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ABF 104

[ Microeconomics
for Business ]

[Amity University]

[Demand refers to the quantities of a commodity that the

consumers are able and willing to buy at each possible price during a given period of time, other things being equal.]

Economics has proved itself as a basic discipline; its applications have a wide range. New and newer areas are being discovered where the logic of economic reasoning and the use of economic tools and techniques come very handy. In particular, the business applications of economics are so numerous in number and varied in forms, that without a basic knowledge and understanding of economics, no business, government, nation, any international body or for that matter any organization, including the NGOs can function in todays world. There is, thus, a need for basic training in economics followed by applications in evaluating the rationality and optimality of business decisions taken by any agent. The emphasis of this e-book is on relating principles of economics at the firm level and help in analyzing demand, cost, production, pricing, output and investment decisions so common in corporate world. I am grateful to Amity, Dr.Shipra Maitra and all those who have directly or indirectly helped me in preparing this course material. I sincerely believe that there is always scope for improvement. Therefore I invite suggestions for further enriching the study material.

Dr. Puja Singhal

Table of Contents
PREFACE ........................................................................................................................................................ 2 Chapter -1- Demand Analysis....................................................................................................................... 5 1.1 Meaning of demand ................................................................................................................................ 5 1.2 Demand Classification: ............................................................................................................................ 6 1.3 Law of demand........................................................................................................................................ 7 1.4 Demand Function (Demand Determinants) ........................................................................................... 9 1.5 Individual Demand ................................................................................................................................ 10 1.6 Movement along demand curve (Change in Demand) ......................................................................... 11 1.7 Concept of Elasticity of demand .......................................................................................................... 14 End Chapter Quizzes ................................................................................................................................... 17 Chapter -2 :- Supply Analysis ..................................................................................................................... 19 2.1 Meaning of supply................................................................................................................................. 19 2.2 The law of supply................................................................................................................................ 19 2.3 Determinants of the supply .................................................................................................................. 21 2.4 Concept of elasticity of supply .............................................................................................................. 22 2.5 Market Equilibrium .............................................................................................................................. 23 End Chapter Quizzes ................................................................................................................................... 25 Chapter -3: Theory of Consumer Behaviour .............................................................................................. 27 3.1 Marginal utility theory .......................................................................................................................... 27 3.2 Indifference curve theory ..................................................................................................................... 29 3.3 Consumer surplus ................................................................................................................................. 34 End Chapter Quizzes ................................................................................................................................... 37 Chapter 4 :- Theory of Production and Cost ........................................................................................... 39 4.1 Meaning of Production ......................................................................................................................... 39 4.2 Production Function.............................................................................................................................. 39 4.3 ISOQUANTS OR EQUAL PRODUCT CURVE ............................................................................................ 40 4.4 Law of Variable proportion ................................................................................................................... 46 4.5 The law of returns to scale.................................................................................................................... 48 4.6 THE COST CONCEPT .............................................................................................................................. 50

4.7 Short run theory of cost ........................................................................................................................ 51 4.8 CONCEPT OF ECONOMIES AND DIS-ECOMNOMIES OF SCALE ............................................................. 54 End Chapter Quizzes ................................................................................................................................... 57
Chapter -5 Market Organisation and Pricing .......................................................................................... 59

5.1 PERFECT COMPETITION ........................................................................................................................ 59 5.2 Price Taking Behaviour:- ...................................................................................................................... 59 5.3 MONOPOLY .......................................................................................................................................... 66 5.4 PRICING UNDER MONOPOLY ................................................................................................................ 68 5.5 PRICE DISCRIMINATION ....................................................................................................................... 71 End Chapter Quizzes ................................................................................................................................... 82 Chapter -6:- Pricing under Oligopoly ................................................................................................. 84 6.1 MEANING OF OLIGOPOLY ..................................................................................................................... 84 6.2 CHARACTERISTICS/FEATURES OF OLIGOPOLY MARKET. ..................................................................... 84 6.3 KINDS OF OLIGOPOLY ........................................................................................................................... 85 6.4 Oligopoly Models .................................................................................................................................. 86 End Chapter Quizzess.................................................................................................................................. 98 Chapter -7:- Theory of Factor pricing ....................................................................................................... 100 7.1 MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION:- .................................................................... 100 7.2 WELFARE ECONOMICS ....................................................................................................................... 105 7.3 PARETO CRITERION OF SOCIAL WELFARE ........................................................................................... 105 End Chapter Quizzes ................................................................................................................................. 110 BIBLIOGRAPHY.......................................................................................................................................... 113

Chapter -1- Demand Analysis DEMAND

1.1 Meaning of demand

According to Prof Ferguson, Demand refers to the quantities of a commodity that the consumers are able and willing to buy at each possible price during a given period of time, other things being equal. Demand is wants for specific products that are backed by an ability and willingness to buy them. Wants are desires for specific satisfiers of the deeper needs Needs are the state of felt deprivation of some basic satisfaction. Examples:Need Food Want Dominos pizza Demand Ready to pay the price of dominos pizza which is wanted Ready to pay price of Chirag din shirt which is wanted


Chirag din shirt

Demand is said to exist provided three conditions are satisfied: 1. Desire to possess the commodity 2. Ability to purchase the commodity 3. Willingness to part with the means (money) for purchasing the commodity There are three additional features of demand: 1 Demand in economics is always at the price

2 Demand is always in reference to the particular period of time. In the words of Prof. Benham the demand for anything at the given price is the amount of it which will be bought per unit of time at that price. 3 Demand is a flow concept i.e. it can be measured over a period of time rather than at a particular point of time.

1.2 Demand Classification:

1 Autonomous Demand and Derived Demand Autonomous Demand is that demand, which is not tied with the demand for other goods. e.g. furniture, garment When the demand for a product is tied to the purchase of some parent product, its demand is called derived or induced demand. E.g. factor inputs. 2 Non durable goods demand and Durable Goods Demand Non durable goods (perishable goods) generally meet the current demand, which depends on current conditions e.g. Milk, fruit etc Durable goods (non perishable goods) are used over a period of time and meet current as well as future demand e.g. furniture, automobiles. 3 Company Demand and Industry Demand Company demand is the demand facing an individual firm. It is similar to an individual demand. On the other hand, the total demand facing all firms producing a particular product in the industry is called the industry demand. Eg demand for an input, say labour by a single firm would be a company demand, while the demand for labour by the industry as a whole is an industry demand. 4 Short run demand and Long run demand Short run demand refers to the existing demand substitutes, element of competition, seasonal patterns and cyclical sensitivity. Long run demand refers to the size and pattern of demand, which will prevail ultimately, when enough time has been allowed to let the market adjust itself to the changes in technology, tastes, etc.

1.3 Law of demand

The law of demand explains the relationship between two variables- price of the commodity and the quantity of the commodity demanded, other things being constant. Diagrammatic representation of this law is as follows:-

It states that people demand a larger quantity of goods and services only at a low price than at a higher price, ceteris paribus( ceteris paribus means all other factors affecting the demand such as income of the buyer, tastes of the buyer, prices of substitute and complementary goods ,are kept constant). Why demand curve slopes downwards? a) Law of Diminishing Marginal Utility: This law states that as the consumption of a commodity by a consumer increases, the satisfaction obtained by consumer from each additional unit (i.e., marginal utility) of the commodity goes on diminishing. For e.g. a thirsty man gets too much satisfaction by drinking a glass of water. But, the second glass of water will not be as much satisfying to him, as the first glass of water. The satisfaction derived from the third glass will even be lesser. b) Income effect: A fall in price of a commodity increases the purchasing power (or the real income) of the consumer. The money so saved because of a fall in the price of the commodity can be spent by the consumer in any way he likes. He will spend a part of this money on buying some more units of the same commodity, whose price has fallen. Thus, a fall in the price of this commodity increases its demand. This is called income effect.

c) Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other commodities, whose prices have not fallen. So the consumer substitutes this commodity for other commodities, which are now relatively dearer. This is known as substitution effect. The sum of income effect and substitution effect is called price effect. The demand curve slopes downward, as a fall in price of a commodity causes more of it to be demanded and vice - versa. d) Diverse uses of a commodity: Many commodities can be put to several uses. A commodity having several uses is said to have a composite demand. For e.g.- electricity can be used for lighting, cooking and so on. At a higher price, electricity may not be used for all of these purposes, i.e. the use of electricity may be restricted to lighting only. But, if price of electricity falls, people may afford to use it for other purposes also. Thus the demand of electricity at a lower price will increase.

Exceptions to the law:a) Giffen goods - These are a special type of inferior goods (named after the economist Sir Robert Giffen who made this proposition popular) such that a rise in their price leads to an increase in quantity demanded for these goods, and vice- versa. So, in the case of Giffen good, demand curve slopes upward and the law of demand does not operate. Example: Cheap bread, cheap vegetables, etc. b) Conspicuous consumption- A few goods are purchased by rich and wealthy sections of the society because the prices of these goods are so high that they are beyond the reach of the common man. More of these commodities is demanded when their prices go up very high. Veblen has termed it as conspicuous consumption. Example: Fancy diamonds, fancy cars, high priced shoes, pens, ties etc. c) Future changes in prices- Households also act as speculators. When the prices are rising, households tend to purchase larger quantities of the commodity, out of apprehension that prices may go up further. Likewise, when prices are expected to fall, a reduced price may not be a sufficient incentive to induce households to purchase more. Example-Shares of good corporate at the stock exchanges etc. d) Emergencies: In a situation like that of war or a famine, households behave in an abnormal way. Households purchase more of the commodities even when their prices are going up. This only worsens the situation. Similarly, during depression, no fall in price is a sufficient inducement for consumers to demand more. e) Change in fashion: When the commodity goes out of fashion, no reduction in its price is a sufficient inducement for a buyer to purchase more of it. Example- Old edition of text book on Indian economy, Big-sized handsets.

1.4 Demand Function (Demand Determinants)

A function always explains the relationship between two or more variables. The demand function for a good is the relation between the various amounts of the commodity that might be bought and the determinants of those amounts in a given market and in a given period of time. The demand function may be expressed symbolically as Q=f(P,Pr ,Y,T,E,O) Where Q stands for the quantity demanded of the commodity, P for the price of the commodity, Pr for prices of related goods, Y for income of the consumer, T for tastes and preferences of the consumer, E for the expectations for the future prices and O stands for the other factors. 1. Price of the commodity-Generally, it is expected that with the fall in the price, the quantity demanded of the commodity increases and with the increase in the price, the quantity demanded of the commodity decreases. Thus there is an inverse relationship between the price of a commodity and its quantity demanded and is commonly known as the law of demand. 2. Prices of related goods: Related commodities are of two types: a) Complementary goods are those that tend to be used jointly with each other. For e.g.-a ballpen without its refill is useless. If the price of refills falls, the demand for ball-pens will go up and vice-versa. This sort of relationship is known as inverse relationship and is represented by downward sloping demand curve b) Substitute goods are those goods that can be substituted for each other. In other words, these goods can satisfy the same need. For e.g. - if the price of coffee falls, consumers may substitute coffee for tea. Demand for tea, as a result thereof, shall come down, even though its price has not changed. This sort of relationship is called direct relationship and is represented by an upward sloping demand curve. 3. Income of the consumer Generally income of the people is directly related to their demand. However this may not always be true. So income demand curve is upward sloping for normal goods .But for necessary goods like salt, demand will not increase with the increase in income and remains constant. For inferior goods like coarse grain like bajra, jwar, etc there is an inverse relationship between income and demand. 4 Tastes and preferences of consumer: The demand for a good is more, which is liked by consumers and for which they have a preference. Consumers taste and preference may change because of a change in the fashion or as a result of the advertisement for various products. So there is a direct relationship between demand and preferences of consumers 5 Expectations about Future Prices: If consumers expect prices of certain goods to rise in the near future, they tend to demand more in the present .Consequently, demand for these goods whose prices are expected to rise goes up and vice versa.

6 Other factors-Other factors like composition of population, distribution of income, size of population also influence consumers demand.

1.5 Individual Demand Definition of Individual Demand:

Individual demand is defined as the quantity of a commodity that an individual is willing to buy (backed by the ability to purchase it) at a given price, during a given period of time. Demand schedule for an individual consumer for a single commodity Price per unit(in Rs ) Quantity demanded ( in units)

70 60 50 40 30 20 10 Market Demand
Definition of Market Demand

2 5 12 25 45 70 95

Market demand refers to the total quantity of a commodity that all individuals are willing and able to purchase at the given price, during a given period of time. It is also called aggregate demand.

Market (consisting of two individuals) Demand Schedule Price per unit(in Rs) 70 60 50 40 30 20 Quantity demanded by a( in units) 2 5 12 25 45 70 Quantity demanded by b (in units) 0 4 10 18 35 45 Market demand(in units ) 2 9 22 43 80 115

1.6 Movement along demand curve (Change in Demand)

Change in demand also called the movement along the demand curve and is possible only when the price of the commodity changes, ceteris paribus. When the price of the commodity falls the quantity demanded extends this is known as extension of demand.

When the price of the commodity raises the quantity demanded contracts this is known as contraction of demand. In both the above cases the movement is along the demand curve.

Shift in the Demand Curve

The demand curve is said to be have shifted when the whole demand curve either shift upward to the right due to an increase in demand or shift downward to the left when there is a decrease in demand. A shift in the demand curve (increase or decrease) is caused by a change in any of the factors influencing the quantity demanded other than price of the commodity.

Increase of Demand
An increase in demand means an upward shift in the demand curve (it may have been caused by an increase in consumers income). Increase in demand thus takes place when the same quantity is demanded at a higher price or more units are demanded at the same price.

Decrease in Demand A decrease in demand means a downward shift in the demand curve (This may be caused by the change in tastes of the consumer away from the product). A decrease in demand means that fewer units are demanded at the same price or the same quantity is demanded at a lower price.

Factor changing demand Increase in the consumer money income Decrease in consumer money income Increase in tastes and preferences for the commodity Decrease in the tastes and preferences for the commodity

Effect on demand Increase Decrease

Direction of shift in demand curve Rightward Leftward





1.7 Concept of Elasticity of demand

The elasticity of demand is the ratio of change in quantity demanded due to change in the invariants affecting demand. These invariants may be price of a commodity, income of the consumer, the price of other commodity etc. It can be represented by following formula: Percentage change in dependent variable ---------------------------------------------------Percentage change in the independent variable Y X ------ ---- = Y X Y X ------- ------X Y

Elasticity= Symbolically,

Y X E= ------ -----Y X

Where, E= Elasticity Y = Quantity of the dependent variable X=Quantity of the independent variable = the change in

Concept of Price Elasticity of Demand

According to Stonier and Hague the price elasticity of demand is defined as the degree of responsiveness of the demand for the good to the change in its price. Thus the price elasticity of demand is the ratio of percentage change in demand to the percentage change in price. It is symbolized by Ed

Where, P = Price Q = quantity of the commodity

Concept of income Elasticity of Demand

Given that the income of the consumer is an important determinant of demand, the income elasticity of the demand measures the responsiveness of quantity demanded of a particular product to the change in consumer income, ceteris paribus. It is defined as the ratio of the percentage change in the quantity demanded to the percentage change in consumer income.

Where, Y = income Q = quantity of the commodity

Concept of Cross Price Elasticity of Demand

The concept of cross price elasticity of demand explains the relationship between the price of one commodity and the quantity demanded of another related. It is defined as the proportionate change in the quantity demanded for a particular commodity in response to a change in the price of another related commodity. It thus measures the responsiveness of

demand of a particular commodity to the changes in prices of another commodity, ceteris paribus


Percentage change in the quantity demanded of commodity X -------------------------------------------------------------------------Percentage change in the price of commodity Y

QX PY Ec= --------- --------PY QX where subscripts X and Y refer to commodity X and Y respectively.

End Chapter Quizzes

Q1 Which best describes a demand curve? a) The quantity consumers would like to buy in an ideal world b) The quantity consumers are willing to sell c) The quantity consumers are willing and able to buy at each and every income all other things unchanged d) The quantity consumers are willing and able to buy at each and every price all other things unchanged Q 2 Market demand is the sum total of a) Supply of all the firms b) Demand of all the consumers c) Supply and demand in the market d) None of the above Q 3 Law of demand explains (a) Inverse relationship between own-price and commodity demanded (b) Inverse relationship between own price and commodity demanded, ceteris paribus (c) Positive relationship between price of related good and given commodity demanded (d) Positive relationship between price of the related good and given commodity demanded, ceteris paribus Q 4 If at a price of Rs. 70, Individual A, B, C demanded 5, 4, 8 units of a commodity respectively and at a price of Rs. 80. Demand of D is 10 units, and then what is the market demand at price Rs. 70. (a) 10 units (b) 17 units (c) 7 units (d) 27 units Q 5 Increase in demand is also called (a) Expansion of demand (b) Contraction of demand (c) Shift in demand curve (d) Rightward shift in demand curve Q 6 Direction of shift in demand curve, in case consumer money income decrease (a) Leftward (b) Rightward (c) Both leftward and rightward (d) None of the above

Q 7 Income elasticity of demand is same as Price elasticity of demand (a) True (b) False (c) May be (d) May be not Q 8 If a product is a Veblen good: a) Demand is inversely related to income b) Demand is inversely related to price c) Demand is directly related to price d) Demand is inversely related to the price of substitutes Q 9 Extension of demand is said to have existed, if (a) Price falls along the downward sloping demand curve (b) Price rise along the downward sloping demand curve (c) Rightward shift of demand curve (d) Leftward shift of demand curve Q 10 If demand is Pizza what would be the corresponding need (a) Fooding (b) Clothing (c) Medication (d) None of the above

Chapter -2 :- Supply Analysis

2.1 Meaning of supply

According to Prof. Benam, Supply may mean the amount offered for sale per unit of time. According to Prof. Thomas, The supply of goods is the quantity offered for sale in a given market at a given time at various prices. Thus the supply is defined as the total quantity of a commodity that a seller is willing to produce and sell at a given price, during a given period. Supply of the commodity is always in the reference to a particular price and to the particular time period and to a certain market.

2.2 The law of supply

According to the law of supply, other things remaining the same, quantity supplied of a commodity is directly related to the price of a commodity. In other words, a higher price will increase the sellers profit incentive to supply the commodity and induce him to supply a greater amount, ceteris paribus.

Law of supply operates on account of the following reasons:

a) Law of Diminishing Marginal Productivity: As we produce more and more beyond a certain limit, the additional return to the variable factor diminishes. Marginal and average cost of production increase as a result. This implies that more quantity of the commodity can be produced and supplied only at a higher price so as to cover higher cost of production. b) Profit maximization-Producers supply a commodity to secure maximum profits. An increase in the price of a commodity raises the level of profit, with conditions of cost remaining same. So producers increase the supply of the commodity by releasing big quantities from their stocks. Exceptions to the law of supply a) Non Maximisation of profits: Sometimes, the goal of firm is not to maximize the profits, but to maximize the sales. In that case, the quantity supplied may increase even when price does not rise. This usually happens when firm is interested in the maximization of long term profits. b) Subsistence farming: In underdeveloped countries , where agricultural farms are in subsistence rather than commercial , as prices of food grains rise , marketable surplus of food grains fall rather than rising, resulting in backward sloping supply curve. With rise in the prices of food grains, farmer can get the required amount of income by selling less and keeping the balance for their own consumption than before. c) Factors other than price not remain constant: The law of supply is stated on the assumption that factors other than price of the commodity remain constant. The quantity supplied of a commodity may fall at a given price, if, prices of other commodities show a rising trend. The change in a state of technology can also bring about a change in the quantity supplied even if the

price of that commodity does not undergo a change. Similarly, expectations of rise in the price in the future may induce the sellers to withhold supplies so as to get greater profits later on.

2.3 Determinants of the supply

a) Objective of the Seller The seller may be guided by the objective of either sales maximization or the profit maximization. If the seller is guided by the sales maximization objective then he will be able to sell a larger quantity compared to a seller guided by the profit maximization objective. b) The own price of the commodity supplied There is the direct and positive relationship between the price per unit of the commodity and the quantity supplied, ceteris paribus. c) The price of the other commodities Suppose that the seller produces two commodities x and y. if the price of the good x rises and the price of the good y remains the same, the seller would prefer to direct the resources from the production of good y and utilize them in the production of good x. the production and supply of good y will decrease without there being a change in its price. The given example holds true only when x and y are substitutes in the production. d) Price of the factor of production If the price of the factor of the production (say labor and capital used in the production of the commodity) rises, the cost of the production shall increase. This will reduce the quantity of the commodity supplied. Only when prices rise and cover the increased cost of factor of production that quantity supplied shall increase. e) State of the technology The ratio in which the factors are combined reflects the technology used in the production. An improvement in the state of the technology would result in more quantity being produced at the same cost or the same quantity being produced at a lower cost. In both the cases the seller shall be able to increase the quantity supplied at its original price or even at the lower price. f) Nature and the size of the industry

Attracted by the profits earned by existing firms, if new firms enter the industry and start production, supply will increase. Generally the greater the number of sellers, the better shall be the supply position. g) Government policy The government policy with respect to the certain commodities in specified quantities, levy of the excise duty on some commodities, subsidy policy etc all influence the supply of that particular commodity on which that policy is applicable. For example, when the government imposes an excise duty on the good its cost will increase and it may be passed on to consumers in terms of higher prices or less quantity may be supplied at the old price.

2.4 Concept of elasticity of supply

Elasticity of supply is defined as the ratio of percentage change in quantity supplied and the percentage change in the price of the commodity. It measures the degree to which the quantity supplied responds to the price changes. Mathematically,


Percentage change in quantity supplied of a commodity -------------------------------------------------------------------Percentage change in the price of the commodity

Es Where Es =Elasticity of supply P=Change in price Q=Change in quantity = ------


P and Q are the original price and quantity supplied respectively.

Factors affecting Elasticity of supply a) Nature of commodity: On the basis of the nature, commodities may be classified as (i) perishable and (ii) durable. Perishable goods cannot store and thus, entire stock of such goods must be disposed of within very short period, whatever may be price. Hence their supply is inelastic in nature. On the other hand, durable goods can be stored and their supply responds to the changes in their price. Thus their supply is generally elastic.

b) Behaviour of costs and output varies: Total cost rises at a falling rate in the beginning, then at a constants rate and finally at rising rate. If total cost rises at falling rate there is more stimuli to expand output in response to rise in price and accordingly, supply will tend to be more elastic. On the other hand, if total cost rises at rapid rate, supply will be less elastic. c) Techniques of production: Simple techniques of production are by and large expensive in nature. In such case, the production and supply of commodities can be easily increased. Thus, supply of such commodities is generally elastic in nature. On the other hand, if the techniques of production of a commodity are complex and time consuming, it may not be possible to change the supply in response to change in price. Supply of such commodities would generally be less elastic. d) Future of price expectations: If the producers expect that the prices will rise in future, they may hoard the stock and may supply less quantity in the market. Supply in such case will be inelastic. On the other hand, if the prices are expected to fall in the future, supply will be more elastic

Concept of Price Elasticity of Supply

Price Elasticity of supply describes the degree of responsiveness of supply for a commodity to a change in its price. It is the ratio of percentage change in the quantity supplied to the percentage change in price per unit of the commodity.

2.5 Market Equilibrium

Market equilibrium is the situation whereby the quantity demanded of a commodity at the given price per unit commodity is same as the quantity supplied of the commodity at the same price. In the given diagram the demand curve is represented by downward sloping straight line whereas the supply curve is represented by the upward sloping straight line.

The market equilibrium is established where the market demand curve intersects the market supply curve.

The market equilibrium is established where the equilibrium price is P* and the equilibrium quantity is Q*. At the price above P*supply is in excess of the demand. This will exert a downward pressure on the price such that finally the equilibrium is established at the (P*, Q*). Similarly, at the price below P* the demand is in excess of the supply , as the result there will be an upward pressure on the price such that finally the equilibrium is established at the (P*,Q*).

End Chapter Quizzes

1 Law of supply explains: a) quantity demanded as a function of price b) quantity supplied as a function of price, ceteris paribus c) quantity supplied as a function of quantity demanded, ceteris paribus d) quantity demanded as a function of price, ceteris paribus. 1 Extension in supply is said to have taken place, when a) quantity supplied expands with the fall in price b) upward movement along the demand curve c) upward movement along the supply curve d) downward movement along the supply curve. 2 Increase in supply , related to: a) outward shift of supply curve to the right b) inward shift of supply curve to the left c) upward movement along the supply curve d) downward movement along the supply curve 3 A change in price of factors of production , would bring: a) outward shift of supply curve to the right b) shift of supply curve c) change in supply along the supply curve d) extension of supply curve 5 An increase in the costs of production will: a) Shift demand outwards b) Shift demand inwards c) Shift supply outwards so more is supplied at each and every price, all other things unchanged d) Shift supply inwards 6 A seller guided by sales maximization will be able and willing to sell a _____ quantity compared to a seller guided by profit________ objective. a) larger, maximization b) larger, minimization c) lesser , maximization d) lesser , minimization

7 Supply of a commodity is always in reference to a particular: a) Price, time period and market b) Price and time period c) Time period d) Price and market 8 There is a direct and positive relationship between price and quantity supplied; explained by the law of supply a) True b) False c) Cant say e) None of the above

9 If demand increases in a market this will usually lead to: a) b) c) d) A higher equilibrium price and output A lower equilibrium price and higher output A lower equilibrium price and output A higher equilibrium price and lower output

10 If the price of commodity X increases then the quantity supplied of commodity Y also increases, then a) X and Y both are complimentary b) X and Y both are substitutes c) Both (a) and (b) d) None of the above

Chapter -3: Theory of Consumer Behaviour

3.1 Marginal utility theory

The marginal utility approach of consumer behaviour was published by Gossen (1854), W.S.Jevons (1871) of England, Leon Walras (1874) of France and Carl Menger of Austria. Alfred Marshall (1890) made important contribution to their work and thus earned the name Marshallian Utility approach. Marginal Utility theory is based on the concept of the law of diminishing marginal utility. Some important terms related to this law are as follows:a) Utility-The notion of utility was accomplished by Jeremy Bentham.Utility does not mean usefulness. It means expected satisfaction to a consumer when he is willing to spend money on a stock of commodity which has the capacity to satisfy his want. b) Total Utility (TU) - It is the aggregate of the utility that a consumer derives from the consumption of a certain amount of a commodity. Mathematically it can be expressed as follows TUn=MU1+MU2+. +MUn c) Marginal Utility Marginal utility of commodity is the change in the total utility resulting from the consumption of one more additional unit of that commodity, ceteris paribus.Marginal utility of the nth unit of a commodity consumed is equal to the total utility from the n units less total utility from the n-1 units of that commodity. Mathematically it can be expressed as follows: MUn=TUn-TUn-1 The law of diminishing marginal utility According to this law the intensity of satisfying a particular want diminishes as the consumer starts consuming more units of the commodity that satisfy that want. The assumptions of the law of diminishing marginal utility 1. 2. 3. 4. Units of the commodity consumed are homogeneous Commodity is consumed in suitable and reasonable units. Commodity is consumed within a suitable time period. The tastes, fashion, customs and habits of the consumer remain unchanged during the period of consumption. 5. The income of the consumer does not change during their period of consumption 6. The consumer is a normal person.

As the consumer goes on consuming more units of a particular commodity, the additional utility that a consumer derives from the consumption of that commodity goes on diminishing i.e. as consumption increases, the utility goes on progressively diminishing.
The law of diminishing marginal utility is also called the law of satiable wants. Kenneth. E. bounding defines the law of diminishing marginal utility as As a consumer increases the consumption of any one commodity, keeping constant the consumption of all other commodities the marginal utility of the variable commodity must eventually decline.


Units of a commodity consumed 1 2 3 4 5 6

Total utility 40 70 90 100 100 90

Marginal utility 40 30 20 10 0 -10

3.2 Indifference curve theory

Marshalls Marginal utility theory deduced the law of demand based upon three restrictive assumptions of cardinal measure of utility, constant marginal utility of money and lack of interdependence between goods. The theory has been severely criticized for its assumptions. Ultimately J.R.Hicks and R.G.D.Allen presented a scientific treatment to the consumer theory on the basis of ordinal utility, graphically represented by indifference curves An indifference curve shows a set of different combinations of quantities of two goods that yield same satisfaction to the consumer.

The assumptions of the indifference curve theory

1. The consumer can state definitely whether the utility derived from the good or the combination of goods is greater, less or equal to the utility derived from another good or the combination of goods. 2. The consumer is assumed to behave in the rational manner. 3. If the consumer prefers good A to the good B in one period then he will not choose good B over good a in another period or treat them as indifferent, ceteris paribus. 4. The consumer has not reached the point of saturation in the consumption of a commodity.

5. The consumer is more unwilling to give up a commodity that is scarce as compared to situation when it is plentiful. 6. The consumer tastes, habits, remain unchanged.

The indifference curve a graphical explanation

As an example, consider the diagram above. Consumer would be most satisfied with any combination of products along curve U3. Consumer would be indifferent between combination Qa1, Qb1, and Qa2, Qb2.

Indifference curve is defined as the locus of various combinations of two commodities that would provide the consumer with the same level of satisfaction. Every point on the given indifference curve represents an equal amount of satisfaction to the consumer.

Properties of the indifference curve

1.An indifference curve always slopes downwards from left to right ; i.e., it has a negative slope-It means that if the quantity of one commodity (say Y) decreases, the quantity of the other (X) must increase, if the consumer is to stay on the same level of satisfaction. This is due to the non-satiety requirement. 2. Indifference curve are convex to the origin.- Convexity of indifference curves is due to the assumption of the diminishing marginal rate of substitution. 3. Indifference curves do not intersect each other-If they did, the point of their intersection would supply two different levels of satisfaction, which is impossible. This is due to the assumption of transitivity. 4 Higher indifference curves represent higher level of satisfaction-an indifference curve, which is nearer to the point of origin represents smaller combinations of the two commodities, while an indifference curve farther from the point of origin represents larger combinations. Larger combination of the two commodities provides greater satisfaction to the consumer. This can be represented by following diagram.

Important term in the indifference curve theory Marginal rate of substitution (MRS) Marginal rate of substitution of good x for good y is defined as the number of units of good y that the consumer is willing to forego for an additional unit of good x so as to maintain the same level of satisfaction.

Marginal rate of substitution of good x for good y MRS xy = (change of units of good y) / (change of units of good x)

As one moves along the indifference curve from left to the right the marginal rate of substitution goes on diminishing. Combinations A B C D Units of biscuits 8 5 3 2 Increase in units of MRSxy (between tea cups tea and biscuits) 2 3 3:1 4 2:1 5 1:1

Direct tax is demanded from the person who it is intended or desired should pay it. Whereas, Indirect tax are those which are demanded from one person in the expectation and intention that he shall indemnify himself at the expense of the other. In other words, Direct tax is paid by the person on whom it is imposed, whereas if the tax is paid by some person and the final burden is borne by some other person the tax would be an Indirect tax.

Examples of Direct tax include income tax and that of Indirect tax includes sales tax, custom duty or commodity tax. To resolve the conflict of choosing between levying a direct tax or an indirect tax for raising revenues indifference curves may be helpful. Let us assume that there is a single consumer faced with the choice between two goods good x measured on X-axis and the money income measured on the Y-axis With the given money income OM the price of good CX the consumer can purchase OA units of x by spending his entire income on the purchase. Thus MA is the budget line faced by the consumer. The consumer is initially in equilibrium at point E3 where the budget line MA becomes tangential to the indifference curve IC3. The state now imposes an indirect tax on good x causing the producers of good x to raise their prices to the extent of the indirect tax levied on them. Due to rise in the price of good x, the budget line M A, pivots inward to the position MB and the consumer reduces the quantity demanded of good x. the consumer reaches equilibrium at point E1, where the budget line MB becomes tangential to the indifference curve IC1. The consumer purchases only OX units of good x and keep an amount of OD income with himself. He therefore pays MD amount to purchase ox units of good x. If the state has not imposed the indirect tax the consumer would have purchased ox units of good x for MF amount of money income. Therefore the indirect tax imposed on the consumer is equal to MD-MF= FD (FD is equal to GE). Imposition of the indirect tax on the good x has caused the consumer to move to a lower indifference curve IC3. His level of satisfaction has therefore been reduced. Suppose instead of imposing an indirect tax on good x the state collects the same amount of indirect tax FD inform of a direct tax say income tax. With the imposition of the income tax of the amount FD the budget line MA will shift parallel downward from MA to M1A1. since the same amount of revenue FD has to be raised through income tax as with the indirect tax the budget line M1A1 passes through point E1 (parallel to MA) with M1A1 as the budget line the consumer reaches equilibrium at point E2 on Ic2. The consumer welfare at equilibrium point E2 is higher than e1. Therefore imposition of an income tax leaves the consumer on the higher indifference curve IC2 than the imposition of an indirect tax of an equal amount. This is because the indirect tax has both an income and substitution effect reducing the consumers quantity demanded, which reduces the quantity demanded only to the extent of income effect.

Comparison of direct tax with the indirect tax

Points of comparison Money income retained by the consumer Units of good x Equilibrium established on IC Final analysis

Indirect tax E1x1 OX1 E1 on ic1 Consumer is better off when the direct tax is imposed as he is on the higher indifference curve IC2

Direct tax E2X2 OX2 E2 on IC2

3.3 Consumer surplus

Prof. Marshal defined consumer surplus as the excess of price which a consumer will be willing to pay rather than go without the commodity over that which he actually does pay is the economic measure of this surplus satisfaction In other words consumer surplus is the excess of what the consumer is ready to pay over what they actually pay. According to the Marshallian concept of consumer surplus- At the consumption of the nth unit of the commodity the consumer willingness to pay is equal to what he actually pays. But for the all pre-marginal units which he derives from the commodity is greater than what he actually pays. Each pre-marginal unit gives him a surplus of utility. The sum total of such surplus is the consumer surplus

Units of commodity 1st 2nd 3rd 4th 5th Total units purchased=5

Marginal utility in Rs 35 28 20 15 10 Total utility=108

Actual price in Rs 10 10 10 10 10 Total money spent=50

Consumer surplus 25 18 10 5 0 Total consumer surplus=58

The above analysis of consumer surplus is based on the Marshallian analysis of consumer surplus the assumption of which includes:

1. 2. 3. 4. 5.

Utility is cardinally measurable. Marginal utility of the money is constant. Market price of the commodity is given. The demand for the price is independent of the price and the quantity of the other goods. There is no close substitute for the commodity.

Mathematically the consumer surplus is given by: Consumer surplus = total utility derived total amount spent Consumer surplus can also be expressed as total utility derived (price * number of units of commodity. As shown in the diagram above the consumer surplus at the level of the Q1th unit of the commodity is ST whereas actual price paid for the Q1th unit is TQ1.

Usefulness of the Concept of Consumer Surplus a) The concept gives an assessment of enjoyment of real income, i.e., total utility derived from the consumption of a commodity is always more than the paid for it. b) The higher the consumer surplus, the more advanced is an economy. Thus, the concept tells us the state of an economy. c) The concept is widely used in determining monopoly prices, i.e., in discriminating monopoly the monopolist charges according to the consumer surplus of the consumers. d) The concept helps in finding out the relative merit of different types of taxes. A tax raises the price and reduces consumer surplus. e) It explains the paradox of value. Adam Smith posed paradox of value in his book. The Wealth of Nations. The paradox of value is: how is it that water which is essential to life has little value while diamonds which are generally used for conspicuous consumption, has more value. Limitations of the Concept of Consumer Surplus a) Utility or satisfaction cannot be measured in money units. b) It is difficult to find the amount a consumer is willing to pay. In a calamity, consumer may be willing to pay more. c) The consumer surplus derived from a commodity is affected by the availability of substitutes.

End Chapter Quizzes

Q1 Every point on a given indifference curve represents a) Unequal amount of satisfaction to the consumer b) Equal amount of satisfaction to the consumer c) Both (a) and (b) Q2 All combinations on a higher indifference curve are always .. to all combinations lying on a lower indifference curve. a) Preferable b) Non-preferable c) Indifferent d) None of these Q3 Higher indifference curves represents . Level of satisfaction. a) Higher b) Lower c) Equal d) Non equal Q4 Indifference curve in case of two goods X and Y being perfect substitutes is a) Straight line b) A curve c) Downward sloping straight line d) Upward sloping straight line e) Horizontal line Q5 Indifference curves dont intersect with each other a) True b) False c) May be d) May not be Q6 If the price per unit is Rs 10, Quantity demanded is 20 units and quantity supplied is 30 units, the revenue is a) Rs 200 b) Indeterminate c) Rs 300 d) Between Rs 200 and Rs 300 Q7 Consumer surplus according to Marshallian analysis of consumer surplus is a) Cardinally measurable b) Ordinally measurable c) Non- measurable d) None of the above

Q8 Law of Diminishing Marginal Utility is also called a) Law of satiable wants b) Law if insatiable wants c) Law of demand d) Law of supply Q9 Law of Diminishing Marginal utility is based on a) Rational Consumer b) Irrational consumer c) Both a and b d) None of the above Q10 Indifference curve are a) Convex to origin and negatively sloped b) Concave to origin and positively sloped c) Convex to origin and positively sloped d) Concave to origin and negatively sloped

Chapter 4 :- Theory of Production and Cost

4.1 Meaning of Production

Production refers to the transformation of resources into products or it is the process whereby inputs are turned into outputs. Economic efficiency of the production process is the issue under analysis. Economic efficiency calls for minimizing the cost of producing any output level during a period of time.For a profit maximizing firm, the revenues and the costs are the two important components. The costs will be related to the production of the good or service by using the different categories of inputs.

4.2 Production Function

The production function gives a mathematical representation of the relationship between 1. the output produced and, 2. the inputs used for production Q = f (X1, X2, , Xk) where Q= output X1 Xk= inputs used in the production process Q is a measure of output at a specific point in time. The production relationship holds for a given level of technology. Q is the maximum amount that can be produced with a given level of inputs. The production function defines the relationship between inputs and the maximum amount that can be produced within a given period of time and with a given level of technology. Traditionally, the production function is written for two categories of inputs, capital (K) and labour (L): Q = f (K, L) The exact mathematical specification of the production function depends upon the productivity of the inputs at various levels of employment. The productivity of the inputs depends on the state of the technology. State of the technology is the inherent ability of inputs to produce output, given the simultaneous efforts of all other inputs in the production process E.g. Labor can be more productive if it works with modern mechanical and computerassisted equipment. E.g. Plant or equipment can be more productive if it is being operated by highly-skilled and well-trained workers.

Types of Production Function a) Short run production function:-A SR production function shows the maximum quantity of a good or service that can be produced by a set of inputs, assuming that the amount of at least one of the inputs used remains constant. b) Long-run production function:-A LR production function shows the maximum quantity of a good or service that can be produced by a set of inputs, assuming that the firm is free to vary the amount of all the inputs being used. Long-run does not refer to a long period of time. The distinction has no direct connection with time at all. When changing the scale of production, the firm must operate under short-run conditions until its most-fixed input becomes variable. E.g. Assembly of an automobile production. Fixed inputs: land and building, assembly lines, computerized plant and equipment. Variable inputs: worker-hours, component parts, energy. Terminology: Inputs: Factors, Factors of production, Resources Output: Quantity (Q), Total Product (TP), Product Q = Total product = f (X, Y) Marginal product of X (MPX) = Q / X, holding Y constant

Average product of X (MPX) = Q / X, holding Y constant Marginal product is the change in total product resulting from a unit change in a variable input. Average product is the total product per unit of input used.


Isoquant technique has been developed to help a firm to make rational choice of input proportions and its substitution in response to changes in relative prices of inputs.

Meaning of Isoquant or Equal product curve

We know an indifference curve shows all those combinations of two goods which provide equal level of satisfaction. Likewise, an equal-product curve represents all those combinations of factor inputs which yield a given quantity of product. In other words, the equal-product curve may be known as the producers indifference curve.However, an equal-product curve measures output in physical units while an indifference

curve cannot measure satisfaction in physical units. All combinations providing the same level of output lie on the same equal-product curve.

Isoquant Curve Schedule

Suppose that a firm is provided with two variable inputs, viz., labour and capital. The firm can produce 100 units of a commodity by employing varying combinations of these inputs. The alternative factor combinations are given below

Equal product Curve Schedule

Combinations Capital (units) Labour (units) Total product (units)

1st 2nd 3rd 4th

10 6 4 3

5 10 15 20

100 100 100 100

Table shows different combinations of labour and capital inputs which jointly produce 100 units of output. For example, 10 units of capital and 5 units of labour provide the same total product as 3 units of capital and 20 units of labour input. The firm is free to choose any one of these combinations to get 100 units of output. All these combinations when depicted through a diagram provide us an isoquant or equal product curve. This diagram shows such an equalproduct curve which represents 100 units of output. The various combinations of factor inputs have been represented by points A, B, C and D on the equal product curve. These points have been drawn by joining those combinations of labour and capital inputs which yield the same amount of total product.i.e, 100 units.

Properties of Isoquants
As we have already said the isoquant analysis is based upon the indifference curve analysis. Therefore, all the properties of indifference curves are also to be found in the isoquants. There are three main properties of isoquants which are as follows: 1. An isoquant slopes downwards to the right: - An isoquant has a downward slope from the left to the right. In other words, it has a negative slope. The implications of such a slope is that if a firm wants to employ more of one factor input it shall have to employ less of another factor input in order to attain the same level of output. It would, however, be conceivable only when there exists a technical substitution between the two inputs. It means that one factor input must be substituted by another factor input. 2. Isoquants are convex to the origin point: - The convexity of the isoquant indicates that curve is relatively steep along the Y-axis and relatively flat along the X-axis. The convexity of isoquants depends upon the diminishing marginal rate of technical substitution (MRTS). If we denote labour by L and capital by K, then the marginal rate of technical substitution between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. Mathematically, MRTSLK = K L Where K is the change in capital and L is change in labour.

The ability to use one factor (or input) in place of another is measured by the marginal rate of technical substitution. If we look back to the table we find that for successive units of labour input lesser units of capital input are sacrificed. Diminishing marginal rate of technical substitution can be explained by means of an adjoining diagram. This figure shows the diminishing marginal rate of technical substitution between labour and capital. In order to employ L1L2 additional unit of labour, the firm forgoes K1K2 unit of capital.Then, the firm is prepared to sacrifice a lesser amount of capital, i.e, K2K3, and finally, for the additional unit of labour L3L4, the firm is prepared to give up only K3K4 amount of capital. In this figure L1L2=L2L3=L3L4 but K1K2>K2K3>K3K4. It means that in order to get the same amount of total product as the firm raises the units of labour, lesser units of capital are required to sacrifice for each successive unit of labour. It is because of the diminishing MRTS that the isoquants are convex to the origin.


Isoquants never intersect each other :-

Isoquants representing different level of output never cut each other. If they did , there would be a logical contradiction. It will mean that isoquants representing different levels of output are showing the same amount of output at the point of intersection, which is not true.

Optimal combination of factors of production

Producers are generally rational and are guided by the objective of profit maximization. As the result the producers are concerned with attainment of optimal combination of factors of production such that the cost of production would remain the least. There are various key terms involved in the analysis of how he producers could attain the optimal combination of factors of production they are:-

Iso-cost line
This represents the various combinations of factors of production that can be employed with a given amount of money. For example- if a firm has Rs.200 to spend on labor (L0 and capital (K) and that the price of capital is Rs. 10 per unit and the price of the labor is Rs. 20 per unit, then the equation for the Iso-cost line is given by 200=10K+20L.

The above equation of the Iso-cost line represents various combinations of both the factors of production that could be combined with the given level of money to be spent on them. The Iso-cost line would shift parallel on with the change in the money to be spent on the factors of production. The diagram of Isocost line is as follows:

Fig:-The slope and intercept of Isocost Line Above diagram shows this line when the X good is cooks and the Y good is mixers. Just like the budget line, the isocost line will shift out along the X axis when the price of the X good falls and shift in along the X axis when it rises, and shift out along the Y axis when the price of the Y good

falls and shift in along the Y axis when it rises. Note that the isoquant and isocost line contain completely separate type of information. Just as the isoquant does not tell us anything about the cost of production, the isocost line does not tell us anything about the production function or the techniques available: It only tells us how much it will cost to use a particular set of inputs, not that these inputs are the slightest bit useful.

Explanation of optimal combination of factors of production

The producer is said to be using an optimal combination of factors of production when a) The given level of output is produced with that combination of factors of production which minimizes the cost of production b) The producer employs that combination of factors of production which produce the maximum output for a given cost of production. Assumptions 1. The firm employs only two factors of production, labor and capital. 2. The producer is guided by the goal of profit maximization 3. The per unit price of labor and capital are given 4. There is perfect competition in the factor market

A) Minimization of cost subject to a given output

A given level of output is represented by a given Isoquant. A map of various possible Iso-cost lines are drawn on the graph with the same given prices for the labor and capital at the different level of money to be spends on them. Then the given Isoquant is superimposed on the Iso-cost line map. The point at which the given Isoquant is tangent to one particular Iso-cost line such that at the point of tangency the Isoquant has the downward trend with the increase in the level of factor of production represented on the X- axis, is the point of producers equilibrium exhibiting the point f optimal combination of the factors of production in the production of a given level of output.

B) Maximization of output subject to a given cost of the production Under this it is assumed that the producer is given with a Iso-cost line. A map of different Isoquant representing different level of output is then superimposed on the graph (drawn on the same scale) of the Iso-cost line, the point of tangency that would be obtained in between the given Iso-cost line and one of the various Isoquant from the Isoquant map would represent the point of optimal combination of the factors of production.

4.4 Law of Variable proportion

Production involves the use of both the fixed factor and variable factor of production. The fixed factor of production includes capital whose supply in the course of production can not be changed in short period of time. They are generally very expensive and involves an installation cost such as large machineries etc Where as the variable factor of production includes labor, raw materials etc When the production is taking place with the involvement of one variable factor then this explains the case of the production in the short run. At each additional level of production the proportion of variable factor units (for example labor units) changes with respect of the given fixed units of the fixed factor of production Production function with one variable factor is represented by: Q=f (K, L) Where Q= level of output units produced K= fixed units of factor of production L= variable factor units Given the production with one variable factor, the law of variable proportion states that if the increasing quantities of one factor of production used in conjugation with fixed quantity of other factors then after a certain point each successive unit of a variable factor will make a smaller and smaller addition to the total product The assumptions of the law of variable proportions include: 1. 2. 3. 4. 5. 6. One input is variable and the inputs are held constant Units of the variable factor are equal in efficiency It is possible to vary the proportions in which the factors units are combined The law is applicable in the short run The state of the technology is given Prices of the factors of the production do not change

7. Output is measured in the physical units

The given table below illustrates the law of variable proportion Fixed factor Variable factor Total product Average Marginal (land or capital) (labor) product product 20 1 8 8 8 20 2 20 10 12 20 3 36 12 16 20 4 48 12 12 20 5 55 11 7 20 6 60 10 5 20 7 63 9 3 20 8 64 8 1 20 9 64 7.11 0 20 10 60 6 -4

Average product of an input is total product divided by the amount of the input used to produce the total product, whereas marginal product of an input is the addition to the total product attributable to the additions of one unit of the variable input to the production process, the fixed input remaining unchanged.

As per the law of variable proportion there are three stages of the production Stage 1 1. It is called the stage of increasing returns 2. The total product increases at an increasing rate up to a point the marginal product of the labor MP is increasing and reaches its highest point vertically downward to that point. 3. Beyond point of maximum of the marginal product of labor the total product increases but at the diminishing rate. Marginal product curve correspondingly starts falling but continues to be positive. 4. In this stage the average product of the labor continues to rise. 5. The stage comes to an end when the average product curve is the highest and is equal to the marginal product of the labor.

Stage 2 1. The total product continues to increase but at the diminishing rate but eventually becomes highest 2. Both average product curve and the marginal product curve diminishes but are positive 3. The stage comes to an end when the total product curve is the highest 4. Throughout this stage average product curve remains above the marginal product curve. Stage 3 In this stage the total product curve declines in the absolute terms The marginal product curve becomes negative Average product curve continues to diminish. To summaries, the returns to the variable factor may be increasing, diminishing or negative. A rational producer will prefer to operate in the range of diminishing returns described by stage II. The law of diminishing returns implies a declining marginal product.

4.5 The law of returns to scale

The law of returns to scale is applicable in the long- run, where all factors of production are in variable supply. In the long run, output can be increased by increasing all the factors of production or the scale of production. Assumptions of returns to scale 1. 2. 3. 4. The firm is employing two factors of production- labor and capital Labor and capital are combined in the fixed proportion of 1:1 No technological changes are introduced The output is measured in physical units.

According to this law if given a certain combination of factors of production, producing a given output, all the factors are increased in the same proportion and the output increases in the same proportion, returns to scale are constant. If the output increases more than proportionately, there are increasing returns to scale, and when the output increases than proportionately there are decreasing returns to scale.

Increasing returns to scale If all the factors of the production are increased in a particular proportion and the output increases more than proportionately, then the production function is said to exhibit increasing returns to scale. Factor labor 1 2 3 Capital 1 2 3 Total product 10 24 42 Average product 10 12 14

Constant returns to scale If the factor of production is increased in the particular proportion and the output increases in the exact proportion ten the production function is said to exhibit constant returns to scale. Factors of labor Capital Total product Average product 1 1 10 10 2 2 20 10 3 3 30 10

Decreasing returns to scale It implies that a proportionate increase in the factors o the production results in a less than proportionate increases in the output. Labor 1 2 3 Capital 1 2 3 Total product 10 15 21 Average product 10 7.5 7

Comparison of law of variable proportion and law of returns to scale

Time period Variability of factors

Law of variable proportion Short run Only one factor is variable

Law of returns to scale Long run All factors are variable but in fixed proportion Fixed

Factor proportion Varying Reasons for the operation of law Phase 1 Stage of increasing returns Increasing returns to scale Phase 2 Stage of diminishing returns Stage of decreasing returns


a) Accounting cost versus economic cost Accounting cost of production includes all cost incurred by the firm in acquiring various inputs from the outside suppliers. Therefore accounting cost represents actual transfer of money recorded in the book of the firm. There are generally in the nature of contractual payments. For example purchase of raw materials, payment of wages, rent on hired land etc. they are also called explicit cost or nominal costs. Economic cost of production includes not only the accounting cost but also implicit cost implicit cost arises when certain inputs are owned by the employer himself and employed in the production process. For example interest on the capital where the capital is contributed by the entrepreneurs himself.

b)Opportunity cost The opportunity cost is defined as the next best alternative that could be produced instead by the same factors or by the equivalent group of factors, costing the same amount of money. c)Explicit Cost vs. Implicit Cost Explicit cost or direct cost is the actual expenditure incurred by a firm to purchase or hire the inputs it needs in the production process. This includes wages, rent, interest etc. Implicit cost or imputed cost is the cost of inputs owned by the firm and used by the firm in its own production process. It include payment for owned premises, self invested capital etc.

4.7 Short run theory of cost

The key terms incorporated in the short run theory of cost, such as Total cost It is the actual cost that must be incurred to produce a given quantity of output in the short run using both fixed and variable inputs.

Total fixed cost It refers to the total obligations incurred by the firm per unit of time for all fixed inputs. For example property tax, insurance fee, payment of factory rent etc.

Total variable cost They are the cost incurred on the employment of variable factors, whose amount can be altered in the short run. Variable cost varies directly with the change in output level. For example cost of raw materials, cost of labor, cost of fuel and electricity.

The postulates of short run costs includes:1. Total variable cost curve is an inverse s- shaped curve 2. In the short run average variable cost(AVC) average cost(AC) and marginal cost (MC) are U-shaped curves 3. The marginal cost curve cut the average cost curve average cost curve at their minimum points fro below 4. At the point of minimum of the average cost curve the combination of fixed and variable factors is optimal

Where ATC= average total cost curve AVC= average variable cost curve MC= marginal cost curve Average total cost is total cost divided by total units of the product Average variable cost is total variable cost divided by the total units of product Marginal cost is additional cost incurred on the production of each additional unit of the product

Long run theory of cost

Introduction to the long run theory of cost In the long period, no factors of production remain fixed. The firm can alter the size and the scale of plant to meet the changed demand conditions. In other words, the firm has no fixed costs in the long run. Key terms in the explanation of the long run theory of the cost Long run average cost curve:
The long run average cost curve is defined as total cost per unit output when the entrepreneur has the time to vary all the factors of production so that he has the most profitable size of the plant and the best proportion of fixed and variable factors for any given output.

Characteristics of the long run average cost curve 1. They are called the envelope curve as it envelops the short run average cost curve (SAC) 2. No portion of the LAC curve be above any portion of SAC curves 3. The firm chooses that short run plant which allows it to produce the expected output at the minimum cost in the long run. therefore LAC helps the firm in the decision making 4. Each point on the LAC is a point of tangency with the corresponding SAC curve.

Explanation to the long run theory of the cost

The U-shape of the LAC reflects the law of returns to scale. Initially due to the economies of scale the long run average costs decreases as the output increases.

When the economies of scale are fully expected and the diseconomies of scale is yet to set in the LAC curve reaches its minimum point. At its minimum the firm is employing the optimal plant size and operating this plant at full capacity. If the plant size increases further than the optimal size there will be dis-economies of scale and cause the LAC to turn upwards. The LAC curve is U-shaped but the sides are more flat than the u-shaped SACs.


The economies and dis-economies of scale are broadly categorized into internal and external economies and dis-economies of scale. The internal economies of scale They are internal to the firm. They are available to the firm independent of the action of other firms. They are further categorized into Technical economies they arises due to the use of state of art technology in the production process. They are:1. Economies of the use of by-products The firm may use the by-product with the financial, technical and managerial resource. 2. Economies of superior technique The large firms are able to purchase and install not only general purpose machines but also specialized machines. The per- unit cost of production would fall. 3. Economies of specialization A large firm is in a position to divide its production processes into sub-processes leading to greater division of operations and increased specialization which would increase the productive efficiency of each-sub processes band result in overall efficiency in operations.

Managerial economies The manager for each of the various departments would results in the improvement of the productive efficiency of each and every worker across the organization. Financial economies Large firms command goodwill in the market and could have accessibility to the cheap finance from the commercial banks, development banks and also from the general public by issue of shares and debentures. Economies of in-house research and development This tend to reduce the cost of consultancy and would contribute to the making of the production system an efficient one. Economies of employees welfare schemes This tends to improve the motivational aspect of the workers. Provision for the housing facilities, medical facilities and the educational facilities for the employees and their family are covered under the employees welfare schemes. External economies of large scale production They are the benefits which accrued to the firm because of the growth of the whole industry. Such benefits cannot be monopolized by a single firm when it grow in size, but are conferred on it when some other firms grow larger. Types of external economies of large scale production Economies of concentration When the industry develops in a particular region it brings with it all the advantages of concentration such as availability of skilled manpower, transportation and communication facilities, banking and insurance and marketing services Economies of ancillarisation Ancillary industry may develop in and around industrial townships manufacturing inputs such as parts of machinery, nuts and bolts, raw materials etc.

Dis-economies of scale They are broadly categorized into internal and external dis-economies of scale Internal economies of the scale They are the demerits which are internal to the firm and accrue to the firm when it over expands its scale of production such as distortion in flow of the information due to complexity bin the managerial hierarchy

External dis-economies of scale They are these disadvantages which are generated outside the firm with the expansion of the industry as a whole such as increase of input price in course of keen competition among the firms for the limited factors of the production, increasing pressure on the infrastructure as in the form of bottlenecks and delays.

End Chapter Quizzes

1 The law of diminishing returns assumes: a) There are no fixed factors of production b) There are no variable factors of production c) Utility is maximised when marginal product falls d) Some factors of production are fixed

When internal economies of scale occur: a) Total costs fall b) Marginal costs increase c) Average costs fall d) Revenue The shape of AFC curve is a) U shaped b) Inverted u shape c) Rectangular hyperbola d) None Cost function shows the relationship between a) Cost and input b) Cost and output c) Both a) and b) d) None Which of following is not a fixed factor a) Raw materials b) Land c) Machinery d) All

6 Total cost is the sum total of a) TFC + AFC b) TVC+AVC c) TFC+TVC d) AFC+AVC 7 Which of the following curve is known as envelop curve?

a) SAC b) LMC c) LAC d) LTC 8 --------------refers to the transformation of resources into products a) Consumption b) Production c) Savings d) Investment Q9 If all the factors of the production are increased in a particular proportion and the output increases more than proportionately, then the production function is said to exhibit a) b) c) d) Increasing returns to scale. Decreasing return to scale Constant returns to scale None of the above

Q10 The substitutability of one factor for another is given by the slope of the isoquant, and is known as a) b) c) d) MRS MRTS LAC SMC

Chapter -5 Market Organisation and Pricing


Meaning and features of Perfect competition market

PERFECT COMPETITION : - Perfect competition is a market in which there are many firms selling identical products with no firm large enough relative to the entire market to be able to influence market price. The price of the product is determined by industry with the forces of demand and supply.

FEATURES OF PERFECT COMPETITION:1) LARGE NUMBER OF BUYERS & SELLERS: - It means there are large number of buyers and sellers in the market. Thus no individual buyer or seller can affect the price. 2) HOMOGENEOUS PRODUCT: - It assumes that all sellers sell homogeneous product. 3) PERFECT KNOWLEDGE: - It means that, there is perfect knowledge of the market and about the nature of the product being sold and the price charged on the part of buyers and sellers. 4) FREE ENTRY AND EXIT:- Under perfect competition, firm can enter into or exit from the industry. 5) PROFIT MAXIMIZATION:-All firms have a common goal of profit maximization. Thus, there is absence of social welfare of the general masses 6) PRICE-TAKER: - An individual firm is a firm-taker. It must passively accept the ruling market price. Prices are determined by supply and demand.

5.2 Price Taking Behaviour:Market supply and market demand collectively set up the market price i.e. the price at which the product will be sold in the market.

Market supply curve has a positive slope, while market demand curve will have a negative slope as shown in the figure above. In the given market, OQ quantity would be offered for sale and demanded by buyers at OP price per unit. Quantity supplied and the quantity demanded are equal at this price OP.OP is the equilibrium price and OQ is the equilibrium quantity. Thus the industry is in equilibrium. A firm that is operating in a perfectly competitive market will be a price-taker. A price-taker cannot control the price of the good it sells; it simply takes the market price as given. The conditions that cause a market to be perfectly competitive also cause the firms in that market to be price-takers. When there are many firms, all producing and selling the same product using the same inputs and technology, competition forces each firm to charge the same market price for its good. Because each firm in the market sells the same, homogeneous product, no single firm can increase the price that it charges above the price charged by the other firms in the market without losing business. It is also impossible for a single firm to affect the market price by changing the quantity of output it supplies because, by assumption, there are many firms and each firm is small in size.

Short Run Price and Output for the Competitive Industry and Firm
In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown below, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximizes profits when marginal revenue = marginal cost. In the diagram below, the profit-maximizing

output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.

Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximizing level of output, the firm is making an economic loss (or sub-normal profits).


Short run equilibrium of a firm is attained at a level of output which satisfies the following two conditions:1) MC=MR 2) MC cuts MR from below When it is in short run equilibrium, a perfectly competitive firm may find itself in any of the following conditions:1) It earns super normal profits 2) It suffers losses 3) It breaks even. 1) SUPER NORMAL PROFITS:A firm would earn super normal profits if at equilibrium output AR>AC.

In the above diagram, the given price is P1. The firm wants to maximise profits, so it produces at the level of output where MC = MR. This occurs at point A. Drop a vertical line to find the firm's output (Q1). At Q1, AR > AC and the difference between average revenue and average cost is the distance AB. This is the profit per unit. To find the total super normal profit, we must multiply the profit per unit per the number of units. In the diagram, this is the area ABCP1 .

2) LOSSES:A firm suffers losses, if at the equilibrium level of output, its average cost (AC) is more than its average revenue (AR) i.e. AC>AR.

In the above diagram, the given price is P2. In this case, it is clear that the firm will not be making a profit. The AC curve is above the AR curve at all levels of output. The firm will still want to minimise its losses, though. This can be done, again, with the formula, MC = MR. This occurs at point D giving output Q2. At Q2, AR < AC and the difference between average revenue and average cost is the distance DE. This is the loss per unit. To find the total losses, we must multiply the loss per unit per the number of units. In the diagram, this is the area DEFP2. 3) BREAK EVEN (NORMAL PROFIT):A firm breaks even when at the equilibrium level of output its AR=AC.

In the above diagram, at the bottom, the given price is P3. Again the firm will produce the level of output for which MC = MR. This occurs at point G, giving a level of output of Q3. Notice that at this point, AR = AC, so the firm is making normal profit. The three diagrams show the three situations in which a firm could find itself in the short run. NOTE:i. ii. The main thing is that the prices P1, P2 and P3 are determined by market demand and market supply. In all three diagrams, the MC curve cuts the AC curve at its lowest point.


In the long run all factors of production and all the costs are variable. Therefore a firm will remain in business in the long run only if its Total revenue (TR) equals or is larger than its Total cost (TC). The best level of output for a perfectly competitive firm in the long run is given by the point where: P or MR equals MC (long run) MC is rising If at this level of output, most firms are making abnormal profits there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms

are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.

Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximising output level Q2 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established

LONG-RUN EQUILIBRIUM OF INDUSTRY:Long-run equilibrium of competitive industry must satisfy the following three conditions:-

All the firms in the industry are maximizing profit. No firm has incentive either to enter or exit the industry because all the firms are earning zero economic profit. The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by the consumers. The key to long run equilibrium in a perfectly competitive industry is entry and exit of firms.
o o o

New firms entering the industry shift the short-run supply curve to the right, causing price to fall. Existing firms leaving the industry shift the short-run supply curve to the left, causing prices to rise. Adjustments occur until economic losses are eliminated and economic profits equal zero in the long-run.

The conditions for long-run perfectly competitive equilibrium can be expressed as equality: P = MR = SRMC = SRATC = LRAC P = Price MR = Marginal Revenue SRMC = Short-Run Marginal Cost SRATC = Short-Run Average Total Cost LRAC = Long-Run Average Cost

MONOPOLY is a market situation in which there is a single seller. There are no close substitutes of the commodity it produces, there are barriers to entry.
FEATURES OF MONOPOLY:a)ONE SELLER & LARGE NUMBER OF BUYERS:- The monopolists firm is the only firm, it is an industry. But the number of buyers is assumed to be large. b) NO CLOSE SUBSTITUES: - There shall not be any close substitutes for the natural or artificial restrictions on the entry of firms into the industry, even when the firm is making abnormal profits. c) PRICE-MAKER: - Monopolist has full control over the supply of the commodity. But due to large number of buyers, demand of any one buyer constitutes an infinitely small part of the total demand. Therefore, buyers have to pay the price fixed by the monopolist. d)DIFFICULTY OF ENTRY OF NEW FIRMS:- There are either natural or artificial restrictions on the entry of firms into the industry, even when the firm is making abnormal profits.

e) MONOPOLY IS ALSO AN INDUSTRY: - Under monopoly there is only one firm which constitutes the industry. There is no difference between firm and industry comes to an end. e.g. Public utilities: gas, electric, water, cable TV, and local telephone service companies, are often pure monopolies. Monopolies may be geographic. A small town may have only one airline, bank, etc. Monopolist will be in equilibrium when two following conditions are fulfilled i.e., i. ii. MC=MR 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

SOURCES OF MONOPOLY:1) NATURAL FACTORS: - A firm can acquire power because of the natural factors. If a transport company in plying buses on a particular route exclusively, it will assume monopoly power. Similarly, if a firm has full control over the localized raw materials or minerals it will have absolutely monopoly power. 2) LEGAL FACTORS: - A firm can legally procure monopoly power. An author may have copyright of his book; a firm may patent a particular design, etc.

3) COST FACTORS: - A firm may produce at such a large scale that it may receive enormous economies of scale. The firm is in position to sell off its product at a low price. Rival firms entry is prohibited by low cost competition 4) MARKET FACTORS: - Sometimes the nature of the market is such that it cannot attract and accommodate more than a single seller. The firm in existence has a relative advantage of experience. Sometimes, different firms join hands to maintain their existence. 5) HEAVY INVESTMENT: - Certain industries like iron, steel, cement, locomotives, etc. require heavy investment. Heavy investment will restrict number of producers and the possibility of the entry of new firms becomes bleak.

6) TARIFF POLICY: - When the Government imposes heavy taxes on imports, these will fall considerably. In the absence of foreign competition, the domestic producers will form their associations to maximize profits. It is often said, Tariff is the mother of trusts. 7) PROTECTION OF PUBLIC RIGHTS:- In order to safeguard the interests of the public and them from exploitation, public monopolies are formed. Railways, Posts and Telegraph, Electricity and Water Supply, etc, are a few examples of the public monopoly.


MONOPOLY PRICE DURING SHORT RUN:In the short-run, a monopoly firm operating in the market must follow two rules:1. Firm should not produce at all unless there is some level of output for which price is at least equal to average variable cost. 2. In case the firm decides to produce, it should extend its output to a level when the cost of producing an extra unit (MC) equals the revenue obtained from the sale of that extra unit (MR). In other words, MC=MR.

SHORT-RUN EQUILIBRIUM:In the equilibrium situation, in the short-run, a monopoly firm is likely to be faced with any of the following three situations: 1) It may be earning abnormal profits, i.e. at the equilibrium output, its AR>AC. 2) It may be incurring losses, i.e. at the equilibrium output, its AR>AC. 3) It may only break- even, or earn only normal profits, i.e. at equilibrium output AR=AC.

1) PURE PROFITS:-If the price determined by the monopolist is more than AC, he will get super normal profits.

2) LOSSES:A monopoly firm will incur losses if at the equilibrium output its AR<AC.


At equilibrium output, firms AR=AC. Therefore the firm earns only

normal profits.

LONG RUN EQUILIBRIUM UNDER MONOPOLY:THE LONG RUN EQUILIBRIUM OF THE MONOPOLY FIRM IS AGAIN ATTAINED WHERE THE MARGINAL COST (MC) = MARGINAL REVENUE (MR). A monopoly firm in the long run will necessarily receive abnormal profits. There are mainly two reasons for the emergence of abnormal profits in the long run. 1. The entry of the new firms is difficult. 2. If the monopolist does not receive profits he will have no attraction to stay in the market.


Price discrimination or discriminating monopoly:

Price discrimination refers to the charging of different prices by the monopolist for the same product. The difference in the product may be on the basis of brand, wrapper, etc. this policy of the monopolist is called price discrimination. Price discrimination or yield management occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs.

Price discrimination exists when the same product is sold at different prices to different buyers. -Koutsoyiannis Price discrimination refers strictly to the practice by a seller of charging different prices from different buyers for the same good. -J.S. Bain Price discrimination is the act of selling the same article produced under single control at different price to different buyers. - Mrs. Joan Robinson Price discrimination refers to the sale of technically similar products at prices which are not proportional their marginal cost. - Stigler

Conditions for Price Discrimination

For price discrimination to exist, it requires basic conditions. These are:

1. Difference in Elasticity of Demand: Price discrimination is possible only when elasticity of demand will be different in different markets. The monopolist will fix higher price where demand is inelastic and low where the demand will be elastic. In this way, he will be able to increase his total revenue. 2. Market Imperfections: Generally, price discrimination is possible only when there is some degree of market imperfections. The individual seller is able to divide his market into separate parts only if it is imperfect. 3. Differentiated Product: Price discrimination is possible when buyers need the same service in connection with differentiated products. For example, railways charges different charges for the transportation of coal and copper. 4. Legal Sanction: In some cases price discrimination is legally sanctioned. As Electricity Board charges lowest for electricity for domestic use and highest for commercial houses. 5. Monopoly Existence: Price discrimination is also called discrimination monopoly. It is evident that price discrimination is possible only under conditions of monopoly.

When Price Discrimination is possible:

Price discrimination is possible under following conditions:
1. Nature of Commodity: In the first place it is said that price discrimination is possible when nature of the commodity or service is such that there is no possibility of transference from one market to the other. That is, the goods sold in the cheaper market cannot be sold in the dearer market; otherwise the monopolists purpose will be defeated. 2. Distance of Two Markets: Price discrimination is possible when the two markets or markets are separated by large distances or tariff barriers, so that it is not possible to transfer goods from cheaper markets to dearer market. For instance, a monopolist may sell the same product at a higher price in Mumbai and lower price in Meerut. 3. Ignorance of the Consumers: Price discrimination is possible when the consumers are ignorant about price discrimination, they are not aware that in one part of the market the prices are lower than in the other part. Thus, he purchases in dearer market, than in cheaper market since he is ignorant of the prices that are prevailing in different markets. 4. Government Regulation: Price discrimination occurs when the government rules and regulations permit. For instance, according to rules, electricity rates are fixed at higher level for industrial purposes and lower for domestic uses. Similarly, railways charge by law higher fares from the first class passengers than from the second class passengers. Hence, price discriminations possible because of legal sanction.

5. Geographical Discrimination: Price discrimination may be possible on account of geographical situations. The monopolist may discriminate between home and foreign buyers by selling at lower price in the foreign market than in the domestic market. Geographical discrimination is possible because no unit of the commodity sold in one market can be transferred to another. 6. Difference in Elasticity of Demand: - A commodity may have different elasticity of demand in different markets. Thus the market of a commodity can be separated in the basis of its elasticity of demand. Hence, a monopolist can charge different prices in different markets classified on the basis of elasticity of demand, low price is charged where demand is more elastic and high price in the market with the less elastic demand or inelastic demand. 7. Artificial Difference between Goods:- A monopolist may create artificial differences by presenting the same commodity under different names and labels, one for the rich and snobbish buyers and other for the ordinary customers. For instance, a biscuit manufacturer may wrap small quantity of the biscuits, give it separate name and charge a higher price. Thus, he may charge different price for substantially the same product. He may charge RS.2 for 100gms. Wrapped biscuits and RS.1.50 for unwrapped biscuits.

Degrees of Price Discrimination:

Price discrimination exists when sales of identical goods are transacted at different prices from a single vendor. Theoretically, price discrimination is a feature only of monopoly markets. In addition to a monopoly market, price discrimination requires some means to discourage discount customers from becoming resellers and by extension competitors. This usually entails either keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate is referred to as a rate fence.

There are three types of price discrimination:

1. First Degree Price Discrimination:

In First Degree Price Discrimination, the price varies by customer. This arises from the fact that the value of goods is subjective. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand. As long as the price elasticity (in absolute value) for a customer is less than one, it is very advantageous to increase the price: the seller gets more money for fewer goods. With an increase of the price the price elasticity tends to rise above one. One can show that in the optimum the price, as it varies by customer, is inversely proportional to one minus the reciprocal of the price elasticity of that customer at that price. This assumes that the consumer passively reacts to the price set by the seller, and that the seller knows the demand curve of the customer. In practice however there is a bargaining situation, which is

more complex: the customer may try to influence the price, e.g. by pretending to like the product less than he or she really does, and by "threatening" not to buy it. This form exists when a seller is able to sell each quantity of a good for the highest possible price that buyers are willing and able to pay. In other words, ALL consumer surplus is transferred from buyers to the seller.

In Second Degree Price Discrimination, the price varies according to quantity sold. Larger quantities are available at a lower unit price. The buyers are divided into different groups and from different groups different price is charged which is the lowest demand price of that group. This type of price discrimination would occur if each individual buyer had a perfectly in-elastic demand curve for a good below and above a certain price.

3Third Degree Price Discrimination:

In Third Degree Price Discrimination price varies by location or by customer segment. Price discrimination of third degree is said to exist when the seller divides his buyers into two or more than two sub-markets and from each group a different price is charged. The price charged in each sub-market depends on the output sold in that sub-market along with demand conditions of that sub-market. In the real world, it is the third degree price discrimination which exists. It is very useful for the price discriminator to determine the optimum prices in each market segment. This is done in the next diagram where each segment is considered as a separate market with its own demand curve. As usual, the profit maximizing output (Qt) is determined by the intersection of the marginal cost curve (MC) with the marginal revenue curve for the total market (MRt).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market. This is determined from the marginal revenue curves in each market. The intersection of the total market price with the marginal revenue curves in each market yields optimum outputs of Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb.

Consequences of Price Discrimination

There are two major consequences of Price Discrimination which are follows:


Monopoly firm can maximize its total revenue, and


Output under discriminating monopoly will be larger as compared to pure monopoly, thus, it reduces the deadweight loss of monopoly.
Maximization of Total Revenue: A multi-price monopolist can discriminate between two markets by charging different prices. The firm will allocate its output in two markets so that marginal revenue from the two markets is equalized. If marginal revenue is not equal, the monopoly firm can increase its total revenue by selling a unit less in the market with lower marginal revenue and selling one more unit in the market with the higher marginal revenue. A Price Discrimination monopolist has the choice to classify buyers into two categories. From one set of buyers, the firm will charge a price more than the marginal cost and from another equal to marginal cost, and thus, can maximize its total revenue.


2. Output under Discriminating Monopoly will be larger as compared with Pure Monopoly:
A single-price monopoly firm maximizes profits by selling less at a high price. It has no incentive to expand its output. But a price discriminating monopoly firm has the incentive to expand its output, selling a part of its output at a high price and selling the remaining quantity at a price greater than or equal to marginal cost. 1.6

Monopolistic Competition

Monopolistic competition refers to a market structure in which there are many sellers selling similar but differentiated products and there is existence of free entry and exit of firms. Its features can be stated as follows: FEATURES OF MONOPOLISTIC COMPETITION

i) Large Number: The number of firms operating under monopolistic competition is sufficiently large which implies that the firms are small in comparison to the entire market. Although they have some power over price (to the extent that their products are differentiated), they do not have sufficient power to retaliate if another firm changes its price. Moreover there is freedom of entry. There are no quantitative restrictions or differences in market conditions. However, each firm differs from its rivals in some qualitative respect. ii) Close Substitutes: In case of a monopoly there are no substitutes available. Under monopolistic competition firms produce very close substitutes. Chocolates of one company may serve a similar purpose as that of some other firm. The only difference may be of some variation in the quality of the product.

iii) Group: Firms under monopolistic competition together form a group. They cannot be called an industry. This is because their products are somewhat dissimilar and not homogenous as under competitive industry.

iv) Entry to market: No barriers to entry or exit exist in monopolistic competition. However, the need to make one's product differentiated may require nonprice action, which, if unsuccessful, would drive the firm out of the market. v) Demand: The demand of a firm in monopolistic competition is down sloping because of the preference of customers for the features of the differentiated product. However, because there are many close (if not perfect) substitutes readily available, the demand is highly elastic. Graphically, this means that the demand in monopolistic competition is flatter than in monopoly i.e. is more elastic. vi) Product Differentiation: Under monopolistic competition products are differentiated. This is the outstanding feature of this form of market. Otherwise monopolistic competition closely resembles perfect competition. The fundamental difference between the two is that products are no more homogenous. Goods produced are deliberately differentiated. By differentiation we mean the goods are made to appear somewhat different and superior to those produced by other firms. Product differentiation may be real or apparent. By real differentiation we mean that a difference is maintained in some physical or chemical composition of a product or in the taste and appearance of that product. This is easily done with the help of attractive packaging; or some extra services are rendered. A product can also be marketed as superior using local advantage. When products are differentiated more buyers are likely to be attracted. Thereby the firm gains extra control over demand and market conditions. (vii) Selling (Advertising) Cost: Selling Cost (SC) is another outstanding feature of a monopolistic competitive market. This is in the form of advertisement expenditure. Selling Cost and Product Differentiation together enable the producer to maintain some control over market conditions and influence the shape of the demand curve. Both features are interdependent. Whenever a product is differentiated it is necessary to inform buyers; and advertisement is the only medium through which buyers can be told about superiority of that product. Selling Cost by itself is apparent product differentiation. When a product does not contain any genuine qualitative difference, buyers can be made to treat a product differently through advertisements. So whenever products are differentiated and advertised, the market becomes a monopolistic competition. These are the hallmarks of this form of market. The presence of selling cost increases the firms cost of production. In order to recover it, firms have to charge a higher price. The net effect of a monopolistic competitive market is pricing goods at a higher rate. Consumers have to bear this extra expenditure. (viii) Lack of Perfect Knowledge: The buyers and sellers do not have perfect knowledge of the market. There are innumerable products each being a close substitute of the other. The buyers do not know about all these products, their qualities and prices. Likewise, the seller does not know the exact preference of buyers and is, therefore, unable to get advantage out of the situation.

(ix) Less Mobility: Under monopolistic competition both the factors of production as well as goods and services are not perfectly mobile. (x) Economic Welfare: Under monopolistic competition the total level of production is low, and the price is higher than the marginal cost. The consumers get very little amount of consumers surplus. Firms are of smaller size, they do not get economies of scale; therefore the cost of production is high. Both efficient and inefficient firms can maintain their existence under monopolistic competition. The unprecedented waste and misuse of the resources minimise the economic welfare.


Under monopolistic competition a firm will make the maximum profits when the following conditions are satisfied: (i) MC = MR (ii) MC must cut MR from below However, in the short period, it is not necessary that all the firms should have iso-classic demand curves. The elasticity of demand curve under monopolistic competition depends upon the attachment of the buyers. So, this it will depend upon the age of the firm (and of the product). If a firm is an old one, it shall be selling its product for a long time and consequently the buyers will have a less elastic or inelastic demand for its products. On the contrary, a comparatively, a new firm will have a more elastic demand curve for its product. Thus, older firms will have greater price advantage while newer firms will have lesser price advantage. Since it is assumed that product differentiation or the effects of selling costs are absent, cost curves of different firms will be identical. It follows therefore that older firms will make abnormal profits while newer firms may have normal profits or even losses. It is stated that in short period under monopolistic competition may be three equilibrium conditions: Supernormal profit: Under monopolistic competition, a firm earns maximum profits or is in equilibrium when MR=MC and MC cuts MR from below. In the Fig. firm is in equilibrium. The firm is earning supernormal profits or abnormal profits since the average revenue is greater than average cost, i.e. AR>AC. The main reason for these abnormal profits is that, the other rival firms are not able to produce closely competitive substitutes. Hence they are not able to attract consumers towards their product. In the Fig. output is measured on Xaxis, whereas price on Y-axis. AR and MR are the average revenue and marginal revenue curves respectively. OQm is the equilibrium quantity produced. The average cost is equal to bQm whereas average revenue is equal to aQm and profit per unit is ab. In this way firms enjoys supernormal profits shown by the shaded area.

Normal Profits: If under monopolistic competition, the price of the product is equal to AC, the firm will be earning normal profit. In the Fig. MC is equal to MR, this is the point of equilibrium where equilibrium output is OQm and equilibrium price is equal to aQm. At this point, AC is aQm and AR is also aQm i.e. AC=AR. Thus firm will be earning only normal profits.

Sustaining losses: However it is also possible that the demand may not be favorable to the firm under monopolistic competition, i.e. it may or may not be able to attract the consumers towards its product, if it fixes price below AC. But it is compelled to sell its product at the price which is less than even its short period average cost. Hence, it may incur losses. Such firm in long run may leave the industry, if it is not possible for it to change its demand relative to its cost conditions trough product differentiation and advertisement. In the fig the shade area represents the losses incurred.

Long Run Equilibrium Long run refers to that time period in which each firm can change its production capacity by changing the fixed as well as variable factors. News firms can enter the industry and old firms can exit it. Basically the firms in the long run will get normal profits. If the existing firms are making super normal profits, it will attract some of the new firms in the industry. The entry of new firms will result into over production which will have a depressing effect on price. Hence all the firms in the long run get normal profits.

In the Fig. output is measured on X-axis whereas price is measured on Y-axis. LRAC is the long run average cost and LRMC is the long run marginal cost curve. The firm is equilibrium because MR=MC. the equilibrium output is OQL and the price is OPL. Since, at this equilibrium average revenue is tangent to long run average cost curve; hence the firms are earning normal profit.

End Chapter Quizzes

Question 1: Firms in perfect competition face a: a) Perfectly elastic demand curve b) Perfectly inelastic demand curve c) Perfectly elastic supply curve d) Perfectly inelastic supply curve

Question 2: In perfect competition: a) The price equals the marginal revenue b) The price equals the average variable cost c) The fixed cost equals the variable costs d) The price equals the total costs Question 3: A profit maximising firm in perfect competition produces where: a) Total revenue is maximised b) Marginal revenue equals zero c) Marginal revenue equals marginal cost d) Marginal revenue equals average cost

4 The marginal revenue curve in monopoly: a) Equals the demand curve b) Is parallel with the demand curve c) Lies below and converges with the demand curve d) Lies below and diverges from the demand curve

5 In monopoly when abnormal profits are made: a) The price set is greater than the marginal cost b) The price is less than the average cost c) The average revenue equals the marginal cost d) Revenue equals total cost

6 In monopoly in long run equilibrium: a) The firm is productively efficient b) The firm is allocatively inefficient c) The firm produces where marginal cost is less than marginal revenue

d) The firm produces at the socially optimal level

7 In a monopoly which of the following is not true? a) Products are differentiated b) There is freedom of entry and exit into the industry in the long run c) The firm is a price taker d) There is one main seller

8 In monopolistic competition: a) Firms face a perfectly elastic demand curve b) All products are homogeneous c) Firms make normal profits in the long run d) There are barriers to entry to prevent entry

9 In monopolistic competition: a) Demand is perfectly elastic b) Products are homogeneous c) Marginal revenue = price d) The marginal revenue is below the demand curve and diverges

10 In monopolistic competition firms profit maximize where: a) Marginal revenue = Average revenue b) Marginal revenue = Marginal cost c) Marginal revenue = Average cost d) Marginal revenue = Total cost

Chapter -6:- Pricing under Oligopoly


An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from two Greek words, oligo, which means a few and polein, means to sell. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion. An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high (i.e. a large % of the market is taken up by the leading firms). Firms within an oligopoly produce branded products (advertising and marketing is an important feature of competition within such markets) and there are also barriers to entry. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil.


A market structure characterized by: 1. Few sellers: A few firms are so large relative to the total market that they can affect the market price. 2. Mutual Interdependence: Another important characteristic of an oligopoly is interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market, while taking business decisions regarding price, output, promotion and investment .Whatever one firm does, affects all others.Eg. Different internet service providers. 3. Either a homogenous or a differentiated product: Buyers may or may not be indifferent as to which seller's product they buy. 4. Difficult market entry: Formidable barriers to entry. For example, exclusive financial requirements control over an essential resource, patent rights, and economies of scale likely to be

significant entry barriers into the market in the long run which allows firms to make supernormal profits. 5. Indeterminate demand curve: An oligopoly firm can never predict its sales correctly. It can never be certain about the nature and position of its demand curve. Any change in price or output by one firm leads to series of reaction by the rival firms. As a result, the demand curve of the oligopoly firm is indeterminate. 6. Role of selling costs: Advertisement, publicity and other sales techniques play an important role in oligopoly pricing. Oligopoly firm employs various techniques of sales promotion to attract large number of buyers and maximise the profits.


The oligopoly situation can be classified into various types on the following bases. 1 Product Differentiation- On the basis of product differentiation oligopoly can be classified into pure and differentiated oligopoly. Oligopoly without product differentiation is termed as pure oligopoly. In this case all the rival firms produce homogenous or identical products, like cement, steel, aluminium and basic metal producing industries. Under differentiated or impure oligopoly, the firms produce differentiated products, which are close but not perfect substitutes to each other like automobiles, computer, and refrigerator industries. 2 Entry of Firms-On the basis of entry of competitors in the market, oligopoly may be classified as open and closed. Under, open oligopoly; new firms are free to enter the market. On the other hand, closed oligopoly is dominated by a few large firms with blockaded entry of new firms. 3 Leadership- On the basis of presence of price leadership, the oligopoly situation may be classified as partial or full. Partial oligopoly refers to the market situation, where one large firm dominates the market and the other firms look to the price leader with regard to the policy of price fixation. Full oligopoly refers to the situation where no firm is dominant enough to take the role of price leader. 4 Agreement- Oligopoly may be classified into collusive and non-collusive oligopoly on the basis of agreement or understanding among the firms. Collusive oligopoly refers to a market situation, where the firms combine together and follow a common price policy. The collusion may be open or secret. On the other hand, non collusive oligopoly implies absence of any agreement or understanding. 5 Coordination- An oligopoly may be classified into organised and syndicated oligopoly on the basis of the degree of coordination found among the firms. Under organised oligopoly the firm organise themselves into a central association for fixing price, output, quota etc. On the contrary, Syndicated or unorganised oligopoly refers to a situation, where the firms sell their products through the centralised syndicate.

6.4 Oligopoly Models

Classical models of oligopoly:1. Non Collusive Model-Cournot 2. Collusive model-Price leadership, Cartel 3. Price Rigidity Model

1)Non- Collusive Model

COURNOT MODEL Cournot model is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Augustin Cournot (1801-1877) after he observed competition in a spring water duopoly. It has the following features: * There is more than one firm and all firms produce a homogeneous product, i.e. there is no product differentiation; * Firms do not cooperate, i.e. there is no collusion; * Firms have market power, i.e. each firm's output decision affects the good's price; * The number of firms is fixed; * Firms compete in quantities, and choose quantities simultaneously; * The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors' decisions. The model One model of duopoly is the strategic game in which * the players are the firms * the actions of each firm are the set of possible outputs (any nonnegative amount) * the payoff of each firm is its profit.

This game models a situation in which each firm chooses its output independently, and the market determines the price at which it is sold. Specifically, if firm 1 produces the output y1 and firm 2 produces the output y2 then the price at which each unit of output is sold is P(y1 + y2), where P is the inverse demand function. Denote firm 1's total cost function by TC1(y) and firm 2's by TC2(y). Then firm 1's total revenue when the pair of outputs chosen by the firms is (y1, y2) is P(y1 + y2)y1, so that its profit is P(y1 + y2)y1 TC1(y1); firm 2's revenue is P(y2 + y2)y2, and hence its profit is

P(y1 + y2)y2 TC2(y2). Notice an essential difference between these specifications of the firms' revenues and those for a competitive firm or for a monopolist. The revenue of both a competitive firm and of a monopolist depends only on the firm's own output: for a competitive firm we assume that the firm's output does not affect the price, and for a monopolist there are no other firms in the market. For a duopolist, however, revenue depends on both its own output and the other firm's output. The solution which applies to this game is that of Nash equilibrium. First consider the nature of the firms' best response functions. The firms' best response functions Firm 1's best response function gives, for each possible output of firm 2, the profit-maximizing output of firm 1. Firm 1's profit-maximizing output when firm 2's output is y2 is the output y1 that maximizes firm 1's profit; that is, the value of y1 that maximizes P(y1 + y2)y1 TC1(y1). Differentiating with respect to y1 (treating y2 as a constant), we conclude that the profitmaximizing output y1 satisfies P'(y1 + y2)y1 + P(y1 + y2) MC1(y1) = 0. We'd like to know the shape of firm 1's best response function---i.e. we'd like to know how the value of y1 that satisfies this condition depends on y2. Consider a case in which firm 1's average cost function takes the "typical" U shape. First suppose that y2 = 0. Then firm 1's problem is the same as that of a monopolist. Its best output satisfies the condition MR = MC1, as illustrated in the left panel of the following figure. The corresponding point on firm 1's best response function is shown in the right panel: when y2 = 0, firm 1's best output is b1 (0).

Now increase y2. Firm 2 now absorbs some of the demand, and less is left over for firm 1: the demand curve firm 1 faces is shifted to the left by the amount y2, as in the left panel of the following figure. Firm 1's best output satisfies the condition that its marginal revenue, given the part of the demand function that it faces, is equal to its marginal cost. This optimal output is indicated as b1 (y2) in the left panel of the figure; the corresponding point on firm 1's best response function is shown in the right panel.

As firm 2's output increases, there comes a point where there is no positive output at which firm 1 can make a profit. The critical point is shown in the left panel of the following figure. In this case, the most profit firm 1 can earn by producing a positive output is 0: the AR curve it faces is tangent to its AC curve. The corresponding point on firm 1's best response function is shown in the right panel.

For larger outputs, firm 1's optimal output is zero, as shown in the following figure.

Firm 1's whole best response function is shown in the following figure. The way to read this figure is to take a point on the vertical axis---a value of y2---and go across to the graph, then down to the horizontal axis; the value of y1 on this axis is firm 1's optimal output given y2.

If firm 2's cost function is the same as firm 1's, then its best response function is symmetric with firm 1's, as shown in the following figure.

Whenever a firm's average cost functions is U-shaped, its best response function has a "jump" in it, for the same reason that a competitive firm's supply function has a "jump" in it: the firm either wants to produce outputs close to its efficient scale of production or it wants to produce an output of zero, but it does not want to produce intermediate outputs (for which the average cost is high). A firm's best output does not necessarily decrease as its rival's output increases. Such a relationship seems likely, though it is possible that for some increases in its rival's output, a firm wants to produce more output, not less. Nash equilibrium To find Nash equilibrium, we need to put together the two best response functions. Any pair (y1, y2) of outputs at which they intersect has the property that y1 = b1(y2) and y2 = b2(y1) and hence is Nash equilibrium. The best response functions are superimposed in the following figure.

We see that for this pair of best response functions there is a unique Nash equilibrium, indicated by the small purple disk. (In general, there may be more than one Nash equilibrium.)

2 Price Leadership Model

Price leadership theories:

Dominant firm price leadership

It means where the dominant firm sets the price for the whole industry. Diagram of this model is as follows

The leader sets a price, PL based on their own MC and MR curves, but taking into account the other firms cost curves. The price needs to be high enough to stop other firms making losses, which would attract the competition commission to investigate the market. The models characterize price leadership in terms of industries where the distribution of firm sizes is highly skewed, resulting in a dominant firm that exists alongside a competitive fringe of much smaller firms, typically supplying a relatively standardized product. The fringe suppliers are small individually but may have a significant share of the market collectively. The dominant firm sets its own price on the basis of industry demand not served by the fringe suppliers, thereby providing a price umbrella for the latter. Market performance then depends on relative costs and ease of market entry. If there are barriers to market entry, the dominant firm will be able to charge supra-competitive prices, though this power will be moderated by the presence in the industry of the competitive fringe. Since it acts as price setter, the dominant firms price cuts will be matched by the competitive fringe. On the other hand, if barriers to entry are low, the price leaders ability to exercise market power will be constrained by the entry [or threat of entry] of additional fringe suppliers.

Barometric price leadership model.

Barometric firm sets the price. The barometric firm is not the largest firm in the market but has better knowledge and ability to forecast the future of the market. This version postulates that the price leader is firms that responds more quickly than its rivals to changing cost and demand conditions, but does not in itself have significant market power. In such circumstances the price leader acts, in effect, as a barometer of market conditions for the rest of the industry, with its price levels set close to those that would emerge even under competition. Barometric price leadership may be indicated by a number of market characteristics, for example occasional switching between firms in the role of price leader; the occurrence of upward price leadership only in response to increased industry costs or demand; occasional and sometimes substantial time lags in the price response of follower firms; and occasional rejection by the rest of the market of price changes initiated by the price leader.

3 CARTELS 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 organization 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, and members 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 oilproducing 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 profitmaximizing decision is the same as that of a monopolist, as Figure 1 reveals. 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 labeled abcd in following figure. 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.

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 the cartel's 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 earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.


In 1939, Prof Sweezy presented the kinked demand curve analysis to explain price rigidity in oligopolistic markets.

The kinked demand curve hypothesis of price rigidity is based o the following assumptions: 1. There are few firms in the market. 2. The product produced by one firm is a close substitute for other firms. 3. The product is of same quality. No product differentiation. 4. No advertising cost. 5. Each sellers attitude depends upon the attitude of its rivals. 6. If one firm raises prices, others will not follow, rather they would stick to the prevailing prices and cater to the customers, leaving the price raising seller behind. Sweezy postulates are as follows: If an oligopolist raises its price, it would lose most of its customers since the other firms in the industry would not match the price increase On the other hand, an oligopolist could not increase its share of the market by lowering its price, since its competitors would immediately match the price reduction.

In these two cases the oligopolist firms have a kink at the prevailing market price, which explains price rigidity. Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve. Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity. The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases. Firms will often enter the industry in the long run

Above the kink, demand is relatively elastic because all other firms prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point. While a theoretical model proposed in 1947, it has failed to receive conclusive evidence for support. Like any other market situation, the aim of an oligopoly firm is to maximise its profits. Equilibrium of the oligopoly firm is obtained at the level of output where the cost of producing an additional unit [i.e. ., MC] is equal to the revenue derived from the additional unit sold [i.e. ., MR]. The equilibrium of the firm is defined by the point of kink. At any point to the left of kink MC is below the MR, while to the right of the kink, the MC is larger than MR. The total profits is maximised at the point of the kink. The above figure shows that so long as the MC curves [MC1, MC2, and MC3] intersect the MR curve in the discontinuous portion of MR, the price remains stable. This is also known as PRICE RIGIDITY. It is only when the MC curve intersects the MR curve in the continuous segments that the price will change. The firms, however does not go for a price change because an increase or decrease in price leads to falls in total profits. This implies stable or sticky prices. CHANGES IN COSTS In oligopoly under kinked demand curve analysis changes costs within a certain range do not affect the prevailing prices. It should be noted that with any cost reduction the new MC curve will always cut MR curve in the gap as cost falls the gap continues to widen due to 2 reasons: As cost falls, the upper portion of the demand curve becomes more elastic because of the fact that a price rise by one seller will not be followed by rivals and his sales would be considerably reduced. With the reduction in the costs, the lower portion of the kinked demand curve becomes more inelastic, because of the greater certainty that a price reduction by one seller will be followed by the other rivals. Therefore the chances of existence of price rigidity are greater where there is a reduction costs than there is a risk in costs.


The reasons for price rigidity / stability are: 1. Individual sellers in oligopolistic industry might have learnt through experience the futility of price wars and thus prefers price stability. 2. They may be content with current prices, outputs and profits and avoid any involvement in unnecessary insecurity and uncertainty. 3. The sellers may intensify there sales promoting efforts at current price rather than price rivalry 4. If a stable price has been set through agreement or collusion, no firm would like to disturb it, for fear of unleashing of price war and engulfing oneself into the era of uncertainty and risks. 5. It is kinked demand curve analysis which is responsible for price rigidity in oligopolistic markets.

The Bad of Oligopoly

Like much of life, oligopoly has both bad and good. The bads are that oligopoly: (1) tends to be inefficient in the allocation of resources and (2) promotes the concentration, and thus inequality, of income and wealth. 1. Inefficiency: First and foremost, oligopoly does NOT efficiently allocate resources. Like any firm with market control, an oligopoly charges a higher price and produces less output than the efficiency benchmark of perfect competition. In fact, oligopoly tends to be the worst efficiency offender in the real world, because perfect competition does not exist, monopolistic competition inefficiency is minor, and monopoly inefficiency has the potential for being so bad that it is inevitably subject to corrective government regulation. 2. Concentration: Another bad is that oligopoly tends to increase the concentration of wealth and income. This is not necessarily bad, but it can be self-reinforcing and inhibit pursuit of the microeconomic goal of equity. While the concentration of wealth is not bad unto itself, such wealth can then be used (or abused) to exert influence over the economy, the political system, and society, which might not be beneficial for society as a whole.

The Good of Oligopoly

With the bad comes a little good. The two most noted goods from oligopoly are (1) by developing product innovations and (2) taking advantage of economies of scale. 1. Innovations: Of the four market structures, oligopoly is the one most likely to develop the innovations that advance the level of technology, expand production capabilities, promote economic growth, and lead to higher living standards. Oligopoly has both the motive and the opportunity to pursue innovation. Motive comes from interdependent competition and opportunity arises from access to abundant resources.

2. Economies of Scale: Oligopoly firms are also able to take advantage of economies of scale that reduce production costs and prices. As large firms, they can "mass produce" at low average cost. Many modern goods--including cars, computers, aircraft, and assorted household products-would be significantly more expensive if produced by a large number of small firms rather than a small number of large firms.

End Chapter Quizzess

1.Which of the following is not a characteristic of oligopoly? a. A few firms control most of the production and sale of a product. b. Firms in the industry make price and output decisions with an eye to the decisions and policies of other firms in the industry. c. Competing firms can enter the industry easily. d. Substantial economies of scale are present in production.

2. Under oligopoly, a few large firms control most of the production and sale of a product because a. economies of scale make it difficult for small firms to compete. b. diseconomies of scale make it difficult for small firms to compete. c. average total costs rise as production expands. d. marginal costs rise as production expands.

3. In an oligopoly such as the U.S. domestic airline industry, a firm such as United Airlines would a. carefully anticipate Delta, American, and Southwests likely responses before it raised or lowered fares. b. pretty much disregard Delta, American, and Southwests likely responses when raising or lowering fares. c. charge the lowest fare possible in order to maximize market share. d. schedule as many flights to as many cities as possible without regard to what competitors do. 4. One of the reasons that collusive oligopolies are usually short lived is that a. they are unable to earn economic profits in the long run. b. they do not set prices where marginal cost equals marginal revenue. c. they set prices below long-run average total costs. d. parties to the collusion often cheat on one another. 5. In a collusive oligopoly, joint profits are maximized when a price is set based on a. its own demand and cost schedules. b. the market demand for the product and the summation of marginal costs of the various firms. c. the price followers demand schedules and the price leaders marginal costs. d. the price leaders demand schedule and the price followers marginal costs. 6. During the 1950s, many profitable manufacturing industries in the United States, such as steel, tires, and autos, were considered oligopolies. Why do you think such firms work hard to keep imports from other countries out of the U.S. market? a. Without import barriers, excess profits in the United States would attract foreign firms, break down existing price agreements, and reduce profits of U.S. firms.

b. Without import barriers, foreign firms would be attracted to the United States and cause the cost in the industry to rise. c. Without import barriers, foreign firms would buy U.S. goods and resell them in the United States, causing profits to fall. d. Without import barriers, prices of goods would rise, so consumers would buy less of the products of these firms.

7. Over the past 20 years, Dominator, Inc., a large firm in an oligopolistic industry, has changed prices a number of times. Each time it does so, the other firms in the industry follow suit. Dominator, Inc., is a a. monopoly. b. perfect competitor. c. price leader. d. price follower.

8. In the kinked demand curve model, starting from the initial price, the demand curve assumed to face a firm is relatively ____ for price increases and relatively ____ for price decreases. a. elastic; elastic b. elastic; inelastic c. inelastic; elastic d. inelastic; inelastic

9. The kinked demand curve model illustrates a. how price rigidity could characterize some oligopoly firms, despite changing marginal costs. b. how price increases and price decreases can elicit different responses from rival firms, in oligopoly. c. why price rigidity may be more common when firms have excess capacity than when operating near capacity. d. the importance of expectations about rival behavior in oligopoly. e. all of the above.

10. Which of the following areas illustrates positive network externalities? a. Telephones b. Software c. fax machines d. the Internet e. all of the above

Chapter -7:- Theory of Factor pricing

7.1 MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION:The most significant theory of factor pricing is the marginal productivity theory of distribution. It was propounded by the German economist T.H. Von Thunen but later many economists like Karl Menger, Walras, Wickstead, Edgeworth and Clark etc. contributed for its development. According to this theory remuneration of each factor of production tends to be equal to its marginal productivity. Marginal productivity is the addition tat the use of one extra unit of the factor makes to the total production. So long as the marginal cost of factor is less than the marginal productivity the entrepreneur will go on employing more and more units of the factors. He will stop giving further employment as soon as the marginal productivity of the factor is equal to the marginal cost of the factors. ASSUMPTIONS OF THE THEORY The main assumptions of the theory are:1 PERFECT COMPTITION:-The marginal productivity theory rests upon the fundamental assumption of perfect competition, as it cannot take into account unequal bargaining power between the buyers and the sellers. Since there is perfect competition in the factor market the prices of the factors throughout the market are uniform. This is because when this condition holds good the marginal productivity shall be equal and factor prices shall be uniform. 2 HOMOGENEOUS FACTORS: - This theory assumes that the factors of production are homogeneous. This implies that the different factors of production have the same efficiency. Thus productivity of all workers offering the particular type of labour is the same. In other words, different units of labour have the same productivity. Likewise the productivity of different units of land, capital and organization is the same. 3 RATIONAL BEHAVIOUR:-The theory assumes that every producer desires to reap maximum profits. This is because the organizer is a rational person and he so combines the different factors of production in such a way that marginal productivity from a unit of money is the same as in case of every factor of production. 4 PERFECT SUBSTITUABILITY: - The theory is also based upon the assumption of perfect substitution not only between the different units of same factor but also between the different units of various factors of production. As per this assumption, the various units of labour are not only perfect substitutes of each other but also different units of labour are perfect substitutes of different units of capital.

5 KNOWLEDGE ABOUT MARGINAL PRODUCTIVITY: - Both the producers and owners of factors of production have means of knowing the value of factors marginal product. 6 LAW OF DIMINISHING MARGINAL RETURNS: - It means that as units of a factor of production are increased the marginal productivity goes on diminishing. 7 LAW OF VARIBALE PROPORTIONS:-The law of variable proportions is applicable in the economy 8 LONG -RUN ANALYSIS: - Marginal productivity theory seeks to explain determination of factors remuneration only in the long run period.

EXPLANATION OF THE THEORY:The marginal productivity theory states that under perfect competition, price of each factor of production will be equal to its marginal productivity. The price of the factor is determined by the industry. The firm will employ that number of a given factor at which the price is equal to its marginal productivity. Thus for an industry it is a theory of factor pricing while for a firm it is a factor demand theory. ANALYSIS OF MARGINAL PRODUCTIVITY THEORY FROM THE POINT OF VIEW OF AN INDUSTRY:Under the condition of perfect competition price of each factor of production is determined by the equality of demand and supply. As the theory assumes that there exists full employment in the economy. Therefore supply of the factor is assumed to be constant. So factor price is determined by its demand which itself is determined by the marginal productivity. Thus under such conditions it becomes essential to throw light on the demand curve or marginal productivity curve of the industry. As the industry consists of a group of many firms accordingly .its demand curve can be drawn with the demand curves of all firms in the industry. Moreover, marginal revenue productivity of a factor constitutes its demand curve. It is only due to this reason that a firms demand or labour depends on its marginal revenue productivity. A firm will employ that number of labourers at which their marginal productivity is equal to the prevailing wage rate. The summation of demand curves of all firms shows demand curve of the industry. Since the number of firms is not constant under perfect competitive market, it is not possible to estimate the summation of demand curves of all firms. However one thing is certain that the demand curve of industry also slopes downwards from left to right.


The point where demand and supply of a factor are equal, it determines the factor price for the industry. Thus the factor price is determined by the demand for factor i.e. factor price will be equal to the marginal revenue productivity.

SS represents the supply curve in the long run. It is a vertical line which shows the total supply of labour is fixed and it is a condition off full employment. DD the marginal productivity curve which is downward sloping from left to right. The factor price is determined at point where DD cuts SS. ANALYSIS OF MARGINAL PRODUCTIVITY THEORY FROM THE POINT OF VIEW OF FIRM:Under perfect competition the number of firms is very large. No single firm can influence the market price of a factor of production. Every firm acts as a price taker and not as price maker. Therefore it has to accept the prevailing price. No employer would like to pay more than what others are paying. A firm will employ that number of factors t which its price is equal to the value of marginal productivity. Other things remaining constant as more and more labourers are employed by a firm, its marginal physical productivity goes ion diminishing. As price remains constant so when marginal physical productivity of labour goes on diminishing, marginal revenue productivity will also go on diminishing. Therefore in order to get the equilibrium position, a firm will employ labourers up to a point where their respective marginal revenue productivity is equal to their wage rate.

In this diagram number of labourers lies on x axis & wage rate on y .MRP is the marginal revenue product curve. WS is the prevailing wage rate in the market. MRP is downward sloping and cuts WS curve at a point at which we get equilibrium wage rate.i.e. Ol. CRITICISM:1 UNREALISTIC ASSUPMTIONS:-The theory assumes that there exists perfect competition in all the markets. But in reality, perfect competition is only imaginary concept. In modern days, perfect competition does not hold good. 2 ALL FACTORS ARE NOT HOMOGENEOUS:-This theory assumes that all units of a given factor are homogeneous. It is wrong. In reality different units of a given factor are heterogeneous. 3 SHORT-PERIOD IGNORED:-The marginal productivity theory holds good in the long run only while it ignores the short period. As LORD KEYNES stated that in the long run we all are dead. Therefore all problems are needed to be solved in the short run. 4 LEVEL OF EMPLOYMENT AND WAGE RATE:- According to this theory, employment can be increased by wage cut. Moreover, according to KEYNES, the volume of employment is not determined by wage rate but by effective demand. 5 UNREALISTIC ASSUMPTION OF FULL EMPLOYMENT:-The marginal productivity theory assumes that the situation of full employment prevails in the economy. It is a rare phenomenon. But, in reality there exists hardly any country in the world whether advanced or

less advanced which enjoys full employment. Therefore, this theory does not hold good in the real world. 6 VAGUES CONCEPT OF MARGINAL PRODUCTIVITY:- The concept of marginal productivity is vague. Production is the result of the cooperative efforts of all the four factors of production and it is not possible to separate out the contribution of one factor.


According to Professor Lange, welfare economics establishes norms of behavior which satisfy the requirements of social rationality of economic activity. According to ,Professor Baumol , Welfare Economics has concerned itself mostly with policy issues which arise out of the allocation of resources , with the distribution of inputs among the various commodities and the distribution of commodities among various consumers. The inter-relationship among various parts of the economy means that certain particular change in one part of the economy affects resource allocation in all parts of it. Thus, a central problem in welfare economics relates to whether a particular change in resource allocation will increase or decrease social welfare. However, an almost insurmountable difficulty which is faced in welfare economics is that it is not possible to measure social welfare objectively, for it involves making interpersonal comparison of utilities or welfares of different individuals comprising the society. In order to avoid making interpersonal comparison of utility, whose scientific nature has been challenged, among others, by Lord Robbins, economists have mostly used what is known as PARETO-OPTIMALITY CRITERION for evaluating whether social welfare increases or decreases as a result of a specific change in economic state, situation or policy. According to Pareto criterion of optimality or efficiency, any change that makes at least one individual better off without making any other worse off is an improvement in social welfare.


Pareto criterion states that if any reorganization of economic resources does not have anybody and makes someone better off, it indicates an increase in social welfare. Pareto criterion can be explained with the help of Edgeworth Box diagram which is based on the assumption of ordinal utility and non-interpersonal comparison of utilities.\ CONDITIONS OF PARETO OPTIMUM The marginal conditions required for the achievement of Pareto Optimum or Maximum social welfare are based on the following important assumptions: 1 Each individual has his own ordinal utility function and possess a definite amount of each product and factor. 2 Production functions of every firm and the state of technology is given and remains constant. 3 Goods are perfectly divisible.

4 A producer tries to produce a given output with the least-cost combination of factors. 5 Every individual wants to maximize his satisfaction. 6 Every individual purchases some quantity of all goods. 7 All factors of production are perfectly mobile. Given the above assumption various marginal conditions require for the achievement of Pareto Optimum are explained below. 1. THE OPTIMUM DISTRIBUTION OF PRODUCTS AMONG THE CONSUMERS: EFFICIENCY IN EXCHANGE The first condition relates to the optimum distribution of the goods among the different consumers composing a society at a particular point of time. The condition says The marginal rate of substitution between any two goods must be the same for every individual who consumes them both. i.e. MRSAXY=MRSBXY Marginal rate of substitution of one good for another is the amount of one good necessary to compensate for the loss of a marginal unit of another to maintain a constant level of satisfaction. So long as the marginal rate of substitution (MRS) between two goods is not equal for any two consumers, they will enter into an exchange which would increase the satisfaction of both or of one without decreasing the satisfaction of the other. This condition can be better explained with the help of Edgeworth box diagram in the figure goods X and Y which are consumed by two individuals A and B the composing a society are represented on the X and Y axis respectively. Oa and Ob are origins Ia1, Ia2, Ia3 and Ib1, Ib2 and Ib3 are the indifference curves showing successively higher level of satisfaction of consumers A and B respectively. CC is the contract curve passing through various tangent points Q,R,S of the indifference curve of A and B. MRS between the two goods for individuals A and B are equal on the various points of the contract curve CC. Any point outside the contract curve does not represent the equality of MRS between the two goods for two individuals A and B of the society.

Let us consider point K where indifference curves Ia1 and Ib1 of individuals A and B respectively intersect each other instead of being tangential. Therefore at point K, (MRS) between two goods X and Y of individual A is not equal to that of B. With thee initial distribution of goods as represented by pt. K ,it is possible to increase the satisfaction of one individual without any decrease in that of the other or to increase the satisfaction of both by redistribution of the two goods X and Y between them. A movement from K to S increases the satisfaction of A without any decrease in the satisfaction of B. Similarly a movement from K to Q increases these satisfaction of B without any decrease in As satisfaction. The movement from K to R increases the satisfaction of both because both move to their higher indifference curves. Thus a movement from K to Q or to S or any other point on the segment SQ of the contract curve will, according to Pareto Criterion, increases the level of social welfare. Since the slope of an indifference curve represents the MRS at every point of the contract curve, which represents tangency points of the indifference curve, MRS of the two individual are equal. Thus, every point on the contract curve denotes maximum social welfare. 2. THE OPTIMUM ALLOCATION OF FACTORS: EEFICIENCY IN PRODUCTION The second condition for Pareto optimum requires that the available factors of production should be utilized in the production of different goods in such a manner that it is impossible to increase the output of one good without a decrease in the output of another or to increase the output of one good without a decrease in the output of another or to increase the output of both the goods by any re-allocation of factors of production. This situation would be achieved if the Marginal technical rate of substitution between any pair of factors must be the same for any two firms producing two different products and using both the factors to produce the products. i.e. MRTSXLK=MRTSYLK

This condition can be explained with the help of Edgeworth Box diagram relating to production. This is depicted in the following figure. Let us assume two firms A and B producing goods X and Y by using two factors labour and capital. The available quantities of labour and capital are represented on X and Y axes respectively. OA and OB are the origins for firms A and B respectively. Isoquants Ia1,Ia2,Ia3 and Ib1,Ib2,Ib3 of firms A and B respectively represent successively higher quantities of goods X and Y respectively which they can produce by different combinations of labour and capital. The slope of the isoquant, which is convex to the origin, represents the marginal technical rate of substitution (MRTS) between two factors. MRTS of one factor for another is the amount of one factor necessary to compensate the loss of the marginal unit of another so that the level of output remains the same. So long as the MRTS between two factors for two firms producing goods X and Y is not equal, total output can be increased by transfer of factors from one firm to another. In terms of the following diagram any movement from K to S or to Q raises the output of one firm without any decrease in the output of the other. The total output of the two firms increases when through redistribution of factors between two firms, a movement is made from the point K to the point Q or S on the contract curve. A glance at the figure will reveal that movement from point K of the contract curve to the point R on the contract curve will raise the output of both the firms individually as well as collectively. Therefore, it follows that corresponding to a point off the contract curve there will be some points on the contract curve production at which will ensure greater output of the two firms. As the contract curve is the locus of the tangency points of the isoquants of the two firms, the (MRS) of the two firms is same at every pt. of the contract curve CC. It, therefore, follows that on the contract curve at every pt. of which MRTS between the two factors of two firms is the same, the allocation of factors between the two firms producing X and Y respectively is optimum. When the allocation of factors between the two firms is such that they are producing at a pt. on the contract curve, then no reallocation of factors will increase the total output of the two firms taken together.

3. THE OPTIMUM DIRECTION OF PRODUCTION: EFFICIENCY IN PRODUCT MIX The third condition relates to the technical conditions of production and the state of consumers preferences. This is also called overall condition of Pareto-Optimality or economic efficiency. The marginal condition for a Pareto optimal composition of output requires that the MRT between any two goods be equal to the MRS between the same two goods In the figure, commodities X and Y have been represented on the X and Y axis respectively. AB is a transformation curve between any pair of goods X and Y. This curve represents the maximum amount of good X that can be produced for any quantity of good Y, given the amount of other goods that are produced and fixed supplies of available resources.IC1 is the indifference curve of a representative consumer reflecting the preferences of the society between the two goods of the society. The MRT of the commodity and the MRS of the consumers of the society are equal to each other at the point K at which the transformation curve is tangent to the indifference curve IC1 of the consumers. Point K represents optimum composition of production in which commodities X and Y are being produced. This is because of all the points on transformation curve, pt. R lies at the highest possible indifference curves IC1 of the consumer.

End Chapter Quizzes

1. The marginal productivity theory states that under perfect competition, price of each factor of production will be:a) Equal to its marginal productivity b) More than its marginal productivity c) Less than its marginal productivity d) Equal to or more than its marginal productivity. 2. The factor price for the industry is determined by the point where:a) Demand > Supply of a factor b) Demand< Supply of a factor c) Demand =Supply of a factor d) None of the above. 3. Which of the following is not an assumption of Marginal Productivity Theory:a) Homogeneous factors b) Perfect Competition c) Short-run analysis d) Law of diminishing marginal returns 4. In order to attain the equilibrium position a firm will employ labourers up to a point where their respective :a) MRP>wage rate b) MRP<wage rate c) MRP <=wage rate d) MRP=wage rate 5. Which of the following is a criticism to The Marginal Productivity Theory of Distribution:a) All factors are not homogeneous b) Unrealistic Perfect competition assumption c) Both (a) and (b) d) None of the above 6. Welfare economics has concerned itself mostly with:a) Policy issues which arise out of allocation of resources b) Distribution of commodities among various consumers c) Distribution of inputs among the various commodities d) All the above 7. Marginal conditions required for the achievement of Pareto Optimum are based on which of the following assumptions: a) Every individual wants to minimise his satisfaction, b) All factors of production are perfectly static

c) None of the above d) Both (A) and (b) 8. Marginal conditions required for the achievement of Pareto Optimum are:a) THE OPTIMUM DISTRIBUTION OF PRODUCTS AMONG THE CONSUMERS b) THE OPTIMUM ALLOCATION OF FACTORS c) THE OPTIMUM DIRECTION OF PRODUCTION d) All the above 9. Pareto criterion can be explained with the help of:a) Ford fuse box diagram b) Edgeworth box diagram c) Lipsey diagram d) Keynes diagram 10. According to Pareto Criterion, a change is good if:a) It leaves no one worse off than before b) It leaves someone better off than before c) It leaves no one worse off and someone better off than before None of the above

Answer Key to Multiple choice questions Chapter 1 1 (c) 2(b) 3(b) 4(b) 5(d) 6(a) 7(b) 8(c) 9(a) 10(a) Chapter 2 1 (b) 2(c) 3(a) 4(b) 5(d) 6(a) 7(a) 8(a) 9(a) 10(a) Chapter 3 1 (b) 2(a) 3(a) 4(c) 5(a) 6(a) 7(a) 8(a) 9(a) 10(a) Chapter 4 1 (d) 2 (c) 3(c) 4 (b) 5 (a) 6 (c) 7 (c) 8 (b) 9 (a) 10 (b) Chapter 5 1 (a) 2(a) 3(c) 4(d) 5(a) 6(b) 7(b) 8(c) 9(d) 10(b) Chapter 6 1 (c) 2(a) 3(a) 4(d) 5(b) 6(a) 7(c) 8(b) 9(e) 10(e) Chapter 7 1 (a) 2(c) 3(c) 4 (d) 5 (c) 6(d) 7 (c) 8 (d) 9 (b) 10 (c)

BIBLIOGRAPHY I.C.Dhingra -Principles of Microeconomics-Sultan Chand & Sons Ahuja, H.L. Advanced Economic Theory (Micro Economics), S. Chand & Co Gupta G.S. - Managerial Economics, Browning & Browning Gould & Lazer Koutsoyiannis, Modern economics Varshney. R and Maheshwari, Managerial Economics-Sultan Chand & Co