Economics Final

Study Material
For
M.B.A.
Based on Latest Syllabus of MBA prescribed By
Maharshi Dayanand University, Rohtak (DDE)
1st Semester
(Part-1)
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CONTENTS
MANAGERIAL ECONOMICS
Syllabus......................................................................5-5
UNIT I.......................................................................6-26
UNIT II....................................................................27-77
UNIT III.................................................................78-121
UNIT IV...............................................................122-134
Past Year Question Paper......................................135-139
Worksheet............................................................140-142
ACCOUNTING FOR MANAGERS

Syllabus...............................................................143-143
UNIT I.................................................................144-175
UNIT II................................................................176-202
UNIT III...............................................................203-227
UNI IV................................................................228-246
Worksheet............................................................254-256
INDIAN ETHOS AND VALUES

Syllabus...............................................................257-257
UNIT I.................................................................258-270
UNIT II................................................................271-283
UNIT III...............................................................284-298
UNI IV................................................................299-304
Worksheet............................................................310-312
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SYLLABUS
MBA1st SEMESTER, M.D.U., ROHTAK
External Marks : 70
Time : 3 hrs.
Internal Marks : 30
UNIT-I
Nature of managerial economics; significance in managerial decision
making, role and responsibility of managerial economist; objectives of a
firm; basic concepts - short and long run, firm and industry,
classification of goods and markets, opportunity cost, risk and
uncertainty and profit; nature of marginal analysis.
UNIT-II
Nature and types of demand; Law of demand; demand elasticity;
elasticity of substitution; consumer's equilibrium utility and
indifference curve approaches; techniques of demand estimation.
UNIT-III
Short-run and long-run production functions; optimal input
combination; short-run and long-run cost curves and their
interrelationship; engineering cost curves; economies of scale;
equilibrium of firm and industry under perfect competition, monopoly,
monopolistic competition and oligopoly; price discrimination.
UNIT-IV
Baumol's theory of sales revenue maximisation basic techniques of
average cost pricing; peak load pricing; limit pricing; multi-product
pricing; pricing strategies and tactics; transfer pricing.
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MBA 1st Semester (DDE)
UNIT I
Q.
What do you mean by Managerial Economics. Explain its Nature and

Scope.
Ans. Meaning of Managerial Economics : Managerial economics is the study

of economic theories, logic and tools of economic analysis that are used in the
process of business decision making. Economic theories and techniques of
economic analysis are applied to analyse business problems, evaluate
business options and opportunities with a view to arriving at an appropriate
business decision. Managerial economics is thus constituted of that part of
economic knowledge, logic, theories and analytical tools that are used for
rational business decision-making.
Managerial economics is that subject which describes how economic analysis
is used in taking business decisions. The purpose of Managerial Economics is
to show how economic analysis can be used in formulating business policies.
Managerial economics is that discipline which uses economic concepts,
principles and economic analysis in taking business decision and formulating
future plans. It integrates economic theory with business practice for choosing
business policies. Managerial economics lies on the borderline between
economics and business management and bridges the gap between the two.
Definition of Managerial Economics :
According to McNair and Meriam :
Managerial economics is the use of economic modes of thought to
analyse business situation.
According to Mansfield :
Managerial economics is concerned with the application of economic
concepts and economics analysis to the problems of formulating rational
decision making.
Nature or Characteristics of Managerial Economics :
1. Managerial Economics is a Science : Managerial economics is a science
because it establishes relationship between causes and effects. It studies the
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effects of a change in price of a commodity factors and forces on the demand of a

particular product. It also studies the effects and implications of the plans,
policies and programmes of a firm on its sales and profit.
2. Managerial Economics is an Art : Managerial economics may also be
called an art. Because it also develops the best way of doing things. It helps
management in the best and most efficient utilization of limited economic
resources of the firm.
3. Managerial Economics is a Micro Economics : Entire study of
economics may be divided into two segments- Macro economics and Micro
economics. Managerial economics is mainly micro-economics. Microeconomics is the study of the behaviour and problems of individual economic
unit. In managerial economics unit of study is firm or business organization
and an individual industry. It is the problem of business firms such as problem
of forecasting demand, cost of production, pricing, profit planning, capital,
management etc.
4. Managerial Economics is the Economics of firms : Managerial
economics largely use that body of economic concepts and principles which is
known as Theory of the Firm or Economics of the Firm.
5. Managerial Economics uses Macro-economic Analysis : Managerial
economics also uses macro-economics to analysis and understand the general
business environment in which the business firm must operate. Business
management must have the adequate knowledge of external forces that affect
the business of the firm. The important macro-factors that affect the firm are
trends in national income and expenditure, business cycles, economic policies
of the government, trends in foreign trade etc.
6. Managerial Economics is Progmatic : It is concerned with practical
problems and results. It has nothing to do with abstract economic theory which
has no practical application to solve the problems faced by business firms.
7. Managerial Economics is Normative Science : There are two types of
science-Normative Science and Positive Science. Positive science studies what
is being done. Normative science studies what should be done. From this point
of view, it can be concluded that managerial economics is normative science
because it suggests what should be done under particular circumstances.
Scope of Managerial Economics : Managerial economics is the application of
economic theories in the process of decision-making and formulation of future
plans. The management will have to analyse the business problems that are
faced by the firm. Thus, the principles relating to following topics constitute the
scope of subject matter of managerial economics:
Demand Analysis : A business firm is in an economic organization which
1
is engaged in transforming productive resources into goods that are to be sold
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in the market. A major part of managerial decision-making depends on

accurate estimates of demand. A forecast of future sales serves as a guide to
management for preparing production schedules and employing resources. It
will help management to maintain or strengthen its market position and profitbase. Demand analysis also identifies a number of other factors influencing the
demand for a product. Demand analysis and forecasting occupies a strategic
place in Managerial Economics.
Cost Analysis : Cost estimates are most useful for management
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decisions. The different factors that cause variations in cost estimates should
be given due consideration for planning purpose. There is the element of
uncertainty of cost as other factor influencing cost are either uncontrollable or
not always known.
Pricing Practices and Policies : As price gives income to the firm, it
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constitutes as the most important field of Managerial Economics. The success
of a business firm depends very much on the correctness of the price decision
taken by it. The various aspects that are deal under it cover the price
determination in various market forms, pricing policies, pricing method,
different pricing, productive pricing and price forecasting.
Profit Management : The chief purpose of a business firm is to earn the
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maximum profit. There is always an element of uncertainty about profits
because of variation in cost and revenue. If knowledge about the future were
perfect, profit analysis would have been very easy task. But in this world of
uncertainty expectations are not always realized. Hence profit planning and its
measurement constitute the most difficult area of managerial economics.
Under profit management we study nature and management of profit, profit
policies and techniques of profit planning like Break Even Analysis.
Capital Management : The problems relating to firms capital
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investments are perhaps the most complex and the troublesome. Capital
management implies planning and control of capital expenditure. The main
topics deal with under capital management are cost of capital, rate of return
and selection of projects.
Analysis of Business Environment : The environmental factors
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influence the working and performance of a business undertaking. Therefore,
the managers will have to consider the environmental factors in the process of
decision-making. The factors which constitute economic environment of a
country include the following factors:
Economic System of the Country

Business Cycles
Fluctuations in National Income and National Production
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Industrial Policy of the Government

Trade and Fiscal Policy of the Government
Taxation Policy
Licensing Policy etc.
Political Environment
Social Factors
Trend in labour and capital markets.
Q. What do you mean by Managerial

significance in Managerial Decision Making.
Economics?
Explain
its
Ans. Meaning of Managerial Economics : Managerial economics is the study

of economic theories, logic and tools of economic analysis that are used in the
process of business decision making. Economic theories and techniques of
economic analysis are applied to analyse business problems, evaluate
business options and opportunities with a view to arriving at an appropriate
business decision. Managerial economics is thus constituted of that part of
economic knowledge, logic, theories and analytical tools that are used for
rational business decision-making.
Managerial economics is that subject which describes how economic analysis
is used in taking business decisions. The purpose of Managerial Economics is
to show how economic analysis can be used in formulating business policies.
Managerial economics is that discipline which uses economic concepts,
principles and economic analysis in taking business decision and formulating
future plans. It integrates economic theory with business practice for choosing
business policies. Managerial economics lies on the borderline between
economics and business management and bridges the gap between the two.
Definition of Managerial Economics :
According to McNair and Meriam :
Managerial economics is the use of economic modes of thought to
analyse business situation.
According to Mansfield :
Managerial economics is concerned with the application of economic
concepts and economics analysis to the problems of formulating rational
decision making.
Significance of Managerial Economics in Managerial Decision Making :
The most important function of management of a business firms is decision
making and future planning. Business decision-making is essentially a
process of selecting the best out of alternative opportunities open to the firm.
The process of decision-making comprises following phases :
(i)
Determining and defining the objective to be achieved

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(ii) Developing and analyzing possible course of action; and

(iii) Selecting a particular course of action.
Economic analysis helps the management in following ways:(1) Reconciling Theoretical Concepts of economics to the Actual
Business Behaviour and Conditions : Managerial economics attempts to
reconcile the tools, techniques, models and theories of economics with actual
business practices and with the environment in which a firm has to operate.
Analytical techniques of economic theory builds models by which we arrive at
certain assumptions and conclusions are reached thereon in relation to certain
firms. There is need to reconcile the theoretical principles based on simplified
assumptions with actual business practice and develop the economic theory, if
necessary.
(2) Estimating Economic Relationship : Managerial economics plays an
important role in business planning and decision making by estimating
economic relationship between different business factors- income, elasticity of
demand like price elasticity, income elasticity, cross elasticity and cost volume
profit analysis etc. The estimates of this economic relationship can be used for
purpose of business forecasts.
(3) Predicting Relevant Economic Quantities : Sound business plans and
policies for future can be formulated on the basis of economic quantities.
Managerial economics helps the management in predicting various economic
quantities such as:
Cost
Profit
Demand
Capital
Production
Price etc.
Since a business manager has to work in an environment of uncertainty,

future should be well predicted in the light of these quantities.
(4) Understanding Significant External Forces : The management has to
identify all the important factors that influence firm. These factors broadly
divided into two parts- Internal Factors and External Factors. External factors
are the factors over which a firm cannot have any control. Therefore, the plans,
policies and programmes of the firm should be adjusted in the light of these
factors. Important external factors affecting decision-making process of a firm
are:
Economic System of the Country

Business Cycles
Fluctuations in National Income and National Production
Industrial Policy of the Government
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Trade and Fiscal Policy of the Government

Taxation Policy
Licensing Policy etc.
Managerial economics plays an important role by assisting management

in understanding these factors.
(5) Basis of Business Policies : Managerial economics is the foundation of
all business policies. All the business policies are prepared on the basis of
studies and findings of managerial economics. It warns the management
against all the turning points in national as well as international economy.
(6) Clear Understanding of Economic Concepts : It gives clear
understanding of various economic concepts (i.e, cost, price, demand etc.) used
in business analysis. For example , the concept of cost includes total,
average, marginal, fixed, variable, actual cost, and opportunity cost.
Economics clarifies which cost concepts are relevant and in what context.
(7) Increases the Analytical Capabilities : Managerial Economics provides
a number of tools and methods which increases the analytical capabilities of
the business analysis.
Q. Who is Managerial Economist? Discuss the Role and Responsibility
of Managerial Economist.
Ans. Managerial Economist : Managerial Economist is an expert who
counsels business management in economic matters and problems faced by a
business organization.
Taking business decision and formulating forward plans are two important
jobs of business management. Specialized skills are needed to perform these
jobs efficiently. The managerial economist can assist the management in using
the specialized skill to solve the problems of business to formulate business
policies.
Role of Managerial Economist : One of the main functions of any
management is to determine the key factor which influences the business over
a period of time. This function is performed by a Managerial Economist. In
general, the factors which influence the business over a period to come fall
under two categories:
(A) External Factors : The external factors are beyond the control of
management.
(B) Internal Factors : The internal factors are well within the control of
management.
Thus, the role of Managerial Economist are :
(A) Analysis of External Factors : The external factors operate outside the
firm and firm has no control over these. Such factors constitute business
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environment and include prices, national income and output, business cycle,
government policies, international trends, etc. These factors are of great
importance to the firm. Managerial economists by studying and analyzing
these factors can contribute effectively in determining business policies.
Certain relevant question relating to these factors are:(i) What are the present trends in nations and international economics?
(ii) What phase of business cycle lies immediately ahead?
(iii) Where are the market and customer opportunities likely to expand or
contract most rapidly?
(iv) What are the possibilities of demand and prices of finished products?
(v) Is competition likely to increase or decrease?
(vi) What changes are expected in government policies and control?
(vii) What are the demand prospects in new and the established markets?
(B)
Analysis of Internal Factors : Internal factors are known as business

operations. In other words internal activities of a firm are called business
operations. A managerial economists can also help the management to
solve problems relating the business operation such as price
determination, use of installed capacity, investment decision, expansion
and diversification of business etc. Relevant questions in this context are
as follows:(i)
(ii)
What will be the reasonable sales and profit targets for the next year?
What will be the most appropriate production schedules and the
inventory policy for the next five or six months?
(iii) What changes in wage and price policies should be made now?
(iv) How much cash will be available in the coming months and how it
should be invested?
(C)
Specific Functions : These Specific functions are as under :

(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
(x)
(xi)
(xii)
Sales Forecasting
Market Research
Economic Analysis of competing firms.
Pricing problem of the industry
Evaluation of Capital Projects.
Advice on foreign exchange.
Advice on trade and public relations
Environmental forecasting.
Investment analysis and forecasts
Production and inventory schedule
Marketing function.
Analysis of underdeveloped economics
Responsibilities of a Managerial Economist :

1.
To make reasonable profits on capital employed : He must have

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strong conviction that profits are essential and his main obligation is to
assist the management in earning reasonable profits on capital invested
by the firm. He should always help the management to enhance the
capacity of the firm to earn profits. If he fails to discharge this
responsibility then his academic knowledge, experience and business
skill will be of no use to the firm.
2.
Successful Forecasts : It is necessary for the managerial economist to

make successful forecasts by making in depth study of internal and
external factors that may have influence over the profitability or the
working of the firm. A managerial economist is supposed to forecast the
trends in the activities of importance to the firm such as sales, profit,
demand, costs etc.
3.
Knowledge of Sources of Economic Informations : A managerial

economist should establish and maintain close contacts with specialists
and data sources in order to collect quickly the relevant and valuable
information in the field. For this purpose he should develop personal
relation with those having specialized knowledge of the field. He should
also join professional associations and take active part in their activities.
4.
His Status in the Firm : A managerial economist must earn full status in
the business ream because only then he can be really helpful to the
management in formulating successful business policies.
Q.
What are the objectives of Business Firms?
Ans. Introduction : Conventional theory of firm assumes profit

maximization, as the sole objective of business firms. Recent researchers on
this issue reveal that the objectives that business firms pursue are more than
one. Some important objectives, other than profit maximization, are:(i)
(ii)
(iii)
(iv)
Maximization of Sales Revenue

Maximization of Firms growth rate
Maximization of managers utility function
Long-run survival of the firm
Therefore the objectives of the Business firms are

Objectives of Business Firms
Main Objective
Alternative Objectives
Profit Maximization

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(A)
Main Objectives :
1.
Profit Maximization Goal of a Business Firm : According to traditional

economic theory profit maximization is the sole objective of business
firms. The traditional theory suggests a number of reasons as to why does
a firm want to maximize profits. All these reasons essentially fall into the
following categories:
(i)
Traditional economic theory assumes that the firm is ownermanaged, and therefore maximizing profit would imply maximizing
the income of the owner; Owner would like to have adequate return
for his activity as n entrepreneur.
(ii)
Firm may pursue goals other than profit-maximization, but they can
achieve these subsidiary goals much easier if they aim for profit
maximization.
Under perfect competition individual firms have to maximize their profits

at price determined by industry. Under imperfect competition firms search
their profit maximizing price output as they are price makers. The profit can be
defined as the difference between total revenue and total cost.
Profit = Total Revenue - Total Cost.
A firm will maximize its profit at that level of output at which the difference
between total revenue and total cost is maximum. Generally conventional price
theory determines profit maximizing price-output in terms of marginal cost
and marginal revenue.
Marginal Revenue : Marginal revenue is the addition to total revenue from the
sale of an additional unit of a commodity.
Marginal Cost : Marginal cost is the addition to total cost from the production
of an additional unit of a commodity.
The two profit maximizing conditions are :
1.
MC = MR : We take first condition

(i)
If MC<MR total profits are not maximized because firm will earn more
profits by increasing output.
(ii)
If MC>MR the level of total profit is being reduced and firm can
increase profit by decreasing production.
(iii) If MC = MR the profits could not increase either by increasing or

decreasing output and hence profits are maximized.
(b)
MC cuts MR from below : Now we take the second condition. The

second condition of profit maximization requires that MC be rising at
the point of its intersection with the MR curve
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Cost/Revenue
Y
P
OUTPUT
MC
AR=MR
At point E both the conditions are satisfied.

Criticism of profit Maximization Approach :
a)
The real world business environment is more complex than what

convention theory of firm thought. The modern business firms face lot of
risk and uncertainty. Long-run survival is more important than short-run
profit.
b)
The other objectives such as sales maximization, growth rate

maximization etc. describe real business behavior more accurately.
c)
Profit maximization objective cannot be realized without the exact

measurement of marginal cost and marginal revenue.
d)
Profits are not only measure of firms efficiency.
e)
Profit maximization assumption may require expansion of business which

means more risks. But firms may prefer less profit instead of bearing
additional uncertainties.
(B)
Alternative Objectives of Business Firms : There are the following

objectives:
(1)
Baumols Hypothesis of Sales Revenue Maximization : Baumols

theory of sales maximization is an alternative theory of firms behaviour.
The basic premise of his theory is that sales maximization, rather than
profit maximization, is the plausible goal of the business firms. He argues
that there is no reason to believe that all firms seek to maximize their
profits. Business firms, in fact, pursue a number of objectives and it is not
easy to single out one as the most common objective pursued by the firms.
However, from his experience as a consultant to many big business
houses, Baumol finds that most managers seek to maximize sales revenue
rather than profits.
(2)
Maximization of firms growth rate : According to Robin Marris

managers maximize firms balanced growth rate. He defines firms
balanced growth rate (G) as
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G = G D = GC
Where G D = Growth rate of demand for firms product
G C = Growth rate of capital supply to the firm
In simple words, a firms growth rate is balance when demand for its
product and supply of capital to the firm increase at the same rate.
(3)
Maximization of Managerial Utility Function : According to this

concept managers seek to maximize their own utility function subject to a
minimum level of profit.
(4)
Long-Run Survival of the firm : According to this concept, the primary

goal of the firm is long-run survival. The managers, therefore, seek to
secure their market share and long-run survival. The firms may seek to
maximize their profit in the long-run though it is not certain.
Q.
Write a short note on the following :

(A)
(B)
(C)
(D)
(E)
(F)
(G)
(H)
(I)
(J)
(K)
Short-Run
Long-Run
Firm
Industry
Classification of Goods
Classification of Markets
Opportunity Cost
Risk
Uncertainty
Profit
Nature of Marginal Analysis.
Ans.
(A) Short-Run : Short-Run refers to that time period in which supply of a
commodity can be increased only up to its existing production capacity. If
demand has increased, there is not enough time for a firm to install new
machines nor for the new firms to enter the industry. The main features of
short-run are :
(1)
In the short-run there are two types of factors of production:
Fixed Factors
Variable Factors
(2)
In the short-run supply can be changed only by varying variable

factors.
(3)
The fixed factors cannot be changed.
(4)
In short-run demand plays greater role than supply in the

determination of price.
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(5)
The price that is determined in the short period is called Sub-normal

price.
(6)
There are two types of cost in the short-run:
Fixed Cost : The costs of fixed inputs are called fixed costs.
Fixed costs are costs which do not change with changes in the
quantity of output.
Variable Cost : Variable costs are those costs which are

incurred on the use of variable factors of production.
Example : Supposing you have a carpet manufacturing factory. If you run

your factory for full 24 hours, you can produce 10 carpets at the most.
Supposing demand for carpets increases to 20 carpets per day for two days
only. You will be unable to meet this additional demand. Your maximum
production capacity is limited to 10 carpets only. You do not have time to install
new looms to increase your production.
(B) Long-Run : Long-Run refers to that time period in which supply of a
commodity can be increased or decreased according to the changed
conditions of demand. The increased demand can be met with increasing
the supply by installing machines. Or new firms can enter the industry.
On the contrary, if demand has gone down, some firms will discontinue
their production. Price, in the long-run is therefore, more influence by
supply than demand. Price that comes to prevail in the long-run is called
Normal Price. The main features of long-run are:(1)
(2)
(3)
(4)
(5)
(6)
In the long-run all factors are variable.

In the long-run supply can be changed by varying all factors of
production.
In long-run demand and supply both plays equal role in the
determination of price.
The price that is determined in the long period is called Normal Price.
In the long-run supply can be increased or decreased according to
the demand.
In the long-run new firms can enter the industry and old firms can
leave it.
(C) Firm : A firm is a unit engaged in the production for sale at a profit and
with the objective of maximizing the profit. A firm is in equilibrium when it
is satisfied with its existing amount of output. A firm is in equilibrium has
no tendency either to increase or to decrease its output. The objectives of a
firm are:17
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Objectives of Business Firms

Main Objective
Alternative Objectives
Profit Maximization

(D) Industry : The group of firms producing homogenous products is called

industry. Homogeneous products are those products in which it is not possible
to make any distinction between the units of the commodity being sold by
different sellers. Such firms are found only under perfect competition. Perfect
competition is that situation of the market in which there are large number of
buyers and sellers of homogeneous product. Under perfect competition, price
of the commodity is determined by the industry. In perfect competition market
firm is a price-taker and not a price-maker.
Equilibrium of Industry : An industry is in equilibrium when it has no
tendency to change its size. There are two conditions of an industrys
equilibrium:
(1)
Constant Number of Firms : An industry will be in equilibrium

when the number of its firms remains constant. In this situation, no
new firm will enter and no old firm will leave the industry.
(2)
Equilibrium of Firms : Another condition of an Industrys

equilibrium is that all firms operating in it are in equilibrium and
have no tendency either to increase or to decrease their output.
Conditions of equilibrium of firm are:
(i)
(ii)
MC=MR
MC curve cuts MR curve from below
Cost/Revenue
Y
P
OUTPUT
MC
AR=MR
At point E both the conditions are satisfied.
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(E)
Classification of Goods : There are basically three types of goods :
1.
Consumers Goods : Those goods which are directly put to use are called
consumers goods. These goods are used in our daily life. For example:Bread, Cloth, Medicines etc.
2.
Shopping Goods : This classification includes durable or semi-durable

items. Shopping goods purchase are characterized by Pre-Planning,
information search & price comparisons. It is divided into:
(i)
Homogeneous Goods : Homogeneous products are those goods in

which it is not possible to make any distinction between the units of
the commodity being sold by different sellers.
(ii)
Heterogeneous Goods : Heterogeneous goods mean that goods are

close substitutes but are not homogeneous. They differ in colour,
name, packing, shape, size, quality etc.
3.
Producer or Capital Goods : Those goods which are used in production

by other industries are capital goods. Huge amount is invested in these
goods. For Example:- Machinery, Plant, etc.
4.
Intermediate Goods : Some industries manufacture such goods as are

processed in some other industry to produce some need goods. Such
goods are called intermediate goods. For example : Plastic, rubber,
aluminum etc.
5.
Specialty Goods : The purchase of specialty goods is characterized by

extensive search to accept substitutes once the purchase choice has been
made. The market for such goods is small but price & profits are high.
6.
Normal Goods : Normal goods are those goods the demand for which
tends to increase following increase in consumers income, and tends to
decrease following decrease in his income. So, there is a positive
relationship between consumers income and quantity demanded.
7.
Inferior Goods : Inferior goods are those goods the demand for which
tends to decline following a rise in consumers income, and tends to
increase following a fall in his income. So there is an inverse relationship
between income of the consumer and demand for a commodity.
8.
Necessaries of Life and Inexpensive Goods : In case of necessaries of

life and inexpensive goods, the demand remains almost constant
irrespective of the level of income.
9.
Luxury Good : A luxury good means an increase in income causes a

bigger % increase in demand.
(F)
Classification of Market : In economics the term market refers not

necessarily to a particular place but to the mechanism by which buyers
and sellers are brought together. The classification of markets are:19
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Classification of Market
Perfect Competition
Imperfect Competition
Monopolistic Competition
1.
Oligopoly
Perfect Competition : Perfect competition refers to a market situation

where there is a large number of buyers and seller. The sellers sell
homogeneous product at a uniform price. The price is determined not by
the firm but by the industry. Features of Perfect Competition market are :
(i)
(ii)
(iii)
(iv)
(v)
(vi)
2.
Monopoly
Large Number of Buyers and Sellers

Homogeneous Products
Free entry and exit of firms
Perfect Knowledge
Absence of Selling costs
Price Taker.
Imperfect Competition : There are two types of market under imperfect

competition :
(a)
Monopolistic Competition : Monopolistic competition is a market

structure in which there are many sellers of a commodity, but the
product of each seller differs from that of the other sellers on one
respect or the other. Thus product differentiation is the main feature
of monopolistic competition. The main feature of this market are :
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(b)
Large Number of Buyers and Sellers

Product Differentiation.
Freedom of Entry and Exit of firms
Higher Selling Costs
Price Control.
Imperfect Knowledge.
Non-Price Competition
Oligopoly : oligopoly is a market structure in which there are few

sellers selling a homogenous or differentiated products and large
number of buyers. The main features of oligopoly are :
(i) Small number of sellers
(ii) Interdependence of decision-making.
(iii) Barriers to Entry
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3.
Monopoly : Monopoly is a market situation in which there is a single

seller, there are no close substitutes for commodity it produces, there are
barriers to entry. The main features of this market are:(i)
(ii)
(iii)
(iv)
(v)
One Seller and Large Number of Buyers

Monopoly is also an Industry
Restriction on the entry of the new firms
Price Maker
Price Discrimination
(G) Opportunity Cost : The concept of opportunity cost is extremely

important in economic analysis. We know that the cost is the value of
inputs in the process of production. An input has got value because it is
scarce or limited. If we use the input to produce one good, it is not available
to produce something else. The cost of producing one thing is measured in
terms of what was given up in terms of next best alternative that is
sacrificed. If several opportunities are given up for producing a particular
commodity, it is the value of the next best foregone opportunity that
constitutes cost. Thus it is called opportunity cost. The opportunity cost is
the cost of next best alternative foregone. It is also called alternative cost.
Example : Supposing a farmer can grow both wheat and gram on a farm.
If on a farm measuring one-hectare land he grows only wheat, he foregoes
the production of gram. If the price of quantity of gram that he foregoes is
Rs. 1,000, then the opportunity cost of growing wheat will be Rs. 1,000.
Thus, the price of gram which the farmer has to forgo in order to produce
wheat is called opportunity cost of wheat.
Definition of Opportunity Cost :
According to Leftwitch
Opportunity cost of a particular product is the value of the foregone
alternative product that resources used in its production, could have produce
Diagram of Opportunity Cost :
Y
12 P
10
8
X-Commodity
6
4
2
O
P
2 4 6 8 10 12
X
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Explanation : In this figure the production line PP shows that if a given

quantity of resources is employed to produce both X and Y, it can produce
(a)
(b)
(c)
12 units of Y and nothing of X

6 units of X and nothing of Y
Any combination of X and Y long the line.
OR
OR
This line shows that to produce X, we must forego the opportunity of

producing some of Y. This is called the opportunity cost of X in terms of Y. In
this figure the opportunity cost of one unit of X is 12Y/6 = 2Y. This means that
the same amount of factors of production that can produce 1 unit of X can
produce 2 units of Y. Likewise, the opportunity cost of producing one unit of Y
in term of X is 6X/12= 0.5 X. The same amount of factors of production
employed in the production of 1 unit of Y can produce 0.5 units of X. The
opportunity cost of Y interns of X is 0.5.
(H) Risk : In common practice, risk means a low profitability of an expected
outcome. From business decision-making point of view, risk refers to a
situation in which business decision is expected to yield more than one
outcome and the profitability of each outcome is known to the decision
makers or can be reliably estimated.
Example : If a company doubles its advertisement expenditure, there are
three probable outcomes:(i) Its sales may more than double
(ii) It may just double
(iii) It may less than double.
The company has the knowledge of these probabilities of the three
outcomes on the basis of its past experience as
(i) more than double- 10%
(ii) almost double- 40%
(iii) Less than double-50%
It means that there is 90 % risk in more than doubling the sales and in
doubling the sale, the risk is 60% and so on.
There are two approaches to estimate probabilities of outcomes of a business
decision, viz.
(i)
(ii)
(I)
A priori approach : This approach based on intuition.

Posteriori approach : This approach is based on past data.
Uncertainty : Uncertainty refers to a situation in which there is more

than one outcome of a business decision and the probability of outcome is
not known or not meaningful. The unpredictability of outcome may be
due to :
Lack of Reliable market information
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Inadequate past experience
Some Examples of Uncertainties :

(i) Life of new plant and future maintenance are unpredictable.
(ii) Technological changes are highly unpredictable.
(iii) The size of the market may not turn out to be as anticipated due to a
number of reasons like, changes in the pattern or fashions, tastes of
the people, etc.
(iv) It is not possible to base scientific judgments about the following
factors which affect the extent of prospective yields in the distant
future:
The extent of new competition

The prices which may fluctuate from year to year
The size of export market during the years to come.
Change in fiscal policies particularly in individual taxation and
corporate taxation, and policies with regard to labour and
wages.
Conditions in the labour market, changes in labour legislation,
level of wages, the possibilities of lockouts and strikes etc.
Political, climate etc.
The long term investment involves a great deal of uncertainty with

unpredictable outcome. But, in really investment decisions involving
uncertainty have to be taken on the basis of whatever information can be
collected, generated. For the purpose of decision-making, the uncertainty
is classified as :
(J)
(i)
Complete Ignorance : In case of complete ignorance, investment

decisions are taken by the investors using their own judgment.
(ii)
Partial Ignorance : In case of partial ignorance, on the other hand,

there is some knowledge about the future market conditions, some
information can be obtained from the experts in the field and some
probability estimates can be made. The available information can be
incomplete and unreliable.
Profit : Profit means different things to different people. The word profit
has different meaning to businessmen, accountants, tax collectors,
workers and economists. In a general sense, profit is regarded as income
accruing to the equity holders, in the same sense as wages accrue to the
labour, rent accrues to the owners of rentable assets and interest accrues
to the money lenders.
Concepts of Profit : The two important concepts of profit in business

decisions are economic profit and accounting profit. It will be useful to
understand the difference between the two concepts of profit.
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(1)
Accounting Profit : Accounting profit is surplus of revenue over and

above all paid-out costs, including both manufacturing and overhead
expenses. Accounting profit may be calculated as follows:
Accounting Profit = TR (W +R + I + M)
Where
TR= Total Revenue
R= Rent
M=Cost of materials
W= Wages and Salaries

I=Interest
Obvious, while calculating accounting profit, only explicit or book costs, i.e.,
the cost recorded in the books of accounts, are considered.
(2)
Economic Profit or Pure Profit : The concept of economic profit differs

from that of accounting profit. Economic profit takes into account also the
implicit or imputed costs. The implicit cost is opportunity cost.
Opportunity cost is the income foregone which a businessman could
expect from the second best alternative use of his resources. There are the
following examples of opportunity cost:
(i)
If an entrepreneur uses his capital in his own business, he foregoes

interest which he might earn by purchasing debentures of other
companies or by depositing his money with joint stock companies for
a period.
(ii)
Furthermore, if an entrepreneur uses his labour in his own business,

he foregoes his income (Salary) which he might earn by working as a
manager in another firm.
(iii) Similarly, by using productive assets (land and building) in his own
business, he sacrifices his market rent.
These foregone incomes-interest, salary and rent are called opportunity
costs or transfer costs. Accounting profit does not take into account the
opportunity cost.
Economic Profit = Total Revenue (Explicit Costs Implicit Costs)
(K)
Nature of Margin Analysis : The concept of marginal is widely used in

economic analysis. The nature of marginal analysis :
(1)
Marginal analysis is related to a unit change in independent variable, say,

increase in cost as a result of a unit change in output, increase in product
as a result of a unit change in labour, increase in revenue as a result of a
unit change in sale, increase in utility as a result of a unit change in
consumption of units. These are explained in the following:
(a)
Marginal Utility (MU) : The marginal utility can be defined as the
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change in total utility from the consumption of an additional or less

unit of a commodity.
TU
MU=
DQ
MU= Marginal Utility
DQ = Change in Quantity
(b)
DTU = Change in Total Utility
Marginal Cost (MC) : Marginal cost can be defined as the change in

to total cost as result of producing one more or less unit of a
commodity.
DTC
MC=
DQ
MC= Marginal Cost
(c)
DTC = Change in Total Cost
Marginal Product (MP) : Marginal Product can be defined as the

change in total product as result of increasing or decreasing one more
unit of labour.
MR
DTP
=
MP
DL
MP= Marginal Product
DL = Change in Labour
(d)
DTP = Change in Total Product
Marginal Revenue (MR) : Marginal product can be defined as the

change in total revenue due to the sale of one additional unit of a
product.
DTR
MR=
DQ
MR= Marginal Revenue
(2)
DTR = Change in Total Revenue
There are certain cases where marginal analysis is superior to any other
analysis. These include the selection of :
(a)
best product-mix, in cases where substitution between products

occurs at a decreasing rate.,
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(b)
(c)
(d)
least cost input-mix where inputs are substitutable at a decreasing

rate.
Optimum input-level where input-output relationship faces
diminishing returns, and
Optimum maturity of assets, having value decreasing over time.
(3)
Whenever the cost and revenue functions are curvilinear, it is more

appropriate to use marginal analysis. Marginal analysis calls for unit-tounit comparison and would, therefore be able to capture the impact of all
points.
(4)
In case of those functions which are linear, in such a case only the end
points of a range are to be compared, and marginal analysis would not give
any different results.
(5)
In case of those alternatives, which are discrete, marginal analysis cannot

be used. If a producer wants to produce a particular level of output and
wants to make a choice between different technologies for the purpose, it
is not possible to compare these processes in terms of marginal cost of
moving from one process to another.
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UNIT II
Q.
Explain Demand and its various types. Also Explain the Determinants
of Demand.
Ans. Meaning of Demand : Demand is defined as the quantities of a product

which a consumer is not only desiring to purchase and able to purchase but is
also ready to purchase at given prices at a given point of time.
Definition of Demand :
According to Ferguson
Demand refers to the quantities of a commodity that the consumers are
able and willing to but at each possible price during a given period of time, other
things being equal.
Constituents of Demand :
(i)
Desire for a thing.
(ii)
Money to satisfy the desire.
(iii) Willingness to spend the money.

(iv) Relationship of the price and the quantity of the commodity demanded.
(v)
Relationship of time and the quantity of the commodity demanded.
Types of Demand : There are various types of demand:

1.
2.
Demand for Consumers Goods and Producers Goods :

i)
Goods and services for final consumption are called consumers

goods. These include those consumed by human beings such as food
items, clothes, medicines etc. Demand for consumers goods is direct.
ii)
Producers goods refer to the ones used for the production of other
goods such as plant and machines, factory buildings, raw materials
etc. Demand for producers goods is derived.
Demand for Perishable Goods and Durable Goods :

i)
Perishable Goods are those goods which can be consumed only once.
For example:- bread, milk and vegetables etc.
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ii)
3.
4.
5.
6.
7.
Durable Goods are those goods the utility from which accrues over a
period of time. For example refrigerator, car, furniture etc.
Direct and Indirect Demand :

(i)
Direct Demand : Goods that are demanded for their own sake have
direct demand.
(ii)
Indirect Demand : Goods that are needed in order to obtain some

other goods possess indirect demand.
Short-Run Demand and Long-Run Demand :

(i)
Short Run Demand : Short-run demand represents the existing

demand which is based on immediate reaction to price changes,
income fluctuations and other explanatory variables.
(ii)
Long Run Demand : Long-run demand on the other hand, is that

demand which emerges after the influence of price changes, product
improvement, promotional efforts and other factors over time is
allowed to adjust the market to the new situation. In the long run,
new customers may start purchasing the product. Some products
may not be demanded any more.
Joint Demand and Composite Demand :

(i)
Joint Demand : When two goods are demanded in conjunction with

one another at the same time to satisfy a single want, they are said to
be joint demand. For Example:- Pens and ink, camera and film, Car
and petrol etc.
(ii)
Composite Demand : A commodity is said to be in composite

demand when it is wanted for several different uses.
Individual Demand and Market Demand :

(i)
Individual Demand : Individual demand schedule is defined as the

table which shows quantities of a given commodity which an
individual consumer will buy at all possible prices at a given time.
(ii)
Market Demand : Market demand schedule is defined as the

quantities of a given commodity which all consumers will buy at all
possible prices at a given moment of time.
Price Demand, Income Demand and Cross Demand :

(i)
Price Demand : Price demand refers to the various quantities of a

product purchased by the consumer at alternative prices.
D= f (P)
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(ii)
Income Demand : Income demand refers to the various quantities

of a commodity demanded by the consumer at alternative levels of his
changing money income.
D= f (Y)
(iii) Cross Demand : Cross demand refers to the various quantities of

commodity (say coffee) purchased by the consumer in relation to
change in the price of a related commodity (say tea) which may either
be a substitute or a complementary product.
Da = f (Pb)
Determinants of Demand : Demand of a consumer for a particular
commodity is determined by the following factors:
(1)
Price of Commodity : There is an inverse relationship between price and

demand for a commodity. When Price increases, then demand decreases
and when price decreases, then demand increases. It is also explained
with the help of following diagram :
D
Y
P1
Price
P
D
Price of Related Goods : Demand for a commodity depends not only on

its own price, but also upon the prices of related goods. Related goods are
broadly classified into two categories :
(i)
Substitute Goods : Substitutes goods are those goods which can be

substituted for each other, such as tea and coffee. Demand of tea is
related to the price of coffee. If price of coffee is raised people may shift
to tea, and vice-versa. In other words, in case of substitute the
demand of one good is positively related to the price of the other good.
Price of Coffee
(2)
Q1 Q
Quantity
Y
P1
P
D
O
Q Q1
Quantity of Tea
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Complementary Goods : Complementary goods are those goods

which complete the demand for each other, such as car and petrol.
There is an inverse relationship between the demand for first good
and the price of the second good.
Price of Car
(ii)
Y
P1
P
O
Q1 Q
Quantity of Petrol
(3)
Income of the Consumer : There is a positive relation between income of

the consumer and his demand for a good in case of normal goods. But
there is a negative relation between income of the consumer and demand
for a good in case of inferior goods.
Normal Goods : There is a positive relation between income of the
consumer and his demand for a good in case of normal goods.
Income of Consumer
(i)
Y
Y1
Y
D
O
Q Q1
Quantity
Inferior Goods : There is a negative relation between income of the

consumer and demand for a good in case of inferior goods.
Income of Consumer
(ii)
(4)
D
Y1
Y
D
X
O
Q1 Q
Quantity of Inferior Goods
Tastes and Preferences : The demand for any goods and service
depends on individuals tastes and preferences. Demand for those goods
increases for which consumers develop tastes and preferences.
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(5)
Expectations : If the consumer expects that price will rise in future, he

will buy more goods in the present even when price is high. In case, he
expects that prices will fall in future, he will either buy less in the present.
(6)
Climate and Weather Conditions : Demand for certain products is

determined by climate or weather conditions. For example, in summer,
there is a greater demand for cold drinks, fans, coolers, etc.
(7)
Size of Population : Market demand is influenced by change in size of

population. Increase in population leads to more demand and decrease in
population means less demand for them.
Q.
Explain the difference between Increase in Demand and Extension of

Demand and Decrease in Demand and Contraction of demand.
OR
Q.
Explain the Change in Demand.
Ans. Change in Demand : Change in demand of two types :

(A)
Movement Along Demand Curve : Other things remaining the same,

when the quantity demanded changes consequent upon the change in
price only, then this change is shown by different points along the same
demand curve. Fall in price is followed by extension of demand and rise in
price is followed by contraction of demand.
Change in Price alone
Change in Quantity Demanded
Movement along the Demand Curve
(1)
Extension of Demand : Extension of demand refers to a rise in quantity

demanded as a result of fall in price, other things remaining the same.
This can be explained with the help of following table and diagram:
Extension of Demand
Price (Rs.)
Quantity Demanded
Description
1Kg
Fall in Price
5 Kg
Extension of
Demand
As shown in the above table, when price of apples is Rs.5 per Kg demand is for 1
Kg of apples, when it falls to Re. 1 per Kg demand extends to 5 Kg of apples.
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A
5
Extension of
Demand
Price
4
3
2
1
B
O
1
2 3
Quantity
In this figure AB is the demand curve of apples. When price of apples is Rs.5 per
Kg demand is for 1 Kg of apples. The consumer is at point A of the demand
curve. As the price of apples falls to Re. 1 per Kg demand extends to 5 Kg and
the consumer moves to point B of the demand curve. Movement along the
demand curve from higher point (A) to lower point (B) is called extension of
demand.
(2)
Contraction of Demand : Contraction of demand refers to a fall in

quantity demanded as a result of rise in price, other things remaining the
same. This can be explained with the help of following table and diagram:
Extension of Demand
Price (Rs.)
Quantity Demanded
5Kg
Description
Rise in Price
1 Kg
Contraction
of Demand
As shown in the above table, when price of apples is Rs.1 per Kg demand is
for 5 Kg of apples, when it rises to Re. 5 per Kg demand contracts to 1 Kg of
apples.
A
5
Contraction of
Demand
Price
4
3
2
1
B
O
1
2 3
Quantity
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In this figure AB is the demand curve of apples. When price of apples is

Rs.1 per Kg demand is for 5 Kg of apples. The consumer is at point B of the
demand curve. As the price of apples rises to Re. 5 per Kg demand contracts to 1
Kg and the consumer moves to point A of the demand curve. Movement along
the demand curve from lower point (B) to higher point (A) is called contraction of
demand.
(B) Shift in Demand Curve : A change in any determinants of the demand
other than price will shift the entire demand curve to the right or to the left.
An increase in demand is shown as rightward shift. A decrease in demand
is a leftward shift of the entire demand curve.
Change in Income, Tastes or Price of other goods
Change in Demand
Shift of Demand Curve
(1)
Increase in Demand : Increase in demand means rise in demand in

response to change in determinants of demand other than price of the
product. Increase in demand refers to rightward shift in demand curve.
Thus, demand may increase in two ways:
(i)
Same Price more Demand : When price of ice cream is Rs. 3 per
unit, demand is for 3 units. If price remains the same, i.e., Rs. 3 per
unit but demand goes up to 4 units, then it will be an instance of
increase in demand.
(ii)
More Price same Demand : When price of ice cream is Rs. 3 per
unit, demand is for 3 units. If price rises to Rs. 4 per unit but demand
remains the same, that is, 3 units, then it will also be an instance of
increase in demand.
This can be explained with the help of following Table and Diagram :
Price of Ice
Cream (Rs.)
Quantity
Purchased
Same Price
More Purchase
More Price
Same Purchase
3
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C
A
Increase of
Demand
Price
4
3
2
B
O
1 2 3
Quantity
Causes of Increase in Demand :

(i)
(ii)
(iii)
(iv)
(v)
(vi)
(2)
Increase in Income
Rise in Price of Substitute Good
Fall in the price of complementary good
Favourable changes in tastes and preferences
Expectation of rise in price
Increase in population.
Decrease in Demand : Decrease in demand means fall in demand in

response to change in determinants of demand other than price of the
product. Decrease in demand refers to leftward shift in demand curve.
Thus, demand may increase in two ways:
(i)
Same Price Less Demand : When price of ice cream is Rs. 3 per
unit, demand is for 3 units. If price remains the same, i.e., Rs. 3 per
unit but demand goes down to 2 units, then it will be an instance of
decrease in demand.
(ii)
Less Price same Demand : When price of ice cream is Rs. 3 per unit,
demand is for 3 units. If price falls to Rs. 2 per unit but demand
remains the same, that is, 3 units, then it will also be an instance of
decrease in demand.
This can be explained with the help of following Table and Diagram :
Price of Ice
Cream (Rs.)
Quantity
Purchased
Same Price
Less Purchase
Less Price
Same Purchase
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A
C
Decrease of
Demand
Price
4
3
2
B
D
1
O
1 2 3
Quantity
Causes of Increase in Demand :

(i)
(ii)
(iii)
(iv)
(v)
(vi)
Decrease in Income
Fall in Price of Substitute Good
Rise in the price of complementary good
UnFavourable changes in tastes and preferences
Expectation of Fall in price
Decrease in population.
Difference between Extension and Increase in Demand :

Extension of Demand : Extension of demand means rise in demand response
to fall in the price of a commodity, other things being equal. It is expressed by
the movement from a higher point to a lower point along the same demand
curve.
Increase in Demand : On the other hand, increase in demand refers to rise in
demand response to change in the determinants of demand other than the
price. It is expressed by the upward shift of the entire demand curve.
This difference can be explained with the help of following diagram :
D1
D
Price
A
P
P1
Extension in
Demand
Increase of
Demand
C
B
D1
D
Q
Q1
Quantity
This figure shows the distinction between extension and increase in

demand. DD is the initial Demand Curve. This figure shows that from the point
A of the demand curve DD two quite different rise in demand are possible. One
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is a rise in the quantity demanded from OQ to OQ , moving along the same

curve from point A to B. Such a rise in quantity demanded results from
consumers adjustment to a reduction in price from OP to OP . It is called
extension of demand.
1
The second is the shift in the entire demand curve from DD to D D . At the
initial price OP the consumer used to purchase OQ, as shown by point A but
now purchases OQ as shown by point C. This change in demand is the
response to change in any determinant of demand, other than the price. This
change is called increase in demand.
1
Difference between Contraction and Decrease in Demand :

Contraction of demand : Contraction in demand means fall in demand in
response to a rise in the price of a commodity, other things being equal. It is
expressed by the movement from a lower point to a higher point on the same
demand curve.
Decrease in Demand : On the other hand, decrease in demand refers to fall in
demand response to change in the determinants of demand other than the
price. It is expressed by the downward shift of the entire demand curve.
This difference can be explained with the help of following diagram :
D
Price
D1
P1
Contraction of
Demand
A
Decrease
in
Demand
D
D1
Q1
Q
Quantity
This figure shows the distinction between Contraction and decrease in

demand. DD is the initial Demand Curve. This figure shows that from the point
A of the demand curve DD two quite different reduction in demand are possible.
One is a fall in the quantity demanded from OQ to OQ , moving along the same
curve from point A to B. Such a fall in quantity demanded results from
consumers adjustment to a rise in price from OP to OP . It is called contraction
of demand.
1
The second is the shift in the entire demand curve from DD to D D . At the
initial price OP the consumer used to purchase OQ. But now purchases OQ .
This change in demand is the response to change in any determinant of
demand, other than the price. This change is called decrease in demand.
1
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Q.
Explain the Law of Demand.
OR
Q.
Why does the demand curve slope downwards to the right?
Ans. Meaning of Demand : Demand is defined as the quantities of a product

which a consumer is not only desiring to purchase and able to purchase but is
also ready to purchase at given prices at a given point of time.
Law of Demand :
Meaning : Law of demand states that, other things being equal, the demand
for a good extends with a fall in price and contracts with a rise in price.
According to law of demand there is an inverse relationship between price and
demand for a commodity.
Definition :
According to Marshall
The law of demand states that amount demanded increases with a fall in
price and diminishes when price increases, other things being equal.
Assumption : Assumptions of the law of demand are that all the determinants
of demand other than the price of good remain unchanged. There are the
following assumptions:(1)
(2)
(3)
(4)
(5)
There should be no change in the price of related goods

There should be no change in the income of the consumer
There should be no change in the tastes and preference of consumer
The consumer does not expect any change in the price of the
commodity in the near future.
There is no change in weather conditions.
Explanation of Law of Demand : Law of demand can be explained with the

help of schedule and diagram :
(A)
Demand Schedule : Demand schedule is a table that shows different

prices of a good and the quantity of that good demanded at each of these
prices. It has two aspects:-
(1)
Individual Demand Schedule : Individual demand schedule is defined

as the table which shows quantities of a given commodity which an
individual consumer will buy at all possible prices at a given time. The
following table shows Individual demand schedule:
Price Per Unit (in Rs.)
Quantity Demanded (Units)
1
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Above schedule indicates that as the price of Ice cream increases, its
demand tends to contract.
(2)
Market Demand Schedule : Market demand schedule is defined as the

possible prices at a given moment of time. The following table show market
demand schedule. The schedule is based on the assumption that there
are, in all two consumers A and B.
Price of
Commodity
Demand
of A
Demand
of B
Market
Demand (A+B)
4+5=9
3+4=7
2+3=5
1+2=3
Above schedule indicates that as the price of Ice Cream increases, its market
demand tends to contract.
(B)
Demand Curve : The demand curve is a graphic presentation of a

demand schedule. The curve which shows the relation between the price
of a commodity and the amount of the commodity that the consumer
wishes to purchase, is called demand curve. It has two aspects:-
(1)
Individual Demand Curve : Individual demand curve is a curve which

shows quantities of a given commodity which an individual consumer will
buy at all possible prices at a given time. The following figure shows
Individual demand curve:
Y
Price
Individual
Demand
2
1
D
O
2
3
Quantity
Quantity demanded is shown on OX-axis. And the price is shown on OY-axis.

DD is the demand curve. Each point on the demand curve expresses the
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relation between price and demand. At a price of Rs. 1 per unit, demand is for 4
units and at a price of Rs. 4 per unit, demand is for 1 unit.
(2)
Market Demand Curve : Market demand curve is defined as the

possible prices at a given moment of time. The following curve shows
market demand. The curve is based on the assumption that there are, in
all two consumers A and B.
Y
4
Market
Demand
Price
3
2
1
D
O
4
6
Quantity
10
Quantity demanded is shown on OX-axis. And the price is shown on OY-axis.

DD is the demand curve. Each point on the demand curve expresses the
relation between price and demand. At a price of Rs. 1 per unit, market demand
is for 9 units and at a price of Rs. 4 per unit, demand is for 3 units.
Causes of Law of Demand
downward :
OR
Why does Demand Curve slope
1.
Law of Diminishing Marginal Utility : A consumer demands a

commodity because it has utility. As he consumes more and more units of
a commodity, in a given time, the utility derived from each successive unit
goes on diminishing. Obviously, a consumer will buy an additional unit of
a commodity only if he has to pay less price for it compared to the previous
unit.
2.
Income Effect : Income effect is the effect that a change in a persons real
income caused by change in the price of a commodity has on the quantity
of that commodity. When the relative price of a good decrease, less of a
persons income would need to be spent to purchase exactly the same
amount of the good; therefore it is possible to purchase more because of
this rise in purchasing power.
For Example : Suppose your income is Rs. 15 per day. You want to buy
apples whose price is Rs. 5 per Kg. It means with your fixed income of Rs.
15 you can buy three Kg. In case, the price of apples comes down to Rs. 3
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per Kg then after buying 3Kg of apples you will be left with Rs.6. This
increased income may be spent on buying two more Kg of apples.
Thus fall in price causes increase in real income and so extension in
demand. On the contrary, rise in price causes decrease in real income and
so contraction in demand.
3.
Substitution Effect : The substitution effect is the effect that a change in

relative prices of substitute goods has on the quantity demanded.
Substitutes are goods that can be used in place of each other. For
example, tea and coffee, coca cola and Pepsi cola are substitutes. In order
to get maximum satisfaction with a fixed income, a consumer will
substitute a lower priced goods for higher priced one.
For Example : Tea and coffee are substitutes of each other. If price of tea
goes down, the consumers may substitute tea for coffee, although price of
coffee remains the same.
4.
Different Uses : Some goods have more than one use. Milk, for example,
may be used for drinking and for making curd and cheese. At its very high
price, an individual consumer may buy milk only for drinking; but at the
reduced price more milk may be bought for making curd and cheese as
well.
5.
Size of Consumer Group : When the price of a commodity falls, then

many consumers, who are unable to buy that commodity at its previous
price, come forward to but it. Consequently, the total number of
consumers goes up. On the contrary, if the price of commodity rises many
consumers will withdraw from the market and in this way total demand
for apples will go down.
Exception of Law of Demand : There are some exceptions of law of demand.

Demand curve of such commodities slopes upwards from left to right.
Y
Price
D
O
(1)
Quantity
Articles of Distinction : Veblen goods are articles of distinction or

luxury goods like jewellery, original works of art by great artists. Articles of
distinction according to Veblen, command more demand when their
prices are high.
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(2)
Ignorance : Many a time, consumer out of poor judgment consider a

commodity to be of low quality of its price is low and of high quality if its
price is high.
(3)
Giffen Goods : Giffen goods are those inferior goods whose demand falls
even when their price falls, so that the law of demand does not hold good.
Q.
Define Elasticity of Demand. What are the degrees of Price Elasticity

of Demand?
Ans. Elasticity of Demand : Law of demand tells us about the direction of

change in demand for a commodity as a result of change in its price. Thus this
law a qualitative statement. It simply states that when price falls demand
extends and when price rises demand contracts. It does not explain how much
the demand will change. It is the concept of price elasticity of demand which
measurers how much the quantity demanded of a good changes when its price
changes. Elasticity of demand is a ratio between a cause and an effect, always
in percentage terms. Elasticity of demand is a quantitative statement.
Types of Elasticity of Demand : Demand for a good depends upon its price,
commodity of the consumer and price of related goods. Therefore, elasticity of
demand is of three types:(1)
(2)
(3)
Price Elasticity of Demand

Income Elasticity of Demand
Cross Elasticity of Demand
Price Elasticity of Demand : The price elasticity of demand is equal to the

ratio of the percentage change in the quantity demanded to a percentage
change in the price, other things being equal. It measures how much the
quantity demanded of a good changes when its price changes. Price elasticity of
demand denotes the ratio at which the demand contracts with a rise in price
and extends with a fall in price. There is an inverse relationship between price
and quantity demanded of a good. Accordingly, elasticity of demand is
expressed by minus(-) sign.
Price
Degrees of Price Elasticity of Demand : There are five degrees of elasticity of

demand:Y
(1) Perfectly Elastic Demand : A perfectly
elastic demand is one in which any quantity
Ed=
D
D
P
will be bought at the prevailing price. In this
case, a very little rise in price causes the
demand to fall to zero and a very little fall in
price cause the demand to extend to infinity. In
this case Elasticity of demand will be infinity.
In this diagram DD represents perfectly elastic
demand curve. It is parallel to OX-axis.
X
Quantity
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Perfectly Inelastic Demand : A perfectly inelastic demand is one in

which a change in price produces no change in the quantity demanded. In
this case price elasticity of demand will be zero.
(2)
Price
P1
P
Ed=0
P2
D
O
Quantity
In this diagram DD represents the perfectly inelastic demand. It is parallel

to OY-axis.
Unitary Elastic Demand : Unitary Elastic demand is one in which a
percentage change in price produces an equal percentage in quantity
demanded. If 5 percent fall in price is followed by 5 percent extension in
demand, then it will be a case of unitary elastic demand i.e. 5%/5% = 1
(3)
Price
P
Ed=1
P1
O
D
Q
Q1
Quantity
In this diagram DD represents the unitary elastic demand. In this diagram
PP (change in price) is equal to OQ (change in quantity). In this case Elasticity of
demand will be one.
1
(4)
Greater than Unitary Elastic Demand : Greater than unitary elastic

demand is one which a given percentage change in price produces
relatively more percentage change in quantity demanded. If 5 percent fall
in price causes 20 percent extension in demand, then it will be an example
of greater than unitary demand i.e. 20% / 5%= 4
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Price
Ed>1
P1
D
Q1
Quantity
In this diagram DD represents greater than unitary elastic demand. In

this diagram OQ (change in price) is more than to PP (change in quantity). In
this case Elasticity of demand will be greater than one.
1
(5)
Less than Unitary Elastic Demand : Less than unitary elastic demand
is one in which a given percentage change in price produces relatively less
percentage change in demand. When fall in price by 4 percent is followed
by 2 percent extension in demand then elasticity of demand will be 2% /
4% = i.e. less than unitary
Price
P
Ed<1
P1
D
O
Q1
Quantity
In this diagram DD represents less than unitary elastic demand. In this

diagram OQ (change in price) is less than to PP (change in quantity). In this
case Elasticity of demand will be less than one.
1
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Q.
Sr.
No.
Value of
Elasticity
Degrees of
Elasticity
Description
1.
Ed=
Perfectly Elastic
Demand
Little Change in price causes

an infinite change in demand.
2.
Ed=0
Perfectly Inelastic Change in price causes no

Demand
change in quantity demanded
3.
Ed=1
Unitary Elastic
Demand
Percentage change in price is

equal to percentage change
in demand
4.
Ed>1
Greater than
Unitary Elastic
Demand
Percentage change in price is

less than percentage change in
demand
5.
Ed<1
Less than Unitary Percentage change in price is

Elastic Demand
more than percentage change
in demand
How can Price Elasticity of Demand be measured ?
Ans. Price Elasticity of Demand : The price elasticity of demand is equal to

the ratio of the percentage change in the quantity demanded to a percentage
change in the price, other things being equal. It measures how much the
quantity demanded of a good changes when its price changes.
Measurement of Price Elasticity of Demand : Whether price elasticity of
demand is unitary, greater than unitary or less than unitary is know by its
measurement. There are five methods of measuring price elasticity of demand:1.
2.
3.
4.
5.
1.
Total Outlay or Total Expenditure Method

Percentage Or Proportionate Method
Point Elasticity Method
Arc Elasticity Method
Revenue Method
Total Outlay Or Total Expenditure Method : Total Expenditure method

was evolved by Marshall. According to this method, in order to measure
the elasticity of demand it is essential to know how much and in what
direction the total expenditure has changed as a result of change in the
price of a good.
Total Expenditure
Price
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Quantity
There may be three situations :

(i)
Unitary Elasticity of Demand : Elasticity of demand is unitary

when due to rise or fall in the price of a good, total expenditure
remains unchanged.
(ii)
Greater than Unitary Elasticity of demand : Elasticity of demand

is greater than unitary when due to fall in price total expenditure goes
up and due to rise in price total expenditure goes down.
(iii) Less than unitary elasticity of demand : Elasticity of demand is

less than unitary when due to fall in price total expenditure goes
down and due to rise in price total expenditure goes up.
This relationship can also be reflected with the help of following table:Sr.
No.
Vale of
Elasticity
Degrees of
Elasticity
Description
Ed = 1
Unitary Elastic
Demand
Ed > 1
Ed < 1
Greater than
Unitary Elastic
Demand
Less than Unitary

Elastic Demand
2.
Price Increases..........No
changes in Total Expenditure
Price Decreases.......No Change
in Total Expenditure
Price Increases.............Total
Expenditure Decreases
Price Decreases ...........Total
Eexpenditure Increases
Price Increases.............Total
Expenditure Increases
Price Decreases ............Total
Expenditure Decreases
Proportionate Or Percentage Method : The second method of

measuring price elasticity of demand is called percentage method.
According to this method, the price elasticity of demand is equal to the
ratio of the percentage change in the quantity demanded to a percentage
change in the price. Its formula is as under:-
Percentage change in Quantity Demanded of Commodity

E = (-) ----------------------------------------------------------------------PercentageChange in Price of Commodity
d
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100 X Change in Quantity Demanded
Initial Demand
E = (-) -100 X Change in Price
Initial Price
d
100 (Q -Q)
Q
E = (-)
100 (P -P)
P
1
100 D Q
Q
E = (-)
100 D P
P
d
DQ
E = (-) X
d
DP
Q = Initial Demand
DQ = Change in Demand (Q -Q)
P = New Price
Q = New Demand
P = Initial Price
DP = Change in Price (P -P)
1
3.
Point Elasticity of Demand : Point elasticity refers to price elasticity of

demand at any point on the demand curve. Its formula is:
Lower Segment
E =
Upper Segment
d
Price elasticity at different points of a straight line shown in the following

figure :
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E d=
M
A
Ed>1
Price
Ed=1
P
Ed<1
B
Ed=0
Quantity
At point P,
lower segment = PN & Upper Segment = PM
Lower Segment
PN
E = = = 1
Upper Segment
PM
d
At point A,
lower segment = AN
& Upper Segment = AM
Lower Segment
AN
E = = >1
Upper Segment
AM
d
At point B,
lower segment = BN& Upper Segment = BM
Lower Segment
BN
E = = < 1
Upper Segment
BM
d
4.
At point M, Elasticity of Demand will be infinity.
At point N. Elasticity of Demand will be Zero.
Arc Elasticity : Arc Elasticity is a measure of the average responsiveness

to price change shown by the demand curve over some definite portion
between two points on a demand curve. An arc is the portion between two
points on a demand curve. The portion between two points A and C on the
demand curve DD as shown in the given figure is called Arc.
Change in Quantity
E = (-)
(Sum of Quantities)
d
Change in Price
(Sum of Prices)
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(Q -Q)
(P -P)
E = (-)
(Q +Q)
d
(P +P)
P1
(Q -Q)
1
(P +P)
E = (-) X
(Q +Q)
(P -P)
(Q -Q)
E = (-)
(Q +Q)
1
Q1
(P +P)
X
(P -P)
1
Q = Initial Demand
P = Initial Price
Q = New Demand
P = New Price
1
Revenue Method : Sales proceeds that a firm is obtained by selling its

products is called its revenue. Supposing by selling 10 meters of cloth, a
firm gets Rs. 50 then this amount of Rs. 50 will be called the total revenue
of the firm. There are three types of revenue:-
5.
Total Revenue : Sale proceeds of a firm is called total revenue.

Average Revenue : When total revenue is divided by the number of
units sold we get average revenue.
(iii) Marginal Revenue : Addition made to the total revenue by the sale
of one more unit of the commodity is called marginal revenue.
According to Revenue Method Elasticity of Demand can be measured
from the following formula :
(i)
(ii)
A
E =
A-M
d
A = Average Revenue
M = Marginal Revenue
Ed = Elasticity of Demand
Q.
Write a short note on the following

(A) Income Elasticity of Demand.
(B) Cross Elasticity Or Elasticity of Substitution.
Ans.
(A)
Income Elasticity of Demand : The income elasticity of demand is equal

to the ratio of the percentage change in the quantity demanded to a
percentage change in the income, other things being equal. It measures
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how much the quantity demanded of a good changes when consumers

income changes.
Definition of Income Elasticity of Demand :
According to Watson
Income Elasticity of demand means the ratio of the percentage change in
the quantity demanded to the percentage change in income.
Measurement of Income Elasticity :
Income Elasticity can be measured by the following formula:Percentage Change in Quantity Demanded
Ey =
Percentage Change in Income
100 D Q
Q
Ed =
100 D Y
Y
DQ
Ed = X
Q
DY
Q
= Initial Demand
DQ = Change in Demand (Q -Q)
Y1 = New Income
1
Q1 = New Demand
Y = Initial Income
DP = Change in Income (P -P)
1
Degrees of Income Elasticity of Demand : Income Elasticity of demand

is of three types:
(1)
Positive Income Elasticity of Demand : Income Elasticity of demand

for a good is positive when with an increase in the income of a consumer
his demand for the good increases and with a decrease in the income of a
consumer his demand for the good decreases. Income elasticity of demand
is positive in case of normal goods.
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Dy
Income
A
B
Dy
O
Q1
Quantity
In this figure DY DY curve represents positive income elasticity of demand.
It shows that when income increased form OB to OA then demand also
increase from OQ to OQ . It slopes upward from left to right i.e. positive
slope.
1
(2)
Negative Income Elasticity of Demand : Income Elasticity of demand

for a good is Negative when with an increase in the income of a consumer
his demand for the good decreases and with a decrease in the income of a
consumer his demand for the good increases. Income elasticity of demand
is positive in case of inferior goods
Y
Income
Dy
A
B
Dy
O
Q1
Quantity
In this figure Dy Dy curve represents negative income elasticity of
demand. It shows that when income increased form OB to OA then
demand decrease from OQ to OQ . It slopes downward right to left i.e.
negative slope.
1
(3)
Zero Income Elasticity of Demand : Income elasticity of demand is

zero, when change in the income of consumer evokes no change in his
demand
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Dy
Income
A
B
Dy
Q
Quantity
In this figure Dy, Dy curve represents zero income elasticity of demand. It

shows that when income increased form OB to OA then demand constant
at point OQ. In this case demand curve will be parallel to OY-axis.
(B)
Cross Elasticity of Demand OR Elasticity of Substitution : There is a

mutual relationship between change in price and quantity demanded of
two related goods. Change in the price of one good can cause change in the
demand for the related good. For example, change in the price of tea
ordinarily causes change in demand for coffee. The cross elasticity of
demand is the proportional change in the quantity demanded of good X
divided by the proportional change in the price of the related good Y.
Measurement of Cross Elasticity of Demand : Cross elasticity of
demand is measure by the following formula:Percentage Change in Quantity Demanded of good X
Ec =
Percentage Change in the Price of good Y
100 X Change in Quantity Demanded of X
Initial Demand of X
E =
100 X Change in Price of Y
Initial Price of Y
c
100 D Q x
Qx
E =
100 D Py
Py
c
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Py
DQx
E = X
Qx
DPy
c
DQx
Qx
DPy
Py
Ec
=
=
=
=
=
Change in the quantity of good X

Initial demand of good X
Change in price of good Y
Initial price of good Y
Cross Elasticity of Demand
Degrees of Cross Elasticity of Demand : Cross elasticity of demand can

be of three types:
1.
Positive Cross Elasticity of Demand : Cross Elasticity of demand is

positive in case of substitutes. In other words when goods are substitutes
of each other, then a given percentage rise in the price of a good will lead to
a given percentage increase in the demand for the substitute good. For
example, rise in the price of coffee will lead to increase in demand for tea,
because the two are close substitute of each other.
Price of Coffee
Ds
A
B
Ds
O
Q
Q1
Quantity fo Tea
In this figure DS DS curves represents cross elasticity of demand. In this

diagram quantity of tea is shown on OX-axis and price of coffee on OYaxis. When price of coffee is OB, demand for tea is OQ. When price of coffee
rises to OA, demand for tea increases to OQ1. This curve slopes upward
from left to right.
2.
Negative Cross Elasticity of Demand : Price Elasticity of demand is

negative in case of complementary goods. In case of complementary goods.
Percentage rise in the price of one good leads to percentage fall in the
demand for the other.
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Price of Bread
Dc
A
B
Dc
Q1
Quantity of Butter
In this figure Dc, Dc curve represents the negative cross elasticity
demand. In this diagram quantity of butter is shown on OX-axis and price
of bread on OY-axis. When price of bread is OB, demand for butter OQ1.
When the price of bread rises to OA, demand for butter decreases to OQ. It
slopes downward from left to right.
3.
Zero Elasticity of Demand : Cross elasticity of demand is zero when two

goods are not related to each other. For example, rise in the price of wheat
will have no effect on the demand for books. Their cross elasticity of
demand will be called zero.
Q.
Discuss factors which influence the Price Elasticity of demand.
Ans. Factors Determining the Price Elasticity of Demand :

(1)
Nature of the Commodity : In economics all goods are divided into three
categories:
(i)
Necessaries : Demand for necessaries like salt, kerosene oil, match

boxes etc. is less than unitary elastic or inelastic.
(ii)
Comfort Goods : Price elasticity of comfort goods ,i.e. cooler, fan

etc. is unitary
(iii) Luxuries : Price elasticity of luxuries goods is greater than unitary

elastic. Change in the price of these goods has a great impact on the
demand.
(2)
(3)
Availability of Substitutes : There are two possibilities:(i)
When Substitutes are available : The greater the number of

substitutes available for the product the greater will be its elasticity of
demand.
(ii)
When Substitutes are not available : Commodities that do not

have any substitutes have inelastic demand.
Goods with Different uses : Goods that can be put to different uses have
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elastic demand. For instance, electricity has many uses. It can be used for
heating, lighting, cooling etc. When electricity charges are high, it is used
for lighting purpose only and so its demand for other less urgent uses will
fall considerably.
(4)
Postponement of the Use : Goods whose demand can be postponed to a

future period have elastic demand. On the other hand, goods whose
demand cannot be postponed have inelastic demand.
(5)
Income of the Consumer : People having very high or very low income
have inelastic demand. On the other hand demand of middle-income
people is elastic.
(6)
Habit of the Consumer : Demand for those goods is inelastic to which

consumers become habituated e.g. cigarette, coffee, etc.
(7)
Time : Elasticity of demand tends to be more elastic in long period than

in short period. The longer the time, the more elastic will be the demand.
(8)
Complementary Goods : Goods demanded jointly or complementary

goods, have relatively inelastic demand, e.g. car and petrol, pen and ink.
Rise in the price of petrol may not contract its demand if there is no fall in
the demand for cars.
Q.
What is the Importance of Price Elasticity of Demand?
Ans. Importance of Price Elasticity of Demand :

(1)
Determination of Price under Monopoly : A monopolist always takes

into consideration the price elasticity of demand of his product while
determining its price. There are two possibilities :
(i)
(ii)
(2)
Price Discrimination : When a monopolist sells the same product at

different prices, it is called price discrimination. A monopolist can practice
price discrimination when price elasticity of demand for his product for
different uses and for different consumers is different. There are two
possibilities :
(i)
(ii)
(3)
If demand is elastic, he will fix low price per unit.

If demand is inelastic, he will fix high price per unit.
He will charge more price from those consumers whose demand is

inelastic
He will charge less price form those consumers whose demand is
elastic.
Price Determination of Joint Supply : Goods which are produced

simultaneously in the same act of production are called joint-supply
goods. Elasticity of demand of such goods is taken into consideration
while fixing their price.
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(4)
Advantage to Finance Minister : While planning new taxes, a finance

minister takes into consideration elasticity of demand:
(i)
(ii)
Taxes on goods having elastic demand will be low

Taxes on goods having inelastic demand will be high.
(5)
International Trade : The concept of elasticity of demand is also

important in the field of international trade. A country will gain by
increasing the price of exports if their demand in the importing country is
inelastic. If their demand in the importing country is elastic then the
exporting country will reduce the price.
(6)
Wage Determination : If the demand of their service of the labourers is

elastic, the possibility of getting their wages raised is less. If, on the other
hand, demand for their services is inelastic then labour unions succeed in
getting their wages increased
Q.
What do you mean by consumers equilibrium? Explain it with the

help of utility analysis?
Ans. Consumers Equilibrium : Consumers equilibrium refers to a situation

wherein a consumer gets maximum satisfaction out of his limited income and
he has no tendency to make any change in his existing expenditure.
Assumptions : Consumers equilibrium through utility analysis is based on
the following assumptions:
1.
Rational Consumer : Consumer is assumed to be rational. A rational

consumer is one who is keen to get maximum satisfaction out of his
limited income.
2.
Cardinal Utility : Utilit of every commodity can be measured in terms of

cardinal numbers, such as, 1,2,3,4 etc.
3.
Independent Utility : It is assumed that the utility derived from one

good is not depend on the utility derived from other goods.
4.
Marginal Utility of money is constant
5.
Fixed Income and Price : It is assumed that the income of the consumer
and the price of the commodity remain fixed.
6.
Tastes are Constant : Tastes of the consumer also remain unchanged.
7.
Perfect Knowledge : The consumer knows the different goods on which

he can spend his income.
Determination of Consumers Equilibrium : Consumers equilibrium

through utility analysis can be ascertained under tow different
situations :
(1)
A Single Commodity with One Use : First of all we shall study the
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equilibrium situation of a consumer who gets maximum satisfaction by

consuming a single commodity with one use. For each unit of commodity
he makes a sacrifice in terms of price. In return he gets some utility from
each unit. Obviously, a rational consumer will consume the commodity
upto a point where the marginal utility of the final unit of the commodity is
equal to the marginal utility of money paid for it.
Marginal Utility of good X =
Price of good X
Explanation : It can also be explained with the help of following table and
diagram :
Consumers Equilibrium in case of One Commodity with One Use :
Unit of X
Commodity
Marginal Utility
of X Commodity
Price of X
Commodity
OR MU of
Money
Surplus
Or
Deficit
50
20
30
40
20
20
30
20
10
20
20
10
20
-10
Supposing the price of commodity X is Rs. 1 per unit which in terms of

marginal utility is taken as equal to 20 utils. When the consumer buys 4 units
of the commodity then the marginal utility of commodity and marginal utility of
money is equal to each other. The consumer will be in equilibrium in this
situation.
Utility/Price
MU=P
50
40
30
20
10
U
1
2 3 4
Quantity
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In this figure Quantity is shown on OX-axis and Utility/Price is shown on OYaxis. MU is the Marginal Utility curve. PP is the price line. E is the equilibrium
point. The consumer is in equilibrium at point E both where marginal utility of
4 unit of commodity is equal to its price.
th
(2)
Several Commodities : When a consumer spends his fixed income on

more than one commodity, he compares the marginal utilities of different
commodities with a view to getting maximum satisfaction. Consumer
arrives at a situation where the last unit of money spent on different
commodities yields him equal marginal utility. This will be the position of
his equilibrium.The position of consumers equilibrium is also explained
with the help of following table and diagram :
Consumers Equilibrium Several Commodities : Supposing a
consumer has Rs. 5 to be spent on two commodities, X and Y. Price of
each commodity is Re. 1 per unit.
Quantity
MU of X
Commodity
MU of Y
Commodity
12
10
10
The table indicates that to be in equilibrium the consumer will spend Rs. 3 on
X-commodity and Rs. 2 on Y-Commodity as he gets equal marginal utility (8)
from the last unit of money so spen
MU of X
MU of Y
= 8 utils
12
10
8
MUx
MUy 12
10
O
5
3
1 2
Quantity of
4 3 2
Quantity of
4
X
1
Y
5
0
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In this figure Quantity is shown on OX-axis and Utility is shown on OY-axis.

MUx is the marginal utility curve of X commodity and MUy is the marginal
utility curve of Y commodity. Consumers equilibrium is at point E where the
consumer consumes 3 units of commodity X and 2 units of commodity Y and
the marginal utility (8) of both the commodities is equal.
Q.
What is an Indifference Curve? Discuss the main Properties or

Characteristics of an Indifference Curve.
Ans. Meaning of Indifference Curve : An indifference curve is a curve which

shows different combinations of two commodities yielding equal satisfaction to
the consumer. It means all the points located on an indifference curve
represent such combinations of two commodities as yield equal satisfaction to
the consumer. Since the combination represented by each point on the
indifference curve yields equal satisfaction, a consumer becomes indifferent
about their choice. In other words, he gives equal importance to all the
combinations on a given indifference curve.
Definition :
According to H.L. Varian
An indifference curve represents all combinations of two commodities
that provided the same level of satisfaction to a person. That person is therefore
indifference among the combinations represented by the points on the curve.
Indifference Schedule : An indifference schedule refers to a schedule that
indicates different combinations of two commodities which yield equal
satisfaction. A consumer, therefore, gives equal importance to each of the
combinations. In other words, he becomes indifferent towards them. The
following indifference schedule indicates different combinations of apples and
oranges yielding equal satisfaction.
Indifference Schedule
Combination of Apples
& Oranges
Apples
Oranges
10
The above schedule shows that the consumer gets equal satisfaction from
all the four combinations, namely A, B, C and D of apples and oranges.
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Indifference Curve : Indifference curve is a diagrammatic presentation of

indifference schedule. Indifference curve is shown in the following figure :
Oranges
10
9
8
7
6
5
4
3
2
1
A
B
C
D
IC
X
3
4
2
Apples
In this diagram, Quantity of apples is shown on OX-axis and that of oranges on
OY-axis. IC is an indifference curve. Different points A, B, C and D on it indicate
those combinations of apples and oranges which yield equal satisfaction to the
consumer. This curve is also known as Iso-Utility curve.
O
Indifference Map : An indifference map is that graph which represents a

group of indifference curves each of which expresses a given level of
satisfaction. Indifference map is shown in the following figure :
Oranges
Indifference
Map
Apples
Properties of Indifference Curves : The following are the main properties of

indifference curves :
(1)
An indifference Curve Slopes Downwards from Left to the Right : An

indifference curve slopes downwards from left to right, or that, its slope is
negative. This property is based on the assumption that if a consumer
uses more quantity of one good he will use less quantity of the other, then
only he will have equal satisfaction from their different combinations. This
property can be explained with the help of following diagram:
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Oranges
10
9
8
7
6
5
4
3
2
1
IC
X
2
3
4
Apples
Convex to the Point of Origin : An indifference curve will ordinarily be
convex (bowed inward) to the point of origin. Convexity of the curve means
that it bows inward to the origin. The slope of the indifference curve is
called the marginal rate of substitution because it indicates the rate at
which the consumer is willing to substitute one good for the other. This
property can be explained with the help of following diagram :
O
(2)
Oranges
10
9
8
7
6
5
4
3
2
1
IC
X
2
3
4
Apples
Two Indifference Curves Never Touch or Intersect each other : Each
indifference curve represents different levels of satisfaction, so they do not
intersect or touch each other. This property can be explained with the help
of following diagram
O
(3)
A
B
IC2
C
IC1
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In this figure two indifference curve IC and IC have been shown

intersecting each other at point A, but it is not possible. Point A and C on
indifference curve IC represent combinations yielding equal satisfaction,
that is, satisfaction from A combination = satisfaction from C Likewise,
point A and B on indifference curve IC represents combinations yielding
equal satisfaction, that is, satisfaction from A combination = satisfaction
from B combination. It implies that satisfaction from B combination is
equal to satisfaction from C combination; but it is not possible because in
B combination quantity of oranges is more than C combination,
although quantity of apples in both combinations is equal.
1
(4)
Higher Indifference Curve Indicates Higher Satisfaction : In

indifference map, higher indifference curve represents those
combinations which yield more satisfaction than the combinations on the
lower indifference curve. This property is illustrated in the following
figure:
Oranges
IC2
IC1
O
Apples
In this figure IC2 is higher and IC1 is lower indifference curve. Point B on IC2
represents more units of apples than point A on IC1 curve, although in both
combinations quantity of oranges is the same. Hence point B on IC2 will give
more satisfaction than point A on IC1.
Oranges
(5) Indifference Curve touches neither X-axis nor Y-axis : It is assumed

in the indifference curve analysis that a consumer buys combinations of
different quantities of two goods. Hence an indifference
curve touches neither OX-axis nor OY-axis. In case an
Y
indifference curve touches either axis it means that the
consumer wants only one commodity and his demand
for the second commodity is zero. An indifference curve
may touch OY-axis if it represents money instead of a
commodity, as shown in the following figure :
IC
In the above figure, IC touches OY-axis at point M. It
means the consumer has in his possession OM
quantity of money and does not want any unit of
Q
Apples
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apples. At point N consumer likes to have a combination of OQ quantity of

apples and OP units of money. This combination will yield him same
satisfaction as by keeping OM units of money.
Oranges
IC3
Sixth
After
IC2
Point
IC1
O
(6)
X
Apples
Indifference Curves need not be parallel to each other : Indifference

curves may or may not be parallel to each other. It all depends on the
marginal rate of substitution of two curves shown in the indifference map.
If marginal rate of substitution as indicated by two curves diminishes at
the same rate, then these curves(IC and IC ) will be parallel to each other,
otherwise they will not be parallel as IC and IC
1
Q.
Explain the Income Effect, Substitution Effect and Price Effect with the
help of Indifference Curves.
Ans. Introduction : Consumers equilibrium is affected by change in his

income, change in the price of substitutes and change in the price of good
consumed. The effect of changes in consumers income, the price of substitutes
or the price of the good consumed on consumers equilibrium are known as:
(A) Income Effect
(B) Substitution Effect
(C) Price Effect
(A)
Income Effect : The income effect may be defined as the effect on the
purchases of the consumer or consumers equilibrium caused by change
in his income, if relative prices remain constant. The income effect can be
studied under the following two types of goods:
(1)
Income Effect in Case of Normal Goods : Income effect of normal goods

is positive. It implies that the quantity demanded increases with an
increase in income and decrease with decrease in income. In other words,
income effect indicates that, in case of normal goods, other things being
equal increase in income increases the satisfaction of the consumer. As a
result, equilibrium point shifts upwards to the right. On the contrary,
decrease in income decreases the satisfaction of the consumer and his
equilibrium point shifts downwards to the left.
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Assumptions :
(a)
(i)
Both the goods are normal goods.
(ii)
The prices of both the goods remain constant.
Income effect of a rise in income : Income effect of an increase in

income shows that increase in income increases the satisfaction of the
consumer. As a result, consumers equilibrium point shifts upwards to
the right. It is because when the income of the consumer increase it
enables him to buy more units of the commodities at given prices. This can
be explained with the help of following figure:
ICC
Oranges
Y
C
A
E1
P1
P
Q Q1
IC1
D
B IC
Apples
In this figure, AB is the initial budget line and IC is the initial indifference
curve. Point E refers to consumers equilibrium at which the budget line
AB is tangent to indifference curve IC. At this point consumer buys OP
units of oranges and OQ units of apples. Suppose the income of the
consumer increases enabling him to buy more units of apples and
oranges. Consequently his budget line shifts upwards to the right as
shown by CD budget line. The consumer moves to a higher indifference
curve IC and his equilibrium point shifts to the right to E . At this point,
consumer will purchase more units of both the goods i.e. OP units of
oranges and OQ units of apples.
1
(b)
Income Effect of fall in Income : Income effect of decrease in income

shows that a decrease in income decreases the satisfaction of the
consumer. As a result equilibrium point shifts downwards to the left. In is
because when the income of the consumer decreases, he has to buy less
units of the commodities at given prices. This can be explained with the
help of following figure:
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Oranges
Y
A
ICC
C
E
IC
E1
P1
B
D IC1
O
Q1 Q
Apples
In this figure, AB is the initial budget line and IC is the initial indifference
curve. Point E refers to consumers equilibrium at which the budget line
AB is tangent to indifference curve IC. At this point consumer buys OP
units of oranges and OQ units of apples. Suppose the income of the
consumer decreases forcing him to buy less units of apples and oranges.
Consequently his budget line shifts downward to the left as shown by CD
budget line. The consumer moves to a lower indifference curve IC and his
equilibrium point shifts to the right to E1. At this point, consumer will
purchase less units of both the goods i.e. OP units of oranges and OQ
units of apples.
1
Income Effect in Case of Inferior Goods : Income effect in case of

inferior good is negative. It implies that quantity demanded decreases as
income increases and quantity demanded increases as income increases.
Assumptions :
(i)
(ii)
Commodity X is inferior good while commodity Y is a normal good

The prices of both the goods remain constant.
Income effect in case of inferior goods can be explained with the help of
following diagram : Y
ICC
C
Y-Commodity
(2)
IC1
E
IC
O
Q1
X-Commodity
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D X
In this figure AB is initial budget line and IC is the initial indifference curve.
Point E refers to consumer equilibrium. Point E indicates that consumer buys
OQ units of X-commodity. Suppose the income of the consumer increases.
Consequently the budget line shifts upwards to the rights as shown by CD. The
consumer moves to indifference curve IC and his equilibrium point shifts to E .
The equilibrium point E1 shows that consumer will purchase less units of Xcommodity i.e. OQ which is an inferior good. It becomes clear that when income
increases, the consumption of inferior good decreases. Similarly it can be
shown that when income decreases the consumption of inferior good increases.
1
(B)
Substitution Effect : The substitution effect may be defined as the

change in the purchase of consumer or consumers equilibrium caused by
changes in relative prices if real income remains constants. If change in
relative prices of the goods is followed by change in the monetary income of
the consumer in such a way that his real income remains constant, then
the consumer will substitute cheaper good for the dearer good.
Consequently it will affect the quantity purchased of both the goods. This
effect is known as substitution effect. Two well known measures of
substitution effect are:
(1)
Slutskys Measure : According to Slutskys measure real income is

constant if the consumer is left with an income which would enable him to
buy his original combination of goods at the new price, if he wanted to do
so. The consumer may move to a higher indifference curve due to fall in the
price of a commodity or to a lower indifference curve due to a rise in the
price of the commodity, other things being equal. This can be explained
Y-Commodity
Y
A
T
E
K
F
IC
IC2
IC1
O
M Q B T
C X
X-Commodity
Substitution Effect
In this figure, point E indicates initial equilibrium of the consumer where price
line AB and indifference curve IC are tangent to each other. The consumer buys
OM quantity of commodity X. When price of X reduces, the price line stretches
to become AC. The consumer is now in equilibrium at point K where IC1 and
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new price line AC are tangent to each other. Now we take away just enough
income (AT) to allow the consumer to purchase the original quantity of
commodity X and Y as indicated by point E. The new budget line TT is drawn
which is parallel to new price line AC and cuts across point E, the old point of
equilibrium. This line indicates that AT amount of money income is withdrawn
from the consumer, allowing him the original combination of both the
commodities. The consumer will trace his new equilibrium some where on the
line TT. Let it be point F where TT and IC2 are tangent to each other. Being in
equilibrium at point F the consumer is buying OQ quantity of X. The change in
the purchase of commodity X which is equal to MQ is Slutskys substitution
effect. The consumer will move to a higher indifference curve IC2 and his
satisfaction will increase.
(2)
Hicks Measure : According to J.R. Hicks constant real income means

that the consumer stays on the same indifference curve as before the
change in price. In other words, due to substitution effect, there will
neither be increase nor decrease in the satisfaction of the consumer. He
will only substitute the relatively cheaper goods for relatively expensive
goods. Hicks substitution effect is discussed in detail as follows :
Y-Commodity
Y
A
G
N
E
F
IC1 D
Q B
IC2
H C X
X-Commodity
Substitution Effect
In this figure AB is the original price line and IC1 is the original indifference
curve. Consumer is in equilibrium at point E. He is getting ON units of
commodity Y and OM units of commodity-X. Supposing commodity A becomes
cheaper. Consequently, AB price line will shift outwards to the right on OX-axis
as AC and be tangent to higher indifference curve IC2 at point D which will be
new equilibrium point of the consumer. If we want that real income of the
consumer should remain the same as before then we will have to take away
some of his monetary income, which should be equal to AG in this figure. Line
GH is drawn parallel to AC so that the new price ratio is not disturbed. Also, GH
is drawn tangent to IC1 as the consumer is to be brought back to the old
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indifference curve offering him the same level of satisfaction. The new price line
GH is tangent to indifference curve IC1 at point F which will be the new point of
equilibrium, with constant real income of the consumer. Being in equilibrium
at point F, the consumer will buy OQ quantity of commodity X. The change in
the purchase of commodity X which is equal to MQ is Hicks substitution effect.
The consumer is substituting MQ quantity of relatively cheaper good X for NP
quantity of relatively expensive good Y. It proves that substitution effect is
always negative.
(C)
Price Effect : The price effect may be defined as the change in the
consumption of goods when the price of either of the two goods changes
while the price of the other goods and the income of the consumer remain
constant.
Definition :
According to Lipsey :
The price effect shows how much satisfaction of the consumer varies due
to the change in the consumption of two goods as the price of one changes the
price of the other and money income remains constant.
Price effect can be explained with the help of following diagram :
Y
Oranges
A
PCC
G
S
R
P
IC1
IC
E1
E
F
IC2
C
M NT
Apples
In this figure IC is the original indifference curve and AB the original budgetline and consumer is in equilibrium at point E. When the income of the
consumer and the price of oranges remain constant but the price of apples
falls, then new budget line assumes the shape of AD which touches higher
indifference curve IC1 at point G, the new equilibrium point. In other words,
demand for apples will increase from ON to OT i.e. by NT which is what we call
Price effect of a fall in price. On the other hand if the price of apples increases,
other things remaining constant, the budget line will move inwards to AC. It
touches indifference curve IC2 at new equilibrium point F. It shows that
demand for apples will decrease from ON to OM i.e. by MN which represents
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price effect of a rise in price. By joining together different equilibrium points

Like E, F, G one gets price consumption curve (PCC).
Q.
How Income Effect and Substitution Effect is separated from Price

Effect?
Ans. Separation of Substitution Effect and Income Effect : We know when

the price of a commodity changes, it has two effects:
(1)
There is a change in the real income of the consumer leading to change in

the consumption of the consumer. It is called income effect.
(2)
Secondly, due to change in relative price, the consumer substitutes

relatively cheaper good for relatively expensive good. It is called
substitution effect. The combination of this income and substitution effect
is called price effect. Thus:
Price Effect = Income Effect + Substitution Effect
There are two different approaches relating to the separation of substitution

effect and income effect given the price effect. These are:
(A)
The Hicksian Approach : Hicksian approach for separation of

substitution effect and income effect is discussed considering following
cases. It may be noted here that substitution effect is always negative
because of the negative slope of the indifference curve, quantity demanded
always increases as the price falls and always decreases as the price rises.
In contrast, income effect is positive or negative depending in whether the
goods are normal or inferior.
(i)
Separation of Substitution Effect and Income Effect for Normal

Goods : Normal goods are those goods whose substitution effect is
negative but income effect is positive. Indeed, substitution effect is always
negative.
(a)
Separation of Substitution and Income Effects for a Normal Good in

case of Price Rise : The separation of substitution and income effect
for a normal good in case of price rise may be explained with the help
of following figure:
R
Oranges
C
A
IC1
Price Effect=SQ
Substitution Effect=TQ
Income Effect=ST
IC
O S T Q N P
Apples
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This figure shows that the LM is the original budget line. The consumer is in
equilibrium at point B on indifference curve IC. He purchases OQ units of
apples. When the price of apples rises, the budget line shifts inwards to LN. The
consumer moves to a new equilibrium position at point A on indifference curve
IC1. At this point he purchases OS units of apples. The price effect is indicated
by the movement from B to A or by the reduction in quantity demanded from
OQ to OS. In other words price effect = OQ-Os= SQ. An increase in price of
apples results in a decline in real income of the consumer as indicated by the
shifting of indifference curve IC to IC1. If the monetary income of the consumer
is increased to such an extent that he remains on his original indifference curve
IC or that his real income remains constant, the new budget line will be RP. It is
tangent to indifference curve IC at point C. It is parallel to the budget line LN
conforming to the new price ratio as indicated by LN after the price of apples
rises.
Substitution Effect is represented by the movement from the original

equilibrium point B to C, both points being situated on the same
indifference curve. The substitution effect is the reduction in the quantity
demanded of apples from OQ to OT. In other words Substitution effect =
OQ- OT = TQ
Income Effect is represented by the movement from point C to A. In other

words it will be ST
Price Effect = SQ
Substitution Effect = TQ
Income Effect = ST
Thus SQ(Price Effect) = TQ (Substitution effect) + ST (Income Effect)
Separation of Substitution Effect and Income Effect in case of a
Normal Good for a Price Fall :
Y
A
Y-Commodity
(b)
G
N
E1
E2
IC1
M
N B
IC2
T L X
X-Commodity
Substitution Effect
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In this figure AB is the original budget line and IC the original indifference
curve. Consumer is in equilibrium at point E. When price of apples falls while
the price of oranges and the income of the consumer remains constant then the
new budget line shifts from AB to AC. The new budget line touches higher
indifference curve IC1 at point E1 which is the new equilibrium of the
consumer. Movement from equilibrium point E to new equilibrium point E1
signifies the effect of changes in the price of apples. Thus price effect is MT. Fall
in the price of apples means increase in the real income of the consumer. If the
monetary income of the consumer is reduced to such an extent that he remains
on his original indifference curve IC, new budget line will be PH and new
equilibrium point E2.
Substitution Effect: It is represented by the movement from E to E2.

Income Effect is represented by the NT
Price Effect = MT
Substitution Effect = MN
Income Effect = NT
MT (Price Effect) = MN (Substitution effect) + NT (Income Effect)
(B) The Slutskys Approach : The following figure explained with the help of
following figure :
Y
Oranges
A
S
Q
T
IC2
O
IC
NB M S
Apples
IC1
C X
In this figure, initially the consumer is in equilibrium at point Q where budget

line AB and indifference curve IC are tangent to each other. Owing to the fall in
the price of Apples, price line shifts to the right to become AC. The consumer is
now in equilibrium at point R where IC1 and budget line AC are tangent to each
other. Movement from Q to R shows the change in quantity demanded of apples
from OL to OM, which is price effect (LM).
Slutsky isolates the substitution effect by withdrawing from the consumer AS
amount of money income. So that the real income of the consumer remains
constant in terms of the original combination of apples and oranges indicated
by point Q. Thus, a new budget line SS is drawn Parallel to AC but passing
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through Q. New budget line SS is tangent to IC2 at point T which emerges as the
new point of equilibrium corresponding to reduced money income, but
constant real income of the consumer. At T the consumer demands ON amount
of apples compared to the OL amount at equilibrium Q. The difference is
substitution effect (LN)
Substitution Effect = LN
Income Effect = NM
Price Effect (LM) = Substitution Effect (LN) + Income Effect (NM)
Q.
What do you mean by consumers equilibrium? Explain it with the

help of Indifference Curve Analysis?
Ans. Consumers Equilibrium : Consumers equilibrium refers to a situation

wherein a consumer gets maximum satisfaction out of his limited income and
he has no tendency to make any change in his existing expenditure. A
consumer may find out with the help of indifference curve analysis as to how he
should spend his limited income on the combination of different goods so that
he gets maximum satisfaction.
Assumptions : Consumers equilibrium through indifference curve analysis
is based on the following assumptions :
(i)
(ii)
(iii)
(iv)
Consumers income is constant

Consumer knows the price of all things.
Consumer can spend his income in small quantities
Consumer is rational and so maximizes his satisfaction from the
purchase of the two goods
(v) Consumer is fully aware of the indifference map.
(vi) Goods are divisible.
Conditions of Consumers Equilibrium : There are two conditions of

consumers equilibrium with the help of indifference curve analysis:(1)
Budget Line Or Price Line should be Tangent to Indifference Curve.
(i)
Indifference Curve : An indifference curve is a curve which shows

ifferent combination of two commodities yielding equal satisfaction to the
consumer. Supposing a consumer consumes two goods, namely apples
and oranges. The following table and diagram indicates different
combination of apples and oranges yielding equal satisfaction.
Combination of Apples
& Oranges
Apples
Oranges
10
4
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Oranges
10
9
8
7
6
5
4
3
2
1
IC
(ii)
2
3
Apples
Budget Line : The budget line is that line which shows all the different
combinations of the two commodities that a consumer can purchase given
his money income and the price of two commodities.
Explanation : Supposing a consumer has an income of Rs. 4 to be spent on

apples and oranges. Price of orange is Rs. 0.50 per orange and that of apple Rs.
1 per apple. With his given income and given prices of apples and oranges, the
different combinations that a consumer can get of these two goods are shown in
the following table and diagram:Income
Apples = Rs. 1.00
Oranges = Rs. 0.50
Four
Four
Four
Four
Four
Oranges
6
4
2
O
2
3
Apples
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B
4
(2)
Indifference curve must be convex to the origin.
Consumers Equilibrium : Consumers equilibrium can be explained with the

help of following diagram :
Oranges
A
Consumer's Equilibrium
6
D
IC2
IC1
2
E
O
2
3
Apples
IC
B
4
In this figure AB is the budget or price line. IC, IC ,IC are the indifference
curves. A consumer can buy any of the combinations, A, B,C,D and E of apples
and oranges shown on the price line AB. Out of A, B,C,D and E combinations,
the consumer will be in equilibrium at combination D (4 oranges and 2 apples)
because at this point price line is tangent to the indifference curve and
indifference curve is convex to the point of the origin.
1
Q.
Discuss critically the different methods of Demand Forecasting.
Ans. Meaning of Demand Forecasting : Demand forecasting is predicting

future demand for a product. The information regarding future demand is
essential for planning and scheduling production, purchase of raw materials,
acquisition of finance and advertising.
This problem may not be of a serious nature for small firms which supply a
very small fraction of the total demand, and whose product caters to the shortterm, seasonal demand or to demand of a routine nature. But, firms working on
a large scale find it extremely difficult to obtain fairly accurate information
regarding the future market demand. In some situations, it is very difficult to
obtain information needed to make even short-term demand forecasts and
extremely difficult to make long-term forecasts.
Methods of Demand Forecasting OR Demand Estimation : There are
various methods of estimating and forecasting demand. The techniques of
forecasting are many, but the choice of a suitable method is a matter of
purpose, experience and expertise. Demand forecasting techniques are :
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Techniques of Demand Forecasting
Survey Methods
Statistical Methods
Trend Projection
Consumer Survey
Direct Interview
Barometric
Econometric
Opinion Poll
Methods
Complete
Enumeration
Expert
Opinion
Graphical
Methods
Regression
Methods
Sample
Survey
Market
Studies
& Experiments
Least
Square Method
Simultaneous
Equations
End-Use
Method
(A)
Survey Methods : Survey methods are generally used where the purpose
is to make short-run forecast of demand. Under this method, consumer
surveys are conducted to collect information about their intentions and
future purchase plans. This method includes:
(1)
Consumer Survey Methods-Direct Interviews : The consumer survey

method of demand forecasting involves direct interview of the potential
consumers. It may be in the form of :
(a)
Complete Enumeration : In this method, almost all potential users

of the product are contacted and asked about their future plan of
purchasing the product in question. The quantities indicated by the
consumers are added together to obtain the probable demand for the
product.
Limitations :
(i)
Consumers themselves may not know their actual demand in future

and hence may be unable or unwilling to answer the query.
(ii) Even if, they answer, their answer to hypothetical questions may be
only hypothetical and not real,
(iii) Consumers response may be biased according to their own
expectations about the market conditions
(iv) Their plans may change with a change in the factors not included in
the questionnaire.
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(b)
Sample Survey : Under this method, only a few potential

consumers and users selected from the relevant market through a
sampling method are surveyed. Method of survey may be direct
interview or mailed questionnaire to the sample-consumers.
Merits :
(i)
(ii)
(iii)
(iv)
This method is simpler

This method is less costly
This method is less time-consuming
This method is generally used to estimate short-term demand.
Limitations : The sample survey method is widely used to forecast

demand. This method, however has some limitations similar to those of
complete enumerations method.
(c)
(2)
End-Use Method : The end-use method of demand forecasting has a

considerable theoretical and practical value, especially in forecasting
demand for inputs. Making forecasts by this method requires
building up a schedule of probable aggregate future demand for
inputs by consuming industries and various other sectors. In this
method, technological, structural and other changes which might
influence the demand are taken into account in the very process of
estimation.
Opinion Poll Methods : The opinion poll methods aim at collecting

opinions of those who are supposed to possess knowledge of the market,
e.g., sales representatives, sales executives, professional marketing
experts and consultants. The opinion poll methods include:
(a)
Expert-Opinion Method : Firms having a good network of sales

representatives can put them to the work of assessing the demand for
the product in the areas, regions or cities that they represent. Sales
representatives, being in close touch with the consumers or users of
goods, are supposed to know the future purchase plans of their
customers, their reaction to the market changes their response to the
introduction of a new product, and the demand for competing
products.
(b)
Market Studies and Experiments : An alternative method of

collecting necessary information regarding demand is to carry out
market studies and experiments on consumers behaviour under
actual, though controlled, market conditions. Under this method,
firms first select some areas if the representatives market. Them they
carry out market experiments by changing prices, advertisement
expenditure and other controllable variables in the demand function
under the assumption that other things remain the same.
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Limitations :
(i)
(ii)
This method is very expensive.

This method is based on short term and controlled conditions which
may not exist in an uncontrolled market.
(B)
Statistical Methods : Statistical methods include :
(1)
Trend Projection Methods : Trend projection method is a classical

method of business forecasting. This method is essentially concerned with
the study of movement of variable through time. The use of this method
requires a long and reliable time-series data. There are two techniques of
trend projection based on time-series data:
(a)
(b)
(2)
Graphical Method
Fitting Trend Equation or Least Square Method
Barometric Method of Forecasting : The barometric method of

forecasting follow the method meteorologists use in weather forecasting.
Meteorologists use the barometer to forecast weather conditions on the
basis of movements of mercury in the barometers. Following the logic of
this method, many economists use economic indicators as a barometer to
forecast trends in business activities. This method was first developed and
used in the 1920s by the Harvard Economic Service. The basic approach
of barometric technique is to construct an index of relevant economic
indicators and to forecast future trends on the basis of movements in the
index of economic indicators. The indicators used in this method are
classified as:
(i) Leading Indicators
(ii) Coincidental Indicators
(iii) Lagging Indicators.
(3)
Econometric Methods : The econometric methods combine statistical

tools with economic theories to estimate economic variables and to
forecast the intended economic variables. The forecasts made through
econometric methods are much more reliable than those made through
any other method. The econometric methods are therefore most widely
used to forecast demand for a product for a group of products and for the
economy as a whole. The econometric methods are briefly described under
two basic methods:
(a)
Regression Method : Regression analysis is the most popular

method of demand estimation. This method combines economic
theory and statistical techniques of estimation In regression
technique of demand forecasting, the analysts estimate the demand
function for a product. In the demand function, the quantity to be
forecast is a dependent variable and the variables that affect or
determine the demand are called independent variables.
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(b)
(i)
Simple Regression Technique : In simple regression

technique a single independent variable is used to estimate a
statistical value of the dependent variable.
(ii)
Multi-Variate Regression : The multi-variate regression

equation is used where demand for a commodity is deemed to be
the function of many variables or in cases in which the number
of explanatory variables is greater than one.
Simultaneous Equation Model : In explaining this model, it will be

helpful to begin with a comparison of simultaneous equation method
with regression method. Regression technique of demand forecasting
consists of a single equation. In contrast, the simultaneous
equations model of forecasting involves estimating several
simultaneous equations. These equations are, generally:
(i) Behavioural Equations

(ii) Mathematical Identities
(iii) Market-Clearing Equations
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UNIT III
Q.
Explain Law of Returns to Factors and Law of Returns to Scale.
Ans. Law of Production : The law of production describe the ways which are
technically possible to increase the level of production. The output can be
increased in various ways:
Law of Production Or Returns
Law of Return ot Factors:
Law of Returns ot Scale:
A single variable factor
All Factors are variable in

the same proportion
Other Factors Constant
Always Long Run Analysis
Generally Short Run Analysis
(A) Law of Return to a Factor : Laws of Returns mainly divided in three

parts :
1.
(i)
Law of Increasing Returns to a Factor.
(i)
Law of Constant Returns to a Factor.
(ii)
Law of Diminishing Returns to a Factor.
Law of Increasing Returns : According to the Increasing returns to a

factor, as more and more units of the variable factor are combined with the
fixed factor total output increases at a increased rate and marginal
product also increases. This tendency is also called Law of Diminishing
Costs.
Explanations : This law can be explained with the help of following table
and diagram:78
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Units of
Labour
Units of
Capital
Total
Production
Marginal
Production
10
18
28
10
40
12
Y
TP
MP
40
12
30
20
10
O 1
Units of Labour
Diagram : Increasing Returns to a Factor
2.
Law of Constant Returns to a Factor : According to the constant

returns to a factor, as more and more units of the variable factor are
combined with the fixed factor total output increases at a constant rate
and marginal product remain constant.
and diagram
Units of
Labour
Units of
Capital
Total
Production
Marginal
Production
10
15
20
25
5
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Y
25
TP
Y
MP
20
4
15
TP
MP 3
10
1
O
1
2
3
4
Units of labour
O 1
2
3
4
5
Units of labour
Diagram : Constant Returns to a factor
3.
Law of Decreasing Return to a Factor : According to the Decreasing

returns to a factor, as more and more units of the variable factor are
combined with the fixed factor total output increases at a decreasing rate
and marginal product will decrease.
and diagram :
Units of
Labour
Units of
Capital
Total
Production
Marginal
Production
10
11
Y
12
Y
5
TP
10
8
TP
MP 3
6
4
Units of Labour
O 1
MP
2
Units of Labour
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(B) Law of Returns to Scale : It is a Long run concept. All factors of

production are variable in the long period. No factor is a fixed factor.
Accordingly, scale of production can be changed by changing the quantity
of all factors.
According to Koutsoyiannis
The term returns to scale refers to the changes in output as all factors
change by the same proportion.
Aspects of Returns to Scale : There are three aspects :
(1)
(2)
(3)
1.
Increasing Return to Scale

Constant Returns to Scale.
Diminishing Returns to Scale.
Increasing Returns to Scale : Increasing returns to scale refers to the

production situation where if all factors are increased in a given
proportion, output increases in a greater proportion. Thus, if by 100 per
cent increase in factors of production, output increases by 120 percent or
more, it will be an instance of increasing returns to scale.
Increasing Returns to Scale
Y
25
20
% Increaase
in Output
15
10
5
O
10
15
20
25 30
% Increase in all Factor Inputs

2.
Constant Returns to Scale : It refers to that production situation where

of all factors of production are increased ion a given proportion, the output
produced increases in exactly the same proportion. If 25 percent increase
in factors of production is followed by 25 percent increase in output, then
it is an instance of constant returns to scale.
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Constant Returns to Scale

Y
25
20
% Increaase
in Output
15
10
5
O
10
15
20
25 30
% Increaseinalll Factor Input

3.
Diminishing Returns to Scale : It refers to that production situation

where if all the factors of production are increased in a given proportion,
the output increases in a smaller proportion. If 20 percent increase if
factor of production is followed by 10 percent increase in output, then it is
an instance of diminishing returns to scale.
Decreasing Returns to Scale
Y
25
20
% Increaase
in Output
15
10
5
O
10
15
20
25 30
% Increase in all Factor Inputs

Q.
Explain Law of Variable Proportion.
Ans. Meaning of Law of Variable Proportions : In short-period when the

output of a good is sought to be increased by way of additional application of the
variable factor, law of variable proportions comes into operation. When the
number of one factor is increased while all other factors remain constant, then
the proportion between the factors is altered. On account of change in the
proportion of factors there will also be a change in total output at different
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rates. In economics, this tendency is called Law of Variable Proportions. The

law states that as the proportion of factors is changed, the total production at
first increases more than proportionately, then equi-proportionately and
finally less than proportionately.
Definition :
According to Samuelson
The law states that an increase in some inputs relative to other fixed
input will, in a given state of technology, cause total output to increase; but
after a point the extra output resulting from the same addition of extra inputs is
likely to become less and less.
Assumptions : The law has following assumptions :
1.
2.
3.
4.
One of the factors is variable while all other factors are fixed.
All units of the variable factor are homogeneous.
There is no change in the technique of production
Factors of production can be used in different proportions.
Explanation of the Law : Law of variable proportion can be explained with the
help of following table and diagram:
Units of
Land
Units of
Labour
Total
Product
Marginal
Product
Average
Product
2.5
12
End of the First Stage Beginning of the Second Stage

1
14
2.8
15
2.5
15
2.1
End of the Second Stage Beginning of the Third Stage

1
14
-1
1.7
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st
nd
1 Stage 2
rd
Stage 3 Stage
Y
G
Product
TP
E
Product
J
AP
-ve
X
MP
No. of Labourers
Explanation : From the above Table and Diagrams drawn on the assumption
that production obeys the law of variable proportions, one can easily discern
three stages of production. These are elucidated in the following table:
Three Stages of Production
Stages
Total Product
Marginal Product
Average Product
1 Stage
Initially it increases
at an increasing rate.
Later at diminishing
rate
Initially increases and

reaches the maximum
point. The starts
decreasing
Increases and
reaches its
maximum point.
2 Stage
Increases at
Decreases and becomes After reaching its
diminishing rate and zero
maximum begins
reaches its
to dcrease
maximum point
3 Stage
Begins to fall
st
nd
rd
Becomes Negative
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Continues to
diminish
Causes of Applicability : Main causes accounting for the application of the

law of variable proportions are as follows:
(1)
Under utilization of Fixed Factor : In the initial stage of production,

fixed factor of production like land or machine, is under-utilized. More
units of variable factor, like labour are needed for its proper utilization.
Thus, as a result of employment of additional units of variable factor there
is proper utilization of fixed factor. Consequently, total production begins
to increase.
(2)
Fixed Factors of production : The principal cause of the operation of

this law is that some of the factors of production are fixed during the short
period. When the fixed factor is used with variable factor, then its ratio if
compared to variable factor falls. Production is the result of the cooperation of all factors. Consequently, marginal return of the variable
factor begins to diminish.
(3)
Optimum Production : After making the optimum use of a fixed factor if

it is combined with increasing units of variable factor, then the marginal
return of such variable factor begins to diminish.
(4)
Imperfect Substitute : It is the imperfect substitution of factors that is

mainly responsible for the operation of the law of diminishing returns.
One factor cannot be used in place of the other factor. Consequently, when
fixed and variable factors are not combined in an appropriate ratio, the
marginal return of the variable factors begins to diminish.
Postponement of the Law : Postponement of the law of variable proportion is

possible under the following conditions:
(1)
Improvement in Technique of Production : Operation of the law can be

postponed if alongwith the increase in variable factors technique of
production is improved.
(2)
Perfect Substitute : The law can also be postponed if factors of

production are made perfect substitutes, i.e., when one factor can be
substituted for the other.
Q.
Explain Internal Economies and External Economies.
Ans. Economies of the Scale : When scale of production is increased, upto a

point, one gets economies of scale. Marshall has divided economies of scale into
two parts :
Economies of Scale
Internal Economies
External Economies
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Real
Economies
1.
2.
3.
4.
5.
6.
Pecuniary
Economies
1.Economies of Concentration
2. Economies of Information
3. Economies of Disintegration
Labour Economies
Technical Economies
Inventory Economies
Selling or Marketing Economies
Managerial Economies
Transport and Storage Economies
(B) Internal Economies : When a firm increases its scale of production it

enjoys several economies. These economies are called internal economies.
Types of Internal Economies : There are two types of internal
economies:
(a)
Real Economies : Real economies are those which are associated

with a reduction in the physical quantity of inputs, raw materials,
various types of labour and various types of capital. Real economies
can be of six types :
(1)
Labour Economies or Specialization : Specialization means to

perform just one task repeatedly which ,makes the labour highly
efficient in its performance. This adds to the productivity and
efficiency of the labour.
(2)
Technical Economies : Technical economies are those economies

which are related with the fixed capital that includes all types of
machines & plants. Tecnhical economies are of three types:(i) Economies of Increased Dimension
(ii) Economies of Linked Processes
(iii) Economies of the use of By-Product.
(3)
Inventory Economies : A large size firm can enjoy several types of

inventory economies, a big firm possess large stocks of raw material.
(4)
Selling Or Marketing Economies : A firm producing a large scale

also enjoy several marketing economies in respect of sale of this large
output.
(5)
Managerial Economies : A firm producing on large scale can

engage efficient & talented managers.
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(6)
Transport and Storage Economies : A firm producing on large

scale enjoys economies of transport & storage.
(b)
Pecuniary Economies : Pecuniary economies are economies

realized from playing lower prices for the factors used in the
production and distribution of the product due to bulk-buying by the
firm as its size increases.
(B)
External Economies : External economies refer to all those benefits and

facilities which are available to all the firms of a given industry.
(1)
Economies of Concentration : When several firms of an industry

establish themselves at one place, then they enjoy many benefits together,
e.g., availability of developed means of communications and transport,
trained labour, by products, development of new inventions pertaining to
that industry etc.
(2)
Economies of Information : When the number of firms in an industry

increase, then it becomes possible for them to have concerted efforts and
collective activities.
(3)
Economies of Disintegration : When an industry develops, the firms

engaged in its mutually agree to divide the production process among
themselves.
Q.
What is Producers Equilibrium? How optimum factor combination

can be achieved.
OR
Q.
Explain Optimum Input combination.
Ans. Producers Equilibrium : The producers equilibrium refers to the

situation in which a producer maximizes his profits. In other words the
producer is producing given amount of output with least cost combination of
factors. The least cost combination of factor s also called optimum combination
of the factor or input. Optimum combination is that combination at which
either
(i)
The output derived from a given level of inputs is maximum OR
(ii) The cost of producing a given output is minimum.

Conditions of Producers Equilibrium : There are two conditions of
producers equilibrium:(1)
At the point of equilibrium the Isocost line must be tangent to

Isoquant curve.
i)
Isoquant Curve:- The isoquant curve is a technical relation showing

how inputs are converted into output. In other words, isoquant curve
is that curve which shows the different possible combination of two
factors inputs yielding the same amount of output.
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Explanation : An isoquant curve can be explained with the help of

the following isoquant schedule and curve showing different possible
combination of two factors (labour and capital) for a given level of
output.
Combinations
Capital
Labour
Output (watches)
90
10
100
60
20
100
40
30
100
30
40
100
100
90
80
Capital
70
60
50
40
IQ
30
20
10
O
10
20
Labour
30
40
The table and curve shows 100 watches can be produced by combining
90 units of capital and 10 units of labour

ii) Isocost Line : An isocost line is that line which shows the various
combination of factors that will result in the same level of total cost. It refers to
those different combinations of two factors that a firm can obtain at the same
cost.
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Explanation Isocost line can be explained with the help of table and
diagram. Suppose the producers budget for the purchase of labour and
capital is fixed at Rs. 100. Further suppose that a unit of labour cost the
producer Rs. 10 while a unit of capital Rs. 20.
Total Expenditure
Labour = Rs. 10
Capital = Rs. 20
100
10
100
100
100
Y
5
Capital
4
3
2
1
(2)
B
0 1 2 3 4 5 6 7 8 9 10
Labour
At the point of tangency the Isoquant curve is convex to the origin.
Explanation
Equilibrium :
of
Optimum
Input
Combination
There are two conditions of producers

equilibrium :
(2)
At the point of equilibrium the

Isocost line must be tangent to
Isoquant curve.
At the point of tangency the
Isoquant curve is convex to the
origin.
Producers equilibrium can be explained

Producers
C
A
Capital
(1)
Or
R M
E
N
S
O
IQ1
IQ
L
Labour
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In this figure AB is the isocost line. IQ, IQ are the isoquant curves. A producer
can buy any of the combinations, A, B,C,D and E of Labour and Capital shown
on the isocost line AB. Out of A, B,C,D and E combinations, the producer will be
in equilibrium at combination D (OL units of Labour and OK units of Capital)
because at this point isocost line is tangent to the isoquant curve and isoquant
curve is convex to the point of the origin.
1
Q.
What is the Cost of Production? Also Explain the Concepts of Cost.
Ans. Cost of Production : In order to produce a good, every firm, makes use of
factors of production. The amount spent on the use of factors of production is
called cost of production. Cost of production mainly depends on the quantity of
production. Therefore:
C
= f(Q)
It will be read as cost is a function of quantity

Concepts of Cost :
(1)
Explicit Cost : Many inputs are bought or hired by the firm. The
monetary payments which a firm makes to those outsiders who supply
inputs are called explicit costs.
For Example :
Wages to Labourers
Cost of Raw Material
Interest on loans etc.
Types of Explicit Costs : Explicit costs may be classified into two types
according to the time.
Types of Explicit Costs
Cost in Short-Run
Total Cost
Cost in Long-Run
Average Cost
Marginal Cost
Total Fixed Cost
Average Fixed Cost
Total Variable Cost
Average Variable Cost

Long-Run
Total Cost
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Long-Run
Average Cost
Long-Run
Marginal Cost
(2)
Implicit Costs : Many inputs are self owned and self employed by the
firm. The firm does not have to make any payment for them to anyone, but
it foregoes the opportunity to receive payments from someone else to
whom it could sell or lease out self owned resources. The cost of using
resources owned by the firm or contributed by its owners is called implicit
cost.
(3)
Opportunity Costs : The concept of opportunity cost is extremely

important in economic analysis. We know that the cost is the value of
inputs in the process of production. An input has got value because it s
scarce or limited. If we use the input to produce one good, it is not available
to produce something else. The cost of producing one thing is measured in
terms of what was given up in terms of next best alternative that is
sacrificed. If several opportunities are given up for producing a particular
commodity, it is the value of the next best foregone opportunity that
constitutes cost. Thus it is called opportunity cost.
The opportunity cost is the cost of next best alternative foregone. It is also
called alternative cost.
Q.
Define Short Run Total Cost. Also explain the relationship between
Total Cost, Variable Cost and Fixed Cost.
Ans. Total Cost : Total cost is the cost of all resources necessary to produce
any particular level of output. Since in the short run we classify factors into
fixed and variable categories, we break up the firms total cost of production in
the same way.
TC= TFC+TVC
TC = Total Cost
TFC = Total Fixed Cost
TVC = Total Variable Cost
There are three aspects of Total Cost :
(1)
Total Fixed Cost : The cost of fixed inputs are called fixed costs. Fixed
costs are costs which do not change with changes in the quantity of
output. Production may be maximum or zero unit, fixed cost remain the
same. The fixed cost is calculated by the following formula:
TFC = Units of Fixed Factors
Price of the Factor
Example : Rent, Depreciation etc.

Total Fixed Cost is also explained with the help of following table a
diagram:
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Fixed Cost
(Rs.)
10
10
10
10
10
10
10
10
10
Fixed Costs
Y
F
10
Cost
Quantity of
Output
0
1
2
3
4
5
6
7
8
6
4
2
0 1 2 3 4 5 6 7 8 9 10
Units of Output
In this figure units of output are shown on OX-axis and costs of production on
OY-axis. FC line represents fixed costs. It is parallel to OX-axis, signifying that
cost remains fixed whether output is more or less. FC line touches OY-axis at
point F, it means even when output is zero, fixed cost remains Rs. 10.
Total Variable Costs : Variable costs are those costs which are incurred
on the use of variable factors of production. Variable costs vary with the
level of output. If output falls these costs also fall and if output rises these
costs also rise. If the output is zero, variable cost will be zero. Some
example of variable costs are :
(i) Expenses on Raw Materials
(iii) Electricity charges etc.
(ii) Wages of Labour
Variable cost can also be explained with the help of table and diagram :
Quantity of
Output
Fixed Cost
(Rs.)
10
18
24
28
32
38
46
62
Y
F
50
VC
40
Cost
(2)
30
20
10
0 1 2 3 4 5 6 7 8 9 10
Output
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In this figure units of output are shown on OX-axis and costs of production
on OY-axis. VC line represents Variable cost. When output is zero, variable
costs are zero. Upward sloping VC curve signifies that output increases,
variable costs also increase.
(3)
Total Cost : Short run total cost is the sum of total fixed cost and total
variable cost.
Quantity of
Output
Q.
Fixed
Cost (Rs.)
Variable
Cost(Rs.)
Total
Cost (Rs.)
10
10
10
20
10
18
28
10
24
34
10
28
38
10
32
42
10
38
48
10
46
56
10
62
72
Define Short-Run Average Cost OR Average Cost.
Ans. Average : Average cost is the cost per unit of output. It is also called unit
cost of production. There are three aspects of average cost :
(1)
Average Fixed Cost : Average fixed cost is per unit fixed cost. It is total
fixed cost divided by output.
TFC
AFC=
Q
AFC = Average Fixed Cost
TFC = Total Fixed Cost
Q
= Quantity of output
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Quantity of
Output
(2)
Fixed
Cost (Rs.)
Average Fixed
Cost(Rs.)
10
10
10
10
3.3
10
2.5
10
10
1.7
10
1.4
10
1.2
Average Variable Cost : Average variable cost is per unit variable cost. It
is total variable cost divided by output.
TVC
AVC =
Q
AVC
TVC
Q
Quantity of
Output
= Average Variable Cost

= Total Variable Cost
Variable
Cost (Rs.)
Average Variable
Cost (Rs.)
10
10
18
24
28
32
6.4
38
6.3
46
6.6
62
7.8
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(3) Average Total Cost : The average total cost is the total cost per unit of
output. We can also define it as the sum of average fixed cost and average
variable cost.
TC
AC= = AFC + AVC
Q
AC
= Average Cost
TC
= Total Cost
AFC
= Average Fixed Cost
AVC
= Average Variable Cost.
Quantity of
Output
Q.
Average Fixed
Cost (Rs.)
Average
Variable
Cost (Rs.)
Average Total
Cost (Rs.)
10
10
20
14
3.3
11.3
2.5
9.5
6.4
8.4
1.7
6.3
1.4
6.6
1.2
7.8
Define Marginal Cost.
Ans. Marginal Cost : Marginal Cost is the increase in total cost when output is
increase by one unit. Marginal Cost is determining by dividing change in total
cost by change in output.
DTC
MC =
DQ
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DTC = Change in Total Cost
DQ = Change in Output
For Example : Total cost of 5 units of commodity is Rs. 135. When 6 units are
produced, total cost of production goes upto Rs. 180. Thus, Marginal Cost:
DTC
MC =
DQ
45
MC = = 45
1
Quantity of
Output
Q.
Total Cost
(Rs.)
Marginal Cost
(Rs.)
20
20-0=20
28
28-20=8
34
34-28=6
38
38-34=4
42
42-38=4
48
48-42=6
56
56-48=8
72
72-56=16
Define Long Run Cost Curves.
Ans.Cost in Long Run : The long run is the period of time in which all inputs
are variable. There are three concepts of costs in the long run, namely
(1)
Long Run Total Cost : Since all inputs are variable in the long run, there
is only one long run total cost curve. The long run total cost is the
minimum cost at which each level of output can be produced. In the long
run firm can produce a given level of output at the minimum cost since it
has sufficient time
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(i)
(ii)
To select the optimum plant size.

To select the least cost factor proportion.
This means that the long run total cost is always less than or equal to short
run total cost, but it is never more than short run total cost. It can be explained
with the help of the following formula:
LTC<STC
Long run total cost is less than or equal to short run total cost.
Y
Cost
LTC
Output
In this figure LTC represents long run total cost. The following are the
main features :
(i)
Long run total cost curve begins from the point of origin O while short run
total cost begins from any point on OY-axis.
(ii)
Long run total cost curve has a positive slope. It costs more to produce
more.
(2)
Long Run Average Cost OR Envelope Curve : Long run average cost
refers to minimum possible per unit cost of producing different quantities
of output in the long period.
LTC
LAC =
Q
LAC
= Long run average cost
LTC
= Long run total cost
= Quantity
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SA
C4
SA
C3
SA
LAC
Cost
SA
SAC1
C2
C5
Output
In this figure long run average cost curve has been shown. Long run average
cost curve is tangent to each short run average cost curve at some point. This
cost curve is also called Envelope Curve.
(3)
Long Run Marginal Cost : In the long run change in the total cost due to
production of one-more or one-less unit of a commodity, is called long run
marginal cost.
Y
Cost
LMC
Output
In this figure LMC is long run marginal cost curve. It first reaches a
minimum and then rises.
Q.
Define Perfect Competition Market. Also explain the equilibrium of

the firm in the short run and long run under perfect competition.
Ans. Perfect Competition Market : Perfect competition is that situation of

the market in which there are large number of buyers and sellers of
homogeneous product. Under perfect competition, price of the commodity is
determined by the industry. In perfect competition market firm is a price-taker
and not a price-maker.
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Assumptions or Features of Perfect Competition : Main assumptions or

features of perfect competition are as under :
(1)
Large number but small size of Buyers and Sellers : The number of
buyers and sellers of a commodity is very large under perfect competition,
but each buyer and each seller is so small in comparison with the entire
market of the product, that by changing the quantity of the product
bought and sold by him, he cannot influence its price.
(2)
Homogeneous Products : The other features of perfect competition is

that all sellers sell homogeneous units of a given product. It is not possible
to make any distinction between the units of the commodity being sold by
different sellers.
(3)
Perfect Knowledge : Buyers and Sellers are fully aware of the price of the
product. Buyers have perfect knowledge about the price being charged by
the sellers for a given product. Sellers also know well, where and from
which buyer, they can charge more price. Because of this knowledge and
awareness, all sellers will charge one price for one product from all buyers
without any distinction.
(4)
Free Entry and Exit of Firms : Under perfect competition, in the longrun, any new firm can enter any industry and any old firm can withdraw
from any industry. There is no legal restriction on the entry of new firms
into any industry.
(5)
Lack of Selling Cost : Under perfect competition, a seller does not spend
on advertisement and publicity etc. It is so because all firms sell
homogeneous product.
(6)
Same Price : Under Perfect competition market, each seller charges the
same price for the same product. Price is determined by the industry. All
firms have to sell their products at this price.
(7)
Average Revenue and Marginal Revenue Curve : Under perfect

competition, average revenue curve is equal to marginal revenue
curve(AR=MR). Therefore both curves are parallel to OX-axis.
Revenue/
Cost
AR=MR
Output
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Meaning of Firms Equilibrium : A firm is in equilibrium when it is satisfied

with its existing amount of output. A firm in equilibrium has no tendency either
to increase or to decrease its output.
Equilibrium of the Firm : Equilibrium of the firm can be studied by two
approaches:
(1)
(2)
(1)
Total Revenue and Total Cost Approach

Marginal Cost and Marginal Revenue Approach
Total Revenue and Total Cost Approach : According to this approach,

profit is the difference between total revenue and total cost. This approach
can be explained with the help of following diagram:
TC
Break-Even Point
TR
B
Revenue/
Cost/Profit
M1
M
Output
M2
TP
Marginal Revenue and Marginal

Cost Approach : According to this
approach, a firm is in equilibrium
when two conditions are fulfilled:
(i) Marginal Cost should be equal
to Marginal Revenue (MC=MR)
(ii) MC curve cuts MR curve from
below
These conditions are also explained

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Equilibrium
MC
E
Cost/Revenue
(2)
AR=MR
MC=MR
MC=MR
Output
Both the conditions of firms equilibrium are explained with the help of this
figure. In this figure PP is the average revenue as well as marginal revenue
curve. It is clear from this figure that MC curve is cutting MR curve PP at two
points A and E. MC curve represents marginal cost. But both conditions of
equilibrium are satisfied at point E.
Determination of Equilibrium of the Firm : Firms equilibrium are studied
into two sections :
(A)
(B)
Short-Run Equilibrium of the Firm

Long-Run Equilibrium of the Firm.
(A)
Short Run Equilibrium of the Firm : A firm in short run equilibrium

may face any of the three situations :
(1)
Super Normal Profits(AR>AC) : A firm is in equilibrium when its

marginal cost is equal to marginal revenue and marginal cost curve cuts
marginal revenue from below. A firm is in equilibrium earns super normal
profit, when average revenue is more than its average cost. It can also be
explained with the help of following diagram
Super-Normal Profit (AR>AC)
MC
Cost/Revenue
AC
P
B
P
A AR=MR
Super-Normal
Profit
O
Output
In this figure, output of the firm is shown on OX-axis and cost/revenue on OYaxis. MC is the marginal cost and AC is average cost curve. PP is the average
revenue and marginal revenue curve (MR=AR). Supposing OP is the price
determined by the industry. At this price, firms equilibrium will be at point E,
where marginal cost is equal to marginal revenue and marginal cost curve cuts
marginal revenue curve from below.
Equilibrium output is OM. At this output AR (price) = EM and AC= AM. Since
AR (EM) > AC (AM), firm is earning EA super normal profit per unit of output.
Per Unit super normal profit
Total Super- Normal Profit
= EA
= EABP
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(2)
Normal Profits (AR=AC) : Normal profits cover just the reward for
entrepreneurial services and are included in the cost of production. So
that, a firm in equilibrium earns normal profits when its average cost is
equal to the average revenue i.e. AC=AR
MC
Y
Revenue/Cost
AC
E
AR=MR
Normal Profit
M
Output
marginal revenue curve from below. The firm earns normal profits at
equilibrium output because its average cost and average revenue are equal.
Normal Profits = MC = MR= AC= AR.
Minimum Loss (AR<AC) : A firm in equilibrium may incurr minimum
loss when the average cost is more than the average revenue and average
revenue is equal to average variable cost. Even if, the firm discontinues its
production, in the short run, it will have to bear the loss of fixed costs. Loss
of fixed costs is the minimum loss of the firm.
Y
Revenue/Cost
(3)
Loss
MC
A
AR=MR
Output
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AC
marginal revenue curve from below.
At equilibrium point AN (AC) is more than EN(AR). In other words, average cost
is more than average revenue by AE which represents per unit loss. As such
firms total loss is AEPB.
Per Unit Loss
Total Loss
(B)
= AE
= AEPB
Long-Run Equilibrium of the Firm : In the long-run also, the firm will
be in equilibrium when:
(i)
LMC=MR
(ii)
LMC cuts MR from below.
In the long run, ordinarily all firms in equilibrium will be earning only normal
profits.
Normal Profit
LMC
Y
Revenue/Cost
LAC
E
Output
AR=MR
In this figure LAC is the long run average cost curve and LMC is the Long run
marginal cost curve. At op price determined by the industry, the firm will be in
equilibrium at point E and OM will be equilibrium output and OP equilibrium
price. At this point AR=LAC i.e. normal profits.
Q.
Explain the short-run and long-run equilibrium of the Industry in

Perfect Competition Market.
Ans. Meaning of Industry : the group of firms producing homogenous

products is called industry. Such firms are found only under perfect
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competition. An industry is in equilibrium when it has no tendency to change

its size.
Conditions of an Industrys Equilibrium : There are two conditions of an
industrys equilibrium:
(i)
Constant number of firms : An industry will be in equilibrium

when the number of its firms remains constant. In this situation, no
new firm will enter and no old firm will leave the industry.
(ii)
Equilibrium of firms : Another condition of an Industrys

equilibrium is that all firms operating in it are in equilibrium and
have no tendency either to increase or to decrease their output.
Conditions of equilibrium of firm are:
MC=MR
MC curve cuts MR curve from below
Equilibrium of Industry : Equilibrium of industry are studied into two

sections:
Short Run Equilibrium of the Industry : The industry is in equilibrium
at that price at which quantity demanded is equal to quantity supplied.
But for industry to be in full equilibrium, in the short run, is very rare. Full
equilibrium position is possible only when all firms earn just normal
profit. But in the short run, some firms may be earning super-normal
profit and others may be incurring losses.
(A)
Short-run equilibrium is explained with the help of following diagram
Revenue/Cost
(A)
Y
(B)
E
S
P
A
E
AR=MR
SAC
Loss
T
B
MC
Y
SAC
Profit
MC
(C)
R
T
E
AR=MR
D
Q
Output
M
Output
Output
In this figure, DD is the demand curve and SS the supply curve of industry.
They both intersect at point E. So point E, indicates equilibrium of industry.
In this case OP is the equilibrium price and OQ is the equilibrium output.
But it will not be full equilibrium of industry, if some firms are getting super
normal profit and others are incurring losses. In Figure(B) the firm is getting
super normal profit at the prevailing price OP as shown by ABEP shaded
area. Figure(C) firm is incurring losses at the prevailing price OP as shown
by PERT shaded area.
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In short, the industry is in equilibrium at that price at which the demand for
and supply of its production are equal. But in the position of equilibrium of
industry, the firms may earn super normal profit or incur losses. As such,
industry is ordinarily not in full equilibrium in short period.
Long-run Equilibrium of the Industry : In the long run, an industry is
in equilibrium when its firms are earning normal profit. Long run
equilibrium of the industry means that no new firm has a tendency to
enter it nor any old firm has a tendency to leave it. Long run equilibrium is
explained with the help of following diagram:
Revenue/Cost
D
S
E
S
O
LMC
Revenue/Cost
(B)
D
Q
Output
LAC
E
AR=MR
Output
In this figure, DD is demand and SS is supply curve of the industry. Both

intersect each other at point E. Thus E is the equilibrium point of the industry,
that determines OP as the equilibrium price. It indicates that firms are getting
only normal profits.
Q.
What do you mean by Monopoly? How are the price and output
determined under it?
Ans. Monopoly : Monopoly is the market structure in which a single firm is

the sole producer of a product for which there are no close substitutes. Since
the monopoly is the only seller in the market, it has no competitors. The
monopolist is the price maker. Its demand curve slopes downward to the right.
Example : For example, you get your electricity supply from one agency, that
is, State Electricity Board; you travel by railway train owned and run by
government of India. All these are examples of Monopoly.
Definition :
According to Koutsoyiannis :
Monopoly is a market situation in which there is a single seller, there are
no close substitutes for commodity it produces, there are barriers to entry.
Features or Assumptions of Monopoly :
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(1)
One seller and large number of buyers : Under monopoly there should
be a single producer of the commodity. He may be a sole-proprietor or
there may be a group of partners or a joint-stock company or a state.
(2)
Monopoly is also an Industry : Under monopoly situation, there is only

one firm. There is no difference between the study of a firm and industry.
(3)
Restrictions on the entry of the new firms : Under monopoly, there are
some restrictions on the entry of new firms into monopoly industry. These
barriers may take several forms as:
Patent rights
Government Laws etc.
(4)
No Close Substitutes : The commodity produced by the firm should have

no close substitute.
(5)
Price Maker : A monopolist is a price maker. A price maker is one who

has got control over the supply of the product. A monopolist has full
control over the supply of the commodity.
(6)
Price Discrimination : A monopolist may be able to charge different

prices for the same product from different customers.
(7)
Average Revenue and Marginal Revenue : Under monopoly, average

revenue and marginal revenue curves are separate from one other. Both
slope downwards. It can also be explained with the help of following
diagram
Revenue
AR
O
MR
Output
Determination of Price and Equilibrium under Monopoly : Under

monopoly, price and equilibrium are determined by two different approaches:
(1)
(2)
(1)
Total Revenue and Total Cost Approach

Marginal Revenue and Marginal Cost Approach
Total Revenue and Total Cost Approach : Monopolist can earn

maximum profit by selling that amount of output at which difference
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between total revenue and total cost is maximum.

Profit = Total Revenue Total Cost
This approach can be explained with the help of following diagram
Y
TC
C
TC
Revenue/Cost/Profit
TR
TP
Output
Marginal revenue and Marginal Cost Approach : According to this

approach, a monopolist will be in equilibrium when two conditions are
fulfilled:
(i)
MC=MR
(ii) MC curve cuts MR curve from below.
This approach can also be explained with the help of following diagram:
Y
Revenue/Cost
(2)
E
AR
MR
Output
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(A)
Price determination under short-period or Short-Run Equilibrium :

Short run refers to that period in which time is so short that a monopolist
cannot change fixed factors, like machinery, plant etc. Monopolist can
increase his output in response to increase in demand by changing his
variable factors.
A monopolist may face three situations in short period :
(1)
Super-Normal Profits : If the price fixed by the monopolist in equilibrium

is more than his average cost, then he will get super normal profits
Revenue/Cost
C
D
Super- Normal Profit
MC
AC
B
E
AR
MR
Output
In this figure, the monopolist is in equilibrium at point E, because at this point

marginal cost is equal to marginal revenue and MC cuts MR from below. The
monopolist will produce OM units of output and sell it at AM price, which is
more than average cost BM by AB per unit. AB is the super normal profit per
unit.
Average Revenue Per Unit= AM
Average Cost Per Unit= BM
Super-Normal Profit per unit= AM-BM = AB
Total Super Profit = ABDC
(2) Normal Profit : If the price fixed by the monopolist in equilibrium is equal
to his average cost, then he will earn only normal profits.
Revenue/Cost
Normal Profit
MC
A
AC
P
E
AR
MR
O
Output
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monopolist will produce OM units of output and sell it at AM price, which is
equal to average cost AM. Monopoly firm, therefore, earns only normal profit in
equilibrium situation.
Average Cost Per Unit= AM
Normal Profit AR=AC
(3)
Minimum Loss : In short run, the monopolist may incurr loss also. If in
the short run price falls due to depression or fall in demand, the
monopolist may continue his production so long as the low price covers
his average variable cost (AVC). In case the monopolist is obliged to fix a
price which is less than average variable cost, then he will prefer to stop
production. Thus Minimum loss = AC-AVC. This can be explained with the
help of following diagram:
Revenue/Cost
AC
MC
N
A
P
P1
AVC
E
O
Output

monopolist will produce OM units of output and sell it at AM price, which is less
than his average cost NM. Monopoly firm, therefore, incurs minimum loss in
equilibrium situation.
Average Cost Per Unit= NM
Minimum Loss = NM-AM = AN
OR Minimum Loss = AC-AVC= NM AM = AN
(B)
Price determination under long-period or Long-run Equilibrium : In the

long run, the monopolist will be in equilibrium at a point where his long
run marginal cost is equal to marginal revenue. In long run price is more
than the long run average cost. If price is less than long run average cost,
the monopolist would like to close down the unit rather than suffer the
loss. In the long run a monopolist earns super normal profit.
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Revenue/Cost

LMC
C
D
LAC
A
B
E
MR
AR
Output
In this figure, point E indicates the equilibrium of the monopolist. At point E,

MR = LMC, hence OM is the equilibrium output and AM is the equilibrium
price. BM is the long run average cost. Price AM being more than long run
average cost BM, the monopolist will get super normal profit.
Super-Normal Profit per unit= AM-BM = AB
Total Super Profit = ABDC
Q.
Explain Price Discrimination.
Ans. Price Discrimination : A monopolist often charges different prices of the

same product from different customers. This price policy of the monopolist is
called price discrimination. The monopolist practicing it is called
discriminating monopolist.
Definition :
According to Koutsoyiannis
Price discrimination exists when the same product is sold at different
prices to different buyers.
Kinds of Discriminating Monopoly : Price discrimination is mainly of three
types:
(1)
Personal Price Discrimination : When a monopolist charges different

price from different customers for the same product, then it is called
personal price discrimination. Personal price discrimination becomes
possible because of the ignorance of the customer, little difference in price
etc.
(2)
Geographical Price Discrimination : When a monopolist charges

different price in different areas for the same product, then it is called
geographical price discrimination. Places where demand is elastic, he
charges low price and where demand is inelastic he charges high price.
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(3)
Price Discrimination according to Use : When a monopolist charges

different prices for different uses of a product, then it is called price
discrimination according to use. For example, rate of electricity charge per
unit for domestic use and commercial purpose are different.
Effects of Price Discrimination : Price discrimination has beneficial as well

as harmful effects on the society. Its effects are therefore studies under two
parts:
(1)
(2)
Q.
Beneficial Effects : Its main beneficial effects are as under :

(i)
Beneficial to the Poor : If the price of a commodity is fixed low as to

benefit the poor and the loss thus suffered is recovered by charging
high price from well-to-do customers, then such a discrimination will
be beneficial to the society as a whole.
(ii)
Public Utility Services : There are many ordinary services which

cannot be made available without resorting to price discrimination,
e.g., the service of railway department. If there is no price
discrimination, then every section of the society may not be able to
avail of these services according to its need.
Harmful Effects : Main harmful effects are as under :

(i)
No Proper use of factors of production : Proper use of factors of

production is not possible. Monopolists are more inclined to produce
luxury goods because of greater scope of price discrimination in their
production. Consequently, production of necessaries falls causing
great hardship to the weaker sections of the society.
(ii)
Less Production : Price discrimination also proves harmful when

monopolists deliberately restrict production and enhance the price in
order to maximize their profits.
What is Monopolistic Competition? How price and output are

determined under it?
Ans. Monopolistic Competition : Monopolistic competition is a market

structure in which there are many sellers of a commodity, but the product of
each seller differs from that of the other sellers in one respect or the other. Thus
product differentiation is the characteristic feature of monopolistic
competition.
Example : Firms producing variety of tooth pastes, such as, forhans, colgate,
cibaca, etc. are examples of monopolistic competition.
Definition :
According to J.S.Bains
Monopolistic competition is market structure where there is a large
number of small sellers, selling differentiated but close substitute products.
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Assumptions or Features of Monopolistic Competition :

(1)
Large Number of Buyers and Sellers : Under monopolistic competition

there are large number of firms producing differentiated product and also
large number of buyers.
(2)
Product Differentiation : Product differentiation is a salient feature of

monopolistic competition. Product differentiation refers to that situation
wherein the buyer can distinguish one product from the other in one way
or the other.
(3)
Freedom of Entry and Exit of Firms : As in case of perfect competition,

there is no restriction on the entry and exit of firms.
(4)
Selling Costs : Each firm spends a lot of funds on advertisement and

publicity of its products. With a view to selling more and more units of the
product it gives wide publicity of its products in:
Newspapers
Cinemas
Radio
T.V. etc.
Journals
(5)
Price Control : Each firm has limited control on the price of its product.
Average and marginal curves of a firm under monopolistic competition
slope downwards as in case of monopoly. It means if a firm wants to sell
more units of its product it will have to lower the price per unit.
(6)
Imperfect Knowledge : Buyers and sellers lack perfect knowledge about

the price of the product. Because it is not possible to compare the products
of different firms due to product differentiation.
(7)
Non-Price Competition : Under monopolistic competition different

firms may compete with one another without changing the price of the
product. Under non-price competition, firms compete with each other in
offering free gifts and other services to attract more and more customers.
Such a competition is called non-price competition.
(8)
Group : Under monopolistic competition , there are many firms

producing a commodity. The aggregate of such firms is known as Group.
(9)
Marginal Revenue and Average Revenue Curves : Under monopolistic

competition marginal revenue and average revenue curve are as under:
Revenue/Cost
MR
O
Output
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AR
X
Price and Equilibrium under Monopolistic Competition : Under

monopolistic competition, there are many firms producing a commodity. The
aggregate of such firms is known as Group. In case of monopolistic
competition, price and equilibrium of the firm and the group will be studied in
two parts:
(1)
(2)
(1)
Firms Equilibrium
Groups Equilibrium
Firms Equilibrium : Even under monopolistic competition aim of each

firm is to get maximum profit. Profit is maximum when:
(i)
(ii)
MC=MR
MC curve cuts MR from below.
Study of firms equilibrium under monopolistic competition is made under

two different time period:
(A)
Short Run Equilibrium : Short run refers to that time period in which
production can be changed by changing variable factors of production.
There is no time available either to increase or decrease the fixed factors of
production lime machines, plants, etc. In the short period, the firms may
face three situations:
(1)
Super Normal Profit : If the average revenue is greater than average cost,
then it is called super normal profit.
Revenue/Cost
AR per Unit = AM
AC per Unit = BM
Super-Normal Profit = AB
Total Super Normal Profit = ABCD
MC
D
C
AC
A
B
E
AR
MR
Output
This figure shows that firm is in equilibrium at point E, because at this point
MC=MR. Point E indicates that the firms equilibrium output is OM. AR of
equilibrium output is AM. This equilibrium average revenue is greater than
average cost BM. Hence the firm earns super normal profit equivalent to the
different between AM and BM , .i.e. AB per unit.
(2)
Normal Profit : If the price fixed by the firm in equilibrium is equal to his
average cost, then he will earn only normal profits.
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Revenue/Cost
Normal Profit
AC
MC
A
AR
MR
O
Output
In this figure, the firm is in equilibrium at point E, because at this point

firm will produce OM units of output and sell it at AM price, which is equal to
average cost AM. Firm, therefore, earns only normal profit in equilibrium
situation.
Average Cost Per Unit= AM
Normal Profit AR=AC
(3)
Minimum Loss : In short run, the firm may incurr loss also. It is the
minimum loss of the firm. If in the short run price falls due to depression
or fall in demand, the firm may continue his production so long as the low
price covers his average variable cost (AVC). In case the firm is obliged to
fix a price which is less than average variable cost, then he will prefer to
stop production. Thus Minimum loss = AC-AVC. This can be explained
with the help of following diagram:
Revenue/Cost
Loss
MC
AC
AVC
B
A
C
D
E
MR
AR
Output
In this figure, the firm is in equilibrium at point E, because at this point

firm will produce OM units of output and sell it at AM price, which is less than
his average cost BM. Firm, therefore, incurs minimum loss in equilibrium
situation.
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Minimum Loss = BM-AM = AB
Total Minimum Losses = BADC
(B)
Long Run Equilibrium : Long period is that time period in which every
firm can change its production capacity in response to change in demand.
In the long run firms earn normal profit only
Normal Profit
LMC
LAC
A
Revenue/Cost
AR
MR
O
Output
Group Equilibrium : Under perfect competition there are large numbers

of firms producing homogeneous products. Collectively, these firms are
called industry. Under monopoly, there is only one firm. There is no
question of industry, Firm is the industry. Under monopolistic
competition there are many firms producing close substitutes.
Chamberlin has used the term group instead of industry, for the group of
such firms as produce differentiated products.
Determination of Group Equilibrium : For the sake of simplicity, we
study group equilibrium on the basis of two assumptions:
(i)
(ii)
Demand and costs of all firms of a group are the same.

Number of firms in the group is so large that no individual firm by its
own decision can influence the price and output of other firms.
Equilibrium can be explained with the help of following diagram :

Cost/REvenue/Price
(2)
D1
R
A
B
EG
D1
O
M1 M
C
D
Output
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In this figure, DD is demand curve and CC is cost curve. Each producer would
like to fix price equal to OA because at this price, difference between revenue
and cost is the maximum. Such a price will yield super normal profits
equivalent to BARG. This super normal profit will attempt many new firms to
join the group. Consequently, the total market demand will be distributed
among several sellers. This will make the demand curve shift to the left as D D .
The number of producers will go on increasing until D D curve becomes
tangent to cost curve CC. This will happen at point E. No firm will now earn
super normal profits. Each firm of the group will, in this situation, be in
equilibrium. OB will be the equilibrium price of the group and OM will be the
equilibrium output.
1
Q.
What do you mean by oligopoly? Give main features.
Ans. Oligopoly : An oligopoly is a market in which there are few producers of a

product. For example, there are only five firms in India, manufacturing Cars.
Hence car-market will be called oligopoly. In this case also each firm has to take
into account the price being charged by the other. To that extent, firms are
inter-dependent. If they enter into some sort of agreement they can charge high
price. On the contrary, if they do not conclude any agreement among
themselves, then they suffer losses. There is no set principle to determine price
under oligopoly.
Features of Oligopolistic Market :
(1)
Few Sellers : In case of oligopoly, the number of sellers is very small but
that of the buyers is very large. The number of sellers being small, each
seller has a control over a very large part of the total supply. Hence, he can
influence the market price.
(2)
Inter-dependence : Each firm sells a substantial part of production of a

commodity. If one firm reduces the price, the other firms also bring down
their price. On the other hand, if one firm raises the price, it is quite
possible the other firms may not like to raise their price. Thus, the sales of
the former will be adversely affected. It means that there exists an interdependence among the firms.
(3)
Selling Costs : Each firm under oligopoly incurs lot of expenditure on

different modes of advertisement in order to push the sale of its products.
(4)
Group Behaviour : Under oligopoly there is inter-dependence as well as

competition among the firms. Each firm intends to maximize its profit. To
achieve this objective either the firms decide independently the price and
output of their product or they enter into a mutual agreement, as a group,
in this respect.
(5)
Uncertainty of Demand Curve : Demand curve is uncertain under

oligopoly. Under oligopoly, the firm face Kinked demand curve.
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Y
Revenue
K
AR
P
D1
R
O
M
Quantity
In this figure, demand curve has two segments. DD1 demand curve has a kink
at point K. Demand curve is also known as average revenue (AR) curve.
Upper segment of AR curve from point K is more elastic. It implies that

when one firm raises its price, the other firms keep their prices
unchanged. Thus, when one firm alone will effect change in price, then
there will be considerable change in its sales.
Lower segment of AR curve from point K i.e., KD1 represents less elastic
demand. It implies that when one firm reduces its price then all other
firms in the market also reduce their prices. When all firms reduce prices,
then there will be no increase in the sale of any one firm, rather all firms
may find a very small increase in their sale. Both these segments of
average revenue curve form a kink at point K.
When average revenue curve is kinked then its corresponding marginal

revenue curve is DPRM.
DP portion of marginal revenue curve which is below the more elastic

portion DK of the average revenue curve, is positive.
On the contrary, RM portion of marginal revenue curve which is below the

inelastic portion KD1 of the average revenue curve is negative. It means
that if a firm lowers its price, its total revenue will not increase.
PR gap in the marginal revenue curve arises because average revenue

curve has suddenly changed from more elastic to inelastic curve.
Difference between Monopolistic Competition and Oligopoly :

Sr.
No.
Basis of
Difference
Monopolistic
Competition
Oligopoly
1.
Number of Sellers
Under monopolistic
competition there are large
number of sellers
Under oligopoly there are

few sellers.
2.
Demand Curve
Under monopolistic
competition there is
Under oligopoly, there is

kinked demand curve
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downward sloping
demand curve
Q.
3.
Price
Determination
Under monopolistic
competition, prices are
determined by the firm
Under oligopoly, prices are

also determined by the
firm but price is influence
by other firms
4.
Relation of firms
Under monopolistic
competition, firms are
almost independent
Under oligopoly, firms are

largely inter-dependent
Differentiate between
Competition.
Monopolistic
Competition
and
Perfect

product differentiation is the characteristic feature of monopolistic
competition.
Perfect Competition : Perfect competition is that situation of the market in
which there are large number of buyers and sellers of homogeneous product.
Under perfect competition, price of the commodity is determined by the
industry. In perfect competition market firm is a price-taker and not a pricemaker
Difference between Monopolistic Competition and Perfect Competition
Sr.
No.
Basis of
Difference
Monopolistic
Competition
Perfect Competition
1.
Assumption
regarding
Buyers and
Sellers
Under Monopolistic
competition there are
large numbers of
buyers and sellers.
Under perfect
competition there are
large numbers but
small size of buyers
and sellers.
2.
Assumption
regarding
Product
Under monopolistic
product differentiation.
Foods produced by the
firms differ in one way
or the other.
Under perfect
competition it is
assumed that all firms
produce homogeneous
products.
3.
Assumption
regarding
Degree of
Knowledge
Under monopolistic
competition it is
assumed that buyers
and sellers are not fully
aware of the market
conditions.
Under perfect
competition it is
assumed that buyers
and sellers have
perfect knowledge of
the market situations.
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4.
Marginal
Revenue and
Average
Revenue Curve
Under monopolistic
competition, marginal
revenue and average
revenue curve are:
Under perfect
revenue and average
revenue curve are:
Y
R/C
AR=MR
MR
O
Q.
Output
AR
X
Output
5.
Comparison
regarding Price
Under monopolistic
competition, firm is
price-maker, not pricetaker.
Under perfect
competition, firm is
price-taker, not pricemaker.
6.
Implications
regarding
Decisions
Under monopolistic
competition, a firm can
determine either the
output to be produced
or the price to be
charged.
Under perfect
competition a firm can
take decision only with
regard to the quantity
of output to be
produced.
7.
Selling Cost
Under monopolistic
competition each firm
spends a lot of funds
on advertisement and
publicity of its product.
Under perfect
competition, a seller
does not spend on
advertisement and
publicity etc.
Differentiate between Monopolistic Competition and Monopoly.

product differentiation is the characteristic feature of monopolistic competition
Monopoly : Monopoly is the market structure in which a single firm is the sole
producer of a product for which there are no close substitutes. Since the
monopoly is the only seller in the market, it has no competitors. The monopolist
is the price maker. Its demand curve slopes downward to the right.
Difference between Monopolistic Competition and Monopoly :
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Sr.
No.
Basis of
Difference
Monopolistic
Competition
Monopoly
1.
Assumptions
regarding Number
of Buyers and
Sellers
Under monopolistic
competition there are large
number of buyers and
sellers.
In case of monopoly, there

is only one seller and
large number of buyers.
2.
Assumption
regarding Product
Under monopolistic
product differentiation.
Product of a monopolist
may or may not be
homogeneous.
3.
Assumption
regarding Entry
Under monopolistic
Under monopoly there are
competition there are no
restrictions on the entry
restrictions on the new
of new firms.
firms to enter into and the
old ones to leave the group.
However, this entry and exit
are not so easy in the short
-period. It is possible in
the long-run only.
4.
Assumption
regarding Degree
of Knowledge
Under monopolistic
competition, buyers and
sellers have imperfect
knowledge of the
market conditions
Under monopoly, it is
assumed, that buyers and
sellers have perfect
knowledge regarding
market conditions.
5.
Marginal Revenue
and Average
Revenue
Under monopolistic
revenue and average
revenue curve are:
Y
Under monopoly marginal

revenue and average
revenue curve are:
R/C
AR
R/C
MR
O
6.
Q.
Comparison
Regarding Profit
Output
MR
X
Under monopolistic
competition in the long run
firm generally earns
normal profits only.
Output
AR
X
Under monopoly, a
monopolist earns super
normal profit only in
long run.
Differentiate between Monopoly and Perfect Competition.
Ans. Monopoly : Monopoly is the market structure in which a single firm is

the sole producer of a product for which there are no close substitutes. Since
the monopoly is the only seller in the market, it has no competitors. The
monopolist is the price maker. Its demand curve slopes downward to the right.
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Perfect Competition : Perfect competition is that situation of the market in

which there are large number of buyers and sellers of homogeneous product.
Under perfect competition, price of the commodity is determined by the
industry. In perfect competition market firm is a price-taker and not a pricemaker
Differentiate between Monopoly and Perfect Competition :
Sr.
No.
Basis of
Difference
Monopoly
Perfect
Competition
1.
Assumptions
regarding Number
of Buyers and
Sellers
In case of monopoly,
there is only one seller
and large number of
buyers.
Under perfect competition

there are large numbers but
small size of buyers and
sellers.
2.
Assumption
regarding
Product
Product of a monopolist Under perfect competition it

may or may not be
is assumed that all firms
homogeneous.
produce homogeneous
products.
3.
Assumption
regarding Entry
Under monopoly there

are restrictions on the
entry of new firms.
Under perfect competition

there are no restriction on
the entry and exit of firms.
4.
Marginal Revenue
and Average
Revenue
Under monopoly
marginal revenue and
average revenue curve
are:
Y
Under perfect competition,

arginal revenue and average
revenue curve are:
R/C
AR=MR
MR
AR
X
Output
Under monopoly, a
monopolist earns super
normal profit in
long run.
X
Output
Under perfect competition a
firm earns normal profits
only in long run.
Under perfect competition, a
firm can take decision only
in respect of the quantity to
be produced.
Comparison
Regarding Profit
6.
Implications
regarding
Decisions
A monopolist can
determine either the
quantum of output
or the price.
7.
Comparison
Regarding Price
Under monopoly, a firm Under perfect competition, a

is price maker, not
firm is price taker, not
price taker
price maker.
8.
Selling Cost
Under monopoly firm

spends a few amount
on advertisement and
publicity of its product.
Under perfect competition, a

seller does not spend on
advertisement and
publicity etc.
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UNIT IV
Q.
Explain Baumols Theory of Sales Revenue Maximization.
Ans. Meaning : Baumols theory of sales maximization is an alternative theory

of firms behaviour. The basic premise of his theory is that sales maximization,
rather than profit maximization, is the plausible goal of the business firms. He
argues that there is no reason to believe that all firms seek to maximize their
profits. Business firms, in fact, pursue a number of objectives and it is not easy
to single out one as the most common objective pursued by the firms. However,
from his experience as a consultant to many big business houses, Baumol
finds that most managers seek to maximize sales revenue rather than profits.
He argues that, in modern business, management is separated from
ownership, and managers enjoy the discretion to pursue goals other than profit
maximization. Their discretion eventually falls in favour of sales maximization.
Causes :
According to Baumol, business managers pursue the goal of sales
maximization for the following reasons :
(1)
First, Financial institutions consider sales as an index of performance of

the firm and are willing to finance the firm with growing sales.
(2)
Second, while profit figures are available only annually, sales figures can
be obtained easily. Maximization of sales is more satisfying for the
managers than the maximization of profits which go to the pockets of the
shareholders.
(3)
Third, salaries and slack earnings of the top managers are linked more
closely to sales than to profit.
(4)
Fourth, the routine personnel problems are more closely handled with
growing sales. Higher payments may be offered to employees if sales
figures indicate better performance.
(5)
Fifth, if profit maximization is the goal and it rises in one period to an

unusually high level, this becomes the standard profit target for the
shareholders which managers find very difficult to maintain in the long
run.
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(6)
Finally, sales growing more than proportionately to market expansion

indicate growing market share and a greater competitive strength and
bargaining power of a firm.
Explanation : To formulate his theory of sales maximization Baumol has

develop two basic models:
1.
1.
Baumols Model Without Advertising
2.
Baumols Model with Advertising
Baumols Model Without Advertising : Baumols Model without

advertising can be explained with the help of following diagram :
TC
H
F
Revenue/Cost/Profit
TR
M
K
E
T
L
P
TP
O
Q1
Q2
Q3
Output
Baumol assumes cost and revenue curves to be given as in conventional theory

of pricing. Suppose that the total cost (TC) and the total revenue (TR) curves are
given in this figure. The profit curve, TP, is obtained by plotting the difference
between the TR and TC curves. Profits are zero where TR = TC. Given the TR and
TC curves, there is a unique level of output at which total sales revenue is
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maximum. The total sales revenue is maximum where the slope of the TR curve
is equal to zero. Such a point lies at the highest point of the TR curve. In this
figure the point H represents the total maximum sales revenue. It implies that a
sales revenue maximizing firm will produce output OQ and its price equal to
HQ / OQ .
3
2.
Baumols Model with Advertising : We have shown above how price and
output are determined in a static single period model without advertising.
Baumol considers in his model with advertising as the typical form of nonprice competition.
In his analysis of advertising, Baumol makes the following assumptions:(i)

(ii)
Firms objectives are to maximize sales.

Advertising causes a shift in the demand curve and hence the total
sales revenue rises with an increase in advertisement expenditure.
(iii) Price remains constant.
(iv) Production costs are independent of advertising.
TC
Y
Revenue/Cost/Profit
TR
Total Profit Curve

B
Ac
Ap
Advertising Qutlay
Explanation : Baumols model with advertising is presented in this figure. The

TR and TC are measured on Y-axis and total advertisement outlay on the Xaxis. The TR curve is drawn on the assumption that advertising increases total
sales in the same manner as does price reduction. The TC curve includes both
production and advertisement costs. The total profit curve is drawn by
subtracting TC from TR. As shown in this figure profit maximizing
advertisement expenditure is OA which maximizes profit MA . Assuming that
minimum profit required is OB, the sales maximizing advertisement outlay
p
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would be OA . This implies that a firm increases its advertisement outlay until it
reaches the profit constraint level which is lower than the maximum profit.
c
Criticism :
1.
First, it has been argued that in the long-run, Baumols sales

maximization hypothesis and the conventional hypothesis would yield
identical results, because the minimum required level of profits would
coincide with the normal level of profits.
2.
Second, Baumols theory does not distinguish between firms equilibrium

and industry equilibrium. Nor does it establish industrys equilibrium
when all the firms are sales maximisers.
3.
Third, it does not clearly bring out the implications of inter-dependence of

the firms price and output decision. Thus, Baumols theory ignores not
only actual competition between the firms but also the threat of potential
competition in an oligopolistic market.
4.
Fourth, Baumols claim that his solution is preferable to the solutions

offered by the conventional theory, from a social welfare point of view, is
not necessarily valid.
Q.
Write a note on Average Cost Pricing.
Ans. Average Cost Pricing : Average cost pricing is also known as mark-up
pricing, cost-plus pricing or full cost pricing. The average cost pricing is the
most common method of pricing used by the manufacturing firms. The general
practice under this method is to add a fair percentage of profit margin to the
average variable cost (AVC). The formula for setting the price is given as:P = AVC + AVC (m)
P
=
AVC
=
m
=
AVC(m) =
Price
Average Variable Cost
Mark-up percentage
Gross Profit Margin (GPM)
The mark-up percentage (m) is fixed so as to cover average fixed cost (AFC) and
a net profit margin (NPM). Thus,
AVC(m) = AFC + NPM
NPM : The fair percentage of profit margin is usually determined on the basis
of the firms past experience and the practice of the rival firms.
Procedure for arriving at AVC and Price Fixation : The procedure for
arriving at AVC and price fixation may be summarized as follows:
1.
The first step in price fixation is to estimate the average variable cost. For
this, the firm has to ascertain the volume of its output for a given period of
time, usually one accounting year. To ascertain the output, the firm uses
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figures of its planned or budgeted output or takes into account its normal
level of production. If the firm is in a position to compute its optimum level
of output or the capacity output, the same is used as standard output in
computing the average cost.
2.
The next step if to compute the total variable cost of the standard output.
The Total Variable Cost includes direct cost i.e.
(a)
(b)
(c)
Cost of Labour
Cost of Raw Material
Other Variable Costs
These costs added together give the total variable cost. The Average
Variable Cost (AVC) is then obtained by dividing the total variable cost (TVC) by
the standard output (Q), i.e.,
AVC
TVC
After AVC is obtained, a mark-up of some percentage of AVC is added to it

as profit margin and the price is fixed. While determining the mark-up, firms
always take into account what the market will bear and the competition in the
market.
Average cost Pricing can be recommended for the following reasons :
(1)
In case of a multi-product firm with large common cost, average cost if far
easier to calculate than the marginal cost.
(2)
Since nobody pays more than the actual cost of production of the goods,
average cost pricing does not result in exploitation.
(3)
Average cost pricing ensures that the entire expenditure of the

undertaking is covered, thereby ensuring the viability and the autonomy
of the production unit.
Limitations of Average Cost Pricing :

(1)
First, average cost pricing assumes that a firms resources are optimally
allocated and the standard cost of production is comparable with the
average of the industry. In reality, however it may not be so and cost
estimates based on these assumptions may be an overestimate or an
underestimate.
(2)
Second, in average cost pricing, generally historical cost rather than

current cost data are used.
(3)
Third, if variable cost fluctuates frequently and significantly, average cost

pricing may not be an appropriate method of pricing.
(4)
Finally, it is also alleged that average cost pricing ignores the demand side
of the market and is solely based on supply conditions.
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Q.
Write a short note on Peak Load Pricing.
Ans. Peak Load Pricing : It is a form of price discrimination where the

monopolist charges a higher price for peak use than for a non-peak use. Peak
load pricing is more usually practiced by Public Utilities, like electricity
companies, telephones etc. Public utilities produce non storable services, their
output is consumed the very moment it is produced. These are demanded in
varying amounts in day and night times. Consumption of electricity reaches its
peak in day time. It is called peak-load time. It reaches it bottom in the night.
This is called off-peak time. Electricity consumption peaks in day times
because all establishments, offices and factories come into operation. It
decreases during nights because most business establishments are closed and
household consumption falls to its basic minimum.
Also in India demand for electricity peaks during summers due to the use
of ACs and coolers and it declines its minimum level during winters. Similarly,
consumption of telephone services is at its peak at day time and at its bottom at
nights.
Another example of peak and off-peak demand is of railway services.
During festivals and summer holidays the demand for railway travel service
rises to its peak.
A technical feature of such products is that they cannot be stored.
Therefore, their production has to be increased in order to meet the peak-load
demand and reduced to off-peak level when demand decreases. Had they been
storable, the excess production in off-peak period could be stored and
supplied during the peak-load period. But this cannot be done.
The rational of peak-load pricing by Electricity Company can be
presented with the help of following figure :
Y
SMC
Price
P3
P2
P1
E
Dp
DL
O
Q1 Q2
Quantity
Q3 Q4
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In this figure, the short-run marginal cost of electricity is shown as SMC. It

slopes upwards. We further assume that demand varies between two periods,
with the demand curve for the peak period shown as D and the demand curve
for the off-peak period shown as D . The price in each period would be set where
SMC intersects the relevant demand curve. Thus, price would be OP in the offpeak period and OP in the peak period. Consumers would purchase OQ in the
off-peak period and OQ in the peak period.
p
Conclusion : Generally a double price system is adopted. A higher price,

called peak-load price is charged during the peak-load period and a lower
price is charged during the off-peak period.
Q : Write a short note on Limit Pricing.
Ans. Meaning of Limit Pricing : A firm may also try to establish a price that
reduced or eliminates the threat of entry of new firms into the industry. This is
called limit pricing.
Limit Pricing is illustrated in the following figure :
Price Revenue, Cost (Rs.)
Y
P1
SRAC1
LMC
LAC
P2
AR
MR
O
Q2
Q1
Units of Output
Suppose that the existing firms in the industry operate at the scale
represented by the short-period average cost curve SRAC1 and price their
product at P1. If the new firms could be expected to enter the industry even at
the scale represented by SRAC1, they could potentially make a profit by
producing and competing at the established price P1. Now if the existing firms
set the price lower, say at P2 potential entrants would incur economic loss by
entering the industry.
If the entry appears initially any firm which plans entry must also consider
the effect of the entry on price. With entry the total supply and demand for the
already existing firms output is going to be affected.
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The price must consequently fall and the new entrant may ultimately find
that price has fallen below SRAC1 and he has, therefore made a wrong decision.
Thus, if the existing firms set their price closer to average cost there will be
less incentive for new entrants, though also lower short-run profits for the
existing firms.
Q.
Explain Multiple Product Pricing Or Product-Line Pricing.
Ans. Multiple Product Pricing : The price theory or microeconomics models

of price determination are based on the assumption that a firm produces a
single, homogenous product. In actual practice, however, production of a
single homogenous product by a firm is an exception rather than a rule. Almost
all firms have more than one product in their line of production. For example,
the various model of refrigerators, TV sets, radio and car models produced by
the same company may be treated as different product for at least pricing
purposes. The various models are so differentiated that consumers view them
as different product and in some cases as perfect substitutes for each other.
It is therefore, not surprising that each model or product has different AR
and MR curves and that one product of the firm competes against the other
product. The pricing under these conditions is known as multi-product pricing
or product-line pricing.
The major problem in pricing multiple products is that each product has a
separate demand curve. But, since all of them are produced under one
organization by interchangeable production facilities, they have only one
inseparable marginal cost curves. That is, while revenue curves, AR and MR,
are separate for each product, cost curves, AC and MC are inseparable.
Therefore, the marginal rule of pricing cannot be applied straightway to fix the
price of each product separately. The problem, however, has been provided
with a solution by E.W. Clemens. The solution is similar to the one employed to
illustrate third degree price discrimination. As a discriminating monopoly tries
to maximize its revenue in all its market, so does a multi-product firm in
respect of each of its products.
Cost/Revenue
D
MC
D1
P1
D2
D3
P2
P3
D4
P4
EMR
MR1 MR2 MR3 MR4

X
O
Q1 Q2 Q3 Q4
Quantities Demanded Per Time Unit
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Explanation : To illustrate the multiple product pricing, let us assume that a

firm has four different product:- A, B, C and D in its line of production. The AR
and MR curves for the four goods are shown in four segments of above
mentioned figure. The marginal cost for all the products taken together is
shown by the curve MC, which is the factory marginal cost curves. Let us
suppose that when the MRs for the individual products are horizontally
summed up, the aggregate MR (not given in the figure) passes through C on the
MC curve. If a line parallel to the X-axis, is drawn from point C to the Y-axis
through the MRs, the intersecting points will show the points where Mc and
MRs are equal for each product, as shown by the line EMR, the Equal Marginal
Revenue line. The point of intersection between EMR and MRs determine the
output level and price for each product.
Outputs of the four products are given as :
(i)
(ii)
(iii)
(iv)
OQ1 of Product A
O1Q2 of Product B
O2Q3 of Product C
O3Q4 of Product D
The prices for the four products are :

(i)
(ii)
(iii)
(iv)
P1Q1 for Product A

P2Q2 for Product B
P3Q3 for Product C
P4Q4 for Product D
These price and output combinations maximize the profit from each
product and hence the overall profit of the firm.
Q.
Write a note on Pricing Strategies and Tactics.
Ans. Pricing Strategies and Tactics : Every firm has to take pricing decisions
from time to time depending upon its pricing policies and conditions prevailing
in the market. Some of the important pricing strategies are discussed below:
(1)
Skimming Price Policy : The skimming price policy is adopted where

close substitutes of a new product are not available. In this pricing policy
prices are decided high. This policy succeeds for the following reasons:(a)
(b)
(c)
(2)
First, in the initial stage of the introduction of product, demand is

relatively inelastic.
Cross elasticity is usually very low for lack of a close substitute.
High initial prices are helpful in recouping the development costs.
Penetration Price Policy : In contrast to skimming price policy, the

penetration price policy involves a reverse strategy. This pricing policy is
adopted generally in the case of new products for which substitutes are
available. This policy requires fixing a lower initial price designed to
penetrate the market as quickly as possible and is intended to maximize
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the profits in the long-rum. This policy succeeds for the following
reasons:(a)
(b)
(c)
(3)
First, the short run demand for the product should have an elasticity
greater than unity.
Second, the potential market for the product is fairly large and has a
good deal of future prospects.
Third, the product should have a high cross-elasticity in relation to
rival products for the initial lower price to be effective.
Pricing in Relation to Established Products : In pricing a product in

relation to its well established substitutes, generally three types of pricing
strategies are adopted :
(i) Pricing below the ongoing price.
(ii) Pricing at par with the prevailing market price
(iii) Pricing above the existing market price.
(4)
Pricing at Prevailing Prices : The strategy is followed to stay in the

market because a price above the market price would sharply bring down
sales while a lower price would not significantly increase sales. The
products offered by different producers are substitutes of each other and
there is no product differentiation. Pricing at the prevailing price is aimed
at avoiding price competition.
(5)
Stay out Price : When a firm is not certain about the price at which it will
be able to sell its product, it starts with a very high price. If at this high
price quotation it is not able to sell, it then lowers the price of its product. It
will keep on lowering the price till it is able to sell the targeted amount of
the product. This approach helps the firm to ascertain the maximum
possible price it can charge from its customers.
(6)
Price Lining : Price lining is used extensively by the retailers. The

retailers usually offer a good, better and best assortment of merchandise
at different price levels. For example, a retailer of readymade shirts may
sell shirts at three prices: Rs. 190, Rs. 360 and Rs. 750. The first price
stands for the economy choice, the second for the medium quality and the
third for the super-fine quality.
(7)
Psychological Pricing : Under this policy, prices are fixed in such a way
that they have some kind of psychological influence on the buyers. Odd
pricing is a form of psychological pricing i.e., prices are set at odd amounts
such as Rs. 19, Rs. 49, Rs.99 etc.
(8)
Limit Pricing : A firm may also try to establish a price that reduces or
eliminates the threat of entry of new firms into the industry. This is called
limit pricing.
(9)
Follow the Leader Pricing : The pricing policy is generally used under
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oligopolistic competition where there are a small number of sellers and

any on of them operates on such a scale that an increase or decrease in his
turnover will appreciably affect the market price. They charge the prices
which are charged by the major producer.
(10) Discriminatory Or Dual Pricing : Some business enterprises follow the
policy of charging different prices from different customers according to
their ability to pay. This policy is very popular with the service enterprises.
E.g, legal and medical services.
Q.
Write a note on Transfer Pricing.
Ans. Meaning of Transfer Pricing : The large size firms divide their operation
very often into product divisions or subsidiaries. Growing firms add new
divisions or departments to the existing ones. The firms then transfer some of
their activities to other divisions. The goods and services produced by the new
division are used by the parent organization. In other words, the parent
division buys the product of its subsidiaries. Such firms face the problem of
determining an appropriate price for the product transferred from one division
or subsidiary to the other. Specially, the problem is of determining the price of a
product produced by one division of the same firm. This problem becomes
much more difficult when each division has a separate profit function to
maximize. Price of intra-firm transfer product is referred to as transfer
pricing. One of the most systematic treatments of the transfer pricing
technique has been provided by Hirshlerifer. We will discuss here briefly his
technique of transfer pricing.
To begin with, let us suppose that a refrigeration company established a
decade ago used to produce and sell refrigerators fitted with compressors
bought from a compressor manufacturing company. Now the refrigeration
company decides to set up its own subsidiary to manufacture compressors.
Assumptions : Let us also assume :
(1)
Both parent and subsidiary companies have their own profit functions to
maximize.
(2)
The refrigeration company sells its product in a competitive market and its
demand is given by a straight horizontal line; and
(3)
The refrigeration company uses all the compressors produced by its

subsidiary.
In addition, we assume that there is no external market for the

compressors. We will later drop this assumption and alternatively assume that
there is an external market for the compressors and discuss the technique of
transfer pricing under both the alternative conditions.
(A)
Transfer Pricing without External Market : Given the foregoing

assumptions, the refrigeration company has to set an appropriate price
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for the compressors so that the profit of its subsidiary too is maximum. This
can be explained with the help of following diagram:
(1)
Price Determination of the Final Product (Refrigerators) :

MCc
Y
P
Price and Cost
ARr=MRr
M
MCb
Number of Refrigerators and Compressors

Diagram: Price Determination of the Fina Product (Refrigerators)
Since the refrigeration company sells its refrigerators presumably in a
competitive market, the demand for its product is given by a straight horizontal
line as shown by the line AR = MR in diagram. The marginal cost of
intermediate good i.e., compressor, is shown by MC curve and that of the
refrigerator body by MC . The MC and MC added vertically give the combined
marginal cost curve, the MC The MCt intersects line AR = MR at point P. An
ordinate drawn from point P down to the horizontal axis determined the most
profitable outputs of refrigerator body and compressors each at OQ.
r
t.
(2)
Determination of Transfer Price : Now, the question arises is what

should be the price of the compressors so that the compressor
manufacturing division too maximizes its profit? The answer is to this
question can be obtained by applying the marginality principle which
requires equalizing MC and MR in respect of compressors. The marginal
cost curve for the compressors is given by MC in the following figure. The
marginal revenue of the compressors MR can be obtained by subtracting
the non- compressor marginal cost of the final good from the MR . Thus,
c
MRc= MRr (MCt-MCc)

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This can be explained with the help of following figure :

MCc
Y
MCc
and
MRr
Q
Quantity
Diagram: Determinationof Transfer Price

In this figure, the MC curve intersects MR curve at point P. At point P MRc =
MCc and output is OQ. Thus the price of compressors is determined at PQ in
above figure. This price enables the compressor division to maximize its own
profit.
c
(B)
Transfer Pricing with External Competitive Market : We have

discussed above the transfer pricing under the assumption that there is
nor external market for the compressors. It implies that the refrigeration
company was the sole purchaser of its own compressors and that the
compressor division had no external market for its product. Let us now
discuss the transfer pricing technique assuming that there is an external
market for the compressors. The existence of the external market implies
that the compressor division has the opportunity to sell its surplus
production to other buyers and the refrigeration company can buy
compressors from other sellers if the compressor division fails to meet its
total demand. Also assume that the external market is perfectly
competitive.
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Past Year Question Papers
JAN 2009
UNITI
1.
2.
Define Managerial Economics ? How does it assist managers in decision

making ?
Profit maximization remains the most important objective of business firms
inspite of the multiplicity of alternative business objectives suggested by
modern economists ? Comment ?
UNITII
3.
4.
Explain various types of demand ? Distinguish between (a) Extension &

increase in demand (b) contraction & decrease in demand ?
Show the break up of price effect into income effect & substitution effect, of a
price of an inferior commodity and a giffen good ?
UNITIII
5.
6.
Explain short term cost, their interrelationship and their importance for
business managers ?
What is meant by price discrimination ? What are its various degrees ?
Describe equilibrium of a firm under discrimination monoploy ?
UNITIV
7.
8.
Explain Baumols theory of sales revenue maximization ?

Write short notes on :
a)
Peak Load Pricing
b)
Average Cost Pricing
JULY 2008
UNITI
1.
2.
What do mean by Managerial Economics ? Explain its significance in

Managerial decision making ?
Critically examine the profit maximization goal of a business firm ?
UNITII
3.
4.
What do you mean by Price Elasticity, Income elasticity and cross elasticity of
demand ? Explain the factors affecting elasticity of demand ?
Explain consumers equilibrium with the help of indifference curve
technique?
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UNITIII
5.
6.
What do you mean by fixed cost, variable cost, total cost, average cost and
marginal cost ? Explain the relationship between AC and MC ?
What is meant by price discrimination ? Discuss the equilibrium of firm
under monopoly ?
UNITIV
7.
8.
Explain Baumols sales revenue maximization theory of the firm ?

Explain Pricing strategies and transfer pricing of a business firm ?
JAN 2008
UNITI
1.
2.
Discuss the role and responsibility of Managerial Economist ?

a)
Short run and long run
b)
Opportunity cost
3.
Explain the law of demand ? Why does demand curve slope downward from
left to right ?
Explain consumers equilibrium with the help of Indifference curve technique
?
UNITII
4.
UNITIII
5.
6.
How does a producer establishes optimum input combination to optimize his

behaviour ?
What do you mean by monopolistic competition ? How is equilibrium
achieved by a firm under monopolistic competition in the short run and long
run ?
7.
8.
Critically examine Baumols sales maximization theory of the firm ?

Explain Average Cost Pricing and Limit Pricing strategy of a business firm ?
UNITIV
JULY 2007
UNITI
1.
2.
Define Managerial Economics ? Discuss its nature and scope ?

Explain and illustrate the following :
a)
Incremental reasoning
b)
Opportunity Cost
3.
What are the conditions for a consumers equilibrium ? Explain and illustrate
consumers equilibrium using indifference curve technique ?
Define elasticity of demand ? What are the different types of price elasticity ?
UNITII
4.
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UNITIII
5.
6.
Explain the laws of returns to variable proportions and laws of returns of sale
? What are the reasons for the operations of law of the diminishing returns ?
Define monopoly ? What are its characteristics ? Discuss the equilibrium of
firm under monopoly ?
UNITIV
7.
8.
Explain Baumols theory of sales revenue maximization ? What are its

assumptions ?
a)
Average Cost
b)
Pricing strategies
JAN 2007
UNITI
1.
2.
What is Managerial Economics ? Discuss the characteristics and scope of

Managerial Economics ? How does Economics theory contribute to
managerial decisions ?
a)
Write detailed notes on Opportunity cost.
b)
Write detailed notes on Incremental reasoning.
UNITII
3.
4.
5.
6.
What are the conditions for a consumers equilibrium ? Explain consumers

equilibrium using indifference curve technique ?
What are the objectives of demand forecasting ? Explain steps involved in
forecasting ?
UNITIII
Explain laws of returns to variable proportions and laws of return of scale ?
Explain the factors, which causes increasing return to scale ? What are the
reasons for the operations of law of the diminishing returns ?
Compare perfect competition and monopolistic competition ? How are price
and output decisions taken under perfect competition ?
UNITIV
7.
8.

a)
Peak Load Pricing
b)
Write short notes on transfer pricing
Explain the sales revenue maximization model with advertisement ?
JULY 2006
UNITI
1.
2.
Define Managerial Economics and briefly discuss its scope ? What are the
responsibilities of managerial economics ?
Explain and illustrate the following :
a)
Opportunity Cost
b)
Incremental reasoning
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UNITII
3.
4.
What are the conditions for a consumers equilibrium ? Explain consumers

equilibrium using indifference curve technique ?
Define and distinguish between :
a)
Arc elasticity and point elasticity
b)
Price elasticity and cross elasticity
UNITIII
5.
From the data given in table

a)
Find the AFC, AVC, AC and C
b)
Why does AFC decline continuously ?
c)
What is the relation between AC and MC ?
Table (a)
Quantity (Units)
TFC (Rs.)
TVC (Rs.)
TC (Rs.)
0
1
2
3
4
5
100
100
100
100
100
100
0
100
150
250
400
600
100
200
250
350
500
700
6.
Compare perfect competition and monopolistic competition ? How are price

and output decisions taken under perfect competitions ?
7.
8.
Explain the sales revenue maximization model with advertisement ?

Explain the following :
a)
Average cost pricing
b)
Pricing strategies
UNITIV
JAN 2006
UNITI
1.
2.
Explain the importance of Managerial Economics from the point of view of

Managerial Decision-making ? What is the role of managerial economist in
business organization ?
a)
Short-run and long-run
b)
Risk and uncertainity
UNITII
3.
4.
Explain the various poll methods of demand forecasting ?

Define income elasticity of demand and define its various types ? Discuss the
significance of income elasticity of demand in managerial decisions ?
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5.
6.
UNITIII
How is monopoly caused ? Explain price and output determination under
monopoly in the short-run and long-run ?
Explain the types of isoquant curves ? Show, with the help of an illustration,
how will you determine the cost combination ?
UNITIV
7.
8.
Briefly explain Baumols theory of sales revenue maximization ?

Give and discuss various techniques price formation in actual business
situation?
JULY 2005
UNITI
1.
2.
What is Managerial Economics ? Discuss the characteristics and scope of

Managerial Economics ? How does Economic theory contribute to managerial
decisions ?
Write a short notes on :
a)
Nature and marginal analysis
b)
Opportunity cost
UNITII
3.
4.
Explain laws of return to variable proportions and laws of return of scale ?

Explain the factors, which causes increasing return to scale ? What are the
reasons for the operations of law of the diminishing return ?
Define price elasticity of demand and define its various types ? Discuss the
determinates of price elasticity of demand in managerial decision ?
UNITIII
5.
6.
Discuss the meaning and main features of monopolistic market situation ?

Draw a diagram to show equilibrium of the firm ?
What is price discrimination ? Under what conditions seller resort to it ?
Explain?
UNITIV
7.
8.
Briefly explain Baumols theory of sales revenue maximization alongwith its

assumption ?
a)
Average cost pricing
b)
Limit pricing
c)
Transfer pricing
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WORKSHEET
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Study Material

Price : Rs. 400.00

The Zad stars & their family are

ACCOUNTING FOR MANAGERS

INDIAN ETHOS AND VALUES

What do you mean by Managerial Economics. Explain its Nature and

Ans. Meaning of Managerial Economics : Managerial economics is the study

effects of a change in price of a commodity factors and forces on the demand of a

in the market. A major part of managerial decision-making depends on

Economic System of the Country

Industrial Policy of the Government

Q. What do you mean by Managerial

Ans. Meaning of Managerial Economics : Managerial economics is the study

Determining and defining the objective to be achieved

(ii) Developing and analyzing possible course of action; and

Since a business manager has to work in an environment of uncertainty,

Economic System of the Country

Trade and Fiscal Policy of the Government

Managerial economics plays an important role by assisting management

Analysis of Internal Factors : Internal factors are known as business

Specific Functions : These Specific functions are as under :

Responsibilities of a Managerial Economist :

To make reasonable profits on capital employed : He must have

Successful Forecasts : It is necessary for the managerial economist to

Knowledge of Sources of Economic Informations : A managerial

What are the objectives of Business Firms?

Ans. Introduction : Conventional theory of firm assumes profit

Maximization of Sales Revenue

Therefore the objectives of the Business firms are

Maximization of Sales Revenue

Profit Maximization Goal of a Business Firm : According to traditional

Under perfect competition individual firms have to maximize their profits

MC = MR : We take first condition

(iii) If MC = MR the profits could not increase either by increasing or

MC cuts MR from below : Now we take the second condition. The

At point E both the conditions are satisfied.

The real world business environment is more complex than what

The other objectives such as sales maximization, growth rate

Profit maximization objective cannot be realized without the exact

Profits are not only measure of firms efficiency.

Profit maximization assumption may require expansion of business which

Alternative Objectives of Business Firms : There are the following

Baumols Hypothesis of Sales Revenue Maximization : Baumols

Maximization of firms growth rate : According to Robin Marris

Maximization of Managerial Utility Function : According to this

Long-Run Survival of the firm : According to this concept, the primary

Write a short note on the following :

In the short-run there are two types of factors of production:

In the short-run supply can be changed only by varying variable

The fixed factors cannot be changed.

In short-run demand plays greater role than supply in the

The price that is determined in the short period is called Sub-normal

There are two types of cost in the short-run:

Variable Cost : Variable costs are those costs which are

Example : Supposing you have a carpet manufacturing factory. If you run

In the long-run all factors are variable.

Objectives of Business Firms

Maximization of Sales Revenue

(D) Industry : The group of firms producing homogenous products is called

Constant Number of Firms : An industry will be in equilibrium

Equilibrium of Firms : Another condition of an Industrys

At point E both the conditions are satisfied.

Classification of Goods : There are basically three types of goods :

Shopping Goods : This classification includes durable or semi-durable