BBA(G)

GGS Indraprastha University

BBA(G) 103: Business Economics

Course Contents

Unit I Lectures:-12
Introduction to Business Economics and Fundamental concepts: Nature, Scope, Definitions of
Business Economics, Difference between Business Economics and Economics, Contribution and
Application of Business Economics to Business. Micro vs. Macro Economics. Opportunity
Costs, Time Value of Money, Marginalism, Incrementalism, Market Forces and Equilibrium,
Risk, Return and Profits.

Unit II Lectures:-18
Consumer Behavior and Demand Analysis: Cardinal Utility Approach: Diminishing Marginal
Utility, Law of Equi-Marginal Utility. Ordinal Utility Approach: Indifference Curves, Marginal
Rate of Substitution, Budget Line and Consumer Equilibrium. Theory of Demand, Law of
Demand, Movement along vs. Shift in Demand Curve,
Concept of Measurement of Elasticity of Demand, Factors Affecting Elasticity of Demand,
Income Elasticity of Demand, Cross Elasticity of Demand, Advertising Elasticity of Demand.
Demand Forecasting: Need, Objectives and Methods (Brief)

Unit III Lectures:-10

Theory of Production: Meaning and Concept of Production, Factors of Production and
Production function, Fixed and Variable Factors, Law of Variable Proportion (Short Run
Production Analysis), Law of Returns to a Scale (Long Run Production Analysis) through the
use of ISO QUANTS.

Unit IV Lectures:-12
Cost Analysis & Price Output Decisions: Concept of Cost, Cost Function, Short Run Cost, Long
Run Cost, Economies and Diseconomies of Scale, Explicit Cost and Implicit Cost, Private and
Social Cost. Pricing Under Perfect Competition, Pricing Under Monopoly, Control of Monopoly,
Price Discrimination, Pricing Under Monopolistic Competition, Pricing Under Oligopoly.
 UNIT-1

Meaning of Business Economics

Business Economics, also called Managerial Economics.
According to Mc Nair and Meriam, Business economic consists of the use of economic
modes of thought to analyze business situations.
Siegel man has defined managerial economic (or business economic) as
The integration of economic theory with business practice for the purpose of facilitating
decision-making and forward planning by management is called business economics.
We may, therefore, define business economic as that discipline which deals with the application
of economic theory to business management.
Business economic thus lies on the borderline between economic and business management and
serves as a bridge between the two disciplines.

Nature of Business Economics

Traditional economic theory has developed along two lines; viz., normative and positive.
Normative focuses on prescriptive statements, and help establish rules aimed at attaining the
specified goals of business. Positive, on the other hand, focuses on description it aims at
describing the manner in which the economic system operates without staffing how they should
operate. The emphasis in business economics is on normative theory.

Business economic seeks to establish rules which help business firms attain their goals, which
indeed is also the essence of the word normative. However, if the firms are to establish valid
decision rules, they must thoroughly understand their environment. This requires the study of
positive or descriptive theory.
Thus, Business economics combines the essentials of the normative and positive economic
theory, the emphasis being more on the former than the latter.

Scope of Business Economics

As regards the scope of business economics, no uniformity of views exists among various
authors. However, the following aspects are said to generally fall under business economics.
1. Demand Analysis and Forecasting
2. Cost and production Analysis.
3. Pricing Decisions, policies and practices.
4. Profit Management.
5. Capital Management.

These various aspects are also considered to comprise the subject matter of business economic.
1. Demand Analysis and Forecasting :
A business firm is an economic organisation which transforms productive resources into goods
to be sold in the market. A major part of business decision making depends on accurate estimates
of demand.
The main topics covered are: Demand Determinants, Demand Distinctions and Demand
Forecast.
2. Cost and Production Analysis :
Production analysis is narrower, in scope than cost analysis. Production analysis frequently
proceeds in physical terms while cost analysis proceeds in monetary terms. The main topics
covered under cost and production analysis are: Cost concepts and classification, Cost-output
Relationships, Economics and Diseconomies of scale, Production function and Cost control.
3. Pricing Decisions, Policies and Practices :
Pricing is an important area of business economic. In fact, price is the genesis of a firms revenue
and as such its success largely depends on how correctly the pricing decisions are taken. Price
Determination in Various Market Forms, Pricing Method, Differential Pricing, Product-line
Pricing and Price Forecasting.
4. Profit Management :
The important aspects covered under this area are :
Nature and Measurement of profit, Profit policies and Technique of Profit Planning like Break-
Even Analysis.
5. Capital Management :
Briefly Capital management implies planning and control of capital expenditure. The main topics
dealt with are: Cost of capital Rate of Return and Selection of Projects.
Conclusion:
The various aspects outlined above represent major uncertainties which a business firm has to
reckon with viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty and
capital uncertainty. We can therefore, conclude that the subject matter of business economic
consists of applying economic principles and concepts to dea1 with various uncertainties faced
by a business firm.

Significance of Business Economics

The significance of business economics can be discussed as under:
1. Business economics is concerned with those aspects of traditional economics which are
relevant for business decision making in real life.

2. Business economics takes the help of other disciplines having a bearing on the business
decisions in relation various explicit and implicit constraints subject to which resource allocation
is to be optimized.
3. Business economics helps in reaching a variety of business decisions in a complicated
environment. Certain examples are:

(i) What products and services should be produced?

(ii) What input and production technique should be used?
(iii)How much output should be produced and at what prices it should be sold?
(iv) What are the best sizes and locations of new plants?
(v) When should equipment be replaced?
(vi) How should the available capital be allocated?
4. Business economics makes a manager a more competent model builder. It helps him
appreciate the essential relationship characterizing a given situation.

Conclusion:
The usefulness of business economics lies in borrowing and adopting the toolkit from economic
theory, incorporating relevant ideas from other disciplines to take better business decisions,
serving as a catalytic agent in the process of decision making by different functional departments
at the firms level, and finally accomplishing a social purpose by orienting business decisions
towards social obligations.

Difference between business economics & economics

Economics is the social science that studies the production, distribution, and consumption of
goods and services. Economics aims to explain how economies work and how economic agents
interact. Economic analysis is applied throughout society, in business and finance but also in
crime, education, the family, health, law, politics, religion, social institutions, and war. Economic
textbooks distinguish between microeconomics ("small" economics), which examines the
economic behavior of agents (including individuals and firms) and "macroeconomics" ("big"
economics), addressing issues of unemployment, inflation, monetary and fiscal policy.

Business economics (also called managerial economics), is a branch of economics that applies
microeconomic analysis to specific business decisions. As such, it bridges economic theory and
economics in practice. It draws heavily from quantitative techniques such as regression analysis
and correlation, linear. If there is a unifying theme that runs through most of business economics
it is the attempt to optimize business decisions given the firm's objectives and given constraints
imposed by scarcity, for example through the use of operations research and programming.

Area of differences Economics Business Economics

1.Nature Economics deals with the It deals with application of
body of principles itself. economic principles to the
problems of business firms.
2.Nature of economics Deals with micro & macro Deals with micro economic
principles studied economics principles principles
3. Focus of study Under micro economics as a Main focus is profit theory
branch of economics,
distribution theories like rent
and wage theories dealt with
the theory of profit.
4. approach to study Economic theory take It modified already existing
assumptions hypothesize, economic models to suit the
economic relationship and specific conditions and
generates economic models problems of the business firms
1. methodology
Economic theory avoids Business economics is
complexities and makes pragmatic in sense.
simplified assumptions

Micro Vs. macro economics

Microeconomics

Those who have studied Latin know that the prefix micro- means small, so it shouldnt be
surprising that microeconomics is the study of small economic units. The field of
microeconomics is concerned with things like:
 Consumer decision making and utility maximization
Firm production and profit maximization
Individual market equilibrium
Effects of government regulation on individual markets
Externalities and other market side effects

Macroeconomics

Macroeconomics can be thought of as the big picture version of economics. Rather than
analyzing individual markets, macroeconomics focuses on aggregate production and
consumption in an economy. Some topics that macroeconomists study are:

The effects of general taxes such as income and sales taxes on output and prices
The causes of economic upswings and downturns
The effects of monetary and fiscal policy on economic health
How interest rates are determined
Why some economies grow faster than others

S.No . Basis Micro Macro

1. Study Individual Economy as a whole
2. Deal With Individual Units Aggregate Units
3. Tools Demand & Supply of a Aggregate Demand
Particular Commodities and Aggregate Supply
of Economy as a
whole
4. Central Problem Price Determination of Determine Level of
Commodities or Factors Income &
of Production Employment
5. Prices Relative Prices Decide Absolute Price
Decide
6. Type of Analysis Particle Equi-Analysis General Equi
Analysis
7 . Scope Narrow Wider
8. Understanding Easier Complex
Opportunity Costs
The cost of an alternative that must be forgone in order to pursue a certain action is called
opportunity cost. Put another way, the benefits you could have received by taking an alternative
action.

The difference in return between a chosen investment and one that is necessarily passed up, Say
you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock,
you gave up the opportunity of another investment - say, a risk-free government bond yielding
6%. In this situation, your opportunity costs are 4% (6% - 2%).

Time Value of Money

If you're like most people, you would choose to receive the $10,000 now. After all, three years is
a long time to wait. Why would any rational person defer payment into the future when he or she
could have the same amount of money now? For most of us, taking the money in the present is
just plain instinctive. So at the most basic level, the time value of money demonstrates that, all
things being equal, it is better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can do much more with the money if you have it now
because over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future value of
your money by investing and gaining interest over a period of time. For Option B, you don't have
time on your side, and the payment received in three years would be your future value. To
illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over
the three years. The future value for Option B, on the other hand, would only be $10,000. So
how can you calculate exactly how much more Option A is worth, compared to Option B?
Marginalism & Incrementalism
The concept of 'margin' is very popular in Economics. For example, in formal economic theory
we learn that a business firm makes a decision to produce by equating marginal revenues with
marginal costs. Marginal product is the addition made to total product (subtraction from the
product) as a result of employing an additional (withdrawing the last factor of production.
In economic theory, the concept of' margin' is very useful; it renders the
determination/derivation of an equilibrium solution quite simple and easy. However, in the real
world of business management, marginalism should better be replaced by incrementalism, -In
making economic decision, management is interested in knowing the impact of a chuck-change
rather than a unit-change. Incremental reasoning involves a measurement of the impact of
decision alternatives on economic variables like revenue and costs. Incremental revenues (or
costs), for example, refer to the total magnitude of changes in total revenues (or costs) that result
from a set of factors like change in prices, products, processes and patterns.
The distinction between marginalism and incrementalism are as follows-
1. Marginal concepts are always defined in' terms of unit changes, but incremental' concepts are
defined in terms of chunk changes.
2. Incremental -concepts are more flexible than marginal concepts.
3. Under special circumstances, incremental and marginal revenue (cost) may be the same.
Incremental revenue and incremental cost are two basic concepts for making optimum economic
decisions. A decision is optimum if it increases revenue more than cost or if it reduces costs
more than revenue, i.e., if the net incremental revenue is positive. This may be termed as the
"incremental principle" to be followed by management in making decisions.

Market forces & Equilibrium:

Market Forces:

Role of market forces, considers their future prospects, and reflects on what U.S. policies toward
market forces should be. The rise of market forces around the world in the past decade has made
the international economic landscape of the 1990s fundamentally different from that of earlier
decades, raising anew the cardinal policy issue of the appropriate roles and relative scale of
government and marketsto what extent should markets or governments determine the
allocation, use, and distribution of resources? The author discusses market-oriented policies in
the "three worlds" (the industrialized nations, communist countries, and developing nations), and
reasons for the rise of market forces, and outlines relevant policies and implications.
Marketing does not occur in a vacuum. The marketing environment consists of external forces
that directly and/or indirectly impact the organization.
Changes in the environment create opportunities and threats for the organizations.

Example:

PRODIGY (On-line service) ran a commercial 24 hours after the LA earth quake to inform
customers/potential customers that they could contact friends/family in LA through its service
when all the telephone lines were jammed. This illustrates a company (Prodigy), reactively
responding to an environmental factor (nature), to further market its services to attract new
customers.

To track these external forces a company uses environmental scanning. Continual monitoring of
what is going on.

Followings are the market forces-

1. Societal Forces
2. Regulatory: Political Forces
3. Competitive forces
4. Technological Forces
5. Economic forces

Market Equilibrium:

Broadly speaking, Equilibrium is a state of rest or balance due to the equal action of opposing
forces. In terms of Economics, Equilibrium Price is the price toward which the invisible hand
drives the market. At this point, the upward and downward pressure on price is equal and the
quantity demanded equals the quantity supplied. The market mechanism naturally present in
most markets consists of these counterbalancing pressures. Equilibrium can occur in all types of
markets, but the commonly assumed model for its occurrence is the perfectly competitive
market. When a market is in equilibrium, there is no excess supply or excess demand.
Equilibrium quantity is the amount bought and sold at the equilibrium price.

Risk, Return and Profits

Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from
a given action, activity and/or inaction. The notion implies that a choice having an influence on
the outcome sometimes exists (or existed). Potential losses themselves may also be called
"risks". Any human endeavor carries some risk, but some are much riskier than others.
The gain or loss of a security in a particular period, the return consists of the income and the
capital gains relative on an investment. It is usually quoted as a percentage.

Profit is the difference between the purchase price and the costs of bringing to market
 UNIT 2

Theory of Consumers Behavior: Utility Analysis

The theory of consumers behavior seeks to explain the determination of consumers
equilibrium. Consumers equilibrium refers to a situation when a consumer gets maximum
satisfaction out of his given resources. A consumer spends his money income on different goods
and services in such a manner as to derive maximum satisfaction. Once a consumer attains
equilibrium position, he would not like to deviate from it. Economic theory has approached the
problem of determination of consumers equilibrium in two different ways: (1) Cardinal Utility
Analysis and (2) Ordinal Utility Analysis Accordingly, we shall examine these two approaches
to the study of consumers equilibrium in greater defeat.
Meaning of Utility:
The term utility in Economics is used to denote that quality in a good or service by virtue of
which our wants are satisfied. In, other words utility is defined as the want satisfying power of a
commodity.
According to, Mrs. Robinson, Utility is the quality in commodities that makes individuals want
to buy them.
According to Hibdon, Utility is the quality of a good to satisfy a want.
Concepts of Utility
There are three concepts of utility :
(1) Initial Utility: The utility derived from the first unit of a commodity is called initial utility.
Utility derived from the first piece of bread is called initial utility. Thus, initial utility, is the
utility obtained from the consumption of the first unit of a commodity. It is always positive.
(2) Total Utility: Total utility is the sum of utility derived from different Units of a commodity
consumed by a household.
According to Leftwitch, Total utility refers to the entire amount of satisfaction obtained from
consuming various quantities of a commodity.
Suppose a consumer consume four units of apple. If the consumer gets 10 utils from the
consumption of first apple, 8 utils from second, 6 utils from third, and 4 utils from fourth apple,
then the total utility will be 10+8+6+4 = 28
Accordingly, total utility can be calculated as :
TU = MU1 + MU2 + MU3 + _________________ + MUn
Or
TU = MU
Here TU = Total utility and MU1, MU2, MU3, + __________ MUn = Marginal Utility derived
from first, second, third __________ and nth unit.
(3) Marginal Utility: Marginal Utility is the utility derived from the additional unit of a
commodity consumed. The change that takes place in the total utility by the consumption of an
additional unit of a commodity is called marginal utility.
According to Chapman, Marginal utility is the addition made to total utility by consuming one
more unit of commodity. Supposing a consumer gets 10 utils from the consumption of one
mango and 18 utils from two mangoes, then. the marginal utility of second .mango will be 18-
10=8 utils. Marginal utility can be measured with the help of the following formula
MUnth = TUn TUn-1
Here MUnth = Marginal utility of nth unit,
TUn = Total utility of n units,
TUn-l = Total utility of n-i units,
Marginal utility can be (i) positive, (ii) zero, or (iii) negative.
(i) Positive Marginal Utility: If by consuming additional units of a commodity, total utility goes
on increasing, marginal utility will be positive.
(ii) Zero Marginal Utility: If the consumption of an additional unit of a commodity causes no
change in total utility, marginal utility will be zero.
(iii) Negative Marginal Utility: If the consumption of an additional unit of a commodity causes
fall in total utility, the marginal utility will be negative.

Utility Analysis or Cardinal Approach

The Cardinal Approach to the theory of consumer behavior is based upon the concept of utility.
It assumes that utility is capable of measurement. It can be added, subtracted, multiplied, and so
on.
According to this approach, utility can be measured in cardinal numbers, like 1,2,3,4 etc. Fisher
has used the term Util as a measure of utility. Thus in terms of cardinal approach it can be said
that one gets from a cup of tea 5 utils, from a cup of coffee 10 utils, and from a rasgulla 15 utils
worth of utility.
Laws of Utility Analysis
Utility analysis consists of two important laws
1. Law of Diminishing Marginal Utility.
2. Law of Equi-Marginal Utility.
1. Law of Diminishing Marginal Utility:
Law of Diminishing Marginal Utility is an important law of utility analysis. This law is related to
the satisfaction of human wants. All of us experience this law in our daily life. If you are set to
buy, say, shirts at any given time, then as the number of shirts with you goes on increasing, the
marginal utility from each successive shirt will go on decreasing. It is the reality of a mans life
which is referred to in economics as law of Diminishing Marginal Utility. This law is also known
as Gossens First Law.
According to Chapman, The more we have of a thing, the less we want additional increments of
it or the more we want not to have additional increments of it.
According to Marshall, The additional benefit which a person derives from a given stock of a
thing diminishes with every increase in the stock that he already has.
According to Samuelson, As the amount consumed of a good increases, the marginal utility of
the goods tends to decrease.
In short, the law of Diminishing Marginal Utility states that, other things being equal, when we
go on consuming additional units of a commodity, the marginal utility from each successive unit
of that commodity goes on diminishing.

Assumptions:
Every law in subject to clause other things being equal This refers to the assumption on which
a law is based. It applies in this case as well. Main assumptions of this law are as follows:
1. Utility can be measured in cardinal number system such as 1, 2, 3_______ etc.
2. There is no change in income of the consumer.
3. Marginal utility of money remains constant.
4. Suitable quantity of the commodity is consumed.
5. There is continuous consumption of the commodity.
6. Marginal Utility of every commodity is independent.
7. Every unit of the commodity being used is of same quality and size.
8. There is no change in the tastes, character, fashion, and habits of the Consumer.
9. There is no change in the price of the commodity and its substitutes.

2. Law of Equi-Marginal Utility

This law states that the consumer maximizing his total utility will allocate his income among
various commodities in such a way that his marginal utility of the last rupee spent on each
commodity is equal. The consumer will spend his money income on different goods in such a
way that marginal utility of each good is proportional to its price
Limitations of Law of Equi-Marginal Utility
It is difficult for the consumer to know the marginal utilities from different commodities
because utility cannot be measured.
Consumers are ignorant and therefore are not in a position to arrive at an equilibrium.
It does not apply to indivisible and inexpensive commodity.
Ordinal utility
Ordinal utility theory states that while the utility of a particular good or service cannot be
measured using a numerical scale bearing economic meaning in and of itself, pairs of alternative
bundles (combinations) of goods can be ordered such that one is considered by an individual to
be worse than, equal to, or better than the other. This contrasts with cardinal utility theory, which
generally treats utility as something whose numerical value is meaningful in its own right. The
concept was first introduced by Pareto in 1906
Ordinal utility Definition: A method of analyzing utility, or satisfaction derived from the
consumption of goods and services, based on a relative ranking of the goods and services
consumed. With ordinal utility, goods are only ranked only in terms of more or less preferred,
there is no attempt to determine how much more one good is preferred to another. Ordinal utility
is the underlying assumption used in the analysis of indifference curves and should be compared
with cardinal utility, which (hypothetically) measures utility using a quantitative scale.
Indifference Curve Approach
An indifference curve is a geometrical presentation of a consumer is scale of preferences. It
represents all those combinations of two goods which will provide equal satisfaction to a
consumer. A consumer is indifferent towards the different combinations located on such a curve.
Since each combination yields the same level of satisfaction, the total satisfaction derived from
any of these combinations remains constant.
An indifference curve is a locus of all such points which shows different combinations of two
commodities which 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.
According to ferguson, An indifference curve is a combination of goods, each of which yield
the same level of total utility to which the consumer is indifferent.
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.
Suppose a consumer two goods, namely apples and oranges. The following indifference schedule
indicates different combinations of apples and oranges that yield him equal satisfaction.
Combination of Apple Oranges

Apple Oranges
A 1 0
 B 2 7
C 3 5
D 4 4
Assumptions:
Indifference curve approach has the following main assumptions:
1. Rational Consumer: It is assumed that the consumer will behave rationally. It means the
consumer would like to get maximum satisfaction out of his total income.
2. Diminishing Marginal rate of Substitution: It means as the stock of a commodity
increases with the consumer, he substitutes it for the other commodity at a diminishing
rate.
3. Ordinal Utility: A consumer can determine his preferences on the basis of satisfaction
derived from different goods or their combinations. Utility can be expressed in terms of
ordinal numbers, i.e., first, second etc.
4. Independent Scale of Preference: It means if the income of the consumer changes or
prices of goods fall or rise in the market, these changes will have no effect on the scale of
preference of the consumer. It is further assumed that scale of preference of a consumer is
not influenced by the scale of preference of another consumer.
5. Non-Satiety: A consumer does not possess any good in more than the required quantity.
He does not reach the level of satiety. Consumer prefers more quantity of a good to less
quantity.
6. Consistency in Selection: There is a consistency in consumersbehaviour. It means that
if at any given time a consumer prefers A combination of goods to B combination, then at
another time he will not prefer B combination to A combination.
7. Transitivity: It means if a consumer prefers A combination to B combination, and B
Combination to C Combination, he will definitely prefer A combination to C
combination. Likewise; if a consumer is indifferent towards A and B and he is also
indifferent towards Band C, then he will also he indifferent towards A and C.

Properties of Indifference Curves

1. Indifference curve slopes downward from left to right, or an indifference curve has a
negative slope
2. Indifference curve is convex to the point of origin:
3. Two Indifference Curves never cut each other:
4. Higher Indifference Curves represent more satisfaction
5. Indifference Curve touches neither x-axis nor y-axis;
6. Indifference curves need not be parallel to each other:
 7. Indifference curves become complex in case of more than two commodities

Marginal Rate of Substitution

The concept of indifference curve analysis is based on law of diminishing marginal rate of
substitution.. To understand the law, it is essential to know marginal rate of substitution.
The study of indifference curve shows that when a consumer gets one more unit of X-commodity
his satisfaction increases. If the consumer wants that his level of satisfaction may remain the
same, that is, if he wants to remain on the same indifference curve, he will have to give up some
units of y commodity.
In other words, in exchange for the satisfaction obtained from the additional unit of apple, he will
have to give up that many units of changes whose satisfaction is equal to the additional
satisfaction obtained from an additional apple.
Utility gained of apples = Utility lost of oranges.
Explanation of the law of Diminishing Marginal Rate of Substitution
According to this law, as a consumer gets more and more units of X, he will be wining to-give
up less and less units of Y. In other words, the marginal rate of substitution of x for y will go on
diminishing while the level of satisfaction of the consumer remains the same. Example:
Marginal Rate of Substitution
Combination Apples (x) Oranges (y) MRSxy
A 1 10 -
B 2 7 3:1
C 3 5 2:1
D 4 4 1:1
Table indicates that the consumer will give up 3 oranges for getting the second apple, 2 oranges
for getting the third apple and 3 orange for getting the fourth apple. In other words, marginal rate
of substitution of apples for oranges goes on diminishing.
It is clear the diagram that when consumer moves from point A to point B, he give up 3 oranges
to obtain one additional apple. In this situation, consumers marginal rate of substitution of apple
for orange is 3: 1. When he moves from B to C, he gives up only 2 oranges to get one additional
apple. The marginal rate of substitution of apple for orange now diminishes to 2 : 1. It is evident
from this example that as the consumer increases the consumption of apples, for getting every
additional unit of apple he gives up less and It less units of oranges, that is, 3: 1, 2: 1, 1: I
respectively. It is called diminishing marginal rate of substitution and the law relating it is called
law of diminishing marginal rate of substitution.
Price Line or Budget Line
It is also known as Budge line, consumption possibility line, or line of attainable combinations.
A price line represents all possible combinations of two goods, that consumer can purchase with
his given income at the given prices of two goods.
Explanation:
Supposing a consumer has an income of Rs.4.00 to be spent on apples and oranges. Price of
orange is Re. 0.50 per orange and that of apples Re. 1.0 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 show in Table and Figure
Income Apples Oranges
(Rs.) (Re. 1.00) (Re. 0.50)
4 0 8
4 1 6
4 2 4
4 3 2
4 4 0
It is clear from the table that if the consumer wants to buy oranges only then he can get a
maximum 8 oranges with his entire income of Rupees four. On the other hand, if the consumer
wants to buy apples only, then he can get a maximum 4 apples with his entire income of Rupees
four. Within these two extreme limits, the other possible combinations that a consumer can get
are 1 apple +6 oranges, 2 apples + 4 oranges, 3 apples +2 oranges.
Assumptions:
1. Consumer is rational and so maximizes his satisfaction from the purchase of two goods.
2. Consumers income is constant.
3. Prices of the goods are constant.
4. Consumer knows the price of all things.
5. Consumer can spend his income in small quantities.
6. Goods are divisible.
7. There is perfect competition in the market.
8. Consumer is fully aware of the indifference map.
Conditions of Consumers Equilibrium
There are two main conditions of consumers equilibrium;
(i) Price line should be tangent to the indifference curve, i.e. MRSxy = Px / Py
(ii) Indifference curve should be convex to the point of origin.
(iii) Price line should be tangent to indifference curve.

Demand
Demand is defined as the quantity of a good or service that consumers are willing and able to
buy at a given price in a given time period. Each of us has an individual demand for particular
goods and services and the level of demand at each market price reflects the value that
consumers place on a product and their expected satisfaction gained from purchase and
consumption.
The Law of Demand
Other factors remaining constant (ceteris paribus) there is an inverse relationship between the
price of a good and demand.
As prices fall, we see an expansion of demand, If price rises, there will be a contraction of
demand. A change in the price of a good or service causes a movement along the demand curve:
Many other factors can affect total demand - when these change, the demand curve can shift.
This is explained below.
Shifts in the Demand Curve Caused by Changes in the Conditions of Demand
There are two possibilities: either the demand curve shifts to the right or it shifts to the left.
Demand Curve
In economics, the demand curve is the graph depicting the relationship between the price of a
certain commodity and the amount of it that consumers are willing and able to purchase at that
given price. It is a graphic representation of a demand schedule. The demand curve for all
consumers together follows from the demand curve of every individual consumer: the individual
demands at each price are added together.

Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to the
factors which can affect individual demand there are three factors that can affect market demand
(cause the market demand curve to shift):
 a change in the number of consumers,
a change in the distribution of tastes among consumers,
a change in the distribution of income among consumers with different tastes.
Some circumstances which can cause the demand curve to shift in include:
Decrease in price of a substitute
Increase in price of a complement
Decrease in income if good is normal good
Increase in income if good is inferior good
Movement along a demand curve
There is movement along a demand curve when a change in price causes the quantity demanded
to change. It is important to distinguish between movement along a demand curve, and a shift in
a demand curve. Movements along a demand curve happen only when the price of the good
changes.
If there is a change in price, there is a movement along the demand curve. An increase in price,
P1 to P2 causes a change in quantity demand from Q2 to Q1
A change in price doesnt shift the demand curve we merely move from one point of demand
curve to another.

Shift of a demand curve

The shift of a demand curve takes place when there is a change in any non-price determinant of
demand, resulting in a new demand curve. When income increases, the demand curve for normal
goods shifts outward as more will be demanded at all prices, while the demand curve for inferior
goods shifts inward due to the increased attainability of superior substitutes. With respect to
related goods, when the price of a good (e.g. a hamburger) rises, the demand curve for substitute
goods (e.g. chicken) shifts out, while the demand curve for complementary goods (e.g. tomato
sauce) shifts in (i.e. there is more demand for substitute goods as they become more attractive in
terms of value for money, while demand for complementary goods contracts in response to the
contraction of quantity demanded of the underlying good).
An example of a demand curve shifting. The shift from D1 To D2 means an increase in demand
with consequences for the other variables

Difference between movement on demand curve and shift of demand curve

Movement on Demand curve Shift of demand curve

1. Movement is caused only by change a) This is caused by change in
in own price of the commodity determinants, other than own
price of the commodity
2. Increase or decrease in own price of b) There can be several causes:
the commodity is the only cause. change in income, change in price
of substitute goods, change in
price of complimentary goods,
change in taste and preferences,
etc.
3. Movement on demand curve is of two c) Shift of demand curve in two
types: ways
i. Contraction i. Decrease in demand curve
ii. Extension. ii. Increase in demand curve
d) In movement demand curve moves 4. In shifting demand curve shifts to the
upward or downward on same curve. right or left from its origin.
Elasticity of Demand
Price elasticity of demand (PED or Ed) is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its
price. More precisely, it gives the percentage change in quantity demanded in response to a one
percent change in price. It was devised by Alfred Marshall.
It is a measure of responsiveness of the quantity of a good or service demanded to changes in its
price.
Measurement of Elasticity of Demand
Elasticity of demand is known as price-elasticity of demand. Because elasticity of demand is the
degree of change in amount demanded of a commodity in response to a change in price. Price
elasticity of demand can be measured through three popular methods. These methods are:
1. Percentage method or Arithmetic method
2. Total Expenditure method
3. Graphic method or point method.
1. Percentage method:-
According to this method price elasticity is estimated by dividing the percentage change in
amount demanded by the percentage change in price of the commodity. Thus given the
percentage change of both amount demanded and price we can derive elasticity of demand. If the
percentage charge in amount demanded is greater than the percentage change in price, the
coefficient thus derived will be greater than one.
If percentage change in amount demanded is less than percentage change in price, the elasticity
is said to be less than one. But if percentage change of both amount demanded and price is same,
elasticity of demand is said to be unit.
2. Total expenditure method
Total expenditure method was formulated by Alfred Marshall. The elasticity of demand can be
measured on the basis of change in total expenditure in response to a change in price. It is worth
noting that unlike percentage method a precise mathematical coefficient cannot be determined to
know the elasticity of demand.
By the help of total expenditure method we can know whether the price elasticity is equal to one,
greater than one, less than one. In such a method the initial expenditure before the change in
price and the expenditure after the fall in price are compared. By such comparison, if it is found
that the expenditure remains the same, elasticity of demand is One (ed=I).
If the total expenditure increases the elasticity of demand is greater than one (ed>l). If the total
expenditure diminished with the change in price elasticity of demand is less than one (ed<I). The
total expenditure method is illustrated by the following diagram.
3. Graphic method:
Graphic method is otherwise known as point method or Geometric method. This method was
popularized by method. According to this method elasticity of demand is measured on different
points on a straight line demand curve. The price elasticity of demand at a point on a straight line
is equal to the lower segment of the demand curve divided by upper segment of the demand
curve.
Thus at mid point on a straight-line demand curve, elasticity will be equal to unity; at higher
points on the same demand curve, but to the left of the mid-point, elasticity will be greater than
unity, at lower points on the demand curve, but to the right of the midpoint, elasticity will be
less than unity.

Factors Affecting Elasticity of Demand

Elasticity of demand differs from commodity to commodity. Not only that, elasticity of demand
of the same commodity may be different for different persons. These differences in elasticity of
demand are due to various causes, which are discussed below:
1. Price level: Generally, the demand for very costly and very cheap goods is elastic. Very
costly goods are demanded by the rich people and hence their demand is not affected much
by changes in prices.
For example, increase in the price of Maruti Car from Rs. 3, 00,000 to Rs. 3, 20,000 will not
make any noticeable difference in its demand. Similarly, the changes in the price of very
cheap goods (such as salt) will not have any effect on their demand, for a very small part of
income is spent on such commodities.
2. Availability of Substitutes: The demand for a commodity will be very elastic if some other
commodities can be used for it. A small rise in the price of such a commodity will induce
consumers to use its substitutes. For example gas, kerosene oil, coal etc. will be used more as
fuel if the price of wood increases. On the other hand, the demand of such commodities is
inelastic which have no substitutes such as salt.
3. Time period: Longer is the time period more elastic is the demand. In the short period if price
of a commodity like petrol is increased, its demand will not fall immediately and hence it
would be inelastic or less elastic. But if period is longer alternative sources of energy can be
developed and hence demand would be elastic.
4. Proportion of total expenditure spent on the product: If a small proportion of total
expenditure is spent on a commodity, its demand will be inelastic such as demand for salt. On
the other hand, if a major portion of total expenditure is spent on a commodity, its demand
will be more or highly elastic such as demand for luxuries.
5. Habits: Some products which are not essential for some individuals are essential for others. If
individuals are habituated of some commodities the demand for such commodities will be
usually inelastic, because they will use them even when their prices go up. A smoker
generally does not smoke less when the price of cigarette goes up.
6. Nature of the commodities: Generally, the demand for necessaries is inelastic and that for
comforts and luxuries of life elastic. This is so because certain goods which are essential to
life will be demanded at any price, whereas goods meant for luxuries and comforts can be
dispensed with easily if they appear to be costly.
7. Various uses: Generally, a commodity which has several uses will have an elastic demand
such as milk, wood etc. On the other hand, a commodity having only one use will have
inelastic demand.
8. Postponement: Usually the demand for such commodities whose use can be postponed for
some time is elastic. For example, the demand for V.C.R. is elastic because its use can be
postponed for some time if its price goes up, but the demand for rice and wheat is inelastic
because their use cannot be postponed when their prices increase.

Cross Elasticity of Demand

An economic concept that measures the responsiveness in the quantity demanded of one good
when a change in price takes place in another good. The measure is calculated by taking the
percentage change in the quantity demanded of one good, divided by the percentage change in
price of the substitute good:
Cross elasticity of demand is synonymous to "cross price elasticity of demand".

Income Elasticity of Demand

A measure of the relationship between a change in the quantity demanded for a particular good
and a change in real income. Income elasticity of demand is an economics term that refers to the
sensitivity of the quantity demanded for a certain product in response to a change in consumer
incomes. The formula for calculating income elasticity of demand is:
Income Elasticity of Demand = % change in quantity demanded / % change in income
For example, if the quantity demanded for a good increases for 15% in response to a
10%increase in income, the income elasticity of demand would be 15% / 10% = 1.5. The degree
to which the quantity demanded for good changes in response to a change in income depends on
whether the good is a necessity or a luxury.

Advertising elasticity of demand

Advertising elasticity of demand (or simply advertising elasticity, often shortened to AED) is an
elasticity measuring the effect of an increase or decrease in advertising on a market. Although
traditionally considered as being positively related, demand for the good that is subject of the
advertising campaign can be inversely related to the amount spent if the advertising is negative.
Definition
Good advertising will result in a positive shift in demand for a good. AED is used to measure the
effectiveness of this strategy in increasing demand versus its cost. Mathematically, then, AED
measures the percentage change in the quantity of a good demanded induced by a given
percentage change in spending on advertising in that sector:

Demand Forecasting
Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal
methods, such as educated guesses, and quantitative methods, such as the use of historical sales
data or current data from test markets. Demand forecasting may be used in making pricing
decisions, in assessing future capacity requirements, or in making decisions on whether to enter a
new market.
Need for Demand Forecasting
Business managers, depending upon their functional area, need various forecasts. They need to
forecast demand, supply, price, profit, costs and returns from investments.
Demand forecasting is essential for a firm because it must plan its output to meet the forecasted
demand according to the quantities demanded and the time at which these are demanded. The
forecasting demand helps a firm to arrange for the supplies of the necessary inputs without any
wastage of materials and time and also helps a firm to diversify its output to stabilize its income
overtime.
The purpose of demand forecasting differs according to the type of forecasting-
(1) The purpose of the Short term forecasting:
It is difficult to define short run for a firm because its duration may differ according to
the nature of the commodity. For a highly sophisticated automatic plant 3 months
time may be considered as short run, while for another plant duration may extend to 6
months or one year. Time duration may be set for demand forecasting depending
upon how frequent the fluctuations in demand are, short- term forecasting can be
undertaken by affirm for the following purpose;
Appropriate scheduling of production to avoid problems of over production and under-
production.
Proper management of inventories
Evolving suitable price strategy to maintain consistent sales
Formulating a suitable sales strategy in accordance with the changing pattern of demand
and extent of competition among the firms.
Forecasting financial requirements for the short period.
(2) The purpose of long- term forecasting:
The concept of demand forecasting is more relevant to the long-run that the short-run. It is
comparatively easy to forecast the immediate future than to forecast the distant future.
Fluctuations of a larger magnitude may take place in the distant future. In fast developing
economy the duration may go up to 5 or 10 years, while in stagnant economy it may go up to 20
years. More over the time duration also depends upon the nature of the product for which
demand forecasting is to be made. The purposes are;
Planning for a new project, expansion and modernization of an existing unit,
diversification and technological up gradation.
Assessing long term financial needs. It takes time to raise financial resources.
Arranging suitable manpower. It can help a firm to arrange for specialized labour force
and personnel.
Evolving a suitable strategy for changing pattern of consumption.
Methods of forecasting
Methods of forecasting too much emphasis should not be placed on mathematical or statistical
techniques of forecasting. Though statistical techniques are essential in clarifying relationships
and providing techniques of analysis, they are not substitutes for judgment. Forecasting also
should not be left entirely to the judgment of the so-called experts. What is needed is some
commonsense mean between pure guessing and too much mathematics.
Various Methods of Forecasting
1. Survey of Buyers Intentions or Market Survey Studies.
2. Delphi Method
3. The Collective Opinion also called as Sales Force Polling or Expert Opinion polls.
4. Analysis of Time Series and Trend Projections
5. Use of Economic Indicators Regression Analysis and Economic Model Building
6. Controlled Experiments Test Marketing.
7. Judgmental Approach

1. Survey of Buyers Intentions (Opinion Surveys): The most direct method of estimating
demand in the short-run is to ask customers what they are planning to buy for the
forthcoming time period usually a year. This is very useful when bulk of the sales is to
industrial producers. Here the burden of forecasting is shifted to the consumer. In this
method, customers may tend to exaggerate their requirements. Customers are numerous,
making the method too laborious, impracticable and costly. This method does not expose
and measure the variables under the managements control . Delphi Method: This is a
variant of the opinion poll or survey method.

2. In Delphi Method, an attempt is made to arrive at a consensus of opinion. The participants

are supplied with responses to previous questions from others in the group by a leader. The
leader provides each expert with opportunity to react to the information given by others,
including reasons advanced, without disclosing the source.

3. Collective Opinion or Sales Force Polling or Expert Opinion Polls Salesmen are required
to estimate expected sales in their territories. Salesmen being the closest to the customers,
have most intimate feel of the market. The estimates of individual salesmen are consolidated
to find out the total estimated sales. These estimates are reviewed to eliminate the bias of
optimism or pessimism. Thereafter they are further revised in the light of factors proposed
 change in prices, product design, advertising budget, expected change in competition,
changes in purchasing power, income distribution, employment, population etc.
The method is known as collective opinion as it takes advantage of the collective wisdom of
salesmen, departmental heads like production manager, sales manager, marketing manager,
managerial economist and top executives, as well as dealers and distributors.
4. Analysis of Time Series and Trend Projections A firm which has been in existence for
some time, will have Accumulated data on sales pertaining to past time periods. Such Data
when arranged chronologically yield time series. Time Series of sales represent the past
pattern of effective demand for a Particular product. Such data can be presented graphically
or in Tabular form. The most popular method of analysis of time series is to project the trend
of the time series data. A trend line can be fitted through a series either visually or by means
of statistical techniques such as method of least squares. The analyst chooses a plausible
algebraic relation (linear, quadratic, logarithmic, etc.) between sales and the independent
variable, time. The trend line is then projected into the future by extrapolation. This method
is popular because it is simple and inexpensive. The basic assumption is that the past rate of
change will continue in the future. Thus the technique yields acceptable results so long as the
time series shows a persistent tendency to move in the same direction.
5. Use of Economic Indicators The use of this approach bases demand forecasting on certain
economic indicators following these steps: See whether a relationship exists between demand
for the product and the economic indicator. Establish the relationship through the method of
least squares and derive the regression equation. Assuming the relationship to be linear, the
equation will be Y = a + bx Once the regression equation is derived, the value of Y i . e.
demand can be estimated for any given value of x. Drawback : Finding an appropriate
economic indicator may be difficult. For new products it is inappropriate as no past data
exists.
 UNIT-3
Production
Production is transformation of tangible inputs (raw materials, semi-finished goods,
subassemblies) and intangible inputs (ideas, information, knowledge) into output(goods or
services) in a specific period of time at given state of technology. Resources are used in this
process to create an output that is suitable for use or has exchange value.

Production Function

Production is transformation of tangible inputs (raw materials, semi-finished goods,

subassemblies) and intangible inputs (ideas, information, knowledge) into output(goods or
services) in a specific period of time at given state of technology. Output is thus, a function of
inputs. Technical relation between inputs and outputs is depicted by production function. It
denotes effective combination of inputs.

In economics, a production function relates physical output of a production process to physical

inputs or factors of production. In macroeconomics, aggregate production functions are
estimated to create a framework in which to distinguish how much of economic growth to
attribute to changes in factor allocation (e.g. the accumulation of capital) and how much to
attribute to advancing technology. Some non-mainstream economists, however, reject the very
concept of an aggregate production function.

Concept of production functions

In general, economic output is not a (mathematical) function of input, because any given set of
inputs can be used to produce a range of outputs. To satisfy the mathematical definition of a
function, a production function is customarily assumed to specify the maximum output
obtainable from a given set of inputs. A production function can be defined as the specification
of the minimum input requirements needed to produce designated quantities of output, given
available technology. In the production function, itself, the relationship of output to inputs is
non-monetary; that is, a production function relates physical inputs to physical outputs, and
prices and costs are not reflected in the function.
In the decision frame of a firm making economic choices regarding productionhow much of
each factor input to use to produce how much outputand facing market prices for output and
inputs, the production function represents the possibilities afforded by an exogenous technology.
Under certain assumptions, the production function can be used to derive a marginal product for
each factor. The profit-maximizing firm in perfect competition (taking output and input prices as
given) will choose to add input right up to the point where the marginal cost of additional input
matches the marginal product in additional output. This implies an ideal division of the income
generated from output into an income due to each input factor of production, equal to the
marginal product of each input.
The inputs to the production function are commonly termed factors of production and may
represent primary factors, which are stocks. Classically, the primary factors of production were
Land, Labor and Capital. Primary factors do not become part of the output product, nor are the
primary factors, themselves, transformed in the production process.
Production function differs from firm to firm, industry to industry. Any change in the state of
technology or managerial ability disturbs the original production function. Production function
can be represented by schedules, graph, tables, mathematical equations, TP, AP & MP Curves,
isoquant and so on.
Specifying the production function
A production function can be expressed in a functional form as the right side of
Q = f (K, L, I, O)
Where:
Q = quantity of output
K, L, I, O stand for quantities of factors of production (capital, labour, land or
organization respectively) used in production

Stages of production

To simplify the interpretation of a production function, it is common to divide its range into 3
stages as follows:

Stage 1 (from the origin to point B): the variable input is being used with increasing output per
unit, the latter reaching a maximum at point B (since the average physical product is at its
maximum at that point). Because the output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always operate beyond this stage.

Stage 2: output increases at a decreasing rate, and the average and marginal physical product are
declining. However, the average product of fixed inputs (not shown) is still rising, because
output is rising while fixed input usage is constant. In this stage, the employment of additional
variable inputs increases the output per unit of fixed input but decreases the output per unit of the
variable input. The optimum input/output combination for the price-taking firm will be in stage
2, although a firm facing a downward-sloped demand curve might find it most profitable to
operate in Stage 1.

Stage 3: too much variable input is being used relative to the available fixed inputs. variable
inputs are over-utilized in the sense that their presence on the margin obstructs the production
process rather than enhancing it. The output per unit of both the fixed and the variable input
declines throughout this stage. At the boundary between stage 2 and stage 3, the highest
possible output is being obtained from the fixed input.
Factor of production
In economics, factors of production are the inputs to the production process. Finished goods are
the output.
Input determines the quantity of output i.e. output depends upon input. Input is the starting point
and output is the end point of production process and such input-output relationship is called a
production function. The product of one industry may be used in another industry. For E.G.,
wheat is a output for a framer; but when it is used to produce bread it becomes a factor of
production.
There are three basic (AKA classical) factors of production:
Land
Labor
Capital
entrepreneur
All three of these are required in combination at a time to produce a commodity.
'Factors of production' may also refer specifically to the 'primary factors', which are stocks
including land, labor (the ability to work), and capital goods applied to production. Materials and
energy are considered secondary factors in classical economics because they are obtained from
land, labor and capital. The primary factors facilitate production but neither become part of the
product (as with raw materials) nor become significantly transformed by the production process
(as with fuel used to power machinery).
Four factors of production

According to Prof. Benham, "Anything that contributes towards output is a factor of

production."

Cooperation among factors is essential to produce anything because production is not a job of
single factor.

Production theory
Production theory is the study of production, or the economic process of converting inputs into
outputs. Some economists define production broadly as all economic activity other than
consumption. They see every commercial activity other than the final purchase as some form of
production. Production is a process, and as such it occurs through time and space. Because it is a
flow concept, production is measured as a rate of output per period of time.
There are three aspects to production processes:
The quantity of the good or service produced
The form of the good or service created
The temporal and spatial distribution of the good or service produced
A production process can be defined as any activity that increases the similarity between the
pattern of demand for goods and services, and the quantity, form, shape, size, length and
distribution of these goods and services available to the market place.

Isoquant

An isoquant is one of the ways of presenting production, where the two factors of production are
explicitly shown. It represents all possible input combination of two factors, which are capable of
producing the same level of output. While an indifference curve mapping helps to solve the
utility-maximizing problem of consumers, the isoquant mapping deals with the cost-
minimization problem of producers. As producer will be indifferent between such combinations,
so it is often referred to as producers indifference curve. A family of isoquants can be
represented by an isoquant map, a graph combining a number of isoquants, each representing a
different quantity of output. Isoquants are also called equal product curves.

Production Isoquant/Isocost Curve

An isoquant shows the extent to which the firm in question has the ability to substitute between
the two different inputs at will in order to produce the same level of output. An isoquant map can
also indicate decreasing or increasing returns to scale based on increasing or decreasing distances
between the isoquant pairs of fixed output increment, as output increases. Isoquant curve
analysis helps a producer to find a combination of two factors, which gives him maximum output
at minimum cost.
As with indifference curves, two isoquants can never cross. Also, every possible combination of
inputs is on an isoquant. Finally, any combination of inputs above or to the right of an isoquant
results in more output than any point on the isoquant. Although the marginal product of an input
decreases as you increase the quantity of the input while holding all other inputs constant, the
marginal product is never negative in the empirically observed range since a rational firm would

Isoquant Map

The isoquant curve

A. The isoquant curve contains all combinations of 2 inputs that produce the same total output.
B. All points on an isoquant curve are technically efficient.
C. The curve is bowed toward the origin because of the law of diminishing marginal
productivity.
D. The slope of the isoquant is called the "Marginal Rate of Technical Substitution" (MRTS) or
the "Marginal Rate of Substitution (MRS).
E. For every possible combination of inputs, there is an isoquant. The whole set of isoquants is
called the "isoquant map". The "isoquant map" is a picture of the state of technology.
F. It slopes downward from left to right
G. Isoquants never touch, intersect each other

Total, average, and marginal product

 Total Product Curve

Average and marginal product curve

The total product (or total physical product) of a variable factor of production identifies what
outputs are possible using various levels of the variable input. This can be displayed in either a
chart that lists the output level corresponding to various levels of input, or a graph that
summarizes the data into a total product curve. The diagram shows a typical total product
curve. In this example, output increases as more inputs are employed up until point A. The
maximum output possible with this production process is Qm. (If there are other inputs used in
the process, they are assumed to be fixed.)
The average physical product is the total production divided by the number of units of variable
input employed. It is the output of each unit of input. If there are 10 employees working on a
production process that manufactures 50 units per day, then the average product of variable
labour input is 5 units per day.
The average product typically varies as more of the input is employed, so this relationship can
also be expressed as a chart or as a graph. A typical average physical product curve is shown
(APP). It can be obtained by drawing a vector from the origin to various points on the total
product curve and plotting the slopes of these vectors.
The marginal physical product of a variable input is the change in total output due to a one unit
change in the variable input (called the discrete marginal product) or alternatively the rate of
change in total output due to an infinitesimally small change in the variable input (called the
continuous marginal product). The discrete marginal product of capital is the additional output
resulting from the use of an additional unit of capital (assuming all other factors are fixed). The
continuous marginal product of a variable input can be calculated as the derivative of quantity
produced with respect to variable input employed. The marginal physical product curve is shown
(MPP). It can be obtained from the slope of the total product curve. Because the marginal
product drives changes in the average product, we know that when the average physical product
is falling, the marginal physical product must be less than the average. Likewise, when the
average physical product is rising, it must be due to a marginal physical product greater than the
average. For this reason, the marginal physical product curve must intersect the maximum point
on the average physical product curve.
Notes: MPP keeps increasing until it reaches its maximum. Up until this point every additional
unit has been adding more value to the total product than the previous one. From this point
onwards, every additional unit adds less to the total product compared to the previous one MPP
is decreasing. But the average product is still increasing till MPP touches APP. At this point, an
additional unit is adding the same value as the average product. From this point onwards, APP
starts to reduce because every additional unit is adding less to APP than the average product. But
the total product is still increasing because every additional unit is still contributing positively.
Therefore, during this period, both, the average as well as marginal products, are decreasing, but
the total product is still increasing. Finally we reach a point when MPP crosses the x-axis. At this
point every additional unit starts to diminish the product of previous units, possibly by getting
into their way. Therefore the total product starts to decrease at this point. This is point A on the
total product curve.
The marginal rate of technical substitution
Isoquants are typically convex to the origin reflecting the fact that the two factors are
substitutable for each other at varying rates. This rate of substitutability is called the marginal
rate of technical substitution (MRTS) or occasionally the marginal rate of substitution in
production. MRTS indicates the rate at which factors can be substituted at the margin in such a
manner that the total output remains unaltered.
It measures the reduction in one input per unit increase in the other input that is just sufficient to
maintain a constant level of production. For example, the marginal rate of substitution of labour
for capital gives the amount of capital that can be replaced by one unit of labour while keeping
output unchanged. To move from point A to point B in the diagram, the amount of capital is
reduced from Ka to Kb while the amount of labour is increased only from La to Lb. To move
from point C to point D, the amount of capital is reduced from Kc to Kd while the amount of
labour is increased from Lc to Ld. The marginal rate of technical substitution of labour for
capital is equivalent to the absolute slope of the isoquant at that point (change in capital divided
by change in labour).
MRTS = Slope = K/L
It is equal to 0 where the isoquant becomes horizontal, and equal to infinity where it becomes
vertical.
The opposite is true when going in the other direction (from D to C to B to A). In this case we
are looking at the marginal rate of technical substitution capital for labour (which is the
reciprocal of the marginal rate of technical substitution labour for capital).
It can also be shown that the marginal rate of substitution labour for capital is equal to the
marginal physical product of labour divided by the marginal physical product of capital.
As the total output remains same at every point of isoquant, so, loss in physical output from a
small reduction in factor K will be equal to gain in physical output from a small increment in
factor L. thus, loss of output = gain of output.

The law of variable proportions

Or Short run production function/return to factor
Definition

The Law of Variable Proportions which is the new name of the famous Law of Diminishing
Returns.
According to Stigler "As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point, the resulting increments of
produce will decrease i.e., the marginal product will diminish".

According to Paul Samulson "An increase in some inputs relative to other fixed inputs
will in a given state of technology cause output to increase, but after a point, the extra
output resulting from the same addition of extra inputs will become less".

The law of variable proportions states that as the quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that factor will eventually decline. This means that
up to the use of a certain amount of variable factor, marginal product of the factor may increase
and after a certain stage it starts diminishing.

Assumptions of Law:

Constant technology--- This law assumes that technology does not change throughout the
operation of the law.
Fixed amount of some factors.one factor of production has to be fixed for this law.
Possibility of varying factor proportionsthis law assumes that variable factors can be --
changed in the short run.
all the units of variable factor are homogenous
input prices remain unchanged
output is measured in physical units

Three stages of law of variable proportion

Stage 1 (stage of increasing return): the variable input is being used with increasing output per
unit, the latter reaching a maximum at point B (since the average physical product is at its
maximum at that point). Because the output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always operate beyond this stage.

Stage 2(stage of diminishing returns): output increases at a decreasing rate, and the average
and marginal physical product are declining. However, the average product of fixed inputs (not
shown) is still rising, because output is rising while fixed input usage is constant. In this stage,
the employment of additional variable inputs increases the output per unit of fixed input but
decreases the output per unit of the variable input. The optimum input/output combination for the
price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve
might find it most profitable to operate in Stage 1.
Stage 3(stage of negative returns): too much variable input is being used relative to the
available fixed inputs. Variable inputs are over-utilized in the sense that their presence on the
margin obstructs the production process rather than enhancing it. The output per unit of both the
fixed and the variable input declines throughout this stage. At the boundary between stage 2
and stage 3, the highest possible output is being obtained from the fixed input.
Long Run Production - Returns to Scale

In the long run, all factors of production are variable. How the output of a business responds
to a change in factor inputs is called returns to scale. Law of return to scale is concerned with
the study of production function in long run. A change in scale means that all inputs or factors
are varied in same proportion, keeping the factor proportions constant. When the quantities of all
factors are changed along a particular scale, size of the firm and scale of output will change.

As we begin to model production in the long run, we will simplify the production function
somewhat as:

Q = f(L, K)
Q = quantity of commodity produced
K, L = Capital & Labour

When we double the factor inputs from (150L + 20K) to (300L + 40K) then the
percentage change in output is 150% - there are increasing returns to scale.
When the scale of production is changed from (600L + 80K0 to (750L + 100K) then the
percentage change in output (13%) is less than the change in inputs (25%) implying a
situation of decreasing returns to scale.
 Increasing returns to scale occur when the % change in output > % change in inputs
Decreasing returns to scale occur when the % change in output < % change in inputs
Constant returns to scale occur when the % change in output = % change in inputs

The nature of the returns to scale affects the shape of a businesss long run average cost curve.

Numerical example of long run returns to scale

Units of Capital Units of Labour Total Output % Change in % Change in Returns to

Inputs Output Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
Possible Cases in Long Run Period of Production

The long run period of production usually analyzes the economies of scale which studies the
increasing returns to scale or economies of mass production. It tends to provided information
about the unit cost and the size of operation in the production of goods. The economies of scale
primarily directed to reduce the unit costs from the increasing size of the operation. That is why
the larger firms are more economically viable in the long run production as it diminishes the
production cost. Take note that the economies of scale tends to increase in specialization and
division of labor. This may lead to increase production inputs and expands the production output.

1. Decreasing Returns to Scale (Increasing Cost): When the firm becomes large
it is likely to encounter problem in the production of a particular product because of the
increase average cost of operation. This is the problem of management when increase of
production input by 60% the production output reaches only to 40%. In this notion the
production is less cheap at a certain scale when it is already large in scale. It requires large-
scale machinery or division of labor to produce greater production output. Hence, the
Decreasing Returns to scale occur when the percent change in output is greater in percent
for the change in inputs.

2. Constant Returns to Scale (Constant Cost): There is a time for a firm to enjoy a long range
of production output for which the average cost is the same proportion to both production
input and output. If there is an increase of the number of machines by 50% then there is also
an increase of the number of units produced by 50%. This is a constant returns in machinery
production. Hence, the Constant Returns to scale occur when the average cost do not
increase as a result of diseconomies of scale.
3. Increasing Return to Scale (Decreasing Cost): This is known as the economies of scale
wherein the firms increase in all production inputs and outputs. Supposing a firm increases
the inputs by 50% the return of scale increases to 60%.The economies scale expands
productive capacity in the long run as it operated by machines and other sophisticated
technology that may reduce the overhead cost in producing the products. This is more on
capital-intensive production wherein there are more equipment utilize than workers in the
production process. In the long run, the manufacturing sectors with high capital investment
of equipment results to higher production output that expands the profitability of the firms.
The economies of scale are the reduction of unit cost in the long run of operation. The
expansion of the firm through a mass production provides greater units of output.
Difference between return to factor & return to scale

The difference between returns to a variable factor and returns to scale flow from the Law of
Diminishing Returns and must be understood in the parameters of the concepts of short-run and
long-run.

Short run (return to factor) is a period when production can be increased only with increase in
variable factors because fixed factors are constant; the firms cannot change their sizes and scales
in the short run. When output is increased by more quantities of variable factors with the fixed
factor held constant, the the proportion between the fixed and variable factors changes and the
change in output follows the Law of Variable Proportions in terms of which initially the total
rises at a higher rate, then it become constant because marginal product reaches zero and
eventually it falls. This locus of the marginal product (MP) i.e. incremental output is called the
Law of Variable Proportions.

Long run (return to scale) is defined as a period which allows the firm to change their sizes and
scales to increase output i.e. in the long run all factors are variable but even in this case initially
there are increasing returns to scale i.e. the total output rises with fast speed, then it becomes
constant and eventually the total output falls because marginal product (MP) becomes negative.
This situation is subservient to the Law of Diminishing Returns to Scale.

The basic difference between the laws of returns to a variable factor and the laws of returns to
scale lies in the assumptions on which these laws are based.

1. In case of the laws of returns to a variable factor, only one input is variableall other
inputs remaining constantwhereas in case of the laws of returns to scale, all the
inputs are variable.
2. The law of returns to a variable factor is a short run phenomenon because supply of
capital in the short run is inelastic. On the contrary, the laws of returns to scale are a
long run phenomenon because supply of all the inputs in the long run is elastic and
more and more of all the inputs can be employed. In the analysis of the inputoutput
relationship, therefore, in case of the law of returns to a variable factor a single-
variable production function is used whereas in case of the laws of returns to scale a
two-variable production function is used.
 UNIT-4
Concept of cost
The term cost means the amount of expenses [actual or national] incurred on or attributable to
specified thing or activity.
A producer requires various factors of production or inputs for producing commodity. He pays
them in a form of money. Such money expenses incurred by a firm in the production of a
commodity are called cost of production.
As per Institute of cost and work accounts (ICWA) India, Cost is measurement in monetary
terms of the amount of resources used for the purpose of production of goods or rendering
services. To get the results we make efforts. Efforts constitute cost of getting the results. It can be
expressed in terms of money; it means the amount of expenses incurred on or attributable to
some specific thing or activity.
Short run cost & long run cost

Short-run cost
Short run cost varies with output, when unlike long run cost all the factors are not variable. This
cost becomes relevant, when a firm has to decide whether or not to produce more in the
immediate future. This cost can be divided into two components of fixed and variable cost on the
basis of variability of factors of production.

1. Fixed cost: In the short period the expenses incurred on fixed factors are called the fixed
cost. These costs dont change with changes in level of output.
The fixed cost is those cost that dont vary with the size of output.

2. Variable cost: VC are those costs which are incurred on the use of variable factors of
production. They directly change with production. The rate of increase of total variable
cost is determined by the law of returns.

3. Total cost: TC of a firm for various levels of output are the sum of total fixed cost and
total variable cost.

4. Average cost: per unit cost of a good is called its average cost. Average cost is total cost
divided by output.

AC= TC/Q
AC= AFC+AVC

a) Average fixed cost: AFC is total fixed cost /total output. AFC is the per unit cost of
the fixed factor of production.
 b) Average variable cost: AVC is found by dividing the total variable cost by the
total unit of output.
5. Marginal cost: MC is the addition made to the total cost by the production of one more
unit of a commodity.
MC = TCn (TCn -1)
MC = TC/Q

Long-run cost
In the long run, all factors of production are variable. Hence there is no distinction between fixed
and variable cost. All cost are variable cost and there is nothing like fixed cost.
a) Long run average cost
b) Long run marginal cost

a) Long run avg. cost: LRAC refers to minimum possible per unit cost of producing
different quantities of output of a good in the long period.

b) Long run marginal cost: change in the total cost in the long run, due to the
production of one more unit, is called LRMC.
Economies and Diseconomies of Scale

Economies of scale are the cost advantages that a business can exploit by expanding the
scale of production
The effect is to reduce the long run average (unit) costs of production.
These lower costs are an improvement in productive efficiency and can benefit consumers
in the form of lower prices. But they give a business a competitive advantage too!

Internal Economies of Scale

Internal economies of scale arise from the growth of the business itself. Examples include:

1. Technical economies of scale:

a. Large-scale businesses can afford to invest in expensive and specialist capital
machinery. For example, a supermarket chain such as Tesco or Sainsbury can
invest in technology that improves stock control. It might not, however, be viable
or cost-efficient for a small corner shop to buy this technology.
 b. Specialization of the workforce: Larger businesses split complex production
processes into separate tasks to boost productivity. The division of labour in
mass production of motor vehicles and in manufacturing electronic products is an
example.
c. The law of increased dimensions. This is linked to the cubic law where
doubling the height and width of a tanker or building leads to a more than
proportionate increase in the cubic capacity this is an important scale economy
in distribution and transport industries and also in travel and leisure sectors.
2. Marketing economies of scale and monopsony power: A large firm can spread its
advertising and marketing budget over a large output and it can purchase its inputs in
bulk at negotiated discounted prices if it has monopsony (buying) power in the market.
A good example would be the ability of the electricity generators to negotiate lower
prices when negotiating coal and gas supply contracts. The big food retailers have
monopsony power when purchasing supplies from farmers.
3. Managerial economies of scale: This is a form of division of labour. Large-scale
manufacturers employ specialists to supervise production systems and oversee human
resources.
4. Financial economies of scale: Larger firms are usually rated by the financial markets to
be more credit worthy and have access to credit facilities, with favorable rates of
borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and
loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra
financial capital) more cheaply through the issue of equities. They are also likely to pay a
lower rate of interest on new company bonds issued through the capital markets.
5. Network economies of scale: This is a demand-side economy of scale. Some networks
and services have huge potential for economies of scale. That is, as they are more widely
used they become more valuable to the business that provides them. The classic examples
are the expansion of a common language and a common currency. We can identify
networks economies in areas such as online auctions, air transport networks. Network
economies are best explained by saying that the marginal cost of adding one more user
to the network is close to zero, but the resulting benefits may be huge because each new
user to the network can then interact, trade with all of the existing members or parts of
the network. The expansion of e-commerce is a great example of network economies of
scale how many of you are devotees of the EBay web site or Facebook?

External economies of scale

External economies of scale occur within an industry and from the expansion of it
Examples include the development of research and development facilities in local
universities that several businesses in an area can benefit from and spending by a local
authority on improving the transport network for a local town or city.
Likewise, the relocation of component suppliers and other support businesses close to
the main centre of manufacturing are also an external cost saving.

Diseconomies of scale
A firm may eventually experience a rise in average costs caused by diseconomies of scale.

Diseconomies of scale a firm might be caused by:

1. Control monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly.
2. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss
of morale. If they do not consider themselves to be an integral part of the business, their
productivity may fall leading to wastage of factor inputs and higher costs. A fall in
productivity means that workers may be less productively efficient in larger firms.
3. Loss of control over costs big businesses may lose control over fixed costs such as
expensive head offices, management expenses and marketing costs. There is also a risk
that very expensive capital projects involving new technology may prove ineffective and
leave the business with too much under-utilized capital.

Evaluation: Do economies of scale always improve the welfare of consumers?

Standardization of products: Mass production might lead to a standardization of

products limiting the amount of consumer choice.
Lack of market demand: Market demand may be insufficient for economies of scale to
be fully exploited leaving businesses with a lot of spare capacity.
Developing monopoly power: Businesses may use economies of scale to build up
monopoly power and this might lead to higher prices, a reduction in consumer welfare
and a loss of allocative efficiency.
Protecting monopoly power: Economies of scale might be used as a barrier to entry
whereby existing firms can drive prices down if there is a threat of the entry of new
suppliers.

Explicit Cost and Implicit Cost

Explicit cost:

All those expenses that a firm incurs to make payment to others are called explicit cost. An
explicit cost is a direct payment made to others in the course of running a business, such as wage,
rent and materials. Explicit costs are taken into account along with implicit ones when
considering economic profit. Accounting profit only takes explicit costs into account.

Implicit cost:

Implicit cost is the cost of entrepreneurs own factors or resources. These includes the rewards
for the entrepreneurs self owned land, building, labour & capital. In economics, an implicit cost,
also called an imputed cost, implied cost.

Implicit costs also represent the divergence between economic profit (total revenues minus total
costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total
revenues minus only explicit costs). Since economic profit includes these extra opportunity costs,
it will always be less than or equal to accounting profit.

Private and Social Cost

Private cost refers to the cost of production incurred & provided for by an individual firm
engaged in the production of a commodity. It is found out to get private profits. It includes both
explicit as well as implicit cost. A firm is interested in minimizing private cost.

Social cost refers to the cost of producing a commodity to the society as a whole. It takes into
consideration of all those costs which were borne by the society directly or indirectly. It is a sum
of private cost & external cost. for example, from pollution of the atmosphere.

SOCIAL COST = PRIVATE COST + EXTERNALITY

For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the
atmosphere. This creates negative externalities which impose higher social costs on other firms
and consumers. e.g. clean up costs and health costs.

Another example of higher social costs comes from the problems caused by traffic congestion in
towns, cities and on major roads and motor ways. It is important to note though that the
manufacture, purchase and use of private cars can also generate external benefits to society. This
why cost-benefit analysis can be useful in measuring and putting some monetary value on both
the social costs and benefits of production.

Key Concepts:

Private Costs + External Costs = Social Costs

If external costs > 0, then private costs < social costs.

Then society tends to:

Price the good or service too low and Produces or consumes too much of the good or
service.

Different Costs Matter:

Private costs for a producer of a good, service, or activity include the costs the firm pays to
purchase capital equipment, hire labor, and buy materials or other inputs. While this is
straightforward from the business side, it also is important to look at this issue from the
consumers perspective. Field, in his 1997 text, Environmental Economics provides an example
of the private costs a consumer faces when driving a car:
The private costs of this (driving a car) include the fuel and oil, maintenance, depreciation, and
even the drive time experienced by the operator of the car.

Private costs are paid by the firm or consumer and must be included in production and
consumption decisions. In a competitive market, considering only the private costs will lead to a
socially efficient rate of output only if there are no external costs.

External costs, on the other hand, are not reflected on firms income statements or in
consumers decisions. However, external costs remain costs to society, regardless of who pays
for them. Consider a firm that attempts to save money by not installing water pollution control
equipment. Because of the firms actions, cities located down river will have to pay to clean the
water before it is fit for drinking, the public may find that recreational use of the river is
restricted, and the fishing industry may be harmed. When external costs like these exist, they
must be added to private costs to determine social costs and to ensure that a socially efficient rate
of output is generated.

Social costs include both the private costs and any other external costs to society arising from the
production or consumption of a good or service. Social costs will differ from private costs, for
example, if a producer can avoid the cost of air pollution control equipment allowing the firms
production to imposes costs (health or environmental degradation) on other parties that are
adversely affected by the air pollution. Remember too, it is not just producers that may impose
external costs on society. Lets also view how consumers actions also may have external costs
using Fields previous example on driving:2

The social costs include all these private costs (fuel, oil, maintenance, insurance, depreciation,
and operators driving time) and also the cost experienced by people other than the operator who
are exposed to the congestion and air pollution resulting from the use of the car.

The key point is that even if a firm or individual avoids paying for the external costs arising from
their actions, the costs to society as a whole (congestion, pollution, environmental cleanup,
visual degradation, wildlife impacts, etc.) remain. Those external costs must be included in the
social costs to ensure that society operates at a socially efficient rate of output.

Market

The term market refers to a place where goods are purchased and sold such as: super bazaar,
Connaught place etc. market should not be restricted to specific place. The term market in
economics is used in a broader sense and market may be defined as an arrangement of
establishing effective relationship between buyers and sellers of the commodities.

Classification of markets

1) Perfect competition
2) Monopoly
3) Monopolistic
 4) oligopoly

Perfect competition
In economic theory, perfect competition (sometimes called pure competition) describes markets
such that no participants are large enough to have the market power to set the price of a
homogeneous product. Because the conditions for perfect competition are strict, there are few if
any perfectly competitive markets. Still, buyers and sellers in some auction-type markets, say for
commodities or some financial assets, may approximate the concept. As a Pareto efficient
allocation of economic resources, perfect competition serves as a natural benchmark against
which to contrast other market structures.
Basic structural characteristics
Generally, a perfectly competitive market exists when every participant is a "price taker", and no
participant influences the price of the product it buys or sells. Specific characteristics may
include:
 Infinite buyers and sellers An infinite number of consumers with the willingness and
ability to buy the product at a certain price, and infinite producers with the willingness
and ability to supply the product at a certain price.
Zero entry and exit barriers A lack of entry and exit barriers makes it extremely easy
to enter or exit a perfectly competitive market.
Perfect factor mobility In the long run factors of production are perfectly mobile,
allowing free long term adjustments to changing market conditions.
Perfect information - All consumers and producers are assumed to have perfect
knowledge of price, utility, quality and production methods of products.
Zero transaction costs - Buyers and sellers do not incur costs in making an exchange of
goods in a perfectly competitive market.
Profit maximization - Firms are assumed to sell where marginal costs meet marginal
revenue, where the most profit is generated.
Homogenous products - The qualities and characteristics of a market good or service do
not vary between different suppliers.
Non-increasing returns to scale - The lack of increasing returns to scale (or economies
of scale) ensures that there will always be a sufficient number of firms in the industry.
Property rights - Well defined property rights determine what may be sold, as well as
what rights are conferred on the buyer.
In the short run, perfectly-competitive markets are not productively efficient as output will not
occur where marginal cost is equal to average cost (MC=AC). They are allocatively efficient, as
output will always occur where marginal cost is equal to marginal revenue (MC=MR). In the
long run, perfectly competitive markets are both allocatively and productively efficient.
In perfect competition, any profit-maximizing producer faces a market price equal to its marginal
cost (P=MC). This implies that a factor's price equals the factor's marginal revenue product. It
allows for derivation of the supply curve on which the neoclassical approach is based. This is
also the reason why "a monopoly does not have a supply curve". The abandonment of price
taking creates considerable difficulties for the demonstration of a general equilibrium except
under other, very specific conditions such as that of monopolistic competition.
Price determination in perfect market
A perfect competition firm will be in equilibrium when it earns maximum profits. Profits here
are abnormal, excess or supernormal. The equilibrium price is determined at a point where the
demand for and the supply of the total industry are equal to each other.
Price determination in short run

In the short run, it is possible for an individual firm to make an economic profit. This situation
is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost
denoted by C.
The equilibrium level of output of the firm is OQ. Now the two conditions to equilibrium can be
stated as under.
a) Necessary condition: MC= MR
b) Sufficient condition: slope of MC > slope of MR
Price determination in long run

However, in the long period, economic profit cannot be sustained. The arrival of new firms or
expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal)
demand curve of each individual firm to shift downward, bringing down at the same time the
price, the average revenue and marginal revenue curve. The final outcome is that, in the long run,
the firm will make only normal profit (zero economic profit). Its horizontal demand curve will
touch its average total cost curve at its lowest point.
With the equilibrium condition of the marginal analysis the long run equilibrium of the
competitive firm requires that the long run marginal cost should be equal to the price( P = AR
=MR).
Monopoly
A monopoly (to sell) exists when a specific person or enterprise is the only supplier of a
particular commodity (this contrasts with a monopsony which relates to a single entity's control
of a market to purchase a good or service, and with oligopoly which consists of a few entities
dominating an industry).Monopolies are thus characterized by a lack of economic competition to
produce the good or service and a lack of viable substitute goods. The verb "monopolize" refers
to the process by which a company gains the ability to raise prices or exclude competitors. In
economics, a monopoly is a single seller. In law, a monopoly is a business entity that has
significant market power, that is, the power to charge high prices. Although monopolies may be
big businesses, size is not a characteristic of a monopoly. A small business may still have the
power to raise prices in a small industry (or market).
A monopoly is distinguished from a monopsony, in which there is only one buyer of a product or
service; a monopoly may also have monopsony control of a sector of a market. Likewise, a
monopoly should be distinguished from a cartel (a form of oligopoly), in which several providers
act together to coordinate services, prices or sale of goods. Monopolies, monopsonies and
oligopolies are all situations such that one or a few of the entities have market power and
therefore interact with their customers (monopoly), suppliers (monopsony) and the other
companies (oligopoly) in ways that leave market interactions distorted.
When not coerced legally to do otherwise, monopolies typically maximize their profit by
producing fewer goods and selling them at higher prices than would be the case for perfect
competition.
Monopolies can be established by a government, form naturally, or form by integration. In many
jurisdictions, competition laws restrict monopolies. Holding a dominant position or a monopoly
of a market is often not illegal in itself, however certain categories of behavior can be considered
abusive and therefore incur legal sanctions when a business is dominant. A government-granted
monopoly or legal monopoly, by contrast, is sanctioned by the state, often to provide an
incentive to invest in a risky venture or enrich a domestic interest group. Patents, copyright, and
trademarks are sometimes used as examples of government granted monopolies, but they rarely
provide market power. The government may also reserve the venture for itself, thus forming a
government monopoly.
Characteristics Profit Maximizer: Maximizes profits.
Price Maker: Decides the price of the good or product to be sold, but does so by
determining the quantity in order to demand the price desired by the firm.
High Barriers to Entry: Other sellers are unable to enter the market of the monopoly.
 Single seller: In a monopoly, there is one seller of the good that produces all the
output.[5] Therefore, the whole market is being served by a single company, and for
practical purposes, the company is the same as the industry.
Price Discrimination: A monopolist can change the price and quality of the product. He
sells more quantities charging less price for the product in a very elastic market and sells
less quantities charging high price in a less elastic market
Price Determination under Monopoly
Monopoly is that market form in which a single producer controls the whole supply of a single
commodity which has no close substitute.
From this definition there are two points that must be noted:

(i) Single Producer: There must be only one producer who may be an individual, a
partnership firm or a joint stock company. Thus single firm constitutes the industry.
The distinction between firm and industry disappears under conditions of monopoly.
(ii) No Close Substitute: the commodity produced by the producer must have any
closely competing substitutes, if he is to be called a monopolist. This ensures that
there is no rival of the monopolist. Therefore, the cross elasticity of demand between
the product of the monopolist and the product of any other producer must be very
low.

Monopoly Price and profit

In economics, a firm is a monopoly when, because of the lack of any viable competition, it is
able to become the sole producer of the industry's product. In a normal competitive situation, the
price the firm gets for its product is exactly the same as the Marginal cost of producing the
product. Because the monopoly firm does not have to worry about losing customers to
competitors, it can set a price that is significantly higher than Marginal (Economic) cost of
producing (the last unit of) the product. Therefore, a monopoly situation usually allows the firm
to set a monopoly price which is higher than the price that would be found in a more competitive
industry. And to generate an economic profit over and above the normal profit that is typically
found in a perfectly competitive industry. The economic profit obtained by a monopoly firm is
referred to as monopoly profit. The existence of a monopoly, and therefore the existence of a
monopoly price and monopoly profit, depends on the existence of barriers to entry: these stop
other firms from entering into the industry and sapping away profits.
A firm with monopoly power setting prices will typically set price at the profit maximizing level.
The most profitable price that they can set (what will become the monopoly price) is where the
optimum output level (where marginal cost (MC) equals marginal revenue (MR), although not in
the diagram below, because it is drawn incorrectly) meets the demand curve. Under normal
market conditions for a monopolist, this price will be higher than the Marginal (Economic) cost
of producing the product, thereby indicating the price paid by the consumer, which is equal to the
marginal benefit for the consumer, is above the firm's marginal cost.[ In the chart below the
shaded area represents the profits of the monopolist, such that MR = MC for the case of
monopoly. The lower half represents the normal profits that would go to a competitive firm
(ignoring output losses). The upper half represents the additional economic profit going to the
monopolist.

Control of Monopoly Power

Monopoly power can be controlled by the government by anti-monopoly laws and restrictive
trade practices legislation. These aim at removing unfair competition, preventing unfair price
discrimination and fixing prices equal to competitive prices.

The government can also bring down monopoly price to competitive level by price regulation
and taxation. It may impose price ceiling so that monopoly price should be near or equal to
competitive price. This can be done by appointing a regulating authority of commission which
fixes a pie for the monopoly product below the monopoly price. Taxation is another way to
control monopoly power. The tax may be levied lump sum without any regard to the output of
the monopolist. Or it may be proportional to the output, the amount of tax rising with the
increase in output. In either case, the aim is to bring monopoly price to the competitive level.
Lastly, Prof. Pigou favoured nationalization of monopoly to put an end to monopoly power.

COMPARISON OF PRICE DETERMINATION UNDER PERFECT COMPETITION

AND MONOPOLY
The key points of comparison of price determination under Perfect Competition and Monopoly is
as below:

Perfect Competition Monopoly

(i) The demand curve or average revenue (i) The demand curve or average revenue
curve is perfectly elastic and is a horizontal curve is relatively elastic and a downward
straight line. sloping from left to right.

(ii) The firm is in equilibrium at the level of

output where MC is equal to MR. Since in
perfect competition MR is equal to AR or
(ii) The firm is in equilibrium at the level of
price, therefore, when MC is equal to MR, it
output where MC is equal to MR.
is also equal to AR or price at the
equlibrium position, i.e., MC=MR=AR
(Price)

(iii) In equilibrium position, the price (iii) In equilibrium position, the price
charged by the firm equals to MC. charged by the firm is above MC.

(iv) The firm is in long-run equilibrium at (iv) The firm is in long-run equilibrium at
the minimum point of the long-run AC the point where AC curve is still declining
curve. and has not reached the minimum point.

(v) The firm is in equilibrium at the level of

(v) The firm is in equilibrium at the level of
output at which MR curve is sloping
output at which MC curve is rising, and is
downwards, and MC curve is cutting it from
cutting MR curve from below.
below or above.
(vi) In the long run, the firm is earning
normal profit. There may be super normal (vi) The firm can earn abnormal or
profit in the short run but they will be swept supernormal profit even in the long run, as
away in the long run, as new firms entered there is no competitor in the industry.
into the industry.

(vii) Price can be set lower at greater output

(vii) Price is set higher and output smaller
in case of constant-cost and decreasing-cost
by the monopolist.
industries.

Price discrimination
Price discrimination or price differentiation exists when sales of identical goods or services are
transacted at different prices from the same provider. In a theoretical market with perfect
information, perfect substitutes, and no transaction costs or prohibition on secondary exchange
(or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and
oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller
tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling
to the consumer buying at the higher price but with a tiny discount. However, product
heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing
unsustainable in the long run) can allow for some degree of differential pricing to different
consumers, even in fully competitive retail or industrial markets.
The effects of price discrimination on social efficiency are unclear. Output can be expanded
when price discrimination is very efficient. Even if output remains constant, price discrimination
can reduce efficiency by misallocating output among consumers.
Price discrimination requires market segmentation and some means to discourage discount
customers from becoming resellers and, by extension, competitors. This usually entails using one
or more means of preventing any resale: keeping the different price groups separate, making
price comparisons difficult, or restricting pricing information. The boundary set up by the
marketer to keep segments separate is referred to as a rate fence. Price discrimination is thus very
common in services where resale is not possible; an example is student discounts at museums: In
theory, students, for their condition as students, may get lower prices than the rest of the
population for a certain product or service, and later will not become resellers, since what they
received, may only be used or consumed by them. Another example of price discrimination is
intellectual property, enforced by law and by technology. In the market for DVDs, DVD-players
are designed and produced- by law- with hardware or software to prevent inexpensive copying or
playing of content purchased legally elsewhere in the world (for example legally purchased in
India) from being used in a higher price market (like in the US or Europe). The Digital
Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the
enhanced monopoly profits that copyright holders can obtain from price discrimination against
higher price market segments.
Price discrimination can also be seen where the requirement that goods be identical is relaxed.
For example, so-called "premium products" (including relatively simple products, such as
cappuccino compared to regular coffee with cream) have a price differential that is not explained
by the cost of production. Some economists have argued that this is a form of price
discrimination exercised by providing a means for consumers to reveal their willingness to pay.
Types of price discrimination
First degree price discrimination
This type of price discrimination requires the monopoly seller of a good or service to know the
absolute maximum price (or reservation price) that every consumer is willing to pay. By
knowing the reservation price, the seller is able to absorb the entire consumer's surplus from the
consumer and transform it into revenues. So the profit is equal to the sum of consumer
surplus and producer surplus.
Second degree price discrimination
In second degree price discrimination, price varies according to quantity demanded. Larger
quantities are available at a lower unit price. This is particularly widespread in sales to industrial
customers, where bulk buyers enjoy higher discounts.
Third degree price discrimination
In third degree price discrimination, price varies by attributes such as location or by customer
segment, or in the most extreme case, by the individual customer's identity; where the attribute in
question is used as a proxy for ability/willingness to pay.
Note that it is not always advantageous to the company to price discriminate even if it is
possible, especially for second and third degree discrimination. In some circumstances, the
demands of different classes of consumers will encourage suppliers to ignore one or more classes
and target entirely to the rest. Whether it is profitable to price discriminate is determined by the
specifics of a particular market.

PRICE DISCRIMINATION IN MONOPOLY

Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:

(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are
charged for different uses to which the commodity is put, for example, electricity is
supplied at cheaper rates for domestic than for commercial purposes.
Some monopolists used product differentiation for price discrimination by means of special
labels, wrappers, packing, etc. For example, the perfume manufacturers discriminate prices of
the same fragrance by packing it with different labels or brands.

Conditions of Price-Discrimination: There are three main types of situation:

(a) When consumers have certain preferences or prejudices. Certain consumers usually
have the irrational feeling that they are paying higher prices for a good because it is of a
better quality, although actually it may be of the same quality. Sometimes, the price
differences may be so small that consumers do not consider it worthwhile to bother about
such differences.
(b) When the nature of the good is such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good in question is a direct service.
(c) When consumers are separated by distance or tariff barriers. A good may be sold in
one town for Re. 1 and in another town for Rs. 2. Similarly, the monopolist can charge
higher prices in a city with greater distance or a country levying heavy import duty.

Conditions making Price Discrimination Possible and Profitable: The following conditions
are essential to make price discrimination possible and profitable:

(a) The elasticities of demand in different markets must be different. The market is
divided into sub-markets. The sub-market will be arranged in ascending order of their
elasticities, the higher price being charged in the least elastic market and vice versa.
(b) The costs incurred in dividing the market into sub-markets and keeping them
separate should not be so large as to neutralise the difference in demand elasticities.
(c) There should be complete agreement among the sellers otherwise the competitors will
gain by selling in the dear market.
(d) When goods are sold on special orders because then the purchaser cannot know what is
being charged from others.

Monopolistic competition
Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another as goods but not perfect substitutes (such as
from branding, quality, or location). In monopolistic competition, a firm takes the prices charged
by its rivals as given and ignores the impact of its own prices on the prices of other firms.
Major characteristics
There are six characteristics of monopolistic competition (MC):
1. Product differentiation
2. Many firms
3. Free entry and exit in the long run
4. Independent decision making
5. Market Power
6. Buyers and Sellers do not have perfect information (Imperfect Information)
Product differentiation: MC firms sell products that have real or perceived non-price
differences. However, the differences are not so great as to eliminate other goods as
substitutes. Technically, the cross price elasticity of demand between goods in such a market
is positive. For example, the basic function of motor vehicles is basically the same to move
people and objects from point A to B in reasonable comfort and safety. Yet there are many
different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs
and many variations even within these categories.
Many firms: There are many firms in each MC product group and many firms on the side
lines prepared to enter the market. A product group is a "collection of similar products". The
fact that there are "many firms" gives each MC firm the freedom to set prices without
engaging in strategic decision making regarding the prices of other firms and each firm's
actions have a negligible impact on the market. For example, a firm could cut prices and
increase sales without fear that its actions will prompt retaliatory responses from competitors.
Free entry and exit: In the long run there is free entry and exit. There are numerous firms
waiting to enter the market each with its own "unique" product or in pursuit of positive
profits and any firm unable to cover its costs can leave the market without incurring
liquidation costs. This assumption implies that there are low start up costs, no sunk costs and
no exit costs. The cost of entering and exit is very low.
Independent decision making: Each MC firm independently sets the terms of exchange for
its product. The firm gives no consideration to what effect its decision may have on
competitors. The theory is that any action will have such a negligible effect on the overall
market demand that an MC firm can act without fear of prompting heightened competition.
In other words each firm feels free to set prices as if it were a monopoly rather than an
oligopoly.
Market power: MC firms have some degree of market power. Market power means that the
firm has control over the terms and conditions of exchange. An MC firm can raise its prices
without losing all its customers.
Imperfect information: No sellers or buyers have complete market information, like market
demand or market supply.

Price and Output Determination in Monopolistic Competition

Monopolistically competitive industries are made up of a large number of firms, each small
relative to the size of the total market. Thus, no one firm can affect market price by virtue of its
size alone. But firms differentiate their products, and by so doing gain some control over price.

Price/Output Determination in the Short Run

Since the firm has a downward-sloping demand curve, it will also have a downward-sloping
marginal revenue (MR) curve. A profit-maximizing firm produces where marginal cost (MC)
equals marginal revenue (q0 in the graph below) and charges the price determined by demand
(P0).

In panel (a) of the figure, the monopolistic competitor will make a profit. However, like a
monopoly, a monopolistic competitor is not guaranteed to make a profit in the short run. The
firm may make a loss in the short run; its profitability will depend on the demand.

Price/Output Determination in the Long Run

The action in a monopolistically competitive market occurs when the market moves to the long
run. Since other competitors selling a similar good can enter the market, two changes will occur:

Firm demand will decrease.

Firm demand will become more elastic.

As more firms enter the market, the demand for any one firm will decrease, since the firm is now
sharing the market with other firms.

A decrease in demand implies a leftward shift in the demand curve. Since the entering firms are
producing substitutes for the existing firms good, the demand for the existing good will become
more elastic. An increase in elasticity implies the demand curve is getting flatter. By combining
these effects, as a monopolistically competitive market moves from short-run profits to the long
run, the firms demand curve will move to the left and get flatter. Furthermore, the demand curve
will continue to move until there are no more firms entering the market. Firms will stop entering
the market when profits are zero.
This occurs when the demand curve just barely touches (i.e., is tangent to) the ATC curve, as
shown in the figure above. Once the demand curve is tangent to the ATC curve, the profit-
maximizing price is equal to the average total cost, and thus, profits are zero. In the long run,
competition will drive monopolistically competitive markets to make zero profits. The goal of
the firm is to try to maintain as much short-run profit as possible by differentiating its product.
Eventually, though, in the long run, economic profits will be zero.

If a monopolistic competitor is losing money in the short run, the opposite holds true. If the
market is not profitable, firms will leave as the market moves towards the long run. When firms
leave, there are fewer substitutes, so demand becomes more inelastic and increases since market
demand is split up among more firms. The demand curve keeps getting steeper and moving to
the right until it is tangent to the ATC curve, where profits become zero and no other firms want
to leave the market. (This would occur at point A in panel (b) of the earlier figure.)

Oligopoly

An oligopoly is a market form in which a market or industry is dominated by a small number of

sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce
competition and lead to higher costs for consumers. Alternatively, oligopolies can see fierce
competition because competitors can realize large gains and losses at each other's expense. In
such oligopolies, outcomes for consumers can often be favorable.

Because there are few sellers, each oligopolist is likely to be aware of the actions of the others.
The decisions of one firm influence and are influenced by the decisions of other firms. Strategic
planning by oligopolists needs to take into account the likely responses of the other market
participants
Characteristics

Profit maximization conditions: An oligopoly maximizes profits by producing where

marginal revenue equals marginal costs.
Ability to set price: Oligopolies are price setters rather than price takers.
Entry and exit: Barriers to entry are high. The most important barriers are economies of
scale, patents, access to expensive and complex technology, and strategic actions by
incumbent firms designed to discourage or destroy nascent firms. Additional sources of
barriers to entry often result from government regulation favoring existing firms making
it difficult for new firms to enter the market.
Number of firms: "Few" a "handful" of sellers. There are so few firms that the actions
of one firm can influence the actions of the other firms.
Long run profits: Oligopolies can retain long run abnormal profits. High barriers of
entry prevent sideline firms from entering market to capture excess profits.
Product differentiation: Product may be homogeneous (steel) or differentiated
(automobiles).
Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of
various economic factors can be generally described as selective. Oligopolies have
perfect knowledge of their own cost and demand functions but their inter-firm
information may be incomplete. Buyers have only imperfect knowledge as to price, cost
and product quality.
Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies
are typically composed of a few large firms. Each firm is so large that its actions affect
market conditions. Therefore the competing firms will be aware of a firm's market
actions and will respond appropriately.

Demand curve

Above the kink, demand is relatively elastic because all other firms' prices remain unchanged.
Below the kink, demand is relatively inelastic because all other firms will introduce a similar
price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to
produce at point E which is the equilibrium point and the kink point. This is a theoretical model
proposed in 1947, which has failed to receive conclusive evidence for support.

In an oligopoly, firms operate under imperfect competition. With the fierce price competitiveness
created by this sticky-upward demand curve, firms use non-price competition in order to accrue
greater revenue and market share.

"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping.
They are distinguished by a hypothesized convex bend with a discontinuity at the bend"kink".
Thus the first derivative at that point is undefined and leads to a jump discontinuity in the
marginal revenue curve.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically
competitive market, firms will not raise their prices because even a small price increase will lose
many customers. This is because competitors will generally ignore price increases, with the hope
of gaining a larger market share as a result of now having comparatively lower prices. However,
even a large price decrease will gain only a few customers because such an action will begin a
price war with other firms. The curve is therefore more price-elastic for price increases and less
so for price decreases. Firms will often enter the industry in the long run.

CLASSIFICATION OF OLIGOPOLY
The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further
classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical
products it is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing
differentiated products it is called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration
the reactions of the rival firms in formulating its own price policy it is called oligopoly.
Oligopoly is further classified as below:

(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical
products it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing
differentiated products it is called imperfect or impure oligopoly.

EFFECTS OF OLIGOPOLY
1. Small output and high prices: As compared with perfect competition,
oligopolist sets the prices at higher level and output at low level.
2. Restriction on the entry: Like monopoly, there is a restriction on the
entry of new firms in an oligopolistic industry.
3. Prices exceed Average Cost: Under oligopoly, the firms fixed the
prices at the level higher than the AC. The consumers have to pay more than it is necessary
to retain the resources in the industry. In other words, the economys productive capacity is
not utilized in conformity with the consumers preferences.
4. Lower efficiency: Some economists argued that there is a low level of
production efficiency in oligopoly. There is no tendency for the oligopolists to build
optimum scales of plant and operate them at the optimum rates of output. However, the
Schumpeterian hypothesis states that there is high tendency of innovation and technological
advancement in oligopolistic industries. As a result, the product cost decreases with
production capacity enhancement. It will offset the loss of consumer surplus from too high
prices.
5. Selling Costs: In order to snatch markets from their rivals, the
oligopolistic firms may engage in aggressive and extensive sales promotion effort by means
of advertisement and by changing the design and improving the quality of their products.
6. Wider range of products: As compared with pure monopoly or pure
competition, differentiated oligopoly places at the consumers disposal a wider variety of
commodities.
7. Welfare Effect: Under oligopoly, vide sums of money are poured into
sales promotion to create quality and design differentiations. Hence, from the point of view
of economic welfare, oligopoly fares fairly badly. The oligopolists push non-price
competition beyond socially desirable limits.
What is kinked demand curve hypothesis
Rival consciousness is the basic feature of oligopoly. Under oligopoly price change by a seller
largely depend upon rivals reaction. This result in one particular shape of an oligopoly i.e
kinked demand curve.
References:

Kumar, Raj and Gupta, Kuldip, Business Economics, UDH Publishers and Distributers
Limited, 2009.
Gupta, S.L. & Chaturvedi, D.D., Business Economics, International Book House Pvt. Ltd.,
2010.
Jain, T.R. & Khanna, O.P., Micro Economics, VK Publications, 2010
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