior entrepreneurs whose costs are
lower than inferior rivals. These entrepreneurs under sell and eliminate most of
their rivals.
6) Mergers
Many oligopolies have been created by combining two or more independent
255
Market firms. The combination of two or more firms into one firm is known a merger.
Structure The main motives of mergers include increasing market powers, more
resources, economies of scale and market extensions etc.
7) Difficulties of Entry into the Industry
Lastly, oligopoly may come to exist because of difficulties of entry into the
industry. One big difficulty in some industries is the large requirements of
capital. Businessmen do not like to venture into those industries entry to which,
even of one firm, is likely to depress prices to such an extent as to make it
unprofitable for all. They may also be afraid of the price war that their entry
may provoke from the established firms in the industry. Prospective entrants to
an industry are also deterred by the difficulty of marketing new products or
new brands in the presence of already well-established, well-entrenched
brands.
Check Your Progress 1
1) What is Oligopoly? Explain with few examples.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Identify and explain the features that shows the existence of oligopoly in
market.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) A market with many buyers and a few dominant sellers is :
A) purely competitive
B) a monopoly
C) monopolistically competitive
D) oligopolistic

12.2 PRICE AND OUTPUT DETERMINATION

UNDER OLIGOPOLY
Unlike other market forms, price and output under oligopoly is never fixed.
Interdependence of firms led uncertainty always exists in the market. In such a
situation, it becomes difficult to determine the equilibrium price and output for
an oligopolistic firm. An oligopolist cannot assume that its competitors will not
change their price and/or output if it changes. Price change by one firm will be
followed by other competitors, which will change the demand conditions
facing this firm. Therefore, demand curve for any firm is not fixed like other
markets. Demand curve for a firm keeps changing as firms change their prices.
Therefore, in the absence of a fixed demand (Average Revenue) curve, it is
difficult to determine the equilibrium price and output. However, economists
have developed some price-output models to explain the behaviour of
256 oligopolistic firms. They are as follows:
I. Some economists ignore the interdependence among the firms when they Oligopoly: Price and
explain the oligopoly market. In such case the demand will be known and Output Decisions
equilibrium price and output can be determined.
II. Another approach is based on collusion. Oligopolists can form a group
and maximise their joint output and profit. Best example of such
collusion is Cartel (it is a situation when oligopolists agree to work
together in the international market). One firm is chosen as a leader. The
prices determined by the leader are followed by others in such a case.
III. Third approach assumes that an oligopolist predicts the reaction of its
competitors. Problems regarding prices and output determination are
solved by such assumptions. Various models based on different
assumptions exist in this category. Few of them are: Chamberlin Model,
Cournot’s Model, and Paul Sweezy Kinked Demand curve Model etc.

12.2.1 Cournot’s Model

In 1838, Augustin Cournot introduced a simple model of duopolies that
remains the standard model for oligopolistic competition.
This modal is based on the following assumptions:
1) The two firms produce homogeneous and indistinguishable goods.
2) There are no other firms in the market who produce the same or
substitute goods.
3) No other firms can or will enter the market.
4) Collusive behaviour is prohibited. Firms cannot act together to form a
cartel.
5) There exists one market for the produced goods.
In addition to the assumptions stated above, the Cournot duopoly model relies
on the following:
1) Each firm chooses a quantity to produce.
2) All firms make this choice simultaneously.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
4) The cost structures of the firms are public information.
In the Cournot model, the strategic variable is the output quantity. Each firm
decides how much of a good to produce. Both firms know the market demand
curve, and each firm knows the cost structures of the other firm. The essence of
the model is that each firm takes the other firm’s choice of output level as fixed
and then sets its own production quantities.
Before explaining the model, let us define the reaction curve.
A reaction curve for Firm 1 is a function Q1 that takes input as the quantity
produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's
production decisions. In other words, Q1 (Q2) is Firm 1's best response to Firm
2's choice of Q2. Likewise, Q2 (Q1) is Firm 2's best response to Firm 1's choice
of Q 1.
257
Market Let’s assume that the two firms face a single market demand curve as follows:
Structure
Q = 100 – P
where P is the single market price and Q is the total quantity of output in the
market. For simplicity’s sake, let’s assume that both firms face cost structures
as follows:
MC1 = 10
MC2 = 12
Given this market demand curve and cost structure, we want to find the
reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and
proceed. Firm 1's reaction curve will satisfy its profit maximising
condition, MR = MC . In order to find Firm 1's marginal revenue, we first
determine its total revenue, which can be described as follows:
Total Revenue = PQ1 = (100 – Q) Q1 = 100Q1 – (Q1+ Q2) Q1
= [100 – (Q1 + Q2)] Q1 = 100Q1 – Q12 – Q2Q1
= 100Q1 – Q12 – Q2 Q1
The marginal revenue is simply the first derivative of the total revenue with
respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for
Firm 1 is thus:
MR1 = 100 – 2Q1 – Q2
Imposing the profit maximising condition of MR = MC , we conclude that
Firm 1's reaction curve is:
100 – 2 Q1 – Q2 = 10
90 Q2
Q1 = –
2 2
Q1 = 45 – Q2
That is, for every choice of Q2, Q1 is Firm 1's optimal choice of output. We can
perform analogous analysis for Firm 2 (which differs only in that its marginal
costs are 12 rather than 10) to determine its reaction curve. We find Firm 2's
reaction curve to be:
Q2 = 44 – Q1/2.
The solution to the Cournot model lies at the intersection of the two reaction
curves. We solve now for Q1. Note that we substitute Q2 for Q2 because we are
looking for a point which lies on Firm 2's reaction curve as well.
Q1 = 45 – Q2/2 = 45 – (44 – Q1/2)/2
= 45 – 22 + Q1/4
= 23 + Q1/4
=> Q1 = 92/3
By the same logic, we find:
Q2 = 86/3
Note that Q1 and Q2 differ due to the difference in marginal costs. In a
perfectly competitive market, only firms with the lowest marginal cost would
survive. In this case, however, Firm 2 still produces a significant quantity of
258 goods, even though its marginal cost is 20% higher than Firm 1's.
An equilibrium cannot occur at a point not at the intersection of the two Oligopoly: Price and
reaction curves. If such an equilibrium existed, at least one firm would not be Output Decisions
on its reaction curve and would therefore not be playing its optimal strategy. It
has incentive to move elsewhere, thus invalidating the equilibrium.
The Cournot equilibrium is a best response made in reaction to a best response
and, by definition, is therefore a Nash equilibrium. Unfortunately, the Cournot
model does not describe the dynamics behind reaching equilibrium from a non-
equilibrium state. If the two firms began out of equilibrium, at least one would
have an incentive to move, thus violating our assumption that the quantities
chosen are fixed. Rest assured that for the examples we have seen, the firms
would tend towards equilibrium. However, we would require more advanced
mathematics to adequately model this movement.

Fig. 12.1

12.2.2 Stackelberg’s Model

The Stackelberg duopoly model of duopolies is very similar to the Cournot
model. Like the Cournot model, the firms choose the quantities they produce.
However, here the firms do not move simultaneously. One firm holds the
privilege to choose production quantities before the other. The assumptions
underlying the Stackelberg model are as follows:
1) Each firm chooses a quantity to produce.
2) A firm chooses before the other in an observable manner.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
To illustrate the Stackelberg model, let’s take an example. Assume Firm 1 is
the first mover with Firm 2 reacting to Firm 1's decision. We assume a market
demand curve of:
Q = 90 – P
Furthermore, we assume all marginal costs are zero, that is:
MC = MC1 = MC2 = 0
We calculate Firm 2's reaction curve in the same way we did for the Cournot
Model. Verify that Firm 2's reaction curve is:
Q2 = 45 – Q1/2
259
Market To calculate Firm 1's optimal quantity, we look at Firm 1's total revenues.
Structure
Firm 1's Total Revenue = P Q1 = (90 – Q1 – Q2) Q1
= 90 Q1 – Q12 – Q2 Q1
However, Firm 1 is not forced to assume Firm 2's quantity is fixed. In fact,
Firm 1 knows that Firm 2 will act along its reaction curve which varies
with Q1 . Firm 2's quantity very much relies on Firm 1's choice of quantity.
Firm 1's Total Revenue can thus be rewritten as a function of Q1:

R1 = 90 Q1 – Q12 – Q1 (45 – Q1/2)

Marginal revenue for firm 1 is thus:
MR1 = 90 – 2 * Q1 – 45 + Q1
= 45 – Q1
When we impose the profit maximising condition (MR = MC), we find:
Q1 = 45
Solving for Q2 , we find:
Q2 = 22.5
In the Cournot model, both firms make their choices simultaneously and have
no communication beforehand. In the Stackelberg model, Firm 1 not only
announces first, but Firm 2 knows that when Firm 1 announces, Firm 1's
actions are credible and fixed. This demonstrates how a slight change in the
flow of information can drastically impact the outcome of a market. Note that
Firm 1 decided first. Its decision is to meet half of the market demand. The
second firm decides to meet half of remaining market demand. Note that firm
which decides first will be able to produce and sell larger quantity. It amounts
to capturing larger market share. That is why we say that essence of
Stackleberg model lies in its First Movers’ Advantage feature.
Illustration 1:
Two firms have marginal costs of 10. They face a market demand curve of P =
100 – 4Q . The government imposes a tax of 10 dollars per unit sold.
Determine the Cournot equilibrium quantity.
Assuming that the tax will be paid by the consumer, the effective demand
curve becomes 90 – 4Q .
R1 = (90 – 4Q1 –4Q2).Q1
MR 1 = 90 – 8Q1 – 4Q2
Setting MR = MC:
•• – ••
Q1 = 10 – Q 2/2 =
•
By symmetry:
• – •!
Q1 = Q2 =
•
Illustration 2 :
Assume three firms face identical marginal costs of 20 with fixed costs of 10.
They face a market demand curve of P = 200 – 2Q. Find the Cournot
equilibrium price and quantity.
260
 R1 = (200 – 2(Q1 + Q2 + Q3))Q1 Oligopoly: Price and
Output Decisions
MR1 = 200 – 4Q1 – 2Q2 – 2Q3
Applying MR = MC:
Q1 = 45 – Q2/2 – Q3/2
By symmetry:
Q1 = Q2 = Q3 = 22.5
12.2.3 Paul Sweezy Model : Kinked Demand Curve Analysis
This model was developed independently by Prof. Paul M. Sweezy on the one
hand and Profs. R. C. Hall and C. J. Hitch on the other hand.
The assumptions of this model are:
i) There are only a few firms in an oligopolistic market.
ii) The firms are producing close-substitute products.
iii) The quality of the products remains constant and the firms do not spend
on advertising.
iv) A set of prices of the product has already been determined and these
prices prevail in the market at present.
v) Each firm believes that if it reduces the price of its product, the rival
firms would follow suit, but if it increases the price, the rivals would not
follow it. They would simply keep their prices unchanged. We shall see
presently that, because of this asymmetric pattern of reaction of the
rivals, the demand curve of each firm would have a kink at the prevailing
price of its product.
12.2.3.1 Why the Kink in the Demand Curve?
In the figure we have drawn two negatively sloped straight line demand curves,
viz., dd' and DD'. Of these two curves, dd' is more flat than DD'. Now, when
one particular firm in the industry changes the price of its product, all other
firms keeping their prices constant, the firm’s demand curve will be relatively
flatter like dd', i.e., the magnitude of the change in the demand for its product
as its price changes would be relatively larger.

Fig. 12.2

This is because, as the firm reduces or increases the price of its product, the
prices of the products of other firms remaining constant, the product of the firm
becomes relatively cheaper or dearer, respectively, than those of the other
firms. This will make the demand curve flatter for this firm.
261
Market On the other hand, if a firm increases its price, the office firms will not follow
Structure the suit. So there will be an asymmetry in responses of the rivals.
If one firm reduces price, all others follow the suit – otherwise they run the risk
of losing their customers to this firm.
If one raises the price, others do not as they expect to win some customers
from this firm. Together, these responses create a kink in demand curve.
Let us suppose that initially the price of the product of the firm is p1 or Op1 and
the demand for the product is q1 or Oq1 If the firm now increases its price from
p1, the rival firms would keep their prices unchanged according to assumption
(v) of this model.
In this case, the firm’s demand would decrease along the segment Rd of the
relatively more elastic demand curve dd'. On the other hand, if it goes on
decreasing its price from p1, its rivals also would be decreasing their prices
according to assumption (v). In this case, the quantity demanded of the firm’s
product will increase along the segment RD' of the relatively steeper demand
curve DD'.
Therefore, at the price p1, the firm’s demand curve would be dRD'. Obviously,
because of assumption (v), the segment dR of this demand curve would be
more flat or more elastic than the segment RD' (and the segment RD' would be
more steep or less elastic than the segment dR).
As a result, there would be a kink at the prevailing price p1, or, at the point R
on the firm’s demand curve d RD', i.e., the demand curve in this model would
be a kinked demand curve.
12.2.3.2 Analysis of the Kinked Demand Curve Model
In the oligopoly model under discussion, the properties of the kinked demand
curve as well as its significance are especially discussed. In the first place, as
the demand curve or the average revenue (AR) curve of the firm has a kink, its
MR curve cannot be obtained as a continuous curve. We may, therefore, begin
with the properties of the MR curve of the kinked demand curve with the help
of Fig. 12.3.
The kinked demand curve of the firm in Fig. 12.3 is dRD'. There is a kink at
the point R (p1, q1) on this curve, because the curve consists of a segment dR of
the relatively flatter curve dd' and another segment RD' of the relatively steeper
curve DD'.
Therefore, in the case of the kinked demand curve dRD', the firm’s MR curve,
up to q = q1, would consist of the MR curve dM associated with the dR
segment of the kinked demand curve and for q > q1, the MR curve would be
the segment NB associated with the segment RD' of the demand curve.

262 Fig. 12.3

We have obtained above that the firm’s MR curve for its kinked demand curve Oligopoly: Price and
would consist of two parts, viz., the segments dM and NB, and there would be Output Decisions
a vertical gap between the points M and N at q = q1.
This implies that as the firm’s output goes on increasing up to q1, its MR would
go on decreasing along the segment dM up to the amount Mq1 and if the firm’s
output increases even by an infinitesimally small quantity at q = q1, its MR
would fall to Nq1, and, thereafter, as q increases, MR would decrease along the
segment NB.
In other words, there would be no MR value between Mq1 and Nq1, i.e., the
dotted segment MN is the discontinuity in the firm’s MR curve. We may also
say that at the point R on the dR segment of the kinked demand curve, the
firm’s MR would be Mq1 and, at the point R on the RD' segment of the demand
curve, MR would be Nq1.
We may now easily see that the numerical coefficient of elasticity of demand
(e1) at the point R on the demand curve segment dR is different from the
coefficient (e2) at the point R on the demand curve segment RD', and the larger
the difference between e1 and e2, the larger would be the length of the
discontinuity of the MR curve at the output q1.
As we know, at any point R (p1, q1) on the firm’s demand curve in Fig.12.4,
numerical coefficient (e) of price-elasticity of demand is
•
e = •• × reciprocal of the numerical slope at that point on the demand curve
•

now, the reciprocal of the numerical slope of the demand curve dRd' at the
point R on the segment dR > the reciprocal of the numerical slope of the
demand curve at the point R on the segment RD'.
Because, the segment dR is more flat than the segment RD', therefore, we have
e1 > e2
Now, MR (= MR1, say) at the point R on the segment dR' is
!
MR1 = Mq1 = p1 •1 − $
"#

Also, MR (=MR2, say) at point R on the segment RD' is

!
MR2 = Nq1 = p1 •1 − $
"%

Therefore, from the above two equations, we obtain

! ! ! !
e1 > e2 ⇒ 1 − " > 1 − " ⇒ p1 •1 − " $ > p1 •1 − " $
# % # %

⇒MR1 (=Mq1) > MR2 (=Nq1)

That is, at the point of kink, R, on the demand curve dRD', or at q = q1, we
have two different values (e1 and e2) of e, and that is why at q = q1, we obtain
two different values (MR1 and MR2) of MR and two different parts of the MR
curve. The vertical gap between the two parts of the MR curve at q = q1 is
Mq1 – Nq1 = MN.
It follows from the above discussion that the larger the difference between e1,
and e2, i.e., the more flat the segment dR would be than the segment RD', i.e.,
the more prominent the kink would be at the point R, the larger would be the
value of MR1 than that of MR2 and the larger would be the discontinuity in the
MR curve at q = q1. 263
Market Second, in the model under discussion, the prices of the products are given
Structure initially, and a relation between these prices has been established already. The
model does not explain how these prices have been determined.
But there is a good chance that the price of the product of a firm would be
consistent with its goal of profit maximisation. For example, in Fig. 12.4, the
firm’s demand curve is dRD' and the associated MR curve is MR1 – the
discontinuity or the vertical gap between the two parts of the MR1 curve is MN.
Now, if the marginal cost (MC1) curve of the firm passes through this gap of
MN, then the firm’s price-output combination R(p1, q1) is consistent with profit
maximisation although here, at q = q1, we have MR (= Mq1) > MC (= Lq1), and
not MR = MC.
Here we see that at q < q1 MR > MC, making the firm increase its output to
reach the profit-maximising point. Now, as q increases and becomes equal to
q1, then also we have MR > MC. But if the firm increases q beyond q1, MR
becomes less than MC (MR < MC), i.e., from the production and sale of the
marginal unit of its output, the firm now would incur a loss.
Therefore, it would not produce more than q1, and its profit would be
maximum at q = q1, in spite of the fact that at q = q1, we have MR > MC, and
not MR = MC.
Third, although the assumption (v) of the model regarding the reaction pattern
of the rival firms may explain the kink in the firm’s demand curve, it cannot
explain how the price of the firm’s product, or, for that matter, the prices of the
rivals’ products are determined.
However, the reaction pattern of the rivals, as given by assumption (v), is able
to explain why the prices would not tend to change, i.e., why they would be
sticky, once they get determined.
For example, if, in Fig. 12.4, the firm’s quantity sold increases from q1 to q2, it
would not be inclined to change the assumption regarding the reaction pattern
of the rivals, for its conception about the rivals’ reactions, is, by no means,
dependent on its quantity sold.
Therefore, it would regard the increase in quantity sold, or an increase in the
demand for its product, as caused by a rightward shift in its demand curve—it
would think that its demand curve has shifted to the right from dRD' to dR'D''.

Fig. 12.4
264
We may note here that although the demand curve has shifted to the right, it Oligopoly: Price and
has kept the price of its product unchanged, resulting not necessarily in the Output Decisions
unfulfilment of its profit maximising goal.
In Fig. 12.4, we have assumed that the two curves, viz., dRD' and dR'D'', are
iso-elastic, and the MC1 curve passes also through the discontinuity (M1N1) of
the MR2 curve which is the marginal curve for the demand curve dR'D''.
Therefore, here the firm is able to maximise its profit at the same price p1 =
R'q2 = Rq1.
Fourth, in the model under discussion, the firm may not have to change the
price of its product, even if its cost of production rises. For example, let us
suppose that initially the firm’s AR and MR curves are dRD' and MR1, and the
MC, curve is the firm’s MC curve.
In this case, the firm’s profit would be maximised if it sells q1 of output at the
price of p1. Now, if the firm’s cost position changes resulting in an upward
shift in its MC curve from MC1 to MC2, and if the MC2 curve also, like MC1,
passes through the discontinuity (MN) of its MR curve, then the firm would
not have to change the price of its product in order to earn the maximum profit.
It would be able to maximise profit if it, like the previous case, sells of output
at the price of p1.
If the cost of production rises along with a shift in the demand curve, then also,
profit maximisation may not require the firm to change the price of its product.
For example, in Fig.12.4, let us suppose that the firm’s AR, MR and MC
curves are, respectively, dRD', MR1and MC1, In this case, the firm’s profit-
maximising price-output combination would be R (p1 q1).
Now, if the firm’s MC curve rises to MC2 along with a rightward shift in its
demand curve to dR'D'', then also the firm would not be required to change the
price of its product if the MC2 curve passes through both the discontinuities,
MN and M1N1, of its dRD' and dR'D'' curves.
It would still be able to earn the maximum profit at the price P1; but now its
quantity of output produced and sold would be q2; that is, now the firm’s price-
output combination would be obtained at the point R' (p1, q2).
On the basis of the above discussion, we may conclude that in the kinked
demand curve model of oligopoly, the firm would not consider it profitable or
rational to change the prevailing price of its product because of the assumption
(v) relating to the reaction pattern of its rivals.
[This assumption states, that if a particular firm increases the price of its
product, its rivals will not increase theirs, but if it reduces the price, they will
promptly reduce their prices.] We have seen that, because of these reactions,
the demand curve of each oligopolistic firm will be kinked, and the MR curve
of this demand curve will have two separate segments, and there will be a
vertical gap between them.
However, it is not that the firm’s goal of profit maximisation can never be
achieved because of the existence of this vertical gap. Even when the firm’s
demand increases, i.e., its demand curve shifts to the right and/or its MC curve
shifts upwards, it is not impossible for it to achieve profit maximisation at the
prevailing price.
Therefore, although the kinked demand curve model cannot explain the process
265
Market of price determination, it can well explain why the prices are sticky in an
Structure oligopolistic market.
Check Your Progress 2
1) Let there be two firms under Cournot’s model having market demand
curve as P = 20 – Q where Q the total production of the two firms 1 and
2. These firms are assumed to be producing under zero cost of
production. Determine:
i) Reaction curves of the two firms,
ii) Equilibrium level of output for both the firms
iii) Equilibrium market price
iv) Show graphically the Cournot’s equilibrium
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Let there be two firms which produce output under zero cost of
production. The market demand curve is given by P = 20 – Q (Where Q =
total output). Calculate output solution for the two firms under
Stakelberg’s model.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) In a duopolist market two firms can produce at a constant average and
marginal cost of AC = MC = 2. They face the market demand curve
P = 14 – Q, Where Q = Q1 + Q2' where Q1 is the output of Firm 1, Q2 is
the output of Firm 2. In the Cournot’s model:
i) Find action-reaction functions of the two firms.
ii) Calculate the profit maximising equilibrium price and output.
iii) What are the profits of the two firms?
iv) Compare it with competitive equilibrium.
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) Assume three firms face identical marginal costs of 20 with fixed costs of
10. They face a market demand curve of P = 200 – 2Q . Find the Cournot
equilibrium price and quantity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
266
5) What do you mean by kink in demand curve? Oligopoly: Price and
Output Decisions
......................................................................................................................
......................................................................................................................
......................................................................................................................

12.3 CO-OPERATIVE VS. NON-

COOPERATIVE BEHAVIOUR
12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
Co-operative behaviour in oligopoly is a situation when firms jointly decide the
prices and output and maximise their joint profit. This situation is called
collusion. In this situation it becomes profitable for one firm if it defects and
undercuts the prices and raises output, as long as others do not do so. Non-
cooperative behaviour is a situation when they do not co-operate and decides
their prices and output separately and compete with each other. When firms in
oligopoly do not co-operate it is called non-cooperative equilibrium or Nash
equilibrium (Named after US mathematician John Nash).
In oligopoly, the basic dilemma the firms face is whether to co-operate or to
compete. If they co-operate, profit will be maximum and if they do not, profit
for all will decrease. Now we will see the behaviour of an oligopolistc firm
through an example of game theory. Game theory is the study of decision
making in situations where strategic interaction (moves and countermoves)
between rival firms occurs. We will assume a case of only two firms in the
market, called Duopoly. The case is as follow:
The Oligopolist’s dilemma: to co-operate or to compete.
Table 12.1

Firm A’s Output

One-half Two-third
Monopoly output Monopoly
output
One-half 20 20 15 22
Monopoly output
Firm B’s Output
Two-third 22 15 17 17
Monopoly output

The figure above explains the dilemma faced by oligopolists of whether to co-
operate or to compete. It is called Payoff Matrix for a two Firm duopoly game.
The right side figures on each cell shows the profits of Firm A and left side
figures on each cell show the profits of Firm B (in Rs. Crores). It can be
explained that if the two firms co-operate and produce one half of market share
each will earn Rs. 20 crores of profit. In case of co-operation they can
maximise their profits. If Firm A defects and produces two thirds of output and
Firm B produces half of monopoly output then Firm A will earn Rs. 22 crores
and Firm B Rs. 15 crores. Similarly if Firm B defects and produces two-third
and Firm A produces one-half then Firm B will earn Rs. 22 crores and Firm A
will earn only Rs. 15 crores. If both decide to compete and produce two-third
267
Market of monopoly output each then profits for both will fall to Rs. 17 crores. This
Structure type of game, where they reach a non-cooperative solution when they could co-
operate, is called Prisoner’s Dilemma. Prisoner’s Dilemma is shown below:
Table 12.2 : The Prisoner's Dilemma

Mr. Ram
Confess Not confess
Mr. Shyam Confess 6 09
Not confess 9 1

Two prisoners Mr. Ram and Mr. Shyam are arrested for committing a crime
and interrogated separately. They are told the following:
a) If both are claimed to be innocent, they will get a light sentence that is 1
year in jail.
b) If one confesses and the other does not, then who confesses will be
released free and the other will be punished for 9 year in jail, and
c) If both confess, then both of them will get a punishment of 6 years in jail.
The payoff matrix presented in Table 12.2 shows the dilemma of the prisoners
about whether to confess or not to confess. If none of them confess then both
will get 1 year of jail, but if Ram confesses and Shyam does not then Ram will
be left free and Shyam will get 9 year of imprisonment and the vise-versa. And
if both of them confess then both will get 6 years of imprisonment. Not
confessing is the best solution in this game (Pareto efficient solution) but this
leaves one always in uncertainty. This solution is not a stable solution as one
gets an imprisonment of 9 years if he/she does not confess and the other does.
Therefore, confession dominates in the mind of both the prisoners. If both of
them confess then they end up with 6 years jail for both. This kind of
equilibrium is called Nash equilibrium. From both the figures above it is clear
that it they co-operate then they will earn the maximum profit than if they
compete.

12.3.2 Types of Co-Operative Behaviour

In order to avoid uncertainty arising out of interdependence and to avoid price
war and cut throat competition, firms under oligopoly often enter into some
agreement about determining uniform price and output. The agreement can be
of the following two types.
• Explicit Collusion: It is situation when firms under oligopoly do formal
(explicit) agreement to determine uniform price and output and maximise
their joint profit. Such an agreement at international level is called Cartel,
Many such agreements have taken place in the past. The best example of
cartel is that of OPEC – Organisation of Petroleum Exporting Countries.
Saudi Arabia and other countries after 1973 formed this cartel. An
individual firm always has incentive to cheat. Possibility of cheating is
larger if number of firms is large. Cheating by a small firm has negligible
effect on the market price.
• Tacit Co-operation: When firms co-operate without any explicit
268 agreement it is called tacit co-operation. For example in Table 12.1, if
 Firm A produces one-half of monopoly output hoping that Firm B will do Oligopoly: Price and
the same and Firm B does so then they achieve the co-operative Output Decisions
equilibrium without any formal agreement.
12.3.3 Types of Non-Cooperative Behaviour
In the absence of formal or informal agreements about co-operation, firms
under oligopoly compete with each other. Non-Cooperative or Competitive
behaviour under oligopoly can be of following types.
Competition for Market Share: Firms under oligopoly always compete with
each other for market share. They use various forms of non-price competition
such as advertising, quality products etc. to increase their market share. For
example in Delhi major mobile service providers like Airtel, Hutch and Idea
compete for increase their mobile connections.
Covert Cheating: In oligopoly, because of huge market share, firms sell their
products through contract. Large scale production and distribution is done
through contracts. When firms provide secret discounts and rebates to their
buyers to increase sales it is called covert cheating.
Contestable Markets and Potential Entry: Theory of contestable markets
explains that in the long-run, abnormal profits earned by oligopolists can be
eliminated without actual entry. Potential entry can also affect the market as
much as an actual entry does. It is possible only when the following two
conditions are fulfilled:
1) Entry must be easy to accomplish: There should not exist any barriers
to entry, either natural or firm created.
2) The existing firms must consider potential entry while making price
and output decisions: The existing firms must react when new firms try
to enter into the market. They must cut their prices and sacrifice profits
(short run) to restrict the new entrants.
Contestable markets always expect potential entry because of huge profits
earned by the existing firms in the market. But entry to such markets is too
costly. Fixed costs are very high. To develop, design, and sale a new product in
such a market involve huge sunk cost. Sunk costs are those costs which cannot
be recovered if a firm leaves the market soon. Firms which produce multiple
and differentiated products can easily distribute these costs among those many
products. For new firms, producing huge number of differentiated products is
not easy. Therefore, these costs are very high for a firm which produces single
product in the market.
If a new firm can enter and leave the market without any sunk costs of entry,
such markets are called perfectly contestable markets. A market can be
perfectly contestable, even if, firms have to pay some costs of entry if these
costs are recovered when firms leave the market. If the sunk costs are lower,
the market will be more contestable and vise-versa.
Sunk costs of entry constitute entry barriers. Higher the sunk costs, larger will
be profits earned by the existing firms. If the firms operate in the market
without large sunk costs of entry, then they will not earn large profits. As part
of strategy, existing firms keep their prices as low as that can only cover the
total costs. If they charge high prices and earn abnormal profits, the new firms
will enter and may capture the profits. Contestability forces the existing firms
to keep the prices low. The threat of entry into a market is as effective as actual
entry to limit profiteering by existing firms. 269
Market
Structure
12.4 CARTEL THEORY OF OLIGOPOLY
A cartel is defined as a group of firms that gets together to make output and
price decisions. The conditions that give rise to an oligopolistic market are also
conducive to the formation of a cartel. In particular, cartels tend to arise in
markets where there are few firms and each firm has a significant share of the
market. In the U.S., cartels are illegal; however, internationally, there are no
restrictions on cartel formation. The Organisation of Petroleum Exporting
Countries (OPEC) is perhaps the best known example of an international
cartel. OPEC members meet regularly to decide how much oil each member of
the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase their market power. Members of the
cartel work together to determine jointly the level of output that each member
will produce and/or the price that each member will charge. By working
together, the cartel members are able to behave like a monopolist. For example,
if each firm in an oligopoly sells an undifferentiated product like oil, the
demand curve that each firm faces will be horizontal at the market price. If,
however, the oil producing firms form a cartel like OPEC to determine their
output and price, they will jointly face a downward sloping market demand
curve, just like a monopolist. In fact, the cartel’s profit maximising decision is
the same as that of a monopolist. The cartel members choose their combined
output at the level where their combined marginal revenue equals their
combined marginal cost. The cartel price is determined by market demand
curve at the level of output chosen by the cartel. The cartel’s profits are equal
to the area of the rectangular box labelled abcd in Fig. 12.5. Note that a cartel,
like a monopolist, will choose to produce less output and charge a higher price
than would be found in a perfectly competitive market.

Fig. 12.5

Once established, cartels are difficult to maintain. The problem is that cartel
members will be tempted to cheat on their agreement to limit production. By
producing more output than it has agreed to produce, a cartel member can
increase its share of profits. Hence, there is a built in incentive for each cartel
member to cheat. Of course, if all members cheated, the cartel would cease to
270
earn monopoly profits, and there would no longer be any incentive for firms to Oligopoly: Price and
remain in the cartel. The cheating problem has plagued the OPEC cartel as well Output Decisions
as other cartels and perhaps explains why so few cartels exist.
Check Your Progress 3
1) Explain the prisoner’s Dilemma in oligopoly market.
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) State the types of Non-cooperative behaviour under oligopoly.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by Cartel?
......................................................................................................................
......................................................................................................................
......................................................................................................................

12.5 LET US SUM UP

Oligopoly is the most prevailing form of markets. It is defined as a market
structure in which there are a few sellers of the homogeneous or differentiated
products. Oligopoly can be pure or differentiated. Characteristics of Oligopoly
are: Few dominant firms, Mutual interdependence, Barriers to entry,
Homogeneous or differentiated products. Factors causing oligopoly are: Huge
capital investment, Absolute cost advantage to the existing firm, Product
differentiation, Economies of large scale production, Mergers.
Price and Output determination in oligopoly is different from other three forms
of market structure. Since there are few rival firms and there is mutual
interdependence, the price and output policy of a firm will affect the price and
quality sold by other firms. There is no general theory under oligopoly. Price
and output indeterminateness is an essential feature of oligopoly.
Among models of Non-Collusive Oligopoly, Cournot’s Duopoly Model states
that firms attain Nash equilibrium. In equilibrium each firm is doing the best it
can given its competitor’s behaviour. It is based on the assumption that each
firm is attempting to maximise its total profits assuming that other firm holds
its output constant.
Stackelberg’s Duopoly Model is ‘First Mover Advantage’ Model as an
alternative explanation of oligopolistic behaviour. In this model, one firm sets
its output before other firms do. In this model, neither firm has an opportunity
to react. The leader firm produces more output and earns more profit than the
other firm. Sweezy’s ‘Kinked demand’ Curve Model explains price rigidity in
an oligopoly market by postulating that oligopolist’s will match price decrease
but not price increases.
271
Market
Structure
12.6 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton & Co,

New York, Chapter 24 & 25, page no. 415-455.

12.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 12.1.1 and answer
2) Read Sub-section 12.1.2 and answer
3) (D)
Check Your Progress 2
•
1) i) Reaction curve for Firm 1: Q1 = 10 – •Q2
•
Reaction curve for Firm 2: Q2 = 10 – Q1
•

ii) The equilibrium level of output for both the Firms: Q = Q1 + Q2

= 6.67 + 6.67 = 13.34
iii) Equilibrium market price P is: P = 6.66
2) Let Firm 1 set its output first (i.e., be a leader) and Firm 2 be a follower
which makes its output decision after studying Firm 1’s output and
assuming that Firm 1’s output as fixed. Cournot’s reaction curve of Firm
2 will decide Firm 2’s profit maximising output.
The calculation of Firm 2’s profit maximising output is as follows:
MR2 = MC
∆!"
=0
∆#"

Or …(MC is zero is given)

R2 (total revenue) is calculated as:
R2 = P.Q2 = (20 – Q) Q2
= 20 Q2 – (Q1 + Q2) Q2

= 20Q2 – Q1Q2 – Q 22
∆!
MR2 = ∆#" =20 – Q1 – 2Q2
"

272
 Putting MR2 = 0, and solving for P2 we get: Oligopoly: Price and
Output Decisions
2Q2 = 20 – Q1
•
Q2 = 10 – Q1 (1)
•

This is Firm 2’s reaction curve.

The calculation of Firm 1’s profit maximising output is as follows:
MR1= MC
R1 = P.Q1 = (20 – Q) Q1= [20 – (Q1 + Q2)] Q1
= 20Q – Q12 – Q1Q2 (2)
It is clear from the above equation that total revenue earned by Firm 1 depends
upon output of Firm 2. Firm 2 will choose Q2 according to its reaction curve Q2
•
= 10 – Q1 .
•

Substituting (1) in (2) we get:

•
R1 = 20 Q1 – Q12 – Q1 (10 – Q1)
•
•
= 20Q1 – Q12 – 10Q1 + •Q12
•
= 10Q1 – •Q12
∆!$
MR1 = = 10 − Q•
∆#$

∴ MR1 = MC = 0 gives Q1 = 10 (3)

Substituting (3) in (1), we get:
•
Q2 = 10 – • . 10

Q2 = 5 (4)
Thus, under the Stackelberg Model, profit maximum output of Firm 1 is
10 and of Firm 2 is 5. Firm 1 produces twice as much as Firm 2.
3) i) Given that the duopolists faces the following market demand curve:
P = 14 – Q
∴ Q = Q1 + Q2
⇒ P = 14 – (Q1 + Q2)
Both the firms have
AC = MC = 2
Case 1:
Reaction Curve for Firm 1
Total revenue R1 is given by
R1 = PQ1 =[14 – ( Q1 + Q2)] Q1
⇒ R1 = 14Q1 – Q12 – Q1Q2 273
Market Marginal revenue, MR1 is just the incremental revenue ΔR1 resulting
Structure from an incremental change in output ΔQ1.
∆••
MR1 = = 14 − 2Q! − Q "
∆••

MR1 = MC…………………………..in equilibrium

∴ 2 = 14 – 2Q1 – Q2

⇒ !
Q1 = (12 – Q2) Reaction curve of Firm 1
"

Similarly,
!
Reaction curve for Firm 2 will be: Q2 = "(12 – Q1)

i) Cournot’s Output is:

! !
Q2 = $12 − (12 − Q " )%
" "
! !
Q2 = $12 − 6 + Q "%
" "
! !
2Q2 = "
− 6+ "
Q"
!
2Q2 – Q" = 6
"
&•'
=6
"
(×"
Q2 = &
=4

and Q1 = 4
Cournot’s price is:
P = 14 – (Q1 + Q1)
P = 14 – (4 + 4)
P = 14 – 8
P=6
ii) Profit of Firm 1 and Firm 2 is:
) = R1 – C1
= PQ1 – AC × Q1
=6×4–2×4
iii) Comparison of output under perfect competition and Duopoly:
Under Perfect Competition:
P = MC
14 – Q = 2
Q = 14 – 2
∴ Q = 12
274
4) R 1 = (200 – 2(Q 1 + Q 2 + Q 3))Q 1 Oligopoly: Price and
MR 1 = 200 – 4Q 1 – 2Q 2 – 2Q 3 Output Decisions

Applying MR = MC:
Q 1 = 45 – Q 2/2 – Q 3/2
By symmetry:
Q 1 = Q 2 = Q 3 = 22.5
5) Read Sub-section 12.2.3.1 and answer
Check Your Progress 3
1) Read Sub-section 12.3.1 and answer
2) Read Sub-section 12.3.3 and answer
3) Read Section 12.4 and answer

275
UNIT 13 FACTOR MARKET AND
PRICING DECISIONS
Structure
13.0 Objectives
13.1 Introduction
13.2 Meaning of Factor Markets
13.3 Concepts of Demand and Supply of a Factor
13.3.1 Demand for Factor
13.3.2 Supply of Factor

13.4 Factor Pricing by Marginal Productivity Theory

13.5 Determination of Returns to a Factor
13.5.1 Rent
13.5.2 Wages
13.5.3 Interest
13.5.4 Profits

13.6 Role of Factor Prices in Pricing Decision of the Firm

13.7 Let Us Sum Up
13.8 References
13.9 Answers or Hints to Check Your Progress Exercises

13.0 OBJECTIVES
After learning about the different market structures viz. Perfect Competition
Monopoly, monopolistic competition and oligopoly in Unit 9 to 12 which
explain the different equilibrium conditions of price and output in the product
market, this unit introduces the concept of factor market i.e. the market for
factors of production in an economy. This unit will develop your understanding
about how factor markets operate distinctly from product markets, how pricing
decisions take place in factor markets and how returns to factors of production
are determined.
After going through this unit, you will be able to:
• state the concept of a factor market;
• explain the demand and supply mechanisms in factor markets;
• discuss marginal productivity theory of factor pricing;
• articulate pricing decisions for a factor and; and

• determine returns to factors of production viz. Wages, interest, rent and

profit.

Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
279
Petrolium University, Ahmedabad.
Factor Market
13.1 INTRODUCTION
Any platform that facilitates sale and purchase of a good or service is known as
a market. In order to produce goods and services, factors of production are
required. Just like product and service markets, factors of production of an
economy also have their markets. Markets are required to determine their
demand, supply and market prices. The primary four factors of production are
land, labour, capital and entrepreneurship. This unit explains briefly the
essence, importance and operations of land, labour and capital market and the
last two units of this block provide detailed explanation on labour and land
markets.
To begin with, it is important to understand why there is a need for factor
markets. For understanding this, there is a need to understand the importance
of factors of production in an economy. As the name suggests, ‘factors’ of
production are important entities in the process of production without which
production cannot take place. It is not possible to produce a computer without a
machine (capital), not possible to produce software without an IT professional
(labour) and not possible to produce anything without some space for
production (land) where capital and labour are engaged through an IT
employer (entrepreneur). All four factors of production are required in an
economy for production to take place irrespective of the fact whether what is
getting produced is a product or a service. However the ratios in which factors
of production are used can differ as per production requirements and
advancement of technology. In the era of artificial intelligence, virtual markets
and robots, production process using the above technologies are likely to
become more capital intensive (and less labour intensive).
Having understood the importance and dynamics of factor markets in an
economy, the following sub-sections will throw light on the meaning of factor
markets and theories of factor market pricing.

13.2 MEANING OF FACTOR MARKETS

Factor markets are the markets where sale and purchase of factors of
production like land, labour and capital takes place. These factors of
production, along with entrepreneur, interact to produce goods and services in
an economy. The broad characteristics and meaning of these factors of
production has been outlined below:
i) Land: It is a physical/tangible factor of production and is a stock
concept. It consists of the total physical resources that are available.
Land not just includes ground, but also includes the forests, water
resources, soil, minerals, mines, etc.
ii) Labour: It is an intangible factor of production as labour services are
endowed with a labourer and cannot be separated from him. The effort
used by households for production purposes, whether manual or
intellectual, is known as labour. Labour is a flow concept.
iii) Capital: It is a tangible factor of production and refers to all forms of
machinery, buildings, transport services, etc. that are used in the
production process.
iv) Entrepreneurship: This refers to the intangible abilities of an
entrepreneur to conduct and organise the production process for
280 producing goods and services.
 Generally, households own or control these factors of production and sell Factor Market and
them to producers. Households provide their services as labour and earn Pricing Decisions
wages in return. They also mobilise their savings for buying physical
capital and also own land. Some households also have members with
entrepreneurial skills and act as entrepreneurs. Households earn by
selling these factors of production in the factor markets and thus
contribute positively to the production process. This interaction can be
shown through a circular flow of income and spending between
households and firms in Fig. 13.1 given below.

HOUSEHOLDS SUPPLY LAND, LABOUR, CAPITAL AND ENTREPRENURIAL SKILLS

FIRMS (PRODUCERS OF HOUSEHOLDS (OWNERS OF

GOODS AND SERVICES) FACTORS OF PRODUCTION)

PRODUCE AND SUPPLY GOODS AND SERVICES TO HOUSEHOLDS

Fig. 13.1: Circular flow of factors of production and goods & services between households
and firms in a simple two-sector economy

13.3 CONCEPT OF DEMAND AND SUPPLY OF A

FACTOR
As a student of microeconomics, you may already be well-versed with the
concepts of demand and supply. The concepts and the laws of demand and
supply that you have previously studied apply largely to the goods market. In
order to understand the demand and supply of a factor, it is important to
understand the inter-relationship between the goods market and factor markets.
Derived Demand
Let us consider the demand for office space by a data analytics firm. A data
analytics company generally requires a rented office space for its analysts,
programmers, managers and other workers. Similarly a bakery owner requires
space for producing and selling bakery products. In each geographical area,
there would be a downward sloping demand curve for office space whose
rental is linked to the quantity of office space demanded by firms i.e. the lower
the rental price, the higher is the demand of firms for office space. An
important distinction between demand for goods and demand for factors is with
regards to utility. While on one hand, consumers demand goods as they derive
utility from its consumption, on the other hand firms do not demand factors of
production for satisfaction of utility but for the purpose of conducting
production operations using the four factors of production. The purpose is to
maximise revenue and gains from production using factors of production.
Moreover the demand for factors of production is dependent on the demand for
goods and services from the consumers. Higher is the demand for goods, 281
Factor Market higher would be the demand for factors of production and vice-versa.
Economists therefore regard demand for factors of production shown in Fig.
13.2 given below as a derived demand.

Fig. 13.2

Interdependent demand
As explained earlier, you may recall that production cannot take place using a
single factor of production. It takes place through an interaction of different
factors of production. Imagine a producer who wants to produce gold
jewellery. This producer would require services of designers (labour), office
space for conducting production process (land) and some machinery for
moulding and heating metals (capital). It is to be noted that interdependence in
production leads to interdependence in productivities of factors of production.
Thus productivity of labour would get directly affected if the casting or rolling
machine used in making gold jewellery gets jammed for two days. In effect, it
is the interdependence of productivities of land, labour and capital that makes
distribution of factor incomes a complex task. In order to estimate the
contributions of the different factors of production in the process of production,
the concept of marginal productivity is used wherein the marginal productivity
of each factor of production is calculated and used for determination of returns
to them.
Marginal Physical Product (MPP), Value of Marginal Product (VMP) and
Marginal Revenue Product (MRP)
The marginal physical product (MPP) of a factor of production (like labour) is
the additional output produced when an extra unit of that factor of production
(worker) is added, other factors of production remaining constant.
MPP = Change in Total product / Change in number of units of factor
of production
The concept of value of marginal product also known as marginal value
product refers to the value of output as estimated using information on market
prices. Thus when price of a product is multiplied with the marginal physical
product of a factor of production, one can derive value of marginal product.
VMP = Price of output × Marginal Physical Product of factor
Marginal revenue product is the additional revenue due to highering of an
additional of worker.
282
 Factor Market and
Pricing Decisions
MRP = Change in Total revenue / change in number of units of a factor
of production
OR
MRP = Marginal revenue × Marginal physical product
These concepts can be easily understood using an illustration of a firm making
decisions on how many workers to hire. The Table 13.1 shows the hypothetical
case of a bread manufacturer with given factors of production. Information on
workers who are variable factors of production is given. In order to calculate
value of marginal product, information on market price of bread is given as
Rs.10.
Table 13.1
Units of Total Marginal Market Value of Total Marginal Marginal
Workers Product Product Price of Marginal Revenue Revenue Revenue
(TP) (MPP) Bread Product (TR) (MR) Product
(VMP) (MRP)
0 0 --------- 10 ------- ------ ----- -------
1 20 20 10 200 200 10 200
2 30 10 10 100 300 10 100
3 35 5 10 50 350 10 50
4 38 3 10 30 380 10 30
5 39 1 10 10 390 10 10

As you can see in the above table, the entries in the VMP column are identical
to the entries in the MRP column. However this is taking place due to the
assumption of perfect competition where price is equal to marginal revenue.
The entries would change in case of imperfectly competitive markets.
Demand for Factors of Production
Demand curve of factors of production can differ depending upon the type of
market structure we are discussing. We have discussed examples of perfectly
competitive market structure so far and observed that in such a market VMP is
equal to MRP. Here VMP gives information about the maximum number of
factors that may be hired. As VMP refers to the value addition of each worker
in the production process, it can be inferred that in perfectly competitive
markets, it is the VMP (as well as MRP) curve which reflects the demand
curve of a perfectly competitive firm. Thus VMP as well as MRP curve
becomes the demand curve for a factor of production. This also implies that
factors which affect the MRP of a firm would also affect the demand curve for
the factor. Factors which may affect MRP of a firm are substitutability of a
factor by other factors, change in demand for finished product as well as the
total cost incurred on a factor of production.
Does VMP as well as MRP curve give the market demand of a factor? A single
MRP curve would not give the market demand for a factor as it reflects
demand only for a single firm. Thus aggregation of the MRP curves of all the
firms of the industry would give industry wide market demand for a factor. In
addition to this, if the market demand for a factor for all the industries is added,
then one can derive the aggregate market demand curve for a factor of
production. 283
Factor Market
Marginal Revenue Product (MRP) as Demand
Curve
250

Marginal Revenue Product

200
150
100
50 Marginal Revenue
0 Product (MRP)
0 2 4 6
No. of workers

Fig. 13.3
Supply of Factors of Production
Most factors of production are privately owned in a free market economy.
Moreover decisions on supply of factors of production like labour, capital and
land are governed by a number of economic and noneconomic factors. The
important determinants of labour supply are the price of labour and
demographic factors such as age, gender, education and family structure.
Factors that affect the supply of land are mostly the one that affects the quality
such as conservation and change in settlement patterns. Factors that affect the
supply of capital are past investments made by businesses, households and
governments.
The supply curve for all inputs may slope positively or be vertical. In some
cases, it may have even a negative slope. To begin with as the supply of land is
fixed, the supply curve of land has a vertical shape. As the supply of capital is
directly affected by a change in its returns, higher the returns, higher would be
the supply of capital. Thus the supply curve of capital is positively sloped.
LAND MARKET CAPITAL MARKET

Fig. 13.4
284
LABOUR MARKET Factor Market and
Pricing Decisions
On the other hand, the supply curve of labour is either positively sloped in the
short-run or backward-bending in the short-run. Reasons for the backward
bending shape of the labour supply curve have been discussed in detail in the
next unit. The interaction of the demand curves of factors of production and the
supply curves of factors determines their equilibrium price level.
Check Your Progress 1
1) What do you understand by the term factor pricing? What are factor
markets?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Is demand for capital a derived demand? Explain the concept of
interdependent demand also.
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3) How is the equilibrium determined in factor markets?
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13.4 FACTOR PRICING BY MARGINAL

PRODUCTIVITY THEORY
So far you have studied that households provide the different factors of
production used in the production process and how their demand and supplies
are determined. You may be curious to understand that how owners of factors
of production get paid for the factors they provide. For understanding this
process, it is important to understand marginal productivity theory of income
distribution.
The theory of marginal productivity of income distribution analyses the way
the national income gets distributed among the different factors. The theory
says that returns to a factor are directly determined by their marginal product of
that factor. This occurs due to the competition among numerous landowners,
labourers and capital-owners. Another fundamental point about the distribution
theory is that the demands for various factors of production are derived from
the revenues that each factor yields on its marginal product. The profit
maximising firms would choose factor combinations according to their
marginal revenue products.

13.5 DETERMINATION OF RETURNS TO A

FACTOR
A) RENT
Land is such a factor of production whose total supply is fixed. The demand for
land is also a derived demand. Suppose a particular piece of land is being used
285
Factor Market to grow soyabean. If the demand for soyabean increases in the market, the
demand for land for growing soyabeans would also increase. However as
supply of land is fixed, an increase in the demand for land would increase the
rental rate of land.

Demand SSupply

Rent
R*

Quantity of Land

Fig. 13.5: Equilibrium in Land market

As per the Fig. 13.5, R* is the equilibrium rental rate of land which has been
determined by the interactions between demand and supply of land. The
various theories of rent have been provided in Unit 15.
B) WAGES
Wages are the price of labour supplied. In competitive markets wages are equal
to the marginal product of labour. Wages are in equilibrium when the
downward sloping labour demand curve crosses the upward sloping labour
supply curve. When due to an external shock, there is lower demand for the
product of the industry, then there is a fall in the price of product. Due to this,
the value of marginal product of labour (VMP) would also fall resulting into
lower wages for the labour. Conversely, a surge in the demand for product of
an industry would raise the prices. This, in turn, would increase the value of
marginal product of labour leading to a rise in wages. This mechanism has
been explained in the Fig. 13.6.

Fig. 13.6: Equilibrium in Labour Market

The determination of wage rates is however different in case of perfectly

286
competitive and imperfectly competitive markets as you would see in Unit 14.
C) INTEREST Factor Market and
Pricing Decisions
Capital is a factor of production made by human beings. The cost of using
capital services is known as the rental rate for capital and the returns to the
owners of capital is known as interest. Interest is a reward for the services of
capital. Rental rate of capital is the opportunity cost of holding capital. Unlike
labour, capital goods can be bought and sold and have an asset price. Buying a
car for Rs.10 lakh entitles one to use it for a number of transport services in
future directly or by renting it to someone. The price of an asset is the sum for
which the capital asset can be purchased outright. The required rental rate of
capital depend on three things: the price of capital good, the real interest rate
and the depreciation rate. The price of capital good depends on the interactions
between demand and supply of capital goods. In general, the price of capital
assets and services is higher when the anticipated rental stream is higher or the
interest rate is lower. Both of these raise the present value of the future rental
streams of capital. The real interest rate depends on the prevailing rate of
inflation and the nominal interest rate. The difference between the nominal rate
of interest and the rate of inflation is known as real interest rate. Depreciation
depends largely on technology and also on how fast the machine wears out
with usage and time.
Theories of Interest
There are a number of theories, which seek to determine the rate of interest.
These theories try to explain the phenomenon of interest in terms of different
set of variables.
i) Loanable Funds Theory
This theory relies on demand for borrowings and supply of loanable funds to
determine the rate at which transaction will take place. It assumes that at any
moment of time there will be some people who would spend less then their
current income (savers) and others who plan to spend more than their income.
The former will constitute the supplies of loanable funds while the latter
constitutes the group which demands such funds. The rate at which demand for
funds equals supply of funds will be the rate of interest. Such a situation is
depicted in Fig 13.7.

Fig. 13.7

Fig. 13.7 Presents a simple demand and supply curve diagram you are so
familiar by now. The curve DD is demand curve for the funds. This shows
287
Factor Market amounts the borrowers would like to borrow at different rates of interest.
Likewise, the amounts all the savers in the society are willing to save and lend
are shown by supply curve marked SS. The intersection of these two at point E
gives us equilibrium rate of interest re and the quantity QE that will be
borrowed and lent at that rate.
At re rate of interest, QE quantity of funds is borrowed (and lent). Note that
demand for funds may arise on account of any three of the following:
a) Investment demand, b) consumption demand and c) financial demand. It is
more likely to be a composite of all the three demands.
Similarly, we can say that supply of funds may arise from net savings, de-
hoarding of past savings and also from new creation of money.
ii) Liquidity-Preference Theory
Keynes had developed this approach and he related demand for money and rate
of interest to aggregate level of income in the society. In his formulation
demand for liquid money would depend on transaction, precaution or
speculation, given the level of income. But supply of money was policy
determined variable. The rate of interest was thus determined by interaction of
a demand function with a given supply of money. However, in his approach,
the rate of interest has nothing to do with determination of rate of remuneration
of factor of production.
iii) Time Preference Approach
Irving Fisher developed this approach. His idea was that consumer tries to
compare present consumption and future consumption. The rate at which future
consumption can substitute for present consumption (and vice-versa) will be
marginal rate of substitution between present and future consumption. This is
called the rate of time preference. It shall be equal to slope of indifference
curve between present and future consumption.
D) PROFITS
We regard entrepreneurship to be the fourth economic factor of production.
Recall that an entrepreneur brings together land, labour and capital and thus
facilitates production. Her role in production is clear. If other factors of
production are not brought together, there may not be any production at all. In
capitalist system, the possibility of profit becomes key determinant of whether
an activity will be undertaken or not. Even under various non-capitalistic
forms of organisation, profit may serve as a benchmark for efficiency of firm
or efficiency of some innovation or technological change. Thus, in all
situations, if a firm is making larger profit compared to some other similarly
placed firm, it must be more efficient or must be using either better resources
or better techniques. But decision like introduction of better techniques
involves some risk as well. Hence, often attempts are made to relate profit to
elements of uncertainty and risk. To understand her role, we can divide
entrepreneurial functions into two parts:
a) Organisation and
b) Risk bearing
a) Organisation: This consists of routine day-to-day activities associated
with a business organisation and is called management. We find that
288 these days, most companies are being managed by professional
 managers, who receive salaries and other benefits. Such an arrangement Factor Market and
places a part of entrepreneurship at par with labour. Pricing Decisions

b) Risk Bearing: Every business activity runs some risk of failure in the
market. This arises because of uncertainty of marketplace, natural causes,
political factors etc. If a business fails, the entrepreneur looses substantial
parts of investment. Thus, risk of loss is always present. However, some
activities like introducing a new product, using a new technology etc.,
involve much greater risks and reward for these activities must be higher.
Otherwise, these would not be undertaken. Hence it is said that profits are
reward for risk bearing.
1) Accounting Profits and Economic Profits
An account defines the profit as the difference between total revenue earned
during the year and cost (including depreciation) incurred during the same
period. The cost comprises payments for raw materials, fuels/energy, wages
and salaries, rents, insurance and interests. The depreciation is provided for
taking care of wear and tear of capital stock. So the net surplus earned during
the year, after meeting the above costs, is called profit by the accountant.
However, such calculations do not seem to account for some implicit costs.
Take for example the remuneration to the person when she is actually working
for her business. Similarly, companies accumulate some funds of their own in
course of time. Should interest of those funds be also calculated and added to
the cost? Economic profit will take into account this kind of implicit cost as
well. So economic profit will be less than accounting profit by the amount of
such implicit costs.
2) Theories of Profits
Economists have, over the years, developed several theories regarding profits.
For example, Joseph Schumpeter attributed profits to innovation. But Frank
Knight associated them with uncertainty.
a) Profits as Rewards for Innovation
Schumpeter regards profit a phenomenon, which is related to a dynamic
economy only. He identifies five types of changes that lead to economic
development or make the society dynamic. These changes are:
i) Introduction of new products
ii) Introduction of new methods of production
iii) Discovery of new raw materials
iv) Discovery of new markets
v) Introduction of new forms of organisation
Innovations are actual application of some new body of knowledge to real
business situation. An innovator need not be an inventor. But she uses some
invention to change her production function or the relationship between inputs
and outputs. Such innovation might be in form of new technique of production,
may involve reaching out to new markets, involving all the activities pertaining
to marketing etc.
Schumpeter is of the opinion that one who innovates is able to earn more
profits, and thus gets more incentive to innovate further. She will soon attract 289
Factor Market followers or imitators. These people, very soon catch up with original
innovator. As a consequence, she makes more efforts to stay ahead. Thus,
innovation leads to profits and profits make it possible to innovate (acting as
incentive).
b) Uncertainty and Profit
Frank Knight defined profit as the difference between selling price and costs.
In such situation profit emerges as a residual. Selling price and costs depend on
a host of factors. Some of those can be covered by ‘risk’. Such risks can be
anticipated and provisions can be incorporated into the cost structure. Most of
predictable risks are ‘insurable’ as well. Hence, company can get an
appropriate insurance policy to cover such risks. The premium paid for such
policy is included in cost of production. This type of risk condition is
completely predictable and discountable. Hence it would be as good or as bad
as production under perfect certainty.
But Knight points to another dimension of uncertainty and says that producer is
all the time anticipating consumer’s wants and preferences in advance. She
must do so, as she has to produce things that can satisfy those swans at a point
of time in future. This essentially happens because of time lag involved
between anticipation of demand, production and offering goods to consumer.
To some extent, future results of her operations to produce things to satisfy that
demand are also uncertain. Further, even the manager doing routine
organisation work is liable to make error of judgement. Here, she bears
uncertainty and risk in the sense of having to protect factors of production
against fluctuation in their income from an uncertain market. Thus, the income
of entrepreneurs consists of two components, a salary or wage component,
which is contractual in nature and another residual income that may fluctuate
in response to change in market place. Some economists prefer to call only this
second component as ‘profit’.
Thus, we find that one significant difference between other factor incomes and
profit. Whereas wage, rent interest are all payments, which have been agreed to
and settled in advance, profits cannot be put on a similar footing. Uncertainty
leads to fluctuation in both costs and revenue. They may not balance. Thus,
ultimately profits are the ‘surplus’ that remain after meting the entire
contractual payment obligation.
c) Profits and Market Structure
Some economists insist that profit as one generally understood is essentially a
result of market imperfections. If perfect competition prevailed, every producer
will use same technology, will have perfect knowledge about product, cost and
market condition. Such a scenario leads to cost minimisation for all the
production. They sell at going market price. All the cost and revenue
determinants are perfectly certain. Hence, entrepreneurship is just organisation
or day-to-day supervision only. So, profits should drop down to bare minimum
or ‘normal’ compensation for supervision etc.
However, if market is not perfect, firm can determine quantities or prices in
such a manner that suits it best. It may involve breaching the condition of
perfect information. Firms may devise some innovation and keep it a secret
from others. So long as that secret is maintained, the concerned firm continues
to earn more than others do.
290 A.P. Lerner tried to measure the effect of monopoly power over profit. We
know that equilibrium condition for a firm is equality between marginal cost Factor Market and
and marginal revenue. When competition is perfect, price (average revenue) is Pricing Decisions
also equal to marginal revenue. Prices tend to deviate from marginal revenue
only when competition is no longer perfect. Hence, the difference between
price and marginal revenue, that is, P – MR (or P – MC) will indicate firms
control over market. It is expressed as a fraction of price. Thus, the degree of
monopoly is (P – MC)/P. Higher this ratio, higher will be the rate of profits
earned by a firm.

13.6 ROLE OF FACTOR PRICES IN PRICING

DECISION OF THE FIRM
Several factors play a role in the decision making of a firm regarding
production of goods and services. The intrinsic factors are cost of production,
marketing, product differentiation and objectives of the firm. These factors
directly shape the production process of the firm. A firm needs to decide its
cost of production which is dependent on the availability and cost of factors of
production. A firm also needs to differentiate its product from similar products
to increase its demand. The quantity of output to be produced depends on the
objectives of the firm. If the objective is to maximise profits, only that much
output would be produced where the cost of production is less than the price.
Similarly a firm needs to decide its marketing strategy and the expenditure for
it. The extrinsic factors are demand, competition, suppliers and economic
conditions.
How can a change in factor prices affect the pricing decisions of the firm?
Suppose due to a government regulation, there is a rise in minimum wage rates
of construction labourers. As wages are an essential part of cost of production
of any industry, rise in the minimum wage rate leads to a rise in the cost of
production of a real estate firm. In this case, the firm has two alternatives.
Either the firm can continue to use the services of the same number of
construction labourers and absorb the rise in cost of production or try to
substitute some amount of capital for labour. For e.g. in place of using services
of 10 labourers to lift the load of cement, the firm may buy a trolley with
wheels which may be dragged by 2 labourers. Thus change in the prices of
factors of production can alter the pricing decisions as well as production
decisions of the firms.
Check Your Progress 2
1) What is theory of marginal productivity? How does it explain the process
of determination of factor prices?
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......................................................................................................................
......................................................................................................................
2) Distinguish between interest and profits as rewards of factors of
production.
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291
Factor Market 3) Explain loanable fund theory in 50 words.
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4) What are the main functions of entrepreneur?
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13.7 LET US SUM UP

This unit introduces the concept of factor markets by discussing the meaning
and need for factors of production in an economy. There are four factors of
production in an economy namely land, labour, capital and entrepreneur. These
factors of production are required in the production of goods and services. As
demand for factors of production is linked to the demand for goods and
services, their demand is derived demand. Moreover more than one factor of
production is used in the production process and so their demand is interlinked
and interdependent. This interdependency between product and factor markets
results into interactions between demand and supply of goods and services.
Each factor of production is paid its return for its contribution in the process of
production. The returns to land are called rent and it is the price paid for the
use of land which is fixed in supply in the short run as well as in long run. The
returns to labour are known as wages and both rent and wages are determined
through the interaction between demand and supply. Interest is the return to
capital. The theories determined the rate of interest are: Loanable fund theory,
liquidity – Preference theory, and time Preference approach. Profits are the
returns to entrepreneurs for their organisation and management skills used in
conducting the production process. Several theories have been developed
regarding profits.

13.8 REFERENCES
1) Economics, Joseph E. Stiglitz and Carl E. Walsh, 4th Edition, W.W.
Norton and Company, Inc. London. 2010.
2) Lipsey. R.G., An Introduction to Positive Economics. (6th edition),
E.L.B.S and Weidenfeld and Nicolson: London.
3) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,
New York, Chapter 26, page no. 456-466.
4) Robert H Frank and Ben S Bernanke, Principles of Economics, Chapter 14
292 and 21, Third Edition, Tata-McGraw Hill, Indian Reprint.
 Factor Market and
13.9 ANSWERS OR HINTS TO CHECK YOUR Pricing Decisions
PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 13.1 and 13.2 and answer.
2) Read Section 13.3 and answer.
3) Read Section 13.3 and answer.
Check Your Progress 2
1) Read Section 13.4 and 13.5 and answer.
2) Read Section 13.5 and answer.
3) Read Section 13.5 (Interest) and answer.
4) Read Section 13.5 (Profit) and answer.

293
 UNIT 14 LABOUR MARKET
Structure
14.0 Objectives
14.1 Introduction
14.2 Meaning of Labour Markets
14.3 Labour Market: Different Market Structures
14.3.1 Perfect Competition
14.3.2 Imperfect Competition

14.4 Labour Market Policies

14.4.1 Minimum Wage Laws
14.4.2 Role of Labour Unions

14.5 Why Wages Differ?

14.6 Let Us Sum Up
14.7 References
14.8 Answers or Hints to Check Your Progress Exercises

14.0 OBJECTIVES
You have already studied the basics of factor markets in the Unit 13. This unit
discusses in detail the characteristics of and price mechanism in labour market
as labour differs significantly from the other factors of production. Households
supply labour and are paid wages in return of their services. Labour is
inseparable from a labourer and this characteristic distinguishes labour market
from land and capital markets. After going through this unit, you will be able
to:
• state the meaning of labour markets;
• explain the demand and supply mechanisms in perfectly competitive
labour markets;
• analyse demand and supply mechanisms in imperfectly competitive
labour markets;
• discuss the policies in labour markets; and
• identify the reasons behind variations in wage rates.

14.1 INTRODUCTION
The decisions that people make about work determine the economy’s supply of
labour. Their decisions about savings determine the economy’s supply of funds
in the capital market. Economists use the basic model of choice to help
understand the patterns of labour supply. The choice of work is a choice
between consumption and leisure. Holding technology and other inputs
constant, there exists a direct relationship between the quantity of labour inputs
and the amount of output. The law of variable proportions states that after a
certain level, each additional unit of labour input will add a smaller and smaller
294
Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
Petrolium University, Ahmedabad.
amount to the total output. Thus, there are diminishing returns to labour. This Labour Market
unit aims at analysing the meaning and mechanism of labour markets by
undertaking a demand-supply analysis of a labour market in both perfectly
competitive and imperfectly competitive market structures.
There are government interventions, labour market policies, labour rights and
labour laws in an economy. This unit has looked into the implications of the
presence of minimum wage laws and labour unions in detail. The last section
of the unit looks into the reasons leading to variation in wage-rates across
professions. A deeper understanding of labour markets would help you to
understand how labour as a resource functions in an economy.

14.2 MEANING OF LABOUR MARKETS

In order to understand the meaning of labour markets, one needs to understand
who are the demanders and suppliers in the labour market. Firms and other
employers demand labour to produce goods and services. Households supply
their labour services and in return, get wages. The labour market is studied by
microeconomists as well as macroeconomists as both use the tools of demand
and supply. The labour market refers to the supply and demand for labour, in
which employees provide the supply and employers the demand. It is a major
component of any economy, and is intricately tied in with markets for capital,
goods and services. At the macroeconomic level, supply and demand are
influenced by domestic and international market dynamics, as well as factors
such as immigration, the age of the population, and education levels.
Commonly used measures in labour markets are unemployment rate, labour
productivity, labour intensity, participation rates and total wage income as a
percentage of GDP. Wages represent the price of labour, which provide an
income to households and represent a cost to firms. In a hypothetical free
market economy, wages are determined by the unregulated interaction of
demand and supply. However, in real mixed economies, governments and trade
unions can exert an influence on wage levels. At the microeconomic level,
individual firms interact with employees, hiring them, firing them, and raising
or cutting wages and hours of work. The interaction between supply and
demand influences the hours the employees work and compensation they
receive in form of wages, salary and other benefits.

14.3 LABOUR MARKET: DIFFERENT MARKET

STRUCURES
As labour is generally demanded for producing goods and services, the demand
for it would depend on the structure of the market for goods and services too.
We would study it under two major heads:
• Perfectly competitive market
• Imperfectly competitive market
14.3.1 Perfect Competition
DEMAND FOR LABOUR
We begin the discussion by analysing what determines the number of workers
the employers would like to hire at any given wage rate. Demand for labour
depends on both productivity of labour and the price that market sets for
295
Factor Market worker’s output. The more productive the workers are, the more is the value of
the goods and services produced by them and the greater the number of
workers an employer wants to hire at the given wage-rate. Table 14.1 shows
the relationship between output and the number of workers employed in a
computer hardware company. Column 1 shows the possible number of workers
that may be employed by the company and Column 2 shows the output
produced depending on the number of workers hired. Column 3 shows the
marginal product of labour which is the additional production due to addition
of one more worker. As discussed earlier, as more and more workers are hired
by an organisation, beyond a certain limit there are decreasing returns to
labour. The law of diminishing returns to labour states that if the quantities of
capital and other inputs are held constant, then the greater the quantity of
labour employed, lesser would be their marginal contributions to production.
This can be observed in Column 3 which depicts marginal product of labour.
Column 4 shows the value of marginal product at each level of employment.
The value of marginal product of labour is the amount of extra revenue that an
additional worker generates for the firm. Specifically, the value of the marginal
product of workers is workers’ marginal product multiplied by the price of
output. Here the price of output is taken as Rs. 20,000 per unit. Monthly wage
rate of computer hardware workers in the market is Rs. 20,000/-.
Table 14.1 : Relationship between output and number of workers

Number of Computers Marginal Value of Marginal

Workers Produced Product Product (In Rs)
per Year
(1) (2) (3) (4)
0 0 - -
1 15 15 15 × 20,000 =
3,00,000
2 28 13 13 × 20,000 =
2,60,000
3 39 11 11 × 20,000 =
2,20,000
4 47 8 8 × 20,000 = 1,60,000
5 52 5 5 × 20,000 = 1,00,000
6 55 3 3 × 20,000 = 60,000
7 57 2 2 × 20,000 = 40,000
8 57 0 0 × 20,000 = 00

The company would hire an extra worker if and only if the value of his
marginal product is at least as great as the wage payable to him. In our example
above, the second worker’s marginal product is 13 computers during the year.
These are valued at Rs. 2,60,000/- but, at the rate of Rs. 20,000 per month, this
worker gets only Rs. 2,40,000/- as wages during the year. Thus, the company
clearly earns Rs. 2,60,000 – Rs. 2,40,000 = 20,000/- as a surplus on giving
employment to this worker. The company will not employ the 3rd worker, his
marginal product will be valued at Rs. 2,20,000/- only, which is Rs. 20,000/-
296
less than the wage payment necessary to employ him.
Suppose market wage rate drops down to Rs. 15000/- per month. There will be Labour Market
a change in employment decision of the company. Every worker will not
receive Rs. 1,80,000/- per annum. We can read from Column 4 of the Table
14.1 that marginal product of the third worker is valued at Rs. 2,20,000/- and
this exceeds annual wage payment to him by Rs. 40,000/-. The company will
definetly employ this person as his employment adds to the surplus. However,
the fourth person will still not be considered ‘employable’ by the company as
his marginal product (Rs. 1,60,000/-) will be less than his wage bill (Rs.
1,80,000/-).

Fig. 14.1: Demand curve of labour

FACTORS AFFECTING DEMAND FOR LABOUR

The number of workers the company hires at any given real wage rate depends
on the value of their marginal product. Changes in the economy that increase
the value of workers’ marginal product will increase the value of extra workers
to the company and would thus affect the demand for labour at any given real
wage. This implies that any factor which raises the value of the marginal
product of the company’s workers will also shift the company’s labour demand
curve to the right. In short, the two factors which directly affect and increase
labour demand are:
a) An increase in the price of company’s output
b) An increase in the labour productivity of company’s workers
This can be easily shown using the above example (Table 14.2). Suppose the
price of output increases from Rs. 20,000 per unit to Rs. 30,000 per unit. The
value of marginal product of labour would change in accordance to the price
change and will also change the number of workers to be hired by the company
if the ongoing wage rate remains the same.
Table 14.2 : Value of Marginal Product and Firm’s decision to Hire

Number of Computers Marginal Value of

Workers Produced per Year Product Marginal Product
(In Rs)
0 0
1 15 15 450000
297
Factor Market 2 28 13 390000
3 39 11 330000
4 47 8 240000
5 52 5 150000
6 55 3 90000
7 57 2 60000
8 57 0 0

Here, if market wage rate remains Rs. 20,000/- per month the 4th worker is also
hired- as value of his marginal product (Rs. 2,40,000/-) equals the wage
payable to him during the year (Rs. 2,40,000/-). But hiring the 5th worker will
not be in the company’s interest – he would add only Rs. 1,50,000/- to the total
revenue, but claim Rs. 2,40,000/- as wages.
The next possibility is rise in labour productivity. We are showing it in Table
14.3. The wage rate is retained at Rs. 20,000/- per month and the market price
of computers is assumed to be Rs. 20,000/- as in Table 14.1.
Table 14.3 : Improvement in labour productivity and Demand for labour

Number of Computers Marginal Value of

Workers Produced per Product Marginal
Year Product
0 0
1 25 25 5,00,000
2 48 23 4,60,000
3 68 20 4,00,000
4 84 16 3,20,000
5 96 12 2,40,000
6 105 9 1,80,000
7 112 7 1,40,000
8 115 3 60,000

The Table 14.3 shows that workers are able to produce more computers at
every level of employment. Now, the value of 5th worker’s marginal product
will be just equal to his wage claim. The company can consider employing him
as well.
We can, now say, in the light of our examples in Tables 14.1 to 14.3 that:
i) if the wage rate declines, employment increases;
ii) if the price of output rises, employment increases; and
iii) if the productivity of labour increases, employment increase, given the
market price of the product, value of the marginal product of labour rises.
SUPPLY OF LABOUR
Economists use the basic model of choice to help understand patterns of labour
298 supply. The decision about how much labour to supply is a choice between
consumption and leisure. Leisure implies the time available to a person when Labour Market
not working. By giving up leisure, a person receives additional income and this
enables him/her to increase consumption. On the other hand, by working less
and giving up some consumption, a person enjoys more leisure.
The suppliers of labour are workers and potential workers. At any given real
wage, potential suppliers of labour must decide if they are willing to work. The
total number of people who are willing to work at each real wage is the supply
of labour. The minimum payment or the reservation price which one sets for
labour is the compensation level that leaves one indifferent between working
and not working. In economic terms, deciding whether to work at any given
wage depends on the cost-benefit principle. The willingness to supply labour is
greater when the wage rate is higher. This results into the upward slope of
supply curve upto a point and then bends backward supply curve.

Fig. 14.2 : Supply curve of labour

The backward-bending shape of labour supply curve results from the fact
higher wage rates create disincentive for longer hours of work. Why? This is so
because longer working hours imply less leisure hours. As the wage rate
increases, the individual’s income rises enabling workers to have access to
more leisure activities. So beyond a certain level of the wage rate, the supply of
labour decreases as the worker prefers to use his income on more leisure
activities.
FACTORS AFFECTING SUPPLY OF LABOUR
Any factor that affects the quantity of labour offered at a given real wage will
shift the labour supply curve. At the macroeconomic level, the most important
factor affecting the supply of labour is the size of the working-age population
which is influenced by factors such as the domestic birth rate, immigration and
emigration rates, and the ages at which people normally enter the workforce
and retire.
Check Your Progress 1
1) State the features of a labour market?
...................................................................................................................
...................................................................................................................
...................................................................................................................

299
Factor Market 2) Derive the demand for labour in a competitive market. How is Value of
Marginal product and Marginal revenue product curve relevant in the
derivation of labour demand?
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) What is the slope of supply curve of labour in perfectly competitive
markets? Comment on its shape.
...................................................................................................................
...................................................................................................................
...................................................................................................................
14.3.2 Imperfect Competition
Demand for Labour
The firms in this market can sell larger output only if they are willing to accept
a lower price. The demand curve facing a typical firm will be downwards
sloping. Employment of an additional worker leads to rise in output which can
be sold at a lower price only. The firm has to compare its rise in cost which
change in revenue because of increase in output on account of hiring of one
more worker.
Consider demand schedule for a product faced by monopolistically competing
firm. It is presented in Table 14.4.
Table 14.4 : Demand schedule of product by a Monopolistic Firm

Price Quantity Total Marginal

Demanded Revenue Revenue
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
3 8 24 -4
2 9 18 -6

Since MR is falling at a rate faster than AR = Price, MRP = MR × MP will

decline at a rate faster than the rate of decline of VMP = Price × MP.
Thus, we get two curves: VMP & MRP, which are depicted in Fig. 14.3.

300
 Labour Market

Fig. 14.3

Under the competitive conditions of the labour market, any firm can hire as
many workers as it deems necessary at the going market wage rate. Therefore,
the supply curve of labour for the firm will be horizontal. It is depicted by its.
Line WSL.
VMP can be regarded as demand curve for labour for a firm which is operating
in competitive, than its demand for labour is represented by MRPL.
Now compare the two situations. The wage rate paid by both firms remains
same, OW- But a competitive firm will employ OLC number of workers while
a monopolistic firm will stop at OLm. This latter firm hires fewer workers. It
shall produce smaller output even when size of plant and state of technology
was one used by competitive firm.
SUPPLY OF LABOUR
The supply of labour is not affected by the fact that firms have monopolistic
power. Market supply of labour is the summation of the supply curves of
individual households. Supply curve that an individual firm faces is however
perfectly elastic and that of the market is positively sloped at the given wage
rate.

(a) Market (b) Individual firm

Fig. 14.4: Supply curve of labour

EQUILIBRIUM
The market price of the factor is determined by the intersection of the market
demand and the market supply. An important difference in this case is that the 301
Factor Market market demand is based on the MRP and not on the VMP. This means that
when the firms have monopolistic power in goods market, the labour is paid its
MRP which is smaller than the VMP. So the workers are paid less than case of
perfect competition where MRP was equal to VMP.
Check Your Progress 2
1) Distinguish the demand for labour in perfectly competitive and
imperfectly competitive markets.
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) Draw and explain the supply curve of labour of an imperfectly
competitive firm.
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) How is equilibrium achieved in an imperfectly competitive market? How
is it different from equilibrium under perfectly competitive markets?
...................................................................................................................
...................................................................................................................
...................................................................................................................

14.4 LABOUR MARKET POLICIES

Labour markets are segmented and are of different types.

14.4.1 Minimum Wage Laws

Minimum wage laws prescribe a wage rate which the employers must pay to
their workers. Minimum wages are most useful to the low-skilled workers. The
mechanism of minimum wage and its effects can be understood using a
diagram.

Fig. 14.5: Implications of Minimum wage laws on labour market

302 You may observe that W is the market-clearing wage at which the quantity of
labour demanded equals the quantity of labour supplied and the corresponding Labour Market
level of employment of low-skilled workers is N. Suppose there is a legal
minimum wage Wmin that exceeds the market-clearing wage W. At the
minimum wage, the number of people who want jobs Nb exceeds the number
of workers that employers are willing to hire. This results into unemployment.
14.4.2 Role of Labour Unions
Labour unions are organisations that negotiate with employers on behalf of
workers. Among the issues that unions negotiate are the wages workers earn,
rules for hiring and firing, duties of different types of workers, work hours and
working conditions, procedures for resolving disputes between workers and
employers. Unions gain negotiating power by their power to call a strike i.e. to
refuse to work until an agreement is reached. Demand for higher wages by the
union comes with its own costs and benefits. The effect of a high union wage
would be similar to minimum wage. Higher union wage would enable union
members and staff to enjoy higher salaries at the cost of other workers who are
unemployed as a result of artificially higher union wage rate. Critics are of the
view that although labour unions are important to safeguard the conditions of
work and workers, yet in today’s times firms having them are finding difficult
to compete with their counterparts that have no unions as the former has
artificially higher wages and thus higher costs.

14.5 WHY WAGES DIFFER?

This section deals with the fundamental question asked in labour economics
that what makes people earn different wages. Why wage rates of doctors are
higher than the wage rates of medical assistants? Why wage-rates of actuaries
are higher than the wage-rates of fire-fighters? Is it the skill or the background
or the age that brings about differential in wages of different workers? The
answer is none of these. Differential wages are a result of the difference in
demand-supply of jobs available. There are several possibilities to the
differential existence of jobs. It is possible that workers currently employed as
clerks may prefer their jobs despite the difference in their salaries as they do
not want to become an engineer. Even acquiring skills of an engineer may have
a significant cost. Wages for engineers may not be sufficiently high to
compensate clerks for the training costs they would have to bear to become
engineers. Moreover even if there were no training costs, clerks may not have
the aptitude for science and mathematics necessary to work as engineers. Thus,
training costs as well as differences in worker’s abilities and preferences for
particular jobs can lead to differences in equilibrium wage rates among persons
and jobs; there is no tendency toward adjustments that would wipe out wage
differentials due to such factors. Let us discuss such factors affecting wage
differentials in some detail:
1) Compensating wage differentials: Many a times workers themselves
make a decision to remain in a certain job even though they may be
qualified for a higher pay package in a different job. For e.g., an
experienced researcher in a university may be offered a job profile
requiring him to work on some country project with a high package but
may not choose to accept it as it may result into less time and freedom for
his independent research.
When workers view some jobs as intrinsically more attractive than
others, the forces of supply and demand produce differences in the wages
303
Factor Market paid. These differences are called ‘compensating wages differentials’
because the less attractive jobs must pay more to equalise real advantages
of employment across jobs. For e.g., a certain person’s abilities are
identical to fit him in a teaching job or as a consultant in an MNC. At
equal wages, he would prefer to be a teacher rather than consultant as the
number of working hours of teacher is less than that of a consultant. So
only if the wage rate of a consultant is 20 per cent higher than that of a
teacher, then would the person shift from a teaching job to a consultancy
job. Difference in money wages are necessary to equate the quantity of
labour supplied and demanded in different occupations when the non-
monetary attractiveness of jobs differs.
2) Differences in human capital Investment: Our ability to perform useful
services can be augmented by training, education and experience. People
can become more productive workers and more productive workers
receive higher wage rates. This process through which workers augment
their earning capacity is sometimes called human capital investment.
Such jobs tend to pay higher wages. The reason is simple: if the wages
were not higher, a few people would be willing to incur the training costs.
The higher wages associated with highly skilled work are, in part, the
returns on past investments in human capital.
3) Differences in ability: Worker’s productive capacities depend not only
on their training and experience (human capital investment) but also on
certain inherited traits. The relative importance of these two factors is
greatly disputed. For years people have debated whether genetic or
environmental factors are more important in explaining IQs. Similarly
possessing abilities that are scarce is no guarantee to a higher wage. What
matters is the supply of persons with abilities required to perform certain
jobs relative to the demand for their services.
Check Your Progress 3
1) What is the minimum wage? Does it influence the level of employment at
firm’s level?
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) How does labour Unions in an economy influence the wage rate and level
of employment?
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) Why do you find variations in the wage-rates across different
professions? Give reasons as to why a professor is paid higher salary than
a school teacher?
...................................................................................................................
...................................................................................................................
...................................................................................................................
304
 Labour Market
14.6 LET US SUM UP
The unit has dealt in some detail with the working of labour markets in an
economy. The first part introduces the meaning of labour markets and explains
how wages are returns to the services rendered by a labourer. In the second
part, perfectly competitive and imperfectly competitive market structures have
been discussed. The first sub section explains the determination of demand and
supply curves of labour in the perfectly competitive markets. It shows how
intersection of value of marginal product curve or marginal revenue product
curve with the supply curve determines the equilibrium in this market
structure. The second sub-section distinguishes demand, supply and
equilibrium mechanisms of the imperfectly competitive markets by discussing
the special case of a monopoly. As price and marginal revenue are different in
case of monopoly, the determination of equilibrium wages and number of
workers hired by a firm entirely depends on the intersection of the marginal
product curve with the supply curve of the labour. The next section discusses
the prominent labour market policies implemented for the welfare of workers
across the world. Minimum wages are the minimum wages that need to be paid
to labour for use of his/her services. Labour unions provide collective
bargaining powers to workers of a firm and can bring about improvements in
work conditions of workers.
The last section of the unit discusses about the most interesting debate in
labour economics that why wages differ across different professions across the
world. This section explains the various factors that lead to variations in the
wage-rates of workers which includes compensating wages, human capital
investment and differences in skill of workers. Yet relative scarcity of supply
of a particular skill compared to the demand for the same remains critical
determinant of its higher price.

14.7 REFERENCES
1) Robert H Frank and Ben S Bernanke, Principles of Economics, Chapter
14 and 21, Third Edition, Tata-McGraw Hill, Indian Reprint.

2) Edgar K Browning and Mark A Zupan, Microeconomics: Theory and

Applications, Chapter 16-17, 8th Edition, John Wiley and Sons, USA.

3) Pindyck , Robert S. and Daniel Rubinfield (2005) Microeconomics,

Collier Macmillan, London, Chapter 13, page 399 to 417.

14.8 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 14.2 and answer.
2) Read Section 14.3 and answer.
3) Read Section 14.3 and answer.
Check Your Progress 2
1) Read Sub-section 14.3.2 and answer.
305
Factor Market 2) Read Sub-section 14.3.2 and answer.
3) Read Sub-section 14.3.2 and answer.
Check Your Progress 3
1) Read Sub-section 14.4.1 and answer.
2) Read Sub-section 14.4.2 and answer.
3) Read Sub-section 14.5 and answer.

306
UNIT 15 LAND MARKET
Structure
15.0 Objectives
15.1 Introduction
15.2 Rent as Return to Land Use
15.3 Effects of Tax on Land
15.4 Theories of Rent
15.4.1 Ricardian Theory of Rent
15.4.2 Marshall’s Theory of Rent
15.4.3 Modern Theory of Rent

15.5 Let Us Sum Up

15.6 References
15.7 Answers or Hints to Check Your Progress Exercises

15.0 OBJECTIVES
After learning in detail about the factor markets and labour markets in Unit 13
and 14, here you will able to know the functioning of land markets. Land
markets are very important in an economy as land is fixed in supply and so
land markets are vulnerable to frequent changes in demand and price. Legally,
the ownership of land consists of a bundle of rights and obligations such as
rights to occupy, to cultivate, to deny access, to build, etc. It is a very crucial
factor of production for any business. An unusual feature of land is that its
fixed quantity (supply) is unresponsive to changes in prices. This is so because
in general the supply curve of any factor of production is upward sloping
implying that a rise in price causes rise in supply of that factor of production.
However, this does not happen in the case of land markets as its supply is
fixed. A detailed reading of this unit would enable you to:
• state the meaning of land markets;
• appreciate how rent can be viewed as a return to land;
• explain what would happen if there is tax on land; and
• discuss the theories of rent.

15.1 INRODUCTION
In common language, the term ‘rent’ is often used for contractual payment for
use of an asset such as a house, shop, vehicle, machine, etc. However
economists have traditionally used the term only for land. In fact, the term has
its origin in feudal societies, where most of land was owned by landlords or
zamindars. They used to charge some payment from the farmers who
cultivated these plots of land. Rent is that payment which is given for
productive use of soil. There is also another important difference in the
Dr. Nausheen Nizami, Assistant Professor of Economics, Pt. Deen Dayal Upadhyay
Petrolium University, Ahemedabad. 307
Factor Market terminology of rent and that is between land rent and land value. While land
rent refers to the price for using one unit of land for a certain period of time,
land value refers to the price for buying one unit of land at a point of time.

15.2 RENT AS RETURN TO LAND USE

The price of a fixed factor is generally known as rent or pure economic rent.
Economists apply the term ‘rent’ not only to land but to any factor of
production which is fixed in supply. The supply curve of land is completely
inelastic i.e. vertical as its supply is fixed. The demand curve for land is
downward sloping. Equilibrium is attained when the demand and supply curves
intersect each other. The point of equilibrium gives the rent of land.
Equilibrium is a stable equilibrium. If rent were above the equilibrium, amount
of land demanded by all firms would be less than the fixed supply. Some
landowners would be unable to rent their land and would have to offer their
land for less and thus bid down the rent. Similarly rent could no longer remain
below equilibrium. Only at a competitive price where the total amount of land
demanded is equal to the total amount of land supplied, the market will be in
equilibrium.
Land is ‘a’ factor of production which comprises free gifts of the nature to
mankind. It includes, besides the surface, all the mineral, forests, water streams
etc. So, some of the statements we make about non-responsiveness of supply of
land to price changes will gave limited applicability to all facts of the resources
grouped into single nomenclature ‘the land’. The surface available for
cultivation may be ‘limited’ – but we can always add to it by clearing forests,
re-claiming barren lands, etc. Similarly, supply of natural resources like
metallic and non-metallic minerals, mineral oils etc. may respond to prices
which permit use of better technology that lets us dig deeper and utilise even
those ores which were earlier regarded as inferior or non-viable for economic
use. Even the fertility of soil can be improved/ enhanced/ restored through
resort to ‘new’ technical and scientific knowledge.
Suppose a certain piece of land can be used to grow only cotton. If demand for
cotton rises, then the demand curve for cotton land will shift up and to the right
and the rent would rise. This leads to an important effect: The price of cotton
land would become high because the price of cotton is high. This shows that
demand for land is also a derived demand which signifies that the demand for
the factor is derived from the demand for the product for which the factor is
employed. Thus, the rent of land derives entirely from the value of the product
and not vice-versa.
Demand for an input is a derived demand. This implies that price of input will
be the value of the input’s marginal product multiplied by the price of the
output being produced. In other words, the amount a firm is willing to pay for
another unit of the input equals the money it will earn when that input is
purchased. This equals the quantity of product that additional unit will produce
multiplied by the marginal revenue that quantity of product will generate in the
marketplace. The horizontal sum of the demand curves of individual firms
equals the market demand for the product. The market supply of an input
typically depends on the behaviour of the owners of that input. In the case of
land, however, the supply is approximately fixed. For most cases, therefore, the
overall supply curve for land can be treated as vertical. In some cases, the
possibility of creating usable land from landfill may move the supply curve
308 somewhat away from vertical. Moreover, the supply of land for a particular
type of activity is not vertical in general because land can be moved from one Land Market
use to another. In competitive markets, all actors are price takers. Hence no
individual can affect the market price of an input. The price of land is found at
the intersection of the (derived) demand curve and the (vertical) supply curve,
and each user of land adjusts the quantity of land he rents (or buys) so that the
value of her marginal product equals the market land rent (or value).

Supply
Rent

E R*(Equilibrium
rent)

Derived Demand for

Quantity of Land Land
Fig. 15.1 : Determination of Equilibrium in Land Markets

The above figure shows how interaction of demand and supply curve in land
market leads to determination of equilibrium rent. It can be observed that R* is
the equilibrium rent where demand curve for land (which is a derived demand)
intersects the supply curve of land (which is fixed).
15.3 EFFECTS OF TAX ON LAND
There is a need to understand the implications of the fixed supply of land.
Suppose the Government wants to tax the incomes of the land-owners and
introduces a land tax of 50 per cent on all land rents ensuring that there is no
further tax on buildings or improvements. What would be the impact of this tax
on total demand and supply of land? The reality is that after the tax, the total
quantity demanded for land’s services does not change even though the
demand curve shifts. Even with a tax at the rate of 50%, people will continue to
demand the entire fixed supply of land. Hence with land fixed in supply, the
market rent on land services (including the tax) will be unchanged and remain
at its original equilibrium at point E1 in the Fig. 15.2.
What will happen to the rent received by the landowners? As the demand and
quantity supplied of land remain unchanged, the market price will also be
unaffected by the tax. Therefore, the tax must be completely paid out of the
landowner’s income. This brings a difference in the price paid by a farmer and
the price received by the landowner. In case of landowners, when the
government steps in to collect the 50 per cent tax, effect is the same as it would
be if the net demand to the owners had shifted down from D1D1 to D2D2 in the
diagram. Landowner’s equilibrium return after taxes is now only E2. The entire
tax would be shifted backwards on to the owners of the factor in perfectly
inelastic supply. However this reduction in factor incomes does not create
economic inefficiencies. This happens because tax on pure rent does not
change anyone’s economic behaviour. Those who demand land are unaffected
because the price of land remains the same. The behaviour of suppliers of land
also remains the same as the supply of land is fixed in nature. Thus, the
economy operates in the same way after tax, as tax leads to no distortions or
inefficiencies in the system.
309
Factor Market

Rent D1D1 SS (Supply)

D2D2

Effect of
E1 Tax on Land

E2

Quantity of Land

Fig. 15.2: Effects of Tax on Land

This result is based on Henry George’s Single-Tax movement, later used by

English economist Frank Ramsey to develop Ramsey tax theory. George
argued, because the value of the unimproved land is unearned, neither the
land’s value nor a tax on the land’s value can affect productive behaviour. If
land were taxed more heavily, the quantity available would not decline, as with
other goods; nor would demand decline because of land’s productive uses. The
reasoning behind Ramsey taxes is essentially the same as that shown in the
diagram above. If a commodity is highly inelastic in supply or demand, a tax
on that sector will have very little impact on production and consumption and
the resulting distortion will be relatively small.
Check Your Progress 1
1) What do you mean by the term economic rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Suppose the current rental rate of a 1BHK house in City X is Rs. 4000.
What would happen to the supply of this type of houses if the
Government decides to impose 5 per cent tax on rent? Give reasons in
support of your answer.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) What is the essence of Henry George’s tax theory?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

15.4 THEORIES OF RENT

It is important to understand why rent is paid and how rent is determined. In
310 order to answer these questions three theories of rent have been propounded:
(i) the classical theory alternatively known as Ricardian theory of rent, (ii) Land Market
Marshall’s theory of rent and (iii) Modern theory of rent.

15.4.1 Ricardian Theory of Rent

David Ricardo, an eminent economist of the 19th century defines rent as, ‘that
portion of the produce of the earth which is paid to the landlord for the use of
the original and indestructible powers of the soil’. So as per this definition,
land possesses original and permanent properties with reference to its nature,
situation, environment and conformation and rent is paid for the use of land
only. However, rent accrues to the landlord both from extensive and intensive
cultivation of land.
What is intensive cultivation? When a farmer keeps on employing more of
other factors of production on the same piece of land in order to increase
production he is using land more intensively. He employs more labour as long
as the marginal revenue product of hiring additional worker is greater than the
market wage rate, it is known as intensive cultivation. Ricardo assumes that the
law of diminishing returns operates in this case in the sense that when more
and more units of labour and capital are used in cultivation, there are
diminishing returns from the agriculture. The following diagram throws light
on how the agricultural yield may decline due to excessive usage of capital and
labour inputs due to law of diminishing returns.

25
Agriculture yield (In kg)

20
15
10
5 Agriculture yield (In kg)
0
1 2 3 4
Capital and Labour Inputs

Fig. 15.3: Diminishing Returns due to Intensive Cultivation

Observe Fig. 15.3 carefully. You can see, that the agricultural yield is declining
from 20 to 9 kgs as the usage of capital and labour increases from 1 to 3.
Would this land earn rent? The answer is yes and requires you to recall the
concept of factor demand curve covered in Unit 13. The demand curve of
labour is given by the marginal revenue product curve of the variable factor.
This demand curve is used to determine the share of labour in total product i.e.
the wage bill and the surplus is called rent as seen the Fig. 15.4 below.
What is extensive cultivation? Extensive cultivation implies that as the demand
for output increases, land under cultivation is also increased. However there is
a difference in the quality of land used for cultivation as the area under the
plough changes owing to increase in demand. Suppose there are 5 different
types of land available to a farmer: A, B, C, D, E arranged in the descending
order of their fertility with plot A as the most fertile land available and plot E
the least fertile land available to the farmer in Fig. 15.5. To begin with, a
farmer would sow crops only in the most fertile plot of land as it would give
him high agriculture yields. Due to rise in population, if the demand for

311
Factor Market

Here it assumed that there are only two factors of production

Fig. 15.4: Determination of Rent in Recardian Theory

agriculture goods increases in such a way that the supply of food grains from
plot A is found insufficient to meet the demand, the farmer would bring plot B
into use. However plot B being of inferior quality would generate lesser
revenue even if same amount of inputs are used.

Fig. 15.5: Extensive Cultivation and Rent

Similarly, due to an increase in demand for agricultural output, plots C, D and

E would also be used by the farmer to increase production so as to be able to
meet the market demand. However plot E being of inferior quality and least
fertile would generate no surplus and plot A generates the highest surplus. This
312
surplus is known as rent. In order to be able to earn rent, the market value of Land Market
agriculture output produced on a plot of land should be higher than the cost of
cultivation on that land and this is the highest on plot A. For inferior quality
lands, the cost of cultivation is very high and so it can be inferred that only the
land of superior quality can generate surplus or rent. Ricardo also explained
that rent of land depends on price of the land’s produce. Rent is thus the excess
of the market value of land produce to the cost of cultivation as seen in the Fig.
15.5.
Ricardo’s theory of rent is based on the following assumptions:
1) There is perfect competition in the economy
2) Supply of land is limited
3) Law of diminishing returns operates
4) Rent is applicable only on land
5) Rent is price determined
6) Land is cultivated in a quality varying sequence in the sense that the most
fertile land is cultivated first and the least fertile is the last.
An interesting aspect of the Ricardian theory is the role of location of land in
determination of rent. The theory says that apart from the fertility of soil, rent
also arises from the difference in the cost of transporting agricultural produce
of a land to the market. As land situated farther and farther away from the
market is brought under cultivation with increase in demand for agriculture
produce, the transportation charges increase. Those plots of land which are
nearer to the market pay lesser transportation charge compared to the distant
lands. Thus, rent would be higher for land situated near the market compared to
the ones away from the market.
The critique of the Ricardian theory of rent can be summarised in few lines.
There is absence of perfect competition in real agricultural markets. The
difference between superior and inferior land occurs due to intervention of the
owner/farmer through use of technology and inputs and does include costs.
Superior quality of land may be inaccessible if it is flooded, covered with
shrubs or under disputed private ownership. The original and indestructible
powers of land are prone to change with the advent of technological progress.
It is now possible to increase the fertility of land and bring more and more land
under cultivation through heavy capital machinery. However despite these
criticisms, Ricardian description of rent as unearned differential surplus that
arises due to economic progress has helped in the policy making across the
world. Abolition of zamindari system in India as well as other countries was on
the grounds of this ‘unearned surplus’ to the owners.
Check Your Progress 2
1) What is the Ricardian concept of rent? How is it different from the usual
notion of rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
..................................................................................................................... 313
Factor Market 2) Do you think supply of land is limited? If yes, in what sense?
.....................................................................................................................
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.....................................................................................................................

15.4.2 Marshall’s Theory of Rent

Alfred Marshall developed the concept of quasi-rent in order to extend the
Ricardian concept of rent to other factors of production. He referred it to the
surplus earnings generated by the factors of production excluding rent.
Marshall’s concept of quasi-rent was a short run concept unlike Ricardian long
run concept of rent. This concept can be easily understood using an example of
housing. Suppose that the demand for houses in an area of Ahmedabad
increase suddenly due to onset of construction of metro rail in that area. It is
not possible to increase the supply of houses in accordance to the demand. The
increase in demand for houses would push up the prices and those who sell
their houses during this period would get surplus earnings. This sudden
increase in their earnings is called as quasi rent. Similarly the rental price of
houses would increase during this period resulting into quasi-rent.
Quasi-rent will disappear in the long-run competitive equilibrium. Professors
Stonier and Hague rightly remark, “The supply of machines is fixed in the
short run whether they are paid much money or little so they earn a kind of
rent. In the long run, this rent disappears for it is not a true rent, but only an
ephemeral reward — a quasi-rent”. But the case of land is quite different. The
supply of land being a free gift of nature and non-reproducible, its supply is
perfectly inelastic in the short run as well as in the long run. Thus the surplus
earnings or rent earned by land persist in the long run also. It is thus clear that
the earnings of land and of capital equipment (machines etc.) are similar only
in the short run.

Fig. 15.6: Determination of Rent in Marshall’s Theory

314
Distinction between quasi-rent, rent and interest: Quasi-rent is similar to Land Market
rent in more than two ways. It arises when the demand for man-made goods
increases, while rent arises when the demand for land increases. Just as the
supply of man-made goods is fixed in the short-run, the supply of land is also
fixed. Transfer earnings help in determination of both rent and quasi-rent.
However still the two differ in the sense that quasi-rent is fixed in the short-run
due to fixed supply of man-made goods and rent is fixed in the short-run as
well as long-run due to fixed supply of land. Quasi-rent is a temporary
phenomena which does not exist in the long run after supply of man-made
goods is resumed. However rent persists in both the periods as supply of land
cannot be changed.

15.4.3 Modern Theory of Rent

The modern theory of rent develops Marshallian theory of rent even further.
This theory is different in terms of the determination of mechanism of rent.
Here rent is determined using the demand-supply framework. The theory
stipulates that even if land is very fertile, rent would arise owing to its fixed
nature i.e. due to scarcity. The modern theory of rent assumes perfect
competition, homogenous product and land of equal quality. Also, rent is
dependent on the marginal revenue productivity of land and its demand curve
is downward sloping indicating that more land would be used at lower rates of
rent. The supply curve of an individual firm is perfectly inelastic but the supply
curve of all the land owners taken together is upward sloping implying that
with higher rates of rent, more and more land is offered for use. This has been
depicted in Fig. 15.7.
The area under the supply curve denotes ‘transfer earnings’ which is the
minimum payment needed to retain the given factor units in the present
employment. In simple words, it is the opportunity cost of the factor. It refers
to the earning of capital/land/labour in its next best use. Let us understand this
concept using an illustration. Suppose cotton is grown in a piece of land and
the cost of its cultivation is Rs.100. The cost of cultivation for wheat remains
the same on this land and so there would be no transfer earnings. However if
by producing soyabean, the cost of cultivation on this land comes down to
Rs.70, then the transfer earning would be Rs. 30 and Rs. 40 would be the rent.
Thus,
Rent = Actual earnings – Transfer earnings.
The above diagram shows the usual demand and supply curves for land. Point
E is the point of intersection of the demand and supply curves. This
equilibrium point shows OP as the equilibrium price at which suppliers of land
are willing to supply OQ units of land. Note that the supply curve also depicts
that how many different units of land are going to be supplied at each price.
This area under the supply curve thus depicts the transfer earnings and the area
above the supply curve depicts the quasi-rent.
As the supply of land is inelastic in nature, one can show how quasi-rent of
land would differ depending on the different elasticities of the supply curves.
Consider the Fig. 15.7, here demand curve intersects the three supply curves S1,
S2 and S3.

315
Factor Market

Fig. 15.7: Rent as per Different Elasticities of Land Supply Curve

These supply curves intersect the demand curve at E. At each of the supply
curves, the equilibrium price and quantity are given by OP and OQ
respectively. Area under a supply curve upto point Q is called transfer earning.
The total factor payment in all the three cases is given by OPEQ. One can note
that with supply curve S1, transfer earning is zero while with S3 supply curve,
the entire factor payment becomes the transfer earning.
It is to be noted that Marshall’s concept of rent was different from Ricardian
concept of rent in the sense that the former calls the excess over the transfer
earnings as rent while Ricardo considers it as the excess earnings of the owner
over the cost of production. The modern theory of land is different from the
original theory of Marshall and was built further by J.S.Mill, Joan Robinson
and other neo classical economists because it was built further using the
demand and supply framework.
Check Your Progress 3
1) What is quasi-rent? How is it different from economic rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) State the distinction between modern theory and Marshallian theory of
rent?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
316
3) Explain how rent can differ depending on the elasticity of supply curve of Land Market
land?
.....................................................................................................................
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.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

15.5 LET US SUM UP

This unit has introduced the concept of land using different approaches. The
term rent has been originally coined by economists to refer to earnings from
ownership of land only. The unit further discusses the implications of a tax on
land. When tax is imposed on land, it does not affect the demand for land as
the price of land remains the same owing to fixed supply of land. Tax directly
affects the landowner’s income and is paid from their earnings without
affecting the total demand and supply of land in the market.
Theories of land give an insight on the different approaches of determining rent
in economic theory. The Ricardian theory of rent determines rent on the basis
of the surplus earnings from land owing to its superior quality. The theory has
two approaches: extensive cultivation and intensive cultivation which depict
how there are surplus earnings and how they differ owing to different quality
of land. The theory has been criticised on the grounds of its assumptions i.e.
perfect competition, original and indestructible power of land which may alter
through use of technology. Marshall’s theory of rent is based on the concept of
transfer earnings wherein the concept of quasi-rent has been developed.
Marshall defines rent as the difference between actual earnings and transfer
earnings from land and uses the notion of quasi-rent for other factors of
production as well. Transfer earnings are those which are just enough to retain
the factor of production in the present use. Rent is anything which is in excess
to transfer earnings. The modern theory of rent developed by later classical
economists like J. S. Mill, Joan Robinson, etc. have built upon the Marshallian
framework by introducing the demand-supply framework.

15.6 REFERENCES
1) Stonier A.W. and Hague D.C. (1980), A Textbook of Economic Theory,
MacMillan: London.
2) M L Jhingan (2006), Principles of Microeconomics, Chapter 42-44, Third
edition, Vrinda Publications Pvt Ltd, New Delhi.

15.7 ANSWERS OR HINTS FOR CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 15.1 and 15.2
2) See Section 15.2 and 15.3
317
Factor Market 3) See Section 15.3
Check Your Progress 2
1) See Sub-section 15.4.1
2) See Section 15.2
Check Your Progress 3
1) See Sub-section 15.4.2
2) See Sub-sections 15.4.2 and 15.4.3
3) See Sub-section 15.4.3

318
UNIT 16 WELFARE: ALLOCATIVE
EFFICIENCY UNDER
PERFECT COMPETITION
Structure
16.0 Objectives
16.1 Introduction
16.2 Efficiency – Definition and Concepts
16.2.1 Productive Efficiency
16.2.2 Technical Efficiency
16.2.3 Efficient Allocation of Resources among Firms
16.2.4 Efficiency in Output Mix

16.3 Efficiency in a Perfectly Competitive Market Firm

16.4 Efficiency in a Perfectly Competitive Market Economy
16.5 Competitive Prices and Efficiency: The First Fundamental Theorem of
Welfare Economics
16.6 Departing from the Competitive Assumptions
16.6.1 Imperfect Competition
16.6.2 Externalities
16.6.3 Public Goods
16.6.4 Imperfect Information

16.7 Let Us Sum Up

16.8 References
16.9 Answers or Hints to Check Your Progress Exercises

16.0 OBJECTIVES
After studying this unit, you will be able to:
• clearly state the concept of economic efficiency (Pareto efficiency);
• identify various types of efficiencies and their interrelationship to achieve
the Pareto Efficiency;
• distinguish between Pareto efficient and inefficient situations;

• describe the Production possibilities frontier and the marginal rate of

transformation;

• appreciate that a perfectly competitive market will exhibit the

‘Productive’ and ‘Allocative’ Efficiencies;

Dr. S.P. Sharma, Associate Professor of Economics, Shyam Lal College (University of
Delhi), Delhi.
321
Welfare, Market • describe the conditions for economic efficiency in a simplified perfectly
Failure and the Role competitive market economy;
of Governemnt
• explain the essence of the relationship between perfect competition and
the efficient allocation of resources also known as First Fundamental
Theorem of Welfare Economics;
• describe the conditions under which perfectly competitive markets will
fail to achieve the efficient allocation of resources;

• explain that efficient outcome of a perfectly competitive market may not

necessarily be socially desirable; and

• briefly explain the policy implications of efficient outcomes reached

under the perfectly competitive markets.

16.1 INTRODUCTION
The fundamental problem of a society, that led the ‘Economics’ discipline to
emerge and take the driver’s seat, is scarcity of resources. The scarcity, which
is the originator of ‘efficiency’, calls for the optimal production, consumption
and distribution of these scarce resources. In a general sense, an economy is
efficient when it provides its consumers with the most desired set of goods and
services, given the resources and technology of the economy. One of the most
important results in economics is that the allocation of resources by a perfectly
competitive market is efficient. This important result assumes that such a
perfectly competitive market does not have externalities like pollution or
imperfect information. In Unit 9, we have studied the basic characteristics of
such a market and how the firms determine their equilibrium level of output
given the price of the product. It is a widely accepted view that perfect
competition is an idealised market structure that achieves an efficient
allocation of resources.
This unit will focus and elaborate in detail this aspect of perfectly competitive
market structures which ensure economic and allocative efficiency and
maximising profit in the perfectly competitive industries. Our analysis of a
close correspondence between the efficient allocation of resources and the
competitive pricing of these resources will however be based on the definition
of economic efficiency in input and output choices, as given by Vilfred Pareto
during the 19th century. The unit will also bring out the situations where
operation of a perfectly competitive market structure breaks down and thereby
loses its property of achieving the efficient allocation of resources.

16.2 EFFICIENCY – DEFINITION AND

CONCEPTS
We begin with Pareto’s definition of economic efficiency:
Pareto efficient allocation: An allocation of resources is Pareto efficient if it is
not possible (through further re-allocations) to make one person better-off
without making someone else worse-off.
It is, however, important to note that the achievement of Pareto efficiency in
resource allocation requires efficiency in production which is possible only
with technically efficient allocation of resources and technical efficiency could
322
be achieved with efficient allocation of resources amongst the firms. Further to Welfare: Allocative
ensure overall Pareto optimality, efficiency in production needs to be tied up Efficiency under
with the individual preferences. These concepts are systematically developed Perfect Competition
in subsequent sub-sections.

16.2.1 Productive Efficiency

An economy is efficient in production if it is on its production possibility
frontier (Fig. 16.1). In terms of Pareto’s terminology, an allocation of
resources is efficient in production (or “technically efficient”) if no further
reallocation would permit more of one good to be produced without
necessarily reducing the output of some other good. It seems easier to grasp
this definition by studying its converse — an allocation would be inefficient if
it were possible to move existing resources around a bit and get additional
amounts of one good and no less of anything else.

Fig. 16.1 : Production possibility frontier of an economy

Suppose resources were allocated so that production was inefficient; that is,
production was occurring at a point inside the production possibility frontier
(point C in Fig. 16.1). It would then be possible to produce more of at least one
good and no less of anything else. This increased output could be given to
some person, making him or her better-off (and no one else worse-off). Points
A and B being on the production possibility curve are productively efficient. It
is impossible to produce more goods without producing less service. Point C is
inefficient because you could produce more goods or services with no
opportunity cost. Hence, inefficiency in production is also Pareto inefficiency.
The trade-offs among outputs necessitated by movements along the production
possibility frontier reflect the technically efficient nature of all of the
allocations on the frontier.
Productive efficiency will also occur at the lowest point on the firms average
costs curve. Thus, Productive efficiency is concerned with producing goods
and services with the optimal combination of inputs to produce maximum
output for the minimum cost. This point is elabourated in Section 16.3 of this
unit.
16.2.2 Technical Efficiency
Technical efficiency is the effectiveness with which a given set of inputs is 323
Welfare, Market used to produce an output. A firm is said to be technically efficient if a firm is
Failure and the Role producing the maximum output from the minimum quantity of inputs, such as
of Governemnt labour, capital and technology. Technical efficiency is thus a precondition for
overall Pareto efficiency1.

16.2.3 Efficient Allocation of Resources among Firms

In order to achieve technical efficiency, resources must be allocated correctly
among firms. Intuitively, resources should be allocated to those firms where
they can be most efficiently used. More precisely, the condition for efficient
allocation is that the marginal physical product of any resource in the
production of a particular good is the same no matter which firm produces that
good.
Although equality of marginal productivities will ensure the efficient allocation
of resources among firms producing any one good, that condition is not enough
to ensure that inputs are allocated efficiently among firms producing different
goods. The additional condition for such efficiency is that the rates of technical
substitution (RTS) among inputs must be the same in the production of each
good if production is to be on the production possibility frontier. For better
understanding of this condition, we have shown it graphically in Fig. 16.2.
Figure shows technically efficient ways to allocate the fixed amounts of k and l
between the productions of the two outputs. The line joining Ox and Oy is the
locus of these efficient points. Along this line, the RTS (of l for k) in the
production of good x is equal to the RTS in the production of y.

Fig. 16.2: Efficiency in Production

In Fig. 16.2, the length of the box represents total labour-hours and the height
of the box represents total capital-hours. The lower left-hand corner of the box
represents the “origin” for measuring capital and labour devoted to production

1
Technical efficiency however, does not guarantee a situation of a Pareto efficiency. For
instance, an economy can be efficient at producing the wrong goods — devoting all available
resources to producing left shoes would be a technically efficient use of those resources, but
324 surely some Pareto improvement could be found in which everyone would be better-off.
of good x. The upper right-hand corner of the box represents the origin for Welfare: Allocative
resources devoted to y. Using these conventions, any point in the box can be Efficiency under
regarded as a fully employed allocation of the available resources between Perfect Competition
goods x and y. We have now introduced the isoquant maps for good x (using
Ox as the origin) and good y (using Oy as the origin). In this figure it is clear
that the arbitrarily chosen allocation A is inefficient. By reallocating capital
and labour one can produce both more x than x2 and more y than y2.
The efficient allocations in Fig. 16.2 are those such as P1,P2,P3, and P4, where
the isoquants are tangent to one another. At any other points in the box
diagram, the two goods’ isoquants will intersect, and we can show inefficiency
as we did for point A. At the points of tangency, however, this kind of
unambiguous improvement cannot be made. In going from P2 to P3, for
example, more x is being produced, but at the cost of less y being produced, so
P3 is not “more efficient” than P2 — both of the points are efficient. Tangency
of the isoquants for good x and good y implies that their slopes are equal. That
is, the Rate of Technical Substitution (RTS) of capital for labour is equal in x
and y production. The curve joining Ox and Oy that includes all of these points
of tangency therefore shows all of the efficient allocations of capital and
labour. Points off this curve are inefficient in that unambiguous increases in
output can be obtained by re-shuffling inputs between the two goods. Points on
the curve OxOy are all efficient allocations, however, because more x can be
produced only by cutting back on production of y and vice versa.

16.2.4 Efficiency in Output Mix

Technical efficiency will not necessarily ensure overall Pareto optimality
unless the individuals’ preferences are tied up with the production possibilities.
The necessary condition to ensure the Pareto optimum product mix is that
goods produced with technical efficient allocation of resources are those which
are most demanded by the consumers. Technically, this condition could be
achieved when the marginal rate of substitution (MRS) for any two goods by
consumers is equal to the rate of product transformation (RPT) of these two
goods. The requirement for efficiency in product mix is illustrated graphically
in Fig. 16.3 in one person economy, which could also be applied to an
economy of many individuals with identical preferences.
It assumes that one person in this economy produces only two goods (x and y).
Those combinations of x and y that can be produced are given by the
production possibility frontier PP. Any point on PP represents a point of
technical efficiency. By superimposing the individual’s indifference map on
the figure, we see that only one point on PP provides maximum utility. This
point of maximum utility is at E, where the curve PP is tangent to the
individual’s highest indifference curve, U2. At this point of tangency, the
individual’s MRS (of x for y) is equal to the technical RPT (of x for y); hence,
this is the required condition for overall efficiency.
In a single-person economy, the curve PP represents those combinations of x
and y that can be produced. Every point on PP is efficient in a production
sense. However, only the output combination at point E is a true utility
maximum for the individual. At E the individual’s MRS is equal to the rate at
which x can technically be traded for y (RPT).

325
Welfare, Market
Failure and the Role
of Governemnt

Fig. 16.3: Graphical representations of efficiency condition

for Optimum Product Mix

Check Your Progress 1

1) What is an economically efficient allocation? How does an economically
efficient allocation differ from an inefficient allocation?
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) What is the production possibilities frontier? What is the marginal rate of
transformation? How does the marginal rate of transformation relate to
the production possibilities frontier?
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) What do you mean by the term ‘technical efficiency’?
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326
 Welfare: Allocative
16.3 EFFICIENCY IN A PERFECTLY Efficiency under
COMPETITIVE MARKET FIRM Perfect Competition

As mentioned in the previous sub-section that there are two versions of

efficiency: productive efficiency and allocative efficiency. By now, it would be
clear that productive efficiency means ‘doing things right’, while allocative
efficiency means ‘doing the right things’.
A firm is productively efficient when total use of resources (factor inputs)
results in the lowest possible cost per unit of output. This would be the point
where average total cost is minimised. Any other level of average costs would
be sub-optimal. In regards to individual firms, the definition of allocative
efficiency is that the individual firm is producing the correct quantity of the
right goods – “doing the right things”. In stating that the correct quantity is
produced, in fact, implies that the last unit produced costs (i.e. marginal costs)
exactly what the consumer is willing to pay (i.e. the price of unit), resources
have been optimally allocated. Resources have been optimally allocated when
there is no waste, i.e. when the price equals marginal cost of the last unit
produced. This occurs when the output level is where P (AR) = MC for the
firm. When all firms fulfil this criterion then supply equals demand on the
market.
The firm operating within a perfectly competitive market will be both
productively and allocatively efficient in the long run. It was proved in Unit 9
that the firm cannot have abnormal profit in the long run due to the entry of
new firms, whereby the subsequent increase in supply and lower market price,
will dissolve any such profits. Nor can the firm survive endless losses.

Fig. 16.4: Productive and Allocative Efficiency and LR Equilibrium

for a PCM firm
Fig. 16.4 shows the LR equilibrium for a PC firm; output is at P = ACmin= MC
= AR = MR.
327
Welfare, Market In sum, we may conclude that the PC firm in the long run produces at an output
Failure and the Role level where P = ACmin = MC = AR = MR. This identity fulfils the criteria for
of Governemnt both productive and allocative efficiency in the long run, i.e.
• Productive efficiency: The LR equilibrium for the perfectly competitive
market shows that AR = ACmin. The firm is productively efficient.
• Allocative efficiency: The horizontal demand curve will set output along
the upward sloping MC curve, inevitably forcing the firm to produce
where the marginal revenue equals the marginal cost. In LR equilibrium,
P (AR) = MC. The firm is allocatively efficient.

16.4 EFFICIENCY IN A PERFECTLY

COMPETITIVE MARKET ECONOMY
Consider a simplified competitive economy where all individuals are identical
and engaged in growing food. Further assume: (a) as per law of diminishing
returns, each extra minute of work on fixed land brings less and less extra food,
(b) each extra unit of food consumed brings diminished marginal utility (MU).
Fig. 16.5 shows supply and demand for our simplified competitive economy.

Fig. 16.5: Efficiency in Competitive Market

When we sum horizontally the identical supply curves of our identical farmers,
we get the upward-stepping MC curve. As we have seen in Unit 9, the MC
curve is also the industry’s supply curve, so the figure shows MC = SS. Also,
the demand curve is the horizontal summation of the identical individuals’
marginal utility (or demand-for-food) curves; it is represented by the
downward-slopping MU = DD curve for food in Fig. 16.5. The intersection of
the SS and DD curves shows the competitive equilibrium for food. At point E,
farmers supply exactly what consumers want to purchase at the equilibrium
market price. Each person will be working up to the critical point where the
declining marginal-utility-of-consuming-food curve intersects the rising
marginal-cost-of-growing-food curve.

328
ECONOMIC SURPLUS AND EFFICIENCY Welfare: Allocative
Efficiency under
Fig. 16.5 also shows a new concept, economic surplus, which is the area Perfect Competition
between the supply and demand curves at the equilibrium. The economic
surplus is the sum of the consumer surplus, which is the area between the
demand curve and the price line, and the producer surplus, which is the area
between the price line and the SS curve. The producer surplus includes the rent
and profits to firms and owners of specialised inputs in the industry and
indicates the excess of revenues over cost of production. The economic surplus
is the welfare or net utility gain from production and consumption of a good; it
is equal to the consumer surplus plus the producer surplus.
Analysis of the competitive equilibrium will show that it maximises the
economic surplus available in that industry. For this reason, it is economically
efficient. At the competitive equilibrium at point E, the representative
consumer will have higher utility or economic surplus than would be possible
with any other feasible allocation of resources. At this point, it is observed as
follows:
a) P = MU, i.e. consumers choose food purchases up to the amount where P
= MU, implying that every person is gaining P utils of satisfaction from
the last unit of food consumed (util is a unit for measuring the utility or
satisfaction).
b) P = MC, i.e. as producers, each person is supplying food up to the point
where the price of food exactly equals the MC of the last unit of food
supplied (the MC here being the cost in terms of the forgone leisure
needed to produce the last unit of food). The price then is the utils of
leisure-time satisfaction lost because of working to grow that last unit of
food.
c) Putting these two equations together, we see that MU = MC. This means
that the utils gained from the last unit of food consumed exactly equal the
leisure utils lost from the time needed to produce that last unit of food. It
is exactly this condition – that the marginal gain to society from the last
unit consumed equals the marginal cost to society of that last unit
produced — which guarantees that a competitive equilibrium is efficient.
The result will remain unchanged even if the model is extended to any number
of commodities. In such a generalised case too, the rule remains the same, i.e.
utility-maximising consumers spread their ` income among different goods
until the marginal utility of the last rupee is equalised for each good consumed.
Since this marginal utility of money is equal to the price ratios which in turn
will be equal to ratio of marginal costs of the corresponding commodities in the
perfectly market economy. Thus, under certain conditions, perfect competition
guarantees efficiency, in which no consumer’s utility can be raised without
lowering another consumer’s utility.
Check Your Progress 2
1) Define the fundamental role of the marginal cost in achieving efficiency
in a perfectly competitive market?
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.................................................................................................................... 329
Welfare, Market 2) What role does consumer utility maximisation and firm cost minimisation
Failure and the Role play in a general equilibrium analysis?
of Governemnt
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3) Briefly explain the cost structure of a PCM firm and its relevance in
determining the price and output of such a firm?
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16.5 COMPETITIVE PRICES AND EFFICIENCY:

THE FIRST FUNDAMENTAL THEOREM OF
WELFARE ECONOMICS
The essence of the relationship between perfect competition and the efficient
allocation of resources can now be easily summarised as below:
• Attaining a Pareto efficient allocation of resources requires that (except
when corner solutions occur) the rate of trade-off between any two goods,
say x and y, should be the same for all economic agents. In other words,
Marginal Rate of Technical Substitution for all producers and Marginal
Rate of Substitution for all consumers should be equal.

• In a perfectly competitive economy, the ratio of the price of x to the price

of y, i.e. px/py provides this common rate of trade-off to which all agents
will adjust. Because prices are treated as fixed parameters both in
individuals’ utility-maximising decisions and in firms’ profit-maximising
decisions, all trade-off rates between x and y will be equalised to the rate
at which x and y can be traded in the market (px/py), i.e.
p•
MRTS•, = MRS•, =
p

• As all agents face the same prices in perfectly competitive market, all
trade-off rates will be equalised and an efficient allocation will be
achieved. This is the First Theorem of Welfare Economics.
The Fig. 16.6 illustrates the efficiency properties of the theorem.

330
Although all the output combinations on PP are technically efficient, only the Welfare: Allocative
combination x*, y* is Pareto optimal. A competitive equilibrium price ratio of Efficiency under
Perfect Competition
Px* = Py* will lead this economy to this Pareto efficient solution.

Fig. 16.6: Competitive Equilibrium and Efficiency in Output Mix

In Fig. 16.6, given the production possibility frontier PP and preferences

represented by the indifference curves, it is clear that combination x*, y*
represents the efficient output mix. Possibly x*, y* could be decided upon in a
centrally planned economy by the planning board or alternatively, in a
competitive market, the self-interest of firms and individuals will also lead to
this allocation. Only with a price ratio of px*/py* will supply and demand be in
equilibrium in this model, and that equilibrium will occur at the efficient
product mix, E, where MRSx,y (the slope of indifference curve) and MRTSx,y
(slope of the isoquant) and px/py (slope of the budget line are all equal. The
price mechanism ensures not only that production is technically efficient (that
output combinations lie on the production possibility frontier) but also that the
forces of supply and demand lead to the Pareto efficient output combination.
This is the First Fundamental Theorem of Welfare Economics.
The correspondence between competitive equilibrium and Pareto efficiency
provides “scientific” support for the laissez-faire position (which is based upon
the free market mechanism without intervention of the Government. For
example, Adam Smith in his book ‘Wealth of Nations’asserted in support for
such a policy with an example, “it is not the “public spirit” of the baker that
provides bread for individuals’ consumption. Rather, bakers (and other
producers) operate in their own self-interest when responding to market
signals. Individuals also respond to these signals when deciding how to
allocate their incomes”. Government intervention in this smoothly functioning
process may only result in a loss of Pareto efficiency.
However, it is difficult to draw policy recommendations from such a
theoretical analysis that pays so little attention to the institutional details of the
real world. The efficiency properties of the competitive system however do
provide a benchmark — a place to start examining reasons why competitive
markets may fail.

331
Welfare, Market
Failure and the Role
16.6 DEPARTING FROM THE COMPETITIVE
of Governemnt ASSUMPTIONS
You will learn in Unit 17 that various factors distort the ability of competitive
markets to achieve efficiency. These include (1) imperfect competition, (2)
externalities, (3) public goods, and (4) imperfect information. A brief summary
of these categories is given below:
16.6.1 Imperfect Competition
“Imperfect competition” includes all those situations in which economic agents
exert some power over the market in determining price. A firm that faces a
downward-sloping demand curve for its product, for example, will recognise
that the marginal revenue from selling one more unit is less than the market
price of that unit. Because it is the marginal return to its decisions that
motivates the profit-maximising firm, marginal revenue rather than market
price becomes the important magnitude. Market prices no longer carry the
informational content required to achieve Pareto efficiency.

16.6.2 Externalities
The competitive price system can also fail to allocate resources efficiently
when there are interactions among firms and individuals that are not adequately
reflected in market prices. For example, a firm polluting the air with industrial
smoke and other debris. Such a situation is termed an externality: an interaction
between the firm’s level of production and individuals’ welfare that is not
accounted for by the price system. With externalities, market prices no longer
reflect all of a good’s costs of production. There is a divergence between
private and social marginal cost, and these extra social costs (or possibly
benefits) will not be reflected in market prices. Hence market prices will not
carry the information about true costs necessary to establish an efficient
allocation of resources.

16.6.3 Public Goods

A similar problem in pricing occurs in the case of “public” goods. These are
goods, such as public education and public health institutions providing free
services, which (usually) have two properties that make them unsuitable for
production in markets. First, the goods are non-rival in that additional people
can consume the benefits of them at zero cost. This property suggests that the
“correct” price for such goods is zero, which obviously a problem for market
mechanism to operate. A second feature of many public goods is non-
exclusion: no individual can be precluded from consuming the good. Hence, in
a market context, most consumers will adopt a “free rider” stance, waiting for
someone else to pay. Both of these technical features of public goods pose
substantial problems for market economies.
16.6.4 Imperfect Information
The efficiency of perfectly competitive pricing is based on the assumption of
availability of full information with both producers and buyers in the market. It
implicitly assumes that buyers and sellers have complete information about the
goods and services they buy and sell. Firms are assumed to know about all the
production functions operating in their industry. Consumers are presumed to
know about the quality and prices of goods. If this assumption breaks down
332
and consumers are uncertain about prices and quality of a good and/or firms Welfare: Allocative
are unaware of the production processes in the industry, it will be difficult to Efficiency under
achieve the efficiency through competitive pricing. Perfect Competition

These four impediments to efficiency suggest that one should be very careful
in applying efficiency properties of perfectly completive markets for policy
formulation in the arena of public welfare.
Check Your Progress 3
1) Explain how the conditions of utility maximisation, cost minimisation,
and profit maximisation in competitive markets imply that the allocation
arising in a general competitive equilibrium is economically efficient.
....................................................................................................................
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2) State the distortions leading to failure in achieving the efficiency in
perfectly competitive market.
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16.7 LET US SUM UP

The efficient allocation of resources requires that the rate of trade-off between
any two goods should be the same for all economic agents. In a perfectly
competitive economy, the ratio of the prices of the goods produced provides
this common rate of trade-off to which all agents will adjust and eventually be
equated. The firm operating within a perfectly competitive market will be both
productively and allocatively efficient in the long run, i.e. in the long run
perfectly competitive market shows that AR = ACmin (the firm is productively
efficient) and P (AR) = MC (The firm is allocatively efficient).
It is, however, very pertinent to note that even though the competitive
equilibrium outcome is efficient, there is no guarantee that all consumers fare
equally well under the equilibrium. The welfare of an individual consumer
depends on his or her endowment of scarce economic resources, which in the
societies are not equally distributed. An economy with great inequalities in
distribution of endowments is not necessarily efficient. In such a society, the
economy might be squeezing a large quantity of guns and butter from its
resources. But the rich few may be eating the butter and feeding it to their cats,
while the guns are mainly protecting the butter of the rich. A society, therefore,
does not live on efficiency alone. A society may choose to alter market
outcomes to improve the equity or fairness of the distribution of income and
wealth. Nations may levy progressive taxes on those with high incomes and 333
Welfare, Market wealth and use the proceeds to finance food, schools, and health care for the
Failure and the Role poor.
of Governemnt
It was also noted that the term ‘Marginal’ (cost, price, revenue and utility) is a
fundamental concept for efficiency.

16.8 REFERENCES
1) David A. Besanko, Ronald R. Braeutigam and Michael J. Gibbs,
Microeconomics, 4th Edition, John Wiley and Sons, p. 648-721.
2) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
3) KristerAhlersten, (2008) Essentials of Microeconomics, First Edition,
bookboon.com, p. 76-87.
4) Sanjay Rode, (2013), Modern Microeconomics, First Edition,
bookboon.com, p. 173-227.

16.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 16.2 and answer
2) Read Sub-section 16.2.1 and answer
3) Read Section 16.2 and answer
Check Your Progress 2
1) Read Section 16.3 and answer
2) Read Section 16.4 and answer
3) Read Section 16.4 and answer
Check Your Progress 3
1) Read Section 16.5 along with Section 16.3 and Section 16.4 and answer
2) Read Section 16.6 and Section 16.7 and answer

334
UNIT 17 EFFICIENCY OF THE
MARKET MECHANISM:
MARKET FAILURE AND THE
ROLE OF THE STATE
Structure
17.0 Objectives
17.1 Introduction
17.2 Departures from the Assumptions of Perfect Competition
17.2.1 Imperfect Markets
17.2.2 Externalities
17.2.3 Public Goods
17.2.4 Imperfect Information
17.2.5 Adverse Selection
17.2.6 Moral Hazard

17.3 Deviations between Marginal Social Costs & Marginal Private Costs
and Social & Private Benefits
17.4 Internalising Externalities
17.4.1 Need for Public Interventions
17.4.2 Taxes and Subsidies
17.4.3 Direct Regulation: Administrative Steps
17.4.3.1 Regulating Privately Determined Prices
17.4.3.2 Regulation of Activities
17.4.4 Public Provision: Expanding Supply of Public Goods

17.5 Let Us Sum Up

17.6 References
17.7 Answers or Hints to Check Your Progress Exercises

17.0 OBJECTIVES
After going through this unit, you will be able to appreciate that in actual
practice, the market may suffer from imperfections on account of several
factors. In fact there may be unavoidable deviations from the assumptions of
perfect competition. So, you will be able to have a fairly good idea about:
• imperfections in the market;
• the problem of externalities;

• the existence of public goods, which have properties of non-exclusion

and non-rivalry leading to some external costs/benefits;

Dr. Mamta Mehar, Post Doctoral Fellow, Value Chain and Nutrition Programme. World
Fish, Malaysia.

335
Welfare, Market • imperfection of information which vitiate the decision making process;
Failure and the Role
of Governemnt • the problem of adverse selection and moral hazards in the functioning of
different agents/ actors in the market;
• how all the above problems lead to the deviation between social and
private marginal costs on the one hand and benefits on the other hand;

• the need for internalising externalities through public interventions which

may take form of taxes and subsidies, regulation of privately determined
prices.

17.1 INTRODUCTION
You have studied in the previous unit that in a perfectly competitive market
system, we are able to achieve technological and economic efficiency in
allocation of resources among alternative usage and distribution of income
among owners of resources. You have also come across 1st Welfare Theorem
which summed up all these ideas based on Pareto Efficiency. We tend to
develop overconfidence in the optimality and desirability of market based
solutions to the day to day economic problems of the society on the basis of
that narration of Unit 16.
However, now we are turning to an examination of possible departures from
the assumptions of perfectly competitive markets. Those assumptions are:
• A very large number of both buyers and sellers;
• Homogenous product;
• Perfect information;
• Free flow of information which is free for both buyers and sellers;
• No barriers to entry into the market or exit there from;
• No body exercises control over the market price through ones own
actions; and
• There does not exist any externality.
In the present unit, in Section 17.2, we are going to examine how deviations
form the above assumptions create situations which lead the markets away
from the path of efficiency and optimality. We give a common name to such
situations – the market failure. In that section, we will examine 6 such sets of
circumstances. We have kept the treatment elementary. You will study such
issues in much greater depth when you pursue a course in economics at a
higher and more rigorous level.
The Section 17.3 is devoted to examine of one single consequence of chain of
events which leads to failure of “efficiency” of the market mechanism. It is
divergence between private and social marginal costs and marginal benefits.
Section 17.4 suggests some approaches to that take care of the factors which
lead to externalities – we call it internalising the externalities. Interestingly,
one approach to solving the problem is to enhance the provisions of “public
goods” – especially in the field of health and education. It is believed by the
economists that positive externalities created by the public provision will help
the society to minimise the negative externality causing distortions present in
the society.
336
 Efficiency of the
17.2 DEPARTURES FORM ASSUMPTIONS OF Market Mechanism:
PERFECT COMPETITION Market Failure and
the Role of the State
The Unit 16 had introduced you to the implications of perfect competition. In
particular, efficiency in production, technical efficiency, efficiency in
allocation of different resources among different uses and firms and efficiency
in decisions regarding product mix were explained. The “efficiency” in general
means “Pareto efficiency”.
We then moved on to describe efficiency in a perfectly competitive market
firm and that of a perfectly competitive market economy. This led us to the
First Fundamental Theorem of Welfare Economics.
You were briefly introduced to the departure from perfect competition in
Section 16.6. The present unit aims at giving you a detailed analysis of what
happens when we stray from the idealised situation of perfect competition –
what will be, in particular, the implications for efficiency in allocation and
distribution, of which particular type of departure.
Here, in this section we will deal with imperfections in the market, positive and
negative externalities, effects of existence of public goods, imperfections of
information, adverse selection and moral hazards.
17.2.1 Imperfect Markets
This occurs with violation of assumption of perfect competition that the
number of buyers and sellers in each market is very large. There are situations
where some goods are produced and sold by one or fewer seller as well as
some goods purchased by few buyers. Following are the examples of each
situations:
a) where some goods are produced and sold by one seller – this is also
called monopoly market structure
• For instance, Indian railways has monopoly in railroad
transportation.
• Electricity boards have monopoly in their respective states.
b) Where some goods are produced and sold by few sellers. This is also
called oligopoly market structure
a) Airlines industry has few providers like Jet airways, Air India,
Indigo etc.
b) Mobile Service Provider like Airtel, Vodafone, Reliance etc.
c) Automobile Industry like Honda, Maruti etc.
c) Where there are a few buyers of product – this is called Oligopsonic
market structure
a) Agriculture products like cocoa, tea, tobacco has few big buying
industries.
b) Indian Railways is the only employer for locomotive engineers in
the country.
17.2.2 Externalities
Externality occurs when the violation of assumptions entail cost or benefit to
third parties. Or in other words, one person’s action affects another person’s
well-being positively or negatively and the relevant cost or benefits accrued to
337
Welfare, Market another persons are not reflected in market prices. For example, a smoker will
Failure and the Role enjoy smoking and smoke alone, but other person near to him will be affected
of Governemnt by the smoke. Another example: a private function where loud music is played
may disturb the peace of neighbourhood.
17.2.3 Public Goods
Another major source of inefficiency or market failure lies in the fact that there
are some goods which are not in interest of private seller or firms to produce.
These goods are usually beneficial for the society but private firms find no
reason to produce them. So in other words, Public goods are those goods
whose consumption cannot be restricted to only those who pay for them. For
instance, road lights will benefit all who use the road, but the exact buyers
cannot be identified and charged for it. [Though it has become possible to
exclude motorists who do not pay toll-tax on highways]. Another classical
example is defense services which protect whole society. These goods and
services are called public goods or social goods.
A public good has two key characteristics: its consumption is non-excludable
and non-rival. These characteristics make it difficult for market producers to
sell the good to individual consumers.
• Non-excludability means that we cannot exclude non-payers from
consuming it. For example, defense services at national borders protect
whole nation, no one can be excluded from that protection. Opposite to
this is an excludable good, if one needs phone services, they have to buy
the phone and pay the call charges.
• Non-rivalry means that when a person consumes a good, it will not
diminish other persons’ share. For example, adding one more person in
the society available to the existing members of the society. Opposite to
this, can be a rival good, say, a Pizza. If one slice of the Pizza is
consumed by one person, the share available to the rest will be reduced
by that slice.
Table 17.1, provides combinations of non-exclusion and non-rival goods.
There are goods which are pure public or pure private good. But there are also
goods which are semi public goods, for example, common resources are
resources where there are many users but no owner. For example, ocean has no
owner and anyone can go for fishing there.
Table 17.1: Combinations of non-exclusion and non-rival goods

Non-Rival
Yes No
Pure Public goods: national Common
defense, street lights, judicial resources- farm
Yes system grazing in
Non- villages, fish
Exclusion taken from
ocean, irrigation
water from river
Toll goods: theaters, toll-tax Pure Private
No roads, cable TV goods: Pizza,
mobile phones

338
Public goods have extreme positive externality. One major problem that arises Efficiency of the
with public good is of ‘free riding’. Free Rider means a person who is using Market Mechanism:
the good without paying anything for it. There is always some over- Market Failure and
consumption of shared resources due to this problem. the Role of the State

17.2.4 Imperfect Information

The second major source of inefficiency or market failure is imperfect
information on the part of buyers and sellers. This implies violation of
assumption that consumers and producers have full knowledge of product
characteristics, available prices etc. Below are few examples to understand the
situation of imperfect information:
a) Second hand vehicle (say car) seller has more information about its
quality than the buyer.
b) In labour market, workers know about their skills, but employers have
limited information about the quality of workers to compare.
c) Insurance agency has less information about the risks taken by their
clients, as the risk varies across clients due to the differences in their
socio-economic background etc.
17.2.5 Adverse Selection
Adverse selection refers to a market process in which buyer and seller have
different access to product information. For example, there are two groups, i.e.,
smokers and non-smokers for health insurance in the market. As the insurance
company cannot differentiate between the two, both groups have to pay the
same premium. This health policy is better for smokers. They are likely to die
younger than average due to bad effects of smoking. The nonsmoker are at
disadvantage as they are paying higher premium, as there exists no policy
which will take care of smoking characteristics. So market failure is involved.
In simple terms, adverse selection tends to result from ineffective price signals
as most information in a market economy is transferred through prices.

17.2.6 Moral Hazard

Moral hazard problem arises when one party to a contract changes behaviour in
response to that contract and thus passes the cost of its behaviour on to the
other party to the contract. We consider the smoker and non-smoker example
again. In normal scenario, smokers have incentive to quit smoking as it
increases cost of premium to them. However, smoker knows that a large
portion of cost of their risk behaviour will be borne by insurance company and
indirectly by non-smoking policy holders. This results in market failure.

17.3 DEVIATIONS BETWEEN MARGINAL

SOCIAL COSTS & MARGINAL PRIVATE
COSTS AND SOCIAL & PRIVATE BENEFITS
Remember, perfectly competitive firms objective is to maximise profits by
producing output where price is equal to marginal cost (P=MC). In absence of
externality, this private marginal cost of firm equals its social marginal cost.
However, in presence of externality there are costs (or benefits) that fall on
someone else, which are called external costs (or external benefits). These
external effects of an activity are in addition to the private costs. The sum total
339
Welfare, Market of private and these third party costs is called social costs. The same logic
Failure and the Role applies to calculation of social benefits.
of Governemnt
As you know, the supply curve for a good or service shows marginal cost (MC)
to those individuals who are producing it. It shows the lowest prices producers
are willing to accept for different quantities of product. In case of externality,
we consider it as marginal private cost (MPC). If there are no negative
externality associated with the producing it, then it is equal to marginal social
cost (MSC). In presence of negative externality, MSC is greater than MPC by
amount of marginal external cost (MEC). Marginal external costs (MEC) are
cost to third-person or society who are directly not involved in the activity
from an extra unit of production. So we can also say that
MSC=MPC+MEC
From consumer side, the demand curve for a good or service shows marginal
benefits (MB) to those individuals who are consuming it. It shows the highest
prices consumers are willing to pay for different quantities of product. In
absence of externality, we consider it as marginal private benefit (MPB). If
there is no positive externality associated with producing it, then it is equal to
marginal social benefit (MSB). In presence of positive externality, MSB is
greater than MPB by the amount of that marginal external benefit (MEB).
MEB shows the benefit to third-person or society who are directly not involved
in the activity of consumption of an extra unit. So we can also say that
MSB=MPB+MEB
Price/ Cost

MPC

q
P
*

MPB

Output
Fig. 17.1: Profit maximising market - no externality case

Fig. 17.1, shows the market equilibrium in presence of no externality.

Consumer preferences are depicted by demand curve as shown by marginal
private benefit curve (MPB) and producer’s production are shown by supply
curve or marginal private cost (MPC) curve. The equilibrium quantity of the
product is where MPB=MPC, where optimum level of price and output are P*
and q* respectively. The presence of market failures, i.e. positive or negative
externalities will result in market producing either too much or too little of the
commodity from society’s perspective. Fig. 17.2, presents socially optimal
outcome in presence of negative production externality. In presence of external
cost, MSC will be higher than MPC. So the MSC curve lies above the supply
340
curve (i.e. MPC) representing the additional external costs. The new
equilibrium will be at a point where price will increase to Ps from P* and Efficiency of the
output will fall from q* to qs. The market level of output is inefficiently larger Market Mechanism:
than the output in presence of external cost. This means there is a loss in Market Failure and
societal benefit i.e. dead weight loss. Dead-weight loss is the triangle as shown the Role of the State
by the shaded area as shown below in Fig. 17.2.

Price/ Cost

MSC

MPC
Dead-weight

Ps
P

qs q Output

Fig. 17.2: Profit maximising market-negative externality

So, with negative externality P>MPC, hence market inefficiency. The

efficiency direction varies with the type of externality. The results of all
possible type of externality are as follows:
• Negative production externalities lead to over production (Seller)
• Positive production externalities lead to under production (Seller)
• Negative consumption externalities lead to over consumption (Buyer)
• Positive consumption externalities lead to under consumption (Buyer)

17.4 INTERNALISING EXTERNALITIES

Our discussion in Sections 17.2 and 17.3 above leads to an inescapable
conclusion: The externalities are simply unavoidable. One reason or the other
will lead to such a situation that some external benefits will be conferred on
some members of society or some external costs will be imposed on some
social group. This implies that the ideal situations visualised in Unit 16 of all
around efficiency and optimality is a misnomer – it is never going to come
true! But is the situation really so “hopeless”? No. The present section outlines
some via-media – we can try to internalise some externalities – that is we can
incorporate them in market calculations to reduce the “external” positive or
negative elements. We can go to the extent of using creation of some positive
externalities to counter-balance the pre-existing negative ones Sub-section
17.4.4. But one thing is absolutely clear – the presence of externalities calls for
state-intervention.

17.4.1 Need for Public Intervention

As we discussed above, when an activity generates either positive or negative 341
Welfare, Market externality, social optimality of output is affected. Thus in presence of
Failure and the Role externality, individual (consumer or producer) objective will not result in
of Governemnt maximum social welfare, hence an economic rationale for some form of
government interventions in such situations. The appropriate way is to
internalise the externality that exists. Take the producers or consumers that
create the externality into account when making policies. The two most
common approaches to solve the problem of externality considered are given
below:

17.4.2 Taxes and Subsidies

The classic way to adjust for the externalities is to tax those who create
externalities. This approach is called Pigouvian Tax. Consider an example: A
coal based thermal power plant generates q* units of electricity. However, in
the process, it pollutes environment imposing negative externalities on the rest
of society. So, in addition to private marginal cost of producing electric power,
there exist external marginal cost also. The total or social marginal cost is sum
of the two (MSC = MPC + MEC). In the absence of no social control, the plant
operators keeps on increasing power generation and pollution. But what
happens if the State imposes a tax equal to marginal external cost? Now, the
MPC plus tax will be equal to the MSC. The producer’s surplus from excessive
power generation will be eliminated. So the socially optimum level of power
will be generated.
Consider different situations. Production of a certain item/service is not
optimal. Private cost calculations restrict supply to q* whereas the consumers
will like to consume qc >qs. This can happen when consumption generates
additional social benefits, not accounted for in the private calculations. Here, it
will be advisable for the state to subsidise the production/distribution/
consumption. We can count examples of subsidised sale of essential fertilizer
by the state agencies – as higher application of, say, Urea, leads to higher food
productions, which is critical for alleviation of hunger and mal-nutrition in the
society.

17.4.3 Direct Regulation: Administrative Steps

17.4.3.1 Regulating the Privately Determined Prices
The price regulation can become an important administrative measure to curb
profiteering on part of firms and to make available essential services and
commodities to the end users at a reasonable price. Two recent examples from
India can be mentioned here: The private (unaided) schools in Delhi did
increase the tuition fee charged from the students disproportionately, on the
pretext of meeting additional cost on account of the implementation of 6th
Central Pay Commission Award. Their bluff was called by the Honourable
High Court of Delhi and they are ordered to refund the excess amount along
with the interest thereon to the pupils. If they fail to do so, the private
managements may lose the control over those organisations.
The second example is that of inordinately high prices charged by pharma-
suppliers for the medical devices – like stents etc. The government has been
forced to impose price ceilings on such devices. Many of essential medicines
also attract the price ceilings.
These measures try to eliminate excessive profits only the costs plus a
reasonable returns are still being recovered by the manufacturers.
342
17.4.3.2 Regulation of the Activities Efficiency of the
Market Mechanism:
Regulation: The problem with taxes and subsidies is that the level of tax or Market Failure and
subsidy cannot be measured accurately in monetary terms. Another way of the Role of the State
controlling externality is to set standard limits for such activities. For example:
• Setting minimum standards for health and safety at the workplace
• Pollution permits: setting maximum quantity of polluting activity and
above that, stricter penalties for firms and consumers who break
regulations
• Banning cigarette advertising and making workplaces no-smoking
environments
Other than these, private bargaining and negotiations by agents are also used to
solve the problem of externality.
17.4.4 Public Provision: Expanding Supply of Public Goods
Now it is being increasingly realised that the society cannot depend on the
market forces to ensure optimum provision of essential services like education,
public health and tertiary health services. On account of presence of massive
divergence between private cost based calculations of the suppliers and the
social needs (signifying huge social benefits), it is being argued that the state
must increasingly enter into these two areas.
Check Your Progress 1
1) What are the assumptions of perfect competition market?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) What do you understand by the market failure? Explain the sources of
market failures?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) How do public and private goods differ?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the policy instruments available for government intervention to
regulate inefficient market situations.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Place each of these goods and services in the list below into the four
boxes in Table 17.2.
a) Private parks b) potato chips c) street lights d) Public toll roads &
bridges e) police and fire protection f) grazing land g) fish taken from
ocean h) timber i) Army j) Cable television k) mobile phones l) ice- 343
Welfare, Market cream m) Public radio n) laptop o) Free Mid-day meal at Public school
Failure and the Role p) parking spaces
of Governemnt
Table 17.2: Combinations of non-exclusion and non-rival goods
Non-Rival
Yes No

Non- Yes
Exclusion No

17.5 LET US SUM UP

We began the unit with narration of some sets of circumstances which
essentially are related to breakdown of some assumptions or other of the
perfect competition. Then, we demonstrated that this breakdown leads to
deviations between private and social costs as well as benefits. Our quest for
internalising the phenomena of externalities lead us to work for some public or
government interventions, in forms of taxes and subsidies, or regulating
minimum /maximum prices, or regulating certain private activities through
legal dictates. We go to the extent of using the instruments of the state to
generate some such externalities which can possibly mitigate the adverse
effects of some pre-existing externality causing maladies.

17.6 REFERENCES
1) Case, Karl E. & Ray C. Fair, Principles of Economics, Pearson
Education, Inc., 8th edition, 2007., Chapter 12.

17.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Section 17.1
2) See Section 17.2.
3) The two characteristics of public goods: non-exclusion and non-rivalry
make them different from private good.
4) See Section 17.4
5) See below
Non-Rival
Yes No
Yes Army, street lights, judicial grazing land, fish taken from
system, police and fire ocean, timber
protection, Free Mid-day
Non- meal at school
Exclusion
No Public toll roads & bridges potato chips, mobile phones,
cable television, Public laptop, ice-cream, cloths, parking
radio, private parks. spaces

344
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product

Accounting Cost : Accounting cost refers to actual expenses of the

firm plus depreciation charges for capital
equipment.
Allocative Efficiency : Producing goods and services demanded by
consumers at a price that reflect the marginal
cost of supply.
Abnormal Profit : Profit in excess of normal profit - also known as
supernormal profit or monopoly profit.
Abnormal profits may be maintained in a
monopolistic market in the long run because of
barriers to entry.
Adverse Selection : When one party to a deal is making suboptimal
choice because of asymmetry in information.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at given
market prices and within the particular income
level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction of
a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by a
Demanded changes in the price of the commodity in
question.
Contraction in : The decrease in quantity supplied because of a
Supply fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded by
neo-classical economists, who believe that utility
is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers,
such as 1, 2, 3 and so on.

345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.

346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).

347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.

349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K (!"#$%,& ) is the quantity of K that
(•••••, ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.
350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.

352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.

353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.

354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.

355
Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

356