Economics

Table of Contents

Part - I

1) Economic Basics: Introduction

2) What Is Economics?
3) Production Possibility Frontier, Growth, Opportunity Cost and Trade
4) Demand and Supply
5) Elasticity
6) Price Controls
7) Utility
8) Theory of Cost
9) Production Analysis
10) Pricing and the Types of Market: Monopolies, Monopolistic, Oligopolies, and Perfect Competition

Part – II

11) Monetary Theory

12) Inflation & Deflation

1) Economics Basics: Introduction

Economics may appear to be the study of complicated tables and charts, statistics and numbers, but,
more specifically, it is the study of what constitutes rational human behaviour in the endeavour to fulfil
needs and wants.

As an individual, for example, you face the problem of having only limited resources with which to
fulfil your wants and needs, as a result, you must make certain choices with your money. You'll
probably spend part of your money on rent, electricity and food. Then you might use the rest to go to
the movies and/or buy a new pair of jeans. Economists are interested in the choices you make, and
inquire into why, for instance, you might choose to spend your money on a new DVD player instead
of replacing your old TV. They would want to know whether you would still buy a carton of cigarettes
if prices increased by Rs.20 per pack. The underlying essence of economics is trying to understand
how both individuals and nations behave in response to certain material constraints.
We can say, therefore, that economics, often referred to as the "dismal science", is a study of certain
aspects of society. Adam Smith (1723 - 1790), the "father of modern economics" and author of the
famous book "An Inquiry into the Nature and Causes of the Wealth of Nations", spawned the
discipline of economics by trying to understand why some nations prospered while others lagged
behind in poverty. Others after him also explored how a nation's allocation of resources affects its
wealth.

To study these things, economics makes the assumption that human beings will aim to fulfil their
self-interests. It also assumes that individuals are rational in their efforts to fulfil their unlimited wants
and needs. Economics, therefore, is a social science, which examines people behaving according to
their self-interests. The definition set out at the turn of the twentieth century by Alfred Marshall,
author of "The Principles of Economics", reflects the complexity underlying economics: "Thus it is on
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one side the study of wealth; and on the other, and more important side, a part of the study of man."

According to Lionel Robbins, “Economics studies human behaviour as a relationship between ends
and scarce which have alternative uses”.

Benham defined Economics “as a study of the factors affecting the size, distribution and stability of a
country’s national income.”

2) What Is Economics?

In order to begin our discussion of economics, we first need to understand (A) the concept of
scarcity and (B) the two branches of study within economics: microeconomics and macroeconomics.

A. Scarcity

Scarcity, a concept we already implicitly discussed in the introduction to this chapter, refers to the
tension between our limited resources and our unlimited wants and needs. For an individual,
resources include time, money and skill. For a country, limited resources include natural
resources, capital, labour force and technology.

Because all of our resources are limited in comparison to all of our wants and needs, individuals
and nations have to make decisions regarding what goods and services they can buy and which
ones they must forgo. For example, if you choose to buy one DVD as opposed to two video tapes,
you must give up owning a second movie of inferior technology in exchange for the higher quality
of the one DVD. Of course, each individual and nation will have different values, but by having
different levels of (scarce) resources, people and nations each form some of these values as a
result of the particular scarcities with which they are faced.

So, because of scarcity, people and economies must make decisions over how to allocate their
resources. Economics, in turn, aims to study why we make these decisions and how we allocate
our resources most efficiently.

Central Problems of an Economy

The problem of scarcity of resources which arises before an individual consumer also arises
collectively before an economy. It asserts that there is scarcity; that is, that the finite resources
available are insufficient to satisfy all human wants and needs. .On account of this problem and
economy has to choose between the following:

(i) Which goods should be produced and in how much quantity?

(ii) What technique should be adopted for production?

(iii) For whom goods should be produced?

These three problems are known as the central problems or the basic problems of an
economy. Scarcity is the root-cause of all of them. This is so because all other economic
problems cluster around these problems. These problems arise in all economics whether it is a
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socialist economy like that of North Korea or a capitalist economy like that of America or a
mixed economy like that of India. Similarly, they arise in developed and under-developed
economics alike.

(i) What to produce?

There are two aspects of this problem— firstly, which goods should be produced, and
secondly, what should be the quantities of the goods that are to be produced. The first problem
relates to the goods which are to be produced. In other words, what goods should be
produced? An economy wants many things but all these cannot be produced with the available
resources.

Therefore, an economy has to choose what goods should be produced and what goods should
not be. In other words, whether consumer goods should be produced or producer goods or
whether general goods should be produced or capital goods or whether civil goods should be
produced or defense goods. The second problem is what should be the quantities of the goods
that are to be produced.

Production of goods depends upon the use of resources. Hence, this problem is the problem of
allocation of resources. If we allocate more resources for the production of one commodity, the
resources for the production of other commodities would be less.

(ii) How to produce?

The second basic problem is which technique should be used for the production of given
commodities. This problem arises because there are various techniques available for the
production of a commodity such as, for the production of wheat, we may use either more of
labour and less of capital or less of labour or more of capital. With the help of both these
techniques, we can produce equal amount of wheat. Such possibilities exist relating to the
production of other commodities also.

Therefore, every economy faces the problem as to how resources should be combined for the
production of a given commodity. The goods would be produced employing those methods and
techniques, whereby the output may be the maximum and cost of production be the minimum.

Broadly speaking, there arc two techniques of production-labour-intensive technique and

capital-intensive technique. Labour-intensive technique involves greater use of labour and
capital-intensive technique involves greater use of capital. Because of abundance of labour
India would prefer labour-intensive technique. Similarly, America will use capital-intensive
technique because of abundance of capital.

(iii) For whom to produce?

The main objective of producing a commodity in a country is its consumption by the people of
the country. However, even after employing all the resources of a country, it is not possible to
produce all the commodities which are required by the people. Therefore, an economy has to
decide as to for whom goods should be produced. This problem is the problem of distribution
of produced goods and services. Therefore, what goods should be consumed and by whom
depends on how national product is distributed among various people.
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 All the three central problems arise because resources are scarce. Had resources been
unlimited, these problems would not have arisen. For example, in the event of resources being
unlimited, we could have produced each and every thing we had wanted, we could have used
any technique and we could have produced for each and everybody.

Besides, what, how and for whom there are three more problems which are also regarded as
basic problems.

(iv) The problem of efficient use of resources:

An economy has to face the problem of efficiently using its resources. Production can be
increased even by improving the use of resources. Resources will be deemed to be better
utilised when by reallocating them in various uses, production of a commodity can be
increased without adversely affecting the production of other commodities.

(v) The problem of fuller employment of resources:

In many economies, especially in developing economies, there is a tendency towards under-

utilisation of resources. Resources lying idle or not being utilised fully is a recurring problem in
many economies. This problem is particularly acute in labour-abundant economies like that of
India where large scale unemployment exists. In many economies, a vital resource like land
too remains under-utilised. Resources being relatively scarce, they should not be allowed to
remain idle as it is a waste.

(vi) The Problem of Growth:

The last problem is of growth. Every economy strives to increase its production for increasing
standards of living of its people. Economic growth of a country depends upon the fact as to
what extent; it can increase its resources. This problem is not confined to developing
economies alone. It is also faced by developed economies which strive for increasing their
resources in order to increase the material comforts of their technically advanced societies.

B. Macro and Microeconomics

Macro and microeconomics are the two vantage points from which the economy is observed.
Macroeconomics looks at the total output of a nation and the way the nation allocates its limited
resources of land, labour and capital in an attempt to maximize production levels and promote
trade and growth for future generations. After observing the society as a whole, Adam Smith noted
that there was an "invisible hand" turning the wheels of the economy: a market force that keeps
the economy functioning.

Microeconomics looks into similar issues, but on the level of the individual people and firms within
the economy. It tends to be more scientific in its approach, and studies the parts that make up the
whole economy. Analyzing certain aspects of human behaviour, microeconomics shows us how
individuals and firms respond to changes in price and why they demand what they do at particular
price levels.

Micro and macroeconomics are intertwined; as economists gain understanding of certain

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phenomena, they can help nations and individuals make more informed decisions when allocating
resources. The systems by which nations allocate their resources can be placed on a spectrum
where the command economy is on the one end and the market economy is on the other. The
market economy advocates forces within a competitive market, which constitute the "invisible
hand", to determine how resources should be allocated. The command economic system relies on
the government to decide how the country's resources would best be allocated. In both systems,
however, scarcity and unlimited wants force governments and individuals to decide how best to
manage resources and allocate them in the most efficient way possible. Nevertheless, there are
always limits to what the economy and government can do.

3) Production Possibility Frontier (PPF), Growth, Opportunity Cost, and Trade:

A. Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at
which an economy is most efficiently producing its goods and services and, therefore, allocating
its resources in the best way possible. If the economy is not producing the quantities indicated by
the PPF, resources are being managed inefficiently and the production of society will dwindle. The
production possibility frontier shows there are limits to production, so an economy, to achieve
efficiency, must decide what combination of goods and services can be produced.

Let's turn to the chart below. Imagine an economy that can produce only wine and cotton.
According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient
use of resources by the economy. Point X represents an inefficient use of resources, while point Y
represents the goals that the economy cannot attain with its present levels of resources.

As we can see, in order for this economy to produce more wine, it must give up some of the
resources it uses to produce cotton (point A). If the economy starts producing more cotton
(represented by points B and C), it would have to divert resources from making wine and,
consequently, it will produce less wine than it is producing at point A. As the chart shows, by
moving production from point A to B, the economy must decrease wine production by a small
amount in comparison to the increase in cotton output. However, if the economy moves from point
B to C, wine output will be significantly reduced while the increase in cotton will be quite small.
Keep in mind that A, B, and C all represent the most efficient allocation of resources for the
economy; the nation must decide how to achieve the PPF and which combination to use. If more
wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton
production.
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Point X means that the country's resources are not being used efficiently or, more specifically, that
the country is not producing enough cotton or wine given the potential of its resources. Point Y, as
we mentioned above, represents an output level that is currently unreachable by this economy.
However, if there was a change in technology while the level of land, labour and capital remained
the same, the time required to pick cotton and grapes would be reduced. Output would increase,
and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent
the new efficient allocation of resources.

When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the
PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most
efficient allocation of resources and optimal production capability. A shrinking economy could be a
result of a decrease in supplies or a deficiency in technology.

An economy can be producing on the PPF curve only in theory. In reality, economies constantly
struggle to reach an optimal production capacity. And because scarcity forces an economy to
forgo one choice for another, the slope of the PPF will always be negative; if production of product
A increases then production of product B will have to decrease accordingly.

B. Opportunity Cost

Opportunity cost is the value of what is foregone in order to have something else. This value is
unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping
of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can
always change your mind in the future because there may be some instances when the mashed
potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's
decisions, therefore, is determined by his or her needs, wants, time and resources (income).

This is important to the PPF because a country will decide how to best allocate its resources
according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the
country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of
giving up the required cotton production.
Let's look at another example to demonstrate how opportunity cost ensures that an individual will
buy the less expensive of two similar goods when given the choice. For example, assume that an
individual has a choice between two telephone services. If he or she were to buy the most
expensive service, that individual may have to reduce the number of times he or she goes to the
movies each month. Giving up these opportunities to go to the movies may be a cost that is too
high for this person, leading him or her to choose the less expensive service.
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Remember that opportunity cost is different for each individual and nation. Thus, what is valued
more than something else will vary among people and countries when decisions are made about
how to allocate resources.

C. Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative Advantage

An economy can focus on producing all of the goods and services it needs to function, but this
may lead to an inefficient allocation of resources and hinder future growth. By using specialization,
a country can concentrate on the production of one thing that it can do best, rather than dividing
up its resources.

For example, let's look at a hypothetical world that has only two countries (Country A and Country
B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose
that Country A has very little fertile land and an abundance of steel for car production. Country B,
on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to
produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of
effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars.
The opportunity cost of producing both cars and cotton is high for Country A, which will have to
give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of
producing both products is high because the effort required to produce cars is greater than that
of producing cotton.

Each country can produce one of the products more efficiently (at a lower cost) than the other.
Country A, which has an abundance of steel, would need to give up more cars than Country B
would to produce the same amount of cotton. Country B would need to give up more cotton than
Country A to produce the same amount of cars. Therefore, County A has a comparative advantage
over Country B in the production of cars, and Country B has a comparative advantage over
Country A in the production of cotton.

Now let's say that both countries (A and B) specialize in producing the goods with which they have
a comparative advantage. If they trade the goods that they produce for other goods in which they
don't have a comparative advantage, both countries will be able to enjoy both products at a lower
opportunity cost.
Furthermore, each country will be exchanging the best product it can make for another good or
service that is the best that the other country can produce. Specialization and trade also works
when several different countries are involved. For example, if Country C specializes in the
production of corn, it can trade its corn for cars from Country A and cotton from Country B.

Determining how countries exchange goods produced by a comparative advantage, is the

backbone of international trade theory. This method of exchange is considered an optimal
allocation of resources, whereby economies, in theory, will no longer be lacking anything that they
need..

Absolute Advantage
Sometimes a country or an individual can produce more than another country, even though
countries both have the same amount of inputs. For example, Country A may have a technological
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advantage that, with the same amount of inputs (arable land, steel, labour), enables the country to
manufacture more of both cars and cotton than Country B. A country that can produce more of
both goods is said to have an absolute advantage. Better quality resources can give a country an
absolute advantage as can a higher level of education and overall technological advancement. It
is not possible, however, for a country to have a comparative advantage in everything that it
produces, so it will always be able to benefit from trade.

4) Demand and Supply

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at
a certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The
correlation between price and how much of a good or service is supplied to the market is known
as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of
resources. In market economy theories, demand and supply theory will allocate resources in the
most efficient way possible.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a
good, the lower the quantity demanded and vice versa. The amount of a good that buyers
purchase at a higher price is less because as the price of a good goes up, so does the opportunity
cost of buying that good. As a result, people will naturally avoid buying a product that will force
them to forgo the consumption of something else they value more. The chart below shows that the
curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between the quantity demanded (Qd) and price (P). So, at point A, the quantity demanded will be
Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative
relationship between price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in demand (C).

Let’s take another look at the concept of Demand: Used in the vernacular to mean almost any
kind of wish or desire or need. But to an economist, demand refers to both willingness and ability to
pay.

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

We refer to all of these things except the price of the good as determinants of demand. We could
talk about the relationship between quantity demanded and any one of these things. But when we
talk about a demand curve, we are focusing on the relationship between quantity demanded and
price (while holding all the others fixed).

The Law of Demand states that when the price of a good rises, and everything else remains the
same, the quantity of the good demanded will fall. In short,

↑P → ↓Qd

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

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

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

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

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

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

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

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

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

Limitations of the Law/Exception to Law of Demand

1. Change in Habit, Customs and Income : Law of Demand tells us that demand goes
up with a fall in price and goes down with a rise in price. But an increase in price will bring
down the demand if at the same time the income of the consumer has also increased.

2. Necessaries of Life : Law of Demand is not applicable in the case of necessaries of life also.
An increase in the price of flour will not bring down its demand. Likewise a fall in its price will
not very much increase the demand for it.

3. Fear of Shortage in Future : If there is a fear of shortage of a commodity in future its

demand will increase in the present as people would start storing it. ‘But according to the Law of
Demand its demand should go up only when its price falls.

4. Fear of a Rise in Prices in Future : Similarly if the people think that the price of a
particular, ^commodity will increase in future, they will store it. In other words, the demand of that
commodity shall increase at the same price. But the Law of Demand states that demand should
go up only if price will lower the demand.

5. Articles of Distinction : This law does not hold good in case of those commodities
which confer, social distinction. When the price of such commodities goes up, their demand shall
also increase. For .example, an increase in the price of demand will raise its demand and a fall in
price will lower the demand.
Giffin Goods : Sir Robert Giffin observed that sometimes people buy less of a good at a lower
price and more of a good at a higher price. He cited the example of low-paid British wage-
earners. During the early period of the nineteenth century, a rise in the price of bread as before.
Hence, al! such inferior goods are known as Giffin Goods and they are considered to be an
exception to the Law of Demand.

Ignorance : It is possible that a consumer may not be aware of the previous price of a
commodity. In this case he might start purchasing more of a commodity when its price has
actually gone up

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

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

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an upward slope. This means
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that the higher the price, the higher the quantity supplied. Producers supply more at a higher price
because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between the quantity supplied (Qs) and price (P). At point B, the quantity supplied will be Q2 and
the price will be P2, and so on.

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in
demand or price. So it is important to try and determine whether a price change that is caused by
demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an
unexpected rainy season; suppliers may simply accommodate demand by using their production
equipment more intensively. If, however, there is a climate change, and the population will need
umbrellas year-round, the change in demand and price will be expected to be long term; suppliers
will have to change their equipment and production facilities in order to meet the long-term levels
of demand.

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

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

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We refer to all of these, with the exception of the price of the good, as determinants of supply.
When we talk about Supply, we’re talking about the relationship between quantity supplied and the
price of the good, while holding everything else constant.

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

↑P → ↑Qs

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

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

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

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

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply
and demand affect price.

Imagine that a special edition CD of your favourite band is released for Rs.200. Because the
record company's previous analysis showed that consumers will not demand CDs at a price
higher than Rs.200, only ten CDs were released because the opportunity cost is too high for
suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will
subsequently rise because, according to the demand relationship, as demand increases, so does
the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply
relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up
because the supply more than accommodates demand. In fact after the 20 consumers have been
satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt
to sell the remaining ten CDs. The lower price will then make the CD more available to people who
had previously decided that the opportunity cost of buying the CD at Rs.200 was too high.

D. Equilibrium

When supply and demand are equal (i.e. when the supply function and demand

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function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is
at its most efficient because the amount of goods being supplied is exactly the same as the
amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied
with the current economic condition. At the given price, suppliers are selling all the goods that they
have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply
curve, which indicates no allocation inefficiency. At this point, the price of the goods will be P* and
the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If price is set too high, excess supply will be created within the economy, and there will be
allocation inefficiency.

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2. At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2.
Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The
suppliers are trying to produce more goods, which they hope to sell in hope of increasing profits,
but those consuming the goods will purchase less because the price is too high, making the
product less attractive.

3. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so
low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the
consumers. However, as consumers have to compete with one other to buy the good at this price,
the demand will push the price up, making suppliers want to supply more and bringing the price
closer to its equilibrium.

F. Shifts vs. Movement

For economics, the “movements” and “shifts” in relation to the supply and demand curves
represent very different market phenomena:

1. Movements -
Like a movement along the demand curve, a movement along the supply curve means that the
supply relationship remains consistent. Therefore, a movement along the supply curve will occur
when the price of the good changes and the quantity supplied changes in accordance to the
original supply relationship. In other words, a movement occurs when a change in quantity supply
is caused only by a change in price, and vice versa.

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2. Shifts - A shift in a demand or supply curve occurs when a good’s quantity demanded or
supplied changes even though price remains the same. For instance, if the price for a bottle of
beer were Rs.200 and the quantity of beer demanded increased from Q1 to Q2, then there would
be a shift in the demand for beer. Shifts in the demand curve imply that the original demand
relationship has changed, meaning that quantity demand is affected by a factor other than price. A
shift in the demand relationship would occur if, for instance, beer were all of a sudden the only
type of alcohol available for consumption.

Conversely, if the price for a bottle of beer were Rs.200 and the quantity supplied decreased from
Q2 to Q1, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift
in the supply curve implies that the original supply relationship has changed, meaning that quantity
supplied is affected by a factor other than price. A shift in the supply curve would occur, if, for
instance, a natural disaster caused a mass shortage of hops: beer manufacturers would therefore
be forced to supply less beer for the same price.

15
G. Constructing the Market

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

P
PH S

P*
PL
D
Qd2 Qs1 Q* Qd1 Qs2 Q
Mathematical example: Suppose P = 20 - .1Q d and P = 5 + .05Qs. In equilibrium, Qd = Qs, so
we have a system of equations. Solve for Q like so:

20 - .1Q = 5 + .05Q
15 = .15Q
Q* = 100.

Then plug Q* into either equation: P = 20 - .1(100) = 10. So the market equilibrium is P* = 10, Q*
= 100.

If price is below P*, at PL, then we have Qd1 > Qs1. This is called “excess demand” or
“shortage.” The quantity that actually occurs will be Q s1. For this quantity, buyers are
willing to pay much more than PL, so they’ll start bidding against each and raising the
price.

If price is above P*, at PH, then we have Qs2 > Qd2. This is called “excess supply” or “surplus.”
The suppliers will start competing against each other for customers by lowering the price.

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

5) Price Controls

Price floors and price ceilings are government mandated prices that attempt to control the price of
a good or service.

16
A price ceiling is usually imposed to keep down the price of something perceived as too
expensive. To have any effect, it must be imposed below the market price.

Example: Rent control on apartments.

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

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

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

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

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

Example: Agricultural price supports.

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

What effect do we predict? As with any above-equilibrium price, we expect to get a surplus, this
time persistent because sellers can’t bid down the price. And for many years, that’s exactly
what the U.S. had. The government usually bought up the surplus (and dumped it on 3rd World
Markets).

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

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

Changes in Market Equilibrium

Market equilibrium refers to a situation in which quantity demanded is equal to the quantity
supplied, the point at which demand and supply curve meets.

Increase in Supply results in a right ward shift in supply curve, leading to a new equilibrium
point( the intersection point of demand and new supply curve.)

17
· With the increase in supply, supply curve shifts rightward.

· The new equilibrium point is E1

· It would result in fall in prices and increase in quantity demanded.

Increase in demand results in a right ward shift in demand curve, leading to a new
equilibrium point (the intersection point of demand and new supply curve).

- With the increase in demand, demand curve shifts rightward.

- The new equilibrium point is E1

18
- It would result in rise in prices and increase in quanity demanded.

Simultaneous increase in demand and supply results in a right ward shift in demand
curve and supply curve, leading to a new equilibrium point( the intersection point of demand
and new supply curve). The changes in both demand and supply is a real market situation,
The supply and demand curve changes as a result of change in market conditions.

- With the simultaneous increase in demand and supply, demand and supply curves shift
rightward.

- The new equilibrium point is E1

- Here, It would result in rise in price P1 and increase in quantity demanded Q1.

6) Elasticity

The degree to which a demand or supply curve reacts to a change in price is the curve's
elasticity. Elasticity varies among products because some products may be more essential to
the consumer. Products that are necessities are more insensitive to price changes because
consumers would continue buying these products despite price increases. Conversely, a price
increase of a good or service that is considered less of a necessity will deter more consumers
because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp
change in the quantity demanded or supplied. Usually these kinds of products are readily
available in the market and a person may not necessarily need them in his or her daily life. On
the other hand, an inelastic good or service is one in which changes in price witness only
modest changes in the quantity demanded or supplied, if any at all. These goods tend to be
things that are more of a necessity to the consumer in his or her daily life.

19
To determine the elasticity of the supply or demand curves, we can use this
simple equation:

Elasticity = | (% change in quantity / % change in price) |

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than
one, the curve is said to be inelastic.
As we mentioned previously, the demand curve is a negative slope, and if there is a large
decrease in the quantity demanded with a small increase in price, the demand curve looks
flatter, or more horizontal. This flatter curve means that the good or service in question is
elastic.

Price Elasticity of Demand : Ed = |%∆Qd/%∆P|

How do you find the percentage change in something? You find out how much it changed, and
divide by the initial value. For example, suppose your income rises from Rs.400 a week to
Rs.500 a week. The change is Rs.100, so the percentage change is Rs.100/Rs.400 =0 .25 or
up 25%. N.B.: The percentage change depends on the direction you're going. If your income
went from Rs.500 to Rs.400, the percentage change would be - Rs.100/Rs.500 = -0.2 or down
20%.

Thus, we can also write

Ed = |(∆Qd/Qd)/(∆P/P)|

Now, we can rearrange this like so:

Ed = |(∆Qd/∆P) × (P/Qd)|

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

20
Ed = |(1/m) × (P/Qd)|

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

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

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

We have the following definitions:

When Ed > 1, we say the curve is elastic at that point.
When Ed < 1, we say the curve is inelastic at that point.
When Ed = 1, we say the curve is unit elastic at that point.

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

Example: continued from above. We can find the unit elastic point by setting Ed = 1

|(-1/0.1)(50 -0 .1Q)/Q| = 1
(50 -0 .1Q)/Q =0 .1
50 -0 .1Q =0 .1Q
50 = 0.2Q
Q = 250

So the point Q = 250, P = 25 is the unit elastic point.

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

Meanwhile, inelastic demand is represented with a much more upright curve as quantity
changes little with a large movement in price.

As we mentioned, elasticity of supply works similarly. If a change in price results in a big

change in the amount supplied, the supply curve appears flatter and is considered elastic.
Elasticity in this case would be greater than or equal to 1.

On the other hand, if a big change in price only results in a minor change in the quantity
supplied, the supply curve is steeper, and its elasticity would be less than one.

21
A. Factors Affecting Demand Elasticity

There are three main factors that influence a demand’s price elasticity:

1. The availability of substitutes - This is probably the most important factor influencing the
elasticity of a good or service. In general, the more substitutes, the more elastic the demand
will be. For example, if the price of a cup of coffee went up by Rs.10, consumers could replace
their morning coffee with a cup of tea. This means that coffee is an elastic good because a
raise in price will cause a large decrease in demand as consumers start buying more tea
instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change
in the consumption of coffee or tea because there are few substitutes for caffeine. Most people
are not willing to give up their morning cup of caffeine no matter what the price. We would,
therefore, say that caffeine is an inelastic product because of its lack of substitutes. Thus, while
a product within an industry is elastic due to the availability of substitutes, the industry itself
tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have
few - if any - substitutes.

2. Amount of income available to spend on the good - This factor affecting demand
elasticity refers to the total a person can spend on a particular good or service. Thus, if the
price of a can of Coke goes up from Rs. 50 to Rs.100 and income stays the same, the income
that is available to spend on Coke, which is Rs.200, is now enough for only two rather than four
cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke.
Thus if there is an increase in price and no change in the amount of income available to spend
on the good, there will be an elastic reaction in demand: demand will be sensitive to a change
in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up Rs.20 per pack, a
smoker, with very little available substitutes, will most likely continue buying his or her daily
cigarettes. This means that tobacco is inelastic because the change in the quantity demand will
have been minor with a change in price. However, if that smoker finds that he or she cannot
afford to spend the extra Rs.20 per day and begins to kick the habit over a period of time, the
price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income stays the
same, demand will decrease. It follows, then, that if there is an increase in income, demand
tends to increase as well. The degree to which an increase in income will cause an increase in

22
demand is called income elasticity of demand, which can be expressed in the following
equation:

If EDy is greater than one, demand for the item is considered to have a high income elasticity.
If however EDy is less than one, demand is considered to be income inelastic. Luxury items
usually have higher income elasticity because when people have a higher income, they don't
have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air
travel.

Rahul has just received a Rs.100,000 increase in his salary, giving him a total of Rs.18,00,000
per annum. With this higher purchasing power, he decides that he can now afford air travel
twice a year instead of his previous once a year. With the following equation we can calculate
income demand elasticity:

(2 -1) / (1) 1
EDy = ----------------------------------------------------- = -------------------- = 17
(18,00,000 – 17,00,000) / 17,00,000 0.0588

Income elasticity of demand for Rahul’s air travel is 17 - highly elastic.

With some goods and services, we may actually notice a decrease in demand as
income increases. These are considered goods and services of inferior quality that will be
dropped by a consumer who receives a salary increase. An example may be the increase in
the demand of DVDs as opposed to video cassettes, which are generally considered to be of
lower quality. Products for which the demand decreases as income increases have an income
elasticity of less than zero. Products that witness no change in demand despite a change in
income usually have an income elasticity of zero - these goods and services are considered
necessities.

C) Cross Price Elasticity of Demand

This is often known by its less cumbersome title of cross elasticity of demand. It is a measure of
responsiveness of demand for one product to a change in the price of another. It enables us to
predict how much the demand curve for the first product will shift when price of the second
product changes. Cross price elasticity can be calculated as:

23
 Proportionate change in demand for product ‘X’
EC = --------------------------------------------------------------------
Proportionate change in demand for product ‘Y’

If Y is a substitute product of X, X’s demand rises as Y’s price rises, and vice versa. If Y is
complementary X, with Y’s price rise, X’s demand falls, and vice versa.

C1) Cross Price Elasticity of Demand and the Firm

The major determinant of cross price elasticity of demand is the closeness of the substitute or
complement. The closer it is, the bigger is the effect on the first good of a change in the price of
the substitute or complement, and therefore, the greater is the cross elasticity, positive or
negative.

Firms wish to know the cross elasticity of demand for their product when considering the effect
on demand for their product of a change in the price of a rival’s product. If firm B cuts its price, is
this going to make inroads into the sales of firm A? If so, firm A may feel forced to cut its prices
too. If not, firm A may keep its prices unchanged. The cross price elasticity of demand between
a firm’s product and those of each of its rivals are thus vital pieces of information for a firm when
making its production, pricing and marketing plans.

Likewise, a firm wishes to know the cross price elasticity of demand for its product with any
complementary product. Car producers may wish to know the effect of persistent petrol price
changes on sales of their cars.

7) Utility

We have already seen that the focus of economics is to understand the problem of scarcity: the
problem of fulfilling the unlimited wants of humankind with limited and/or scarce resources.
Because of scarcity, economies need to allocate their resources efficiently. Underlying the laws
of demand and supply is the concept of utility, which represents the advantage or fulfilment a
person receives from consuming a good or service. Utility, then, explains how individuals and
economies aim to gain optimal satisfaction in dealing with scarcity.
Utility is an abstract concept rather than a concrete, observable quantity. The units to which we
assign an “amount” of utility, therefore, are arbitrary, representing a relative value. Total utility is
the aggregate sum of satisfaction or benefit that an individual gains from consuming a given
amount of goods or services in an economy. The amount of a person's total utility corresponds
to the person's level of consumption. Usually, the more the person consumes, the larger his or
her total utility will be. Marginal utility is the additional satisfaction, or amount of utility,
gained from each extra unit of consumption. In mathematical term it is expressed as:
Mux = du / dx, where Mux is the marginal utility at x units of consumption.
Although total utility usually increases as more of a good is consumed, marginal utility usually
decreases with each additional increase in the consumption of a good. This decrease
demonstrates the law of diminishing marginal utility. Because there is a certain threshold of
satisfaction, the consumer will no longer receive the same pleasure from consumption once
that threshold is crossed. In other words, total utility will increase at a slower pace as an
individual increases the quantity consumed.

24
 Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet
tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar
will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate
bar will be less than the pleasure you received from eating the one before - probably because
you are starting to feel full or you have had too many sweets for one day.

5 -1 87
6 -10 78

This table shows that total utility will increase at a much slower rate as marginal utility
diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70
but the next three chocolate bars together increase total utility by only 18 additional units.

The law of diminishing marginal utility helps economists understand the law of demand
and the negative sloping demand curve. Prices are lower at a higher quantity demanded
because your additional satisfaction diminishes as you demand more. According to the law of
diminishing marginal utility, when a person consumes more and more units of a good, his total
utility increases first while the extra utility derived from consuming successive units of the good
diminishes. The total utility reaches a maximum value when marginal utility approaches zero
and then total utility starts declining.

MU (Marginal Utlity)
Marginal Utlity Price

TU4 (Max. Total Utlity)

88
Total Utlity Price

80 TU2
TU (Total Utlity Curve)

Number of Units of Consumpton

2 4
As you can see above that the marginal
Number of Units of Consumpton
utility is decreasing with each extra unit of
In order to determine what a consumer's utility and total utility are, economists
consumption. turn diminishing
This is called to
consumer demand theory, which studies consumer behaviour and satisfaction.
marginal utility. Economists
assume the consumer is rational and will thus maximize his or her total utility by purchasing a
combination of different products rather than more of one particular product. Thus, instead of
25
spending all of your money on three chocolate bars, which has a total utility of 85, you should
instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk,
which has a utility of 50. This combination will give you a maximized total utility of 120 but at the
same cost as the three chocolate bars.

Assumptions of Utility:
 Utility can be measured.
 Marginal Utility of money remains constant
 No change in income of the consumer, his taste & fashion to be constant
 No substitute
 Marginal utility of each unit of commodity is independent
 The utility is additive, the utilities derived from different independent goods can be added to
get the measure of total utility.

Characteristics of Utility:
 Utility is not measurable in reality.
 Utility is variable.

 Utility is different from usefulness.

 No legal or moral connotations.

Total Utility (TU)

Total Utility refers to the total satisfaction derived by the consumer from the consumption of a
given quantity of a good.
TU = Sum of all utilities.

Marginal Utility (MU)

Marginal Utility refers to the addition made to the total utility by consuming one more unit of a
commodity.
MUn = TUn - TUn-1

Where, MUn = Marginal Utility of n th unit; TUn = Sum of all n number of utilities;
TUn-1 = Sum of first (n-1) number of utilities

Consumer’s Equilibrium: Law of Equi-marginal Utility

The principle of equi-marginal utility says "a person can get maximum utility with his given
income when it is spent on different commodities in such a way that the marginal utility of
money spent on each item is equal".

It is clear that consumer can get maximum utility from the expenditure of his limited income. He
should purchase such amount of each commodity that the last unit of money spend on each
item provides same marginal utility.

Assumptions of the Law of Equi-marginal Utility:

1. Consumer’s income is given (limited resources).

26
 2. The law operates based on the law of diminishing marginal utility.
3. The consumer is a rational economic individual. This means that the consumer wants to
gain maximum satisfaction with limited resources.
4. The marginal utility of money is constant.
5. Another important assumption is that the utility of each commodity is measurable in
cardinal numbers (1, 2, 3 and so on).
6. The prices of the commodities are constant.
7. There prevails perfect competition in the market.

Suppose, the consumer’s utility function is U = u (x). The consumer buys x units of commodity
X. His total expenditure is x.px. px stands for unit price of X.

Presumably, he wants to maximize the difference between his utility and expenditure
L = u (x) – x.px

By way of first order condition:

dL/dx = [(du/dx) - px] = 0

Since Mux = du/dx,

At equilibrium, Mux = px. Similarly Muy = py for y units.

Therefore, Mux / px = Muy / py - - - - - (v)

And note by definition, Mux / px = Muy / py = Mum, which is constant.

Where, Mum = Marginal utility of money

Mux and Muy are marginal utility of products X and Y, respectively.
px and py are unit price of products X and Y, respectively.

The proportionality rule stated above (v) is the tenet of the law of consumer equilibrium. The
assumption of diminishing marginal utility proportionality rule when considered along with
equi-marginal concept imply that a single price prevails for a commodity in the market. This is
true of a perfectly competitive market.

Limitations of the Law of Equi-marginal Utility

1. Unmeasurable concept :-
The concept of utility is unmeasurable so it is very difficult to behave according to the law.

2. Carelessness :-
Sometimes due to ignorance, people do not obtain the maximum advantage by equating
the marginal utilities.

3. Indivisible units :-

27
 If the unit of expenditure is indivisible then this law will not operate.

4. Customs :-
People are accustomed to customs and traditions, so they use the goods like gold even
there is less utility.

5. Freedom of choice :-
If there is no perfect freedom to choose between various commodities, then the law will
not operate.

The diminishing marginal utility and the law of demand

The law of demand can be directly derived from the law of diminishing marginal utility. The
marginal utility declines as more units of a commodity are consumed. The consumer will go
on purchasing more units of a commodity until the marginal utility becomes equal to the
market price of the commodity. The condition of equilibrium when only one good is purchased
is: “marginal utility is equal to the market price”. If marginal utility of a good is measured in
terms of money, then the marginal utility curve becomes the demand curve of the good. If the
market price P1, the consumer buys Q1 units of this good, and then if the market price
declines to P2, the consumer buys more units as in the following figure. The marginal utility
curve becomes the demand curve.

Marginal Utlity Curve (diminishing) / Demand

P1
Marginal Utlity / Price

Demand Curve
Price

P2

Q1 Q2
Number of Units of Consumpton

Indifference Curve Analysis

(i) Assumptions: The following are the implicit assumptions on consumer psychology in
this analysis:

 Transitivity: If consumer is indifferent to two combinations of two goods, then he is

unaware of the third combination, also.

 Diminishing marginal rate of substitution: The scarcer a good, the greater is its
substitution value.

 Rationality: The consumer aims to maximize his total satisfaction and has got
complete market information.

 Ordinal utility: Utility in this approach is not measurable. A consumer can only specify
28
 his preference for a particular combination of two goods, he cannot specify ‘how
much’.

(ii) The indifference curve: If a consumer is asked whether he prefers combination of 1 of

two goods X & Y (assuming that the market price of X & Y are fixed), or combination 2,
he may give one of the following answers:

 He prefers combination 1 to 2

 He prefers combination 2 to 1

 He is indifferent to combinations 1 and 2

The third answer implies that the consumer prefers 1 as much as he prefers 2. There may
be some more combinations of goods X & Y, which are equally preferable to him. For
example, there may be 5 different combinations of X & Y such that each combination gives
him the same satisfaction.

Indifference Combination of X & Y goods

Combination Units of X Units of Y

1 3 21
2 4 15
3 5 11
4 6 8
5 7 6
The following figure shows the indifference curve. It depicts, in general, all combinations of
two goods, which yield the same level of satisfaction to the customer. The consumer is
indifferent about any two points lying on this curve.

20

15
Units of Y

10

1 2 3 4 5 6 7

Number of Units of X
The Indifference Curve
An indifference curve of a consumer represents a particular level of satisfaction for the
consumer. A consumer may, in fact, specify a large number of such curves each

29
 representing a different level of satisfaction. An indifference map gives a complete
description of a consumer’s tastes and preferences as shown in in the following figure
where I1 through I4 show the different satisfaction levels.

20

15 I4
Units of Y

10
I3
I2
I1
5

1 2 3 4 5 6 7

Number of Units of X
Indifference Map

8) Theory of Cost

Costs play a very important role in managerial decisions involving a selection between
alternative courses of action. It is important to understand various concepts of cost, as
different business problems call for different kinds of costs.

Future and Past Costs

Future costs are the estimates of time adjusted past or present costs. Future costs are
reasonably expected to be incurred in some future period or periods. Their actual incurrence
is a forecast and their management is an estimate. They are the only costs that matter for
managerial decisions because they are only subject to management control.

Incremental and Sunk Costs

Incremental costs are the change in overall costs that result from particular decision
being made. Incremental costs may include both fixed and variable costs. In the short period,
incremental cost will consist of variable cost – cost of additional labour, additional raw
materials, additional raw materials, power, fuel etc., which is the result of a new decision
being made by the firm. Since incremental costs may also be regarded as the difference in
total costs resulting from a contemplated change, they are also called differential costs.

Sunk cost is one, which is not affected or altered by a change in the level or nature of
30
business activity. The most important example of sunk cost is the amortization of past
expenses, e.g. depreciation. Sunk costs are irrelevant for decision making, as they do not
vary with changes contemplated for future by the management.

Historical and Replacement Costs

Historical cost of an asset states the cost of plant, equipment and materials at the price
paid originally for them, while the replacement cost states the cost that the firm would have to
incur if it wanted to replace or acquire the same asset now. For example, if the price of a
Boiler Feed Pump at the time of purchase in 1980 was Rs.15 lakh, and if the present price is
Rs.1 crore, then the original cost of Rs.15 lakh is the historical cost while Rs.1 crore is the
replacement cost. Replacement cost means the price that would have to be paid currently for
acquiring the same plant or the same piece of equipment.

Explicit Costs and Implicit Costs

Explicit costs are those expenses which are actually paid by the firm (paid-out-costs).
These costs appear in the accounting records of the firm. On the other hand, implicit costs
are theoretical costs in the sense that they go unrecognized by the accounting system.

Fixed, Variable, Semi-variable, and Step Costs

The cost which varies directly in proportion to every increase or decrease in the volume of
output or production is known as variable cost. The cost which does not vary, but remains
constant within a given period of time and range of activity, in spite of the fluctuations in
production, is known as fixed cost. The cost which does not vary proportionately, but
simultaneously cannot remain stationary at all times is known as semi-variable cost. Certain
costs remain fixed over a range of activity, and then jump to a new level as activity changes.
Such costs are treated as “Step Costs”. For example, a foreman is in a position to supervise a
given number of employees. Beyond this number it will be necessary to hire a second then third
and so on.

Product Costs and Step Costs

Costs which become part of the cost of product rather than an expense of the period in
which they are incurred are called ‘Product Costs’. They are included in inventory values. In
financial statements such costs are treated as assets until the goods that are assigned to, are
sold. They become an expense at that time. Costs which are not associated with production are
called ‘Period Costs’. They are treated as an expense of the period in which they are incurred.
They may also be fixed as well as variable. Such as, general & administrative costs, sales
commission.

Direct and Indirect Costs

The expenses on material and labour that can be economically and easily traceable to a
product, service or a job are considered as direct costs. Other expenses that can similarly be
traceable to a product, service or a job, are also included in direct costs. On the other hand, the
expenses incurred on those items which are not directly chargeable to production are known as
indirect costs. For example, in the production, salaries of store-keepers, security guards cannot
directly be traceable to production costs. That is why, such expenses are indirect costs.
31
 Controllable and Uncontrollable Costs

Controllable costs are those costs which can be influenced by the action of a specified
member of an undertaking. Costs which cannot be so influenced are termed as uncontrollable
costs. A factory is usually, divided into a number of responsibility centres, each of which is in
charge of a specified level of management. The Officer-in-charge of a particular department or
cost centre can control costs only of those matters which come directly under his control, but not
of other matters. For example, the expenditure incurred by the Tool Room is controllable by the
foreman-in-charge of that section but the share of the Tool Room expenditure which is
appointed to a Machine Shop cannot be controlled by a Machine Shop foreman.

9) Production Analysis

Production is defined as organized activities of transforming resources into finished

32
products.

9a) Factors of Production

An economic term to describe the inputs that are used in the production of goods or services
in the attempt to make an economic profit. The factors of production include land, labour, capital
and entrepreneurship. In essence, land, labour, capital and entrepreneurship encompass all of
the inputs needed to produce a good or service.

Land (also Natural Resources) - Land is the economic resource encompassing natural
resources found within a nation. This resource includes timber, land, fisheries, farms and other
similar natural resources. Land is usually a limited resource for many economies. Although
some natural resources, such as timber, food and animals, are renewable, the physical land is
usually a fixed resource. Nations must carefully use their land resource by creating a mix of
natural and industrial uses. Using land for industrial purposes allows nations to improve the
production processes for turning natural resources into goods.

Labour - Labour represents the human capital available to transform raw or national
resources into consumer goods. Human capital includes all able-bodied individuals capable of
working in the nation’s economy and providing various services to other individuals or
businesses. This factor of production is a flexible resource as workers can be allocated to
different areas of the economy for producing goods or services. Human capital can also be
improved through training or educating workers to complete technical functions or business
tasks when working with other economic resources.

Capital - Capital has two economic definitions as a factor of production. Capital can
represent the monetary resources companies use to purchase natural resources, land and
other capital goods. Monetary resources flow through a nation’s economy as individuals buy
and sell resources to individuals and businesses.

Capital also represents the major physical assets individuals and companies use when
producing goods or services. These assets include buildings, production facilities, equipment,
vehicles and other similar items. Individuals may create their own capital production resources,
purchase them from another individual or business or lease them for a specific amount of time
from individuals or other businesses.

Entrepreneurship - Entrepreneurship is considered a factor of production because

economic resources can exist in an economy and not be transformed into goods. Entrepreneurs
usually have an idea for creating a valuable good or service and assume the risk involved with
transforming economic resources into products. Entrepreneurship is also considered a factor of
production since someone must complete the managerial functions of gathering, allocating and
distributing economic resources or consumer products to individuals and other businesses in
the economy.

9b) Production Function

According to Samuelson, the production function is the technical relationship that reveals
the maximum amount of output capable at being produced by each and every set of inputs
under given state of technical knowledge.

33
 Michael R. Baye opined, “Production function is the function that defines the maximum
amount of output produced with a given set of inputs”.

Importance of Production Function

 It indicates the maximum output produced by using given set of inputs.

 It indicates the proportion of various factors in production.
 It shows the most optimum combination of factors.
 It gives the nature of output in relation to inputs under different conditions.

Assumptions of Production Function

 The production technology remains same throughout the process.

 Production function is considered for a definite period.
 Best available technology is employed for production.
 All inputs are separable.
 All inputs are utilized to their optimum efficiency.

Uses of Production Function

 To obtain maximum output with the given set of inputs.

 To reduce number of inputs and cost of inputs.
 To determine the required quantity of factor inputs for producing desired output.

Types of Production Function

There are two types of production functions:

.
 Short-run production function.

In short-run production function, some of the production inputs are fixed and some
inputs are variable. Production is increased because of additional input variables. When
variation is made only in one factor keeping other factor fixed and effect is studied on
output proportions, it is called law of variable proportions.

 Long-run production function.

In long-run production function, all factors of production or inputs are variable. When
there are large quantities of inputs, there is change in scale of production. The
relationship between input and output is given by the law of returns.

Law of Variable Proportions / One Variable Input

Definitions:

“As the proportion of the factor in a combination of factors is increased after a point, first the
marginal and then the average product of that factor will diminish.” Benham
34
“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 additions
of extra inputs will become less and less.” Samuelson

“The law of variable proportion states that if the inputs of one resource is increased by
equal increment per unit of time while the inputs of other resources are held constant, total
output will increase, but beyond some point the resulting output increases will become
smaller and smaller.” Leftwitch

Assumptions:

Law of variable proportions is based on following assumptions:

(i) Constant Technology:

The state of technology is assumed to be given and constant. If there is an improvement in

technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to be
combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount
with every other unit.

(iv) Short-Run:

The law operates in the short-run when it is not possible to vary all factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture.
Suppose land and labour are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labour can be
shown with the help of the following table:

35
From the table 1 it is clear that there are three stages of the law of variable proportion. In
the first stage average production increases as there are more and more doses of labour
and capital employed with fixed factors (land). We see that total product, average product,
and marginal product increases but average product and marginal product increases up to
40 units. Later on, both start decreasing because proportion of workers to land was
sufficient and land is not properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage,
average product and marginal product start falling. We should note that marginal product
falls at a faster rate than the average product. Here, total product increases at a diminishing
rate. It is also maximum at 70 units of labour where marginal product becomes zero while
average product is never zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal
product is negative and total product falls but average product is still positive. At this stage,
any additional dose leads to positive nuisance because additional dose leads to negative
marginal product.

Graphic Presentation:

In the following diagram, on OX axis, we have measured number of labourers while quantity
of product is shown on OY axis. TP is total product curve. Up to point ‘E’, total product is
increasing at increasing rate. Between points E and G it is increasing at the decreasing
rate. Here marginal product has started falling. At point ‘G’ i.e., when 7 units of labourers
are employed, total product is maximum while, marginal product is zero. Thereafter, it
begins to diminish corresponding to negative marginal product. In the lower part of the
figure MP is marginal product curve.

36
 1st Stage 2nd Stage 3rd Stage
Stage Stage

T
o
t
a
l

O
u
t
p
u
t

Variable Inputs

Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are
employed, it is maximum. After that, marginal product begins to decrease. Before point ‘I’
marginal product becomes zero at point C and it turns negative. AP curve represents
average product. Before point ‘I’, average product is less than marginal product. At point ‘I’
average product is maximum. Up to point T, average product increases but after that it
starts to diminish.

Three Stages of the Law:

1. First Stage:

First stage starts from point ‘O’ and ends up to point F. At point F average product is
maximum and is equal to marginal product. In this stage, total product increases initially at
increasing rate up to point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly
marginal product also increases initially and reaches its maximum at point ‘H’. Later on, it
begins to diminish and becomes equal to average product at point T. In this stage, marginal
product exceeds average product (MP > AP).

2. Second Stage:

It begins from the point F. In this stage, total product increases at diminishing rate and is at
its maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes

37
‘zero’ at point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to
decrease. In this stage, marginal product is less than average product (MP < AP).

3. Third Stage:

This stage begins beyond point ‘G’. Here total product starts diminishing. Average product
also declines. Marginal product turns negative. Law of diminishing returns firmly manifests
itself. In this stage, no firm will produce anything. This happens because marginal product
of the labour becomes negative. The employer will suffer losses by employing more units of
labourers. However, of the three stages, a firm will like to produce up to any given point in
the second stage only.

In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor and b is the fixed factor.
And a1, a2 , a3….are units of a and b1 b2b3…… are unit of b.

Stage I is characterized by increasing AP, so that the total product must also be increasing.
This means that the efficiency of the variable factor of production is increasing i.e., output
per unit of a is increasing. The efficiency of b, the fixed factor, is also increasing, since the
total product with b1 is increasing.

The stage II is characterized by decreasing AP and a decreasing MP, but with MP not
negative. Thus, the efficiency of the variable factor is falling, while the efficiency of b, the
fixed factor, is increasing, since the TP with b1 continues to increase.

Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus,
the efficiency of both the fixed and variable factor is decreasing.

Rational Decision:

Stage II becomes the relevant and important stage of production. Production will not take
place in either of the other two stages. It means production will not take place in stage III
and stage I. Thus, a rational producer will operate in stage II.

38
Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want
to achieve the greatest efficiency possible from the factor for which he is paying, i.e., from
factor a. Thus, he would want to produce where AP is maximum or at the boundary
between stage I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most
efficient point; this is the boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II.
At what place in this stage production takes place would depend upon the relative prices of
a and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of the law of variable
proportions.

They are as follows:

1. Under Utilization of Fixed Factor:

In initial stage of production, fixed factors of production like land or machine, is under-
utilized. More units of variable factor, like labour, are needed for its proper utilization. As a
result of employment of additional units of variable factors there is proper utilization of fixed
factor. In short, increasing returns to a factor begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the factors of production are
fixed during the short period. When the fixed factor is used with variable factor, then its ratio
compared to variable factor falls. Production is the result of the co-operation of all factors.
When an additional unit of a variable factor has to produce with the help of relatively fixed
factor, then the marginal return of variable factor begins to decline.

3. Optimum Production:

After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of fixed
and variable factors become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed on it. If 5 labourers are
put on it, then total production increases very little and the marginal product diminishes.

4. Imperfect Substitutes:

Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly
responsible for the operation of the law of diminishing returns. One factor cannot be used in
place of the other factor. After optimum use of fixed factors, variable factors are increased
and the amount of fixed factor could be increased by its substitutes.

39
Such a substitution would increase the production in the same proportion as earlier. But in
real practice factors are imperfect substitutes. However, after the optimum use of a fixed
factor, it cannot be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law
applies to any field of production where some factors are fixed and others are variable. That
is why it is called the law of universal application.

The main cause of application of this law is the fixity of any one factor. Land, mines,
fisheries, and house building etc. are not the only examples of fixed factors. Machines, raw
materials may also become fixed in the short period. Therefore, this law holds good in all
activities of production etc. agriculture, mining, manufacturing industries.

1. Application to Agriculture:

With a view of raising agricultural production, labour and capital can be increased to any
extent but not the land, being fixed factor. Thus when more and more units of variable
factors like labour and capital are applied to a fixed factor then their marginal product starts
to diminish and this law becomes operative.

2. Application to Industries:

In order to increase production of manufactured goods, factors of production has to be

increased. It can be increased as desired for a long period, being variable factors. Thus, law
of increasing returns operates in industries for a long period. But, this situation arises when
additional units of labour, capital and enterprise are of inferior quality or are available at
higher cost.

As a result, after a point, marginal product increases less proportionately than increase in
the units of labour and capital. In this way, the law is equally valid in industries.

Postponement of the Law:

The postponement of the law of variable proportions is possible under following

conditions:

(i) Improvement in Technique of Production:

The operation of the law can be postponed in case variable factors techniques of production
are improved.

(ii) Perfect Substitute:

The law of variable proportion can also be postponed in case factors of production are
made perfect substitutes i.e., when one factor can be substituted for the other.

40
Isoquants

Iso means equal and quant means quantity. An isoquant is a curve that shows combinations of
two inputs for producing same level of output. Isoquant curves are also known as isoproduct
curves or product indifference curves. The following table shows different combinations of input
factors yielding the same output:

Different input combinations for producing 10,000 units of output

Combinations Input Factors
Capital ( Rs. In Lakh) Number of Labourers
P 1 25
Q 2 20
R 4 10
S 6 8
T 8 5

The above table shows that as the investment goes up, the required number of labourer are
reduced for producing same output. An isoquant is obtained by plotting these points as shown
below:

C
a T
Output = 10,000 Units
p
i S
t
a R
l
P
Q

Labour

Features of Isoquants

a) Downward sloping: Since if one input reduces, the other input increases. This
results in negative slopes curves.
b) Convex to origin: Since inputs are not perfect substitute for each other, isoquants
bulge towards the origin.
c) Do not intersect : Each isoquant represent represents different output level.
Therefore, they do not intersect each other.
d) Do not touch or intersect axes: As both inputs are required to produce output,
isoquants do neither touch, nor intersect any axis.

Marginal Rate of Technical Substitution (MRTS)

41
The Marginal Rate of Technical Substitution (MRTS) refers to the rate by which one input factor
is substituted with the other to attain a given level of output. When two factors of production,
labour and capital, are employed, then MRTS of capital for labour is number of labours which
can be replaced by one unit of capital, usually the combinations of capital and labour are MRTS.
MRTS are the isoquants where input factors are perfect substitutes as shown in the following
diagram. These are called linear isoquants.

C
Producton Level = 10,000 Units
a
p
i
t
a Producton Level = 20,000 Units
l

Labour

Isocosts

Isocosts are the cost curves that show the various combinations of inputs which will cost a
producer the same amount of money. When the production level changes, the total cost
involved also changes. Thus isocost curve moves upward and vice-versa. Any changes in input
prices causes change in slope of isocost lines. Isocost and isoquant curves are used to
determine the input factors for minimizing cost of production. The following figure shows isocost
curves with different levels of total cost.
Isocost Curves
C
a
p Total cost = Rs. 4 lakh
i
t Total cost = Rs. 2 lakh
a
l
Total cost = Rs. 1 lakh

Labour

Least-Cost Combinations of Inputs

42
In order to gain maximum profit, the cost of production must be reduced. Isocosts and isoquants
are used to determine input factors for minimizing cost of production at maximum output. This is
known as Least-cost combination of inputs.

The least-cost combination of inputs is obtained by superimposing the isocost and isoquant
curves. The point of tangencies A, B and C on isoquant curves shows the least-cost combination
of inputs A, B and C for different levels of output is called expansion path or scale line.
Isocost Curve

C Expansion Path
a
p
i
C
t
a Isoquant Curve
l
B
A

Labour

Cobb-Douglas Production Functions

In economics, the Cobb–Douglas production function is a particular functional form of the

production function, widely used to represent the technological relationship between the
amounts of two or more inputs, particularly physical capital and labor, and the amount of output
that can be produced by those inputs. Sometimes the term has a more restricted meaning,
requiring that the function display constant returns to scale (in which case in the formula below).
The Cobb-Douglas form was developed and tested against statistical evidence by Charles Cobb
and Paul Douglas during 1927–194

Cobb and Douglas defines the relation between physical rates of input and physical rates of output
by expression:

Y(L,K) = A Lβ Kα where:

 Y = total production (the real value of all goods produced in a year)

 L = labor input (the total number of person-hours worked in a year)
 K = capital input (the real value of all machinery, equipment, and buildings)
 A = total factor productivity
 α and β are the output elasticities of capital and labour, respectively. These values are
constants determined by available technology.

43
Output elasticity measures the responsiveness of output to a change in levels of either labor or
capital used in production, ceteris paribus. For example, if α = 0.45, a 1% increase in capital
usage would lead to approximately a 0.45% increase in output.

Further, if

α + β = 1,

the production function has constant returns to scale, meaning that doubling the usage of
capital K and labour L will also double output Y. If

α + β < 1,

returns to scale are decreasing, and if

α + β > 1,

returns to scale are increasing. Assuming perfect competition and α + β = 1, α and β can be
shown to be capital's and labour's shares of output.

Cobb and Douglas were influenced by statistical evidence that appeared to show that labour
and capital shares of total output were constant over time in developed countries; they
explained this by statistical fitting least-squares regression of their production function. There is
now doubt over whether constancy over time exists.

Law of Returns

The law of returns states that production output of a firm changes with change in inputs. The law
of returns to scale governs the production function in three stages:

a) Law of increasing returns: The return increases in much greater proportions than the
change in input volume. The reason for increase in production is:
 Division of labour
 Technical expertise
 Economies of large machines

b) Law of constant returns: When the production returns are proportional to the input factor,
constant returns to scale is said to operate. The rate of increase in output remains constant,
all the factors of increasing production becomes less effective, such as, group technology,
division of labour, economies of ;large scale etc.

c) Law of decreasing returns: When there is no proportional increase in production returns in

spite of increase in inputs, decreasing returns to scale is said to operate. The decreasing
returns to scale is caused mainly by:
 Wear and tear of machinery
 Old technology
 Increase in waste
 Lack of training

44
Production

Returns

or
Increasing Constant Decreasing Returns
Output Returns Returns

Inputs

Law of Returns

Economies of Scale

When production is done in large scale and the average cost of production reduces, this
phenomenon is called economies of scale. There exists two types of economies of scale: (a)
internal economies of scale, and (b) external economies of scale.

(a) Internal Economies of Scale

The internal economies of scale refer to the benefits enjoyed when the firm increases its
size and output (production). Internal economies in production reduce the production costs.
Internal economies arise within a firm due to its own expansion or increase in scale of
production. Hence, it is called economies of scale.

Classification of Internal Economies

1) Technical economies
2) Managerial economies
3) Commercial economies
4) Financial economies
5) Risk bearing economies
6) Marketing economies
7) R & D economies

Technical Economies

 Technical economies can be achieved because of:

45
 o Adopting better techniques of production
o Use of powerful machineries
o Employing specialized technical knowhow

 Use of new technology for production process increases the volume of production
and reduces wastages.

Managerial Economies

 Managerial economies are achieved from:

o Creating special departments
o Creating functional specialization
o Delegation of responsibilities

 In a large scale production, managers are required for separate departments. Their
functional specialization leads to minimum wastages, optimum use of resources,
therefore, the cost of production becomes low.

Commercial Economies

 Managerial economies come from:

o Bulk purchase of materials
o Bargaining advantage
o Sales of goods

 When raw materials and spares are purchased on large quantities, there is huge
savings in cost of material, cost of procurement, transportation and storage costs.
These factors further reduce the cost of production and increases profits.

Financial Economies

 Financial economies arise from the fact that a big firm has better credit and can
borrow at more favourable rates. Share of this company enjoy wider market and
encourages prospective investors.

Risk Bearing Economies

 Risk can be spread by diversifying the output. Diversification of products and

services provides strength and stability.

 Large companies can divide their risks by several ways, such as:
o Insuring plant, machineries, employees with insurance companies
o Producing multiple products
o Purchasing raw materials from different sources

Marketing Economies

 A large company can maintain a professional marketing division for various related
activities, such as, customer surveys, effective advertising, and sales promotion.
46
 R & D Economies

 Large organizations can set up and invest on separate research and development
activities for making innovative products. This is very important for survival in the
global competition.

(b) External Economies of Scale

External economies of scale refers to the benefits of the firms which are not dependant on
size of the firm and also not on products. External economies benefits all the firms in the
industry.

As a result of expansion, industry enjoys the following benefits:

 Availability of new and cheaper raw materials

 Availability of better machinery
 Invention and diffusion of superior technologies knowledge
 Trained labour
 Credit facilities

Classification of External Economies of Scale:

1) Economies of Concentration
2) Economies of Information
3) Economies of Disintegration
4) Locational Economies

Economies of Concentration

 Economies of Concentration is due to advantages from availability of skilled labour,

better transport, credit facilities etc Scattered firm can not avail these benefits..

Economies of Information

 Economies of Information refers to the benefit to the firm by trade journal

advertisement, technical journal, technical knowhow from research institutions etc.

Economies of Disintegration

 When industry expands, some of processes can be given to other related firms, e.g.
a number of steel or petroleum company.

Locational Economies

 Locational Economies are conventionally classified as urbanization and localization

economies of scale.

47
  Urbanization Economies of Scale refers to the benefits of locating in a larger city
rather than a smaller one, while the localization refers to the benefits of locating
among a concentration of firms in the same and related industries.
 Urbanization Economies of Scale results in cheaper transportation services, access
to larger labour pools and access to wider range of business services and amenities
in general. Large cities can also impose dis-economies of scale in the form of
congestion, pollution and crime.

10) Pricing and the Types of Market

Monopolies, Monopolistic, Oligopolies and Perfect Competition

48
Economists assume that there are a number of different buyers and sellers in the marketplace.
This means that we have competition in the market, which allows price to change in response
to changes in supply and demand. Furthermore, for almost every product there are substitutes,
so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In
a market with many buyers and sellers, both the consumer and the supplier have equal ability
to influence price.

In some industries, there are no substitutes and there is no competition. In a market that has
only one or few suppliers of a good or service, the producer(s) can control price, meaning that
a consumer does not have choice, cannot maximize his or her total utility and has have very
little influence over the price of goods.

A monopoly is a market structure in which there is only one producer/seller for a product. In
other words, the single business is the industry. Entry into such a market is restricted due to
high costs or other impediments, which may be economic, social or political. For instance, a
government can create a monopoly over an industry that it wants to control, such as electricity.
Another reason for the barriers against entry into a monopoly industry is that oftentimes, one
entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the
government has sole control over the oil industry. A monopoly may also form when a company
has a copyright or patent that prevents others from entering the market. Pfizer, for instance,
had a patent on Viagra.

Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another (e.g. by branding or quality) and hence are
not perfect substitutes. 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. [1][2] In the
presence of coercive government, monopolistic competition will fall into government-granted
monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of
monopolistic competition are often used to model industries. Textbook examples of industries
with market structures similar to monopolistic competition include restaurants, cereal,
clothing, shoes, and service industries in large cities.

In an oligopoly, there are only a few firms that make up an industry. This select group of firms
has control over the price and, like a monopoly; an oligopoly has high barriers to entry. The
products that the oligopolistic firms produce are often nearly identical and, therefore, the
companies, which are competing for market share, are interdependent as a result of market
forces. Assume, for example, that an economy needs only 100 widgets. Company X produces
50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands
will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a
lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as
well.

There are two extreme forms of market structure: monopoly and, its opposite, perfect
competition. Perfect competition is characterized by many buyers and sellers, many products
that are similar in nature and, as a result, many substitutes. Perfect competition means there
are few, if any, barriers to entry for new companies, and prices are determined by supply and
demand. Thus, producers in a perfectly competitive market are subject to the prices
determined by the market and do not have any leverage. For example, in a perfectly
competitive market, should a single firm decide to increase its selling price of a good, the
consumers can just turn to the nearest competitor for a better price, causing any firm that
49
 increases its prices to lose market share and profits.

Four broad categories of market types

 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly

Perfect competition

A perfectly competitive market is a hypothetical market where competition is at its greatest

possible level. Neo-classical economists argued that perfect competition would produce the best
possible outcomes for consumers, and society.

Key characteristics

Perfectly competitive markets exhibit the following characteristics:

1. There is perfect knowledge, with no information failure or time lags. Knowledge is freely
available to all participants, which means that risk-taking is minimal and the role of the
entrepreneur is limited.
2. There are no barriers to entry into or exit out of the market.

3. Firms produce homogeneous, identical, units of output that are not branded.

4. Each unit of input, such as units of labour, are also homogeneous.

5. No single firm can influence the market price, or market conditions. The single firm is said
to be a price taker, taking its price from the whole industry.

6. There are a very large numbers of firms in the market.

7. There is no need for government regulation, except to make markets more competitive.

8. There are assumed to be no externalities, that is no external costs or benefits.

9. Firms can only make normal profits in the long run, but they can make abnormal profits in
the short run.

The firm as price taker

The single firm takes its price from the industry, and is, consequently, referred to as a price taker.
The industry is composed of all firms in the industry and the market price is where market demand
is equal to market supply. Each single firm must charge this price and cannot diverge from it.

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Equilibrium in perfect competition

In the short run

Under perfect competition, firms can make super-normal profits or losses.

In the long run

However, in the long run firms are attracted into the industry if the incumbent firms are making
supernormal profits. This is because there are no barriers to entry and because there is perfect
knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right,
which drives down price until the point where all super-normal profits are exhausted. If firms are
making losses, they will leave the market as there are no exit barriers, and this will shift the

51
industry supply to the left, which raises price and enables those left in the market to derive normal
profits.

In the long run

The super-normal profit derived by the firm in the short run acts as an incentive for new firms to
enter the market, which increases industry supply and market price falls for all firms until only
normal profit is made.

Evaluation

The benefits

It can be argued that perfect competition will yield the following benefits:

1. Because there is perfect knowledge, there is no information failure and knowledge is

shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.

3. Only normal profits made, so producers just cover their opportunity cost.

4. There is no need to spend money on advertising, because there is perfect knowledge and
firms can sell all they can produce. In addition, selling unbranded goods makes it hard to
construct an effective advertising campaign.

5. There is maximum possible:

o Consumer surplus

o Economic welfare

6. There is maximum allocative and productive efficiency:

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 o Equilibrium will occur where P = MC, hence allocative efficiency.

o In the long run equilibrium will occur at output where MC = ATC, which is productive
efficiency.

7. There is also maximum choice for consumers.

How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For example, how
homogeneous is the output of real firms, given that even the smallest of firms working in
manufacturing or services try to differentiate their product.

Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity
markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such
as the number of individual producers that exist, and their inability to influence market price.
Secondly, for other markets in manufacturing and services, the model is a useful yardstick by
which economists and regulators can evaluate levels of competition that exist in real markets.

Monopolies

A pure monopoly is a single supplier in a market. For the purposes of regulation, monopoly power
exists when a single firm controls 25% or more of a particular market.

Formation of monopolies

Monopolies can form for a variety of reasons, including the following:

1. If a firm has exclusive ownership of a scarce resource, such as Microsoft owning the
Windows operating system brand, it has monopoly power over this resource and is the only
firm that can exploit it.
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 2. Governments may grant a firm monopoly status, such as with the Post Office

3. Producers may have patents over designs, or copyright over ideas, characters, images,
sounds or names, giving them exclusive rights to sell a good or service, such as a song
writer having a monopoly over their own material.

4. A monopoly could be created following the merger of two or more firms. Given that this will
reduce competition, such mergers are subject to close regulation and may be prevented if
the two firms gain a combined market share of 25% or more.

Key characteristics

1. Monopolies can maintain super-normal profits in the long run. As with all firms, profits are
maximised when MC = MR. In general, the level of profit depends upon the degree of
competition in the market, which for a pure monopoly is zero. At profit maximisation, MC =
MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal
profits are possible (area PABC).

2. With no close substitutes, the monopolist can derive super-normal profits, area PABC.
3. A monopolist with no substitutes would be able to derive the greatest monopoly power.

Evaluation of monopolies

The advantages of monopolies

Monopolies can be defended on the following grounds:

1. They can benefit from economies of scale, and may be ‘natural’ monopolies, so it may be
argued that it is best for them to remain monopolies to avoid the wasteful duplication of
infrastructure that would happen if new firms were encouraged to build their own
infrastructure.
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 2. Domestic monopolies can become dominant in their own territory and then penetrate
overseas markets, earning a country valuable export revenues. This is certainly the case
with Microsoft.

3. According to Austrian economist Joseph Schumpeter, inefficient firms, including

monopolies, would eventually be replaced by more efficient and effective firms through a
process called creative destruction.

4. It has been consistently argued by some economists that monopoly power is required to
generate dynamic efficiency, that is, technological progressiveness. This is because:

1. High profit levels boost investment in R&D.

2. Innovation is more likely with large enterprises and this innovation can lead to lower
costs than in competitive markets.

3. A firm needs a dominant position to bear the risks associated with innovation.

4. Firms need to be able to protect their intellectual property by establishing barriers to

entry; otherwise, there will be a free rider problem.

5. Why spend large sums on R&D if ideas or designs are instantly copied by rivals who
have not allocated funds to R&D?

6. However, monopolies are protected from competition by barriers to entry and this will
generate high levels of supernormal profits.

7. If some of these profits are invested in new technology, costs are reduced via
process innovation. This makes the monopolist’s supply curve to the right of the
industry supply curve. The result is lower price and higher output in the long run.

The disadvantages of monopoly to the consumer

Monopolies can be criticised because of their potential negative effects on the consumer,
including:

1. Restricting output onto the market.

2. Charging a higher price than in a more competitive market.

3. Reducing consumer surplus and economic welfare.

4. Restricting choice for consumers.

5. Reducing consumer sovereignty.

Higher prices

The traditional view of monopoly stresses the costs to society associated with higher prices.
Because of the lack of competition, the monopolist can charge a higher price (P1) than in a more
competitive market (at P).
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The area of economic welfare under perfect competition is E, F, B. The loss of consumer surplus if
the market is taken over by a monopoly is P P1 A B. The new area of producer surplus, at the
higher price P1, is E, P1, A, C. Thus, the overall (net) loss of economic welfare is area A B C.

The area of deadweight loss for a monopolist can also be shown in a more simple form,
comparing perfect competition with monopoly.

Alternative diagram

The following diagram assumes that average cost is constant, and equal to marginal cost (ATC =
MC).Under perfect competition, equilibrium price and output is at P and Q. If the market is
controlled by a single firm, equilibrium for the firm is where MC = MR, at P1 and Q1. Under perfect
competition, the area representing economic welfare is P, F and A, but under monopoly the area of
welfare is P, F, C, B. Therefore, the deadweight loss is the area B, C, A.

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The wider and external costs of monopolies

Monopolies can also lead to:

1. A less competitive economy in the global market-place.

2. A less efficient economy.

1. Less productively efficient

2. Less allocatively efficient

3. The economy is also likely to suffer from ‘X’ inefficiency, which is the loss of management
efficiency associated with markets where competition is limited or absent.

4. Less employment in the economy, as higher prices lead to lower output and les need to
employ labour.

Remedies

Monopoly power can be controlled, or reduced, in several ways, including price controls and
prohibiting mergers.

It is widely believed that the costs to society arising from the existence of monopolies and
monopoly power are greater than the benefits and that monopolies should be regulated.

Options available to regulators include:

1. Regulators can set price controls and formulae, often called price capping. This means
forcing the monopolist to charge a price, often below profit maximising price. For example,
in the UK the RPI – ‘X’ formula has been widely used to regulate the prices of the privatised
utilities. In the formula, the RPI (Retail Price Index) represents the current inflation rate and
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 ‘X’ is a figure which is set at the expected efficiency gain, which the regulator believes
would have existed in a competitive market. However, there is a dilemma with price controls
because price-capping results in lower prices, but lower prices also deter entry into the
market. The formula for water is RPI + K + U, where K is the price limit, and U is any
unused 'credit' from previous years. For example, if K is 3% in 2010, but a water company
only 'uses' 2%, it can add on the unused 1% to K in 2011. Regulators may remove price
caps if they judge that competition in the market has increased sufficiently, as in the case of
OFCOM who removed BT's price cap in 2006.
2. An alternative to price-cap regulation is rate-of-return regulation. Rate of return regulation,
which was developed in the USA, is a method of regulating the average price of private or
privatised public utilities, such as water, electricity and gas supply. The system, which
employs accounting rules for the calculation of operating costs, allows firms to cover these
costs, and earn a ‘fair’ rate of return on capital invested. The ‘fair’ rate is based on typical
rates of return which might be expected in a competitive market.

3. Regulators can prevent mergers or acquisitions, or set conditions for successful mergers.

4. Breaking-up the monopoly, such as forcing Microsoft to split into two separate businesses –
one for the operating system and one for software sales. In 2004, the UK telecom's
regulator Ofcom recommended that BT is split into two businesses: retail and wholesale.

5. A less popular option would be to bring the monopoly under public control, in other words to
nationalise it.

6. Regulators can also force firms to unbundle their products and open-up their infrastructure.
Bundling means selling a number of products together in a single bundle. For example,
Microsoft sells PowerPoint, Access, Excel and Word as one product rather than separate
ones. Unbundling makes it easier for firms to enter the market, as in the case of UK
telecoms, when BT was forced to apply local loop unbundling, which enabled new
broadband operators to enter the market.

7. Regulators can use yardstick competition, such as setting punctuality targets for train
operators based on the highly efficient Bullet trains of Japan.

8. It is also possible to split up a service into regional sections to compare the performance of
one region against another. In the UK, this is applied to both water supply and rail services.

Monopolitic competition

The model of monopolistic competition describes a common market structure in which firms have
many competitors, but each one sells a slightly different product.

Monopolistic competition as a market structure was first identified in the 1930s by American
economist Edward Chamberlin, and English economist Joan Robinson.

Many small businesses operate under conditions of monopolistic competition, including

independently owned and operated high-street stores and restaurants. In the case of restaurants,
each one offers something different and possesses an element of uniqueness, but all are
essentially competing for the same customers.
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Characteristics

Monopolistically competitive markets exhibit the following characteristics:

1. Each firm makes independent decisions about price and output, based on its product, its
market, and its costs of production.
2. Knowledge is widely spread between participants, but it is unlikely to be perfect. For
example, diners can review all the menus available from restaurants in a town, before they
make their choice. Once inside the restaurant, they can view the menu again, before
ordering. However, they cannot fully appreciate the restaurant or the meal until after they
have dined.

3. The entrepreneur has a more significant role than in firms that are perfectly competitive
because of the increased risks associated with decision making.

4. There is freedom to enter or leave the market, as there are no major barriers to entry or
exit.

5. A central feature of monopolistic competition is that products are differentiated. There are
four main types of differentiation:

1. Physical product differentiation, where firms use size, design, colour, shape,
performance, and features to make their products different. For example, consumer
electronics can easily be physically differentiated.

2. Marketing differentiation, where firms try to differentiate their product by distinctive

packaging and other promotional techniques. For example, breakfast cereals can
easily be differentiated through packaging.

3. Human capital differentiation, where the firm creates differences through the skill of
its employees, the level of training received, distinctive uniforms, and so on.

4. Differentiation through distribution, including distribution via mail order or through

internet shopping, such as Amazon.com, which differentiates itself from traditional
bookstores by selling online.

6. Firms are price makers and are faced with a downward sloping demand curve. Because
each firm makes a unique product, it can charge a higher or lower price than its rivals. The
firm can set its own price and does not have to ‘take' it from the industry as a whole, though
the industry price may be a guideline, or becomes a constraint. This also means that the
demand curve will slope downwards.

7. Firms operating under monopolistic competition usually have to engage in advertising.

Firms are often in fierce competition with other (local) firms offering a similar product or
service, and may need to advertise on a local basis, to let customers know their differences.
Common methods of advertising for these firms are through local press and radio, local
cinema, posters, leaflets and special promotions.

9. Monopolistically competitive firms are assumed to be profit maximisers because firms tend
to be small with entrepreneurs actively involved in managing the business.

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 10. There are usually a large numbers of independent firms competing in the market.

Equilibrium under monopolistic competition

In the short run supernormal profits are possible, but in the long run new firms are attracted into
the industry, because of low barriers to entry, good knowledge and an opportunity to differentiate.

Monopolistic competition in the short run

At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC
at Q, supernormal profits are possible (area PABC).

As new firms enter the market, demand for the existing firm’s products becomes more elastic and
the demand curve shifts to the left, driving down price. Eventually, all super-normal profits are
eroded away.

Monopolistic competition in the long run

Super-normal profits attract in new entrants, which shifts the demand curve for existing firm to the
left. New entrants continue until only normal profit is available. At this point, firms have reached
their long run equilibrium.

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Clearly, the firm benefits most when it is in its short run and will try to stay in the short run by
innovating, and further product differentiation.

Examples of monopolistic competition

Examples of monopolistic competition can be found in every high street.

Monopolistically competitive firms are most common in industries where differentiation is possible,
such as:

 The restaurant business

 Hotels and pubs

 General specialist retailing

 Consumer services, such as hairdressing

The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms in modern
economies. The majority of small firms in the real world operate in markets that could be said to be
monopolistically competitive.

Evaluation

The advantages of monopolistic competition

Monopolistic competition can bring the following advantages:

1. There are no significant barriers to entry; therefore markets are relatively contestable.

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 2. Differentiation creates diversity, choice and utility. For example, a typical high street in any
town will have a number of different restaurants from which to choose.

3. The market is more efficient than monopoly but less efficient than perfect competition - less
allocatively and less productively efficient. However, they may be dynamically efficient,
innovative in terms of new production processes or new products. For example, retailers
often constantly have to develop new ways to attract and retain local custom.

The disadvantages of monopolistic competition

There are several potential disadvantages associated with monopolistic competition, including:

1. Some differentiation does not create utility but generates unnecessary waste, such as
excess packaging. Advertising may also be considered wasteful, though most is informative
rather than persuasive.
2. As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in
both the long and short run. This is because price is above marginal cost in both cases. In
the long run the firm is less allocatively inefficient, but it is still inefficient.

Inefficiency

The firm is allocatively and productively inefficient in both the long and short run.

There is a tendency for excess capacity because firms can never fully exploit their fixed factors
because mass production is difficult. This means they are productively inefficient in both the long
and short run. However, this is may be outweighed by the advantages of diversity and choice.

As an economic model of competition, monopolistic competition is more realistic than perfect

competition - many familiar and commonplace markets have many of the characteristics of this
model.

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Oligopoly

Defining and measuring oligopoly

An oligopoly is a market structure in which a few firms dominate. When a market is shared
between a few firms, it is said to be highly concentrated. Although only a few firms dominate, it is
possible that many small firms may also operate in the market. For example, major airlines like
British Airways (BA) and Air France operate their routes with only a few close competitors, but
there are also many small airlines catering for the holidaymaker or offering specialist services.

Concentration ratios

Oligopolies may be identified using concentration ratios, which measure the proportion of total
market share controlled by a given number of firms. When there is a high concentration ratio in an
industry, economists tend to identify the industry as an oligopoly.

Example of a hypothetical concentration ratio

The following are the annual sales, in Rs. (Cr.), of the six firms in a hypothetical market:

A = 56

B = 43

C = 22

D = 12

E=3

F=1

In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.

Key characteristics

The main characteristics of firms operating in a market with few close rivals include:

Interdependence

Firms that are interdependent cannot act independently of each other. A firm operating in a market
with just a few competitors must take the potential reaction of its closest rivals into account when
making its own decisions. For example, if a petrol retailer like Texaco wishes to increase its market
share by reducing price, it must take into account the possibility that close rivals, such as Shell
and BP, may reduce their price in retaliation. An understanding of game theory and the Prisoner’s
Dilemma helps appreciate the concept of interdependence.

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Strategy

Strategy is extremely important to firms that are interdependent. Because firms cannot act
independently, they must anticipate the likely response of a rival to any given change in their price,
or their non-price activity. In other words, they need to plan, and work out a range of possible
options based on how they think rivals might react.

Oligopolists have to make critical strategic decisions, such as:

 Whether to compete with rivals, or collude with them.

 Whether to raise or lower price, or keep price constant.

 Whether to be the first firm to implement a new strategy, or whether to wait and see what
rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and
2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-
start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies
are launched by rivals, and then try to improve on them or find ways to undermine them.

Barriers to entry

Oligopolies and monopolies frequently maintain their position of dominance in a market might
because it is too costly or difficult for potential rivals to enter the market. These hurdles are called
barriers to entry and the incumbent can erect them deliberately, or they can exploit natural barriers
that exist.

Natural entry barriers include:

Economies of large scale production.

If a market has significant economies of scale that have already been exploited by the incumbents,
new entrants are deterred.

Ownership or control of a key scarce resource.

Owning scarce resources that other firms would like to use creates a considerable barrier to entry,
such as an airline controlling access to an airport.

High set-up costs.

High set-up costs deter initial market entry, because they increase break-even output, and delay
the possibility of making profits. Many of these costs are sunk costs, which are costs that cannot
be recovered when a firm leaves a market, and include marketing and advertising costs and other
fixed costs.

High R&D costs

Spending money on Research and Development (R & D) is often a signal to potential entrants that
the firm has large financial reserves. In order to compete, new entrants will have to match, or
exceed, this level of spending in order to compete in the future. This deters entry, and is widely
found in oligopolistic markets such as pharmaceuticals and the chemical industry.
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Artificial barriers include:

Predatory pricing.

Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out
of the market.

Limit pricing.

Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot
make a profit at that price. This is best achieved by selling at a price just below the average total
costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to
make.

Superior knowledge

An incumbent may, over time, have built up a superior level of knowledge of the market, its
customers, and its production costs. This superior knowledge can deter entrants into the market.

Predatory acquisition

Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a
controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators, like the
Competition Commission, may prevent this because it is likely to reduce competition.

Advertising

Advertising is another sunk cost - the more that is spent by incumbent firms the greater the
deterrent to new entrants.

A strong brand

A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry.

Loyalty schemes

Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter entrants
who need to gain market share.

Exclusive contracts, patents and licences

These make entry difficult as they favour existing firms who have won the contracts or own the
licenses. For example, contracts between suppliers and retailers can exclude other retailers from
entering the market.

Vertical integration

Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants, such as
an electronics manufacturer like Sony having its own retail outlets (Sony Centres), and a brewer
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like Heineken owning its own chain of UK pubs, which it acquired from the brewers Scottish and
Newcastle in 2008.

Collusive oligopolies

Another key feature of oligopolistic markets is that firms may attempt to collude, rather than
compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher profits
over the long term.

Types of collusion

Overt

Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form
trade associations like the Association of Petrol Retailers.

Covert

Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid
detection by regulators, such as when fixing prices.

Tacit

Tacit collusion arises when firms act together, called acting in concert, but where there is no formal
or even informal agreement. For example, it may be accepted that a particular firm is the price
leader in an industry, and other firms simply follow the lead of this firm. All firms may ‘understand’
this, but no agreement or record exists to prove it. If firms do collude, and their behaviour can be
proven to result in reduced competition, they are likely to be subject to regulation. In many cases,
tacit collusion is difficult or impossible to prove, though regulators are becoming increasingly
sophisticated in developing new methods of detection.

Competitive oligopolies

When competing, oligopolists prefer non-price competition in order to avoid price wars. A price
reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the
danger is that rivals will simply reduce their prices in response.

This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more
beneficial strategy may be to undertake non-price competition.

Pricing strategies of oligopolies

Oligopolies may pursue the following pricing strategies:

1. Oligopolists may use predatory pricing to force rivals out of the market. This means keeping
price artificially low, and often below the full cost of production.
2. They may also operate a limit-pricing strategy to deter entrants, which is also called entry
forestalling price.

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3. Oligopolists may collude with rivals and raise price together, but this may attract new
entrants.

4. Cost-plus pricing is a straightforward pricing method, where a firm sets a price by

calculating average production costs and then adding a fixed mark-up to achieve a desired
profit level. Cost-plus pricing is also called rule of thumb pricing.

There are different versions of cost-pus pricing, including full cost pricing, where all costs -
that is, fixed and variable costs - are calculated, plus a mark up for profits, and contribution
pricing, where only variable costs are calculated with precision and the mark-up is a
contribution to both fixed costs and profits.

Cost-plus pricing is very useful for firms that produce a number of different products, or
where uncertainty exists. It has been suggested that cost-plus pricing is common because a
precise calculation of marginal cost and marginal revenue is difficult for many oligopolists.
Hence, it can be regarded as a response to information failure. Cost-plus pricing is also
common in oligopoly markets because it is likely that the few firms that dominate may often
share similar costs, as in the case of petrol retailers.

However, there is a risk with such a rigid pricing strategy as rivals could adopt a more
flexible discounting strategy to gain market share.

Cost-plus pricing can also be explained through the application of game theory. If one firm
uses cost-plus pricing - perhaps the dominant firm with the greatest market share - others
may follow-suit so that the strategy becomes a shared one, which acts as a pricing rule.
This takes some of the risk out of pricing decisions, given that all firms will abide by the rule.
This could be considered a form of tacit collusion.

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Non-price strategies

Non-price competition is the favoured strategy for oligopolists because price competition can lead
to destructive price wars – examples include:

1. Trying to improve quality and after sales servicing, such as offering extended guarantees.
2. Spending on advertising, sponsorship and product placement - also called hidden
advertising – is very significant to many oligopolists.

3. Sales promotion, such as buy-one-get-one-free (BOGOF), is associated with the large

supermarkets, which is a highly oligopolistic market, dominated by three or four large
chains.

4. Loyalty schemes, which are common in the supermarket sector.

Each strategy can be evaluated in terms of:

1. How successful is it likely to be?

2. Will rivals be able to copy the strategy?

3. Will the firms get a 1st - mover advantage?

4. How expensive is it to introduce the strategy? If the cost of implementation is greater than
the pay-off, clearly it will be rejected.

5. How long will it take to work? A strategy that takes five years to generate a pay-off may be
rejected in favour of a strategy with a quicker pay-off.

Price stickiness

The theory of oligopoly suggests that, once a price has been determined, will stick it at this price.
This is largely because firms cannot pursue independent strategies. For example, if an airline
raises the price of its tickets from London to New York, rivals will not follow suit and the airline will
lose revenue - the demand curve for the price increase is relatively elastic. Rivals have no need to
follow suit because it is to their competitive advantage to keep their prices as they are.

However, if the airline lowers its price, rivals would be forced to follow suit and drop their prices in
response. Again, the airline will lose sales revenue and market share. The demand curve is
relatively inelastic in this context.

Kinked demand curve

The reaction of rivals to a price change depends on whether price is raised or lowered. The
elasticity of demand, and hence the gradient of the demand curve, will be also be different. The
demand curve will be kinked, at the current price.

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Even when there is a large rise in marginal cost, price tends to stick close to its original, given the
high price elasticity of demand for any price rise.

At price P, and output Q, revenue will be maximised.

Maximising profits

If marginal revenue and marginal costs are added it is possible to show that profits will also be
maximised at price P. Profits will always be maximised when MC = MR, and so long as MC cuts
MR in its vertical portion, then profit maximisation is still at P. Furthermore, if MC changes in the
vertical portion of the MR curve, price still sticks at P. Even when MC moves out of the vertical

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portion, the effect on price is minimal, and consumers will not gain the benefit of any cost
reduction.

A game theory approach to price stickiness

Pricing strategies can also be looked at in terms of game theory; that is in terms of strategies and
payoffs. There are three possible price strategies, with different pay-offs and risks:

 Raise price
 Lower price

 Keep price constant

The choice of strategy will depend upon the pay-offs, which depends upon the actions of
competitors. Raising price or lowering price could lead to a beneficial pay-off, but both strategies
can lead to losses, which could be potentially disastrous. In short, changing price is too risky to
undertake.

Therefore, although keeping price constant will not lead to the single best outcome, it may be the
least risky strategy for an oligopolist.

The Prisoner’s Dilemma

Game theory also predicts that:

There is a tendency for cartels to form because co-operation is likely to be highly rewarding. Co-
operation reduces the uncertainty associated with the mutual interdependence of rivals in an
oligopolistic market. While cartels are ‘unlawful’ in most countries, they may still operate, with
members concealing their unlawful behaviour.

Cartels are designed to protect the interests of members, and the interests of consumers may
suffer because of:

1. Higher prices or hidden prices, such as the hidden charges in credit card transactions
2. Lower output

3. Restricted choice or other limiting conditions associated with the transaction

A classic game called the Prisoner's Dilemma is often used to demonstrate the interdependence of
oligopolists.

Examples of Oligopoly

Oligopolies are common in the airline industry, banking, brewing, soft-drinks, supermarkets and
music. For example, the manufacture, distribution and publication of music products in the UK, as
in the EU and USA, is highly concentrated, with a 4-firm concentration ratio of around 75%, and is
usually identified as an oligopoly.

The key players in 2011 were:

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Evaluation of oligopolies

Oligopolies are significant because they generate a considerable share of the UK’s national
income, and they dominate many sectors of the UK economy.

The disadvantages of oligopolies

Oligopolies can be criticised on a number of obvious grounds, including:

1. High concentration reduces consumer choice.

2. Cartel-like behaviour reduces competition and can lead to higher prices and reduced
output.

3. Firms can be prevented from entering a market because of deliberate barriers to entry.

4. There is a potential loss of economic welfare.

5. Oligopolists may be allocatively and productively inefficient.

Oligopolies tend to be both allocatively and productively inefficient. At profit maximising

equilibrium, P, prce is above MC, and output, Q, is less than the productively efficient output, Q1,
at point A.

The advantages of oligopolies

However, oligopolies may provide the following benefits:

1. Oligopolies may adopt a highly competitive strategy, in which case they can generate
similar benefits to more competitive market structures, such as lower prices. Even though
there are a few firms, making the market uncompetitive, their behaviour may be highly
competitive.
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 2. Oligopolists may be dynamically efficient in terms of innovation and new product and
process development. The super-normal profits they generate may be used to innovate, in
which case the consumer may gain.

3. Price stability may bring advantages to consumers and the macro-economy because it
helps consumers plan ahead and stabilises their expenditure, which may help stabilise the
trade cycle.

Price discrimination

Price discrimination is the practice of charging a different price for the same good or service. There
are three types of price discrimination – first-degree, second-degree, and third-degree price
discrimination.

First degree
discrimination, alternatively known as perfect price discrimination, occurs when a firm charges a
different price for every unit consumed.

The firm is able to charge the maximum possible price for each unit which enables the firm to
capture all available consumer surplus for itself. In practice, first-degree discrimination is rare.

Second degree

Second-degree price discrimination means charging a different price for different quantities, such
as quantity discounts for bulk purchases.

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Third degree

Third-degree price discrimination means charging a different price to different consumer groups.
For example, rail and tube travellers can be subdivided into commuter and casual travellers, and
cinema goers can be subdivide into adults and children. Splitting the market into peak and off peak
use is very common and occurs with gas, electricity, and telephone supply, as well as gym
membership and parking charges. Third-degree discrimination is the commonest type.

Necessary conditions for successful discrimination

Price discrimination can only occur if certain conditions are met.

1. The firm must be able to identify different market segments, such as domestic users and
industrial users.
2. Different segments must have different price elasticities (PEDs).

3. Markets must be kept separate, either by time, physical distance and nature of use, such as
Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a
lower price.

4. There must be no seepage between the two markets, which means that a consumer cannot
purchase at the low price in the elastic sub-market, and then re-sell to other consumers in
the inelastic sub-market, at a higher price.

5. The firm must have some degree of monopoly power.

Diagram for price discrimination

If we assume marginal cost (MC) is constant across all markets, whether or not the market is
divided, it will equal average total cost (ATC). Profit maximisation will occur at the price and output
where MC = MR. If the market can be separated, the price and output in the relatively inelastic
sub-market will be P and Q and P1 and Q1 in the relatively elastic sub-market.

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When the markets are separated, profits will be the area MC, P,X,Y + MC1,P1,X1,Y1. If the market
cannot be separated, and the two submarkets are combined, profits will be the area
MC2,P2,X2,Y2.

If the profit from separating the sub-markets is greater than for combining the sub-markets, then
the rational profit maximizing monopolist will price discriminate.

Market separation and elasticity

Discrimination is only worth undertaking if the profit from separating the markets is greater than
from keeping the markets combined, and this will depend upon the relative elasticities of demand
in the sub-markets. Consumers in the relatively inelastic sub-market will be charged the higher
price, and those in the relatively elastic sub-market will be charged the lower price.

Footnote

In the above example we are assuming that the price at which consumers in the relatively elastic
sub-market (students, for example, looking to travel into a major city) are prepared to enter the
market is lower than those in the relatively inelastic sub-market (commuters, for example). This
gives the combined demand (AR) curve an outward kink, and the combined MR curve a
discontinuous portion (indicated by the vertical dotted line.) If, however, both types of consumer
are prepared to enter the market at the higher price then the combined demand (AR) curve is
simply shifted further to the right, and will not have the kink. This is illustrated in the diagram
below:

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In all cases it should be noted that that profit maximisation must occur where MC = MR. This
means that profit maximising equilibrium for the discriminating monopolist must occur where MR is
positive, which means that, irrespective of the gradient of the demand curves in the submarkets,
the price will always be set in the elastic portion of the demand curve (individually, and when
combined).

9) Conclusion

Let's recap what we've learned:

a) Economics is best described as the study of humans behaving in response to having only
limited resources to fulfil unlimited wants and needs.

b) Scarcity refers to the limited resources in an economy. Macroeconomics is the study of the
economy as a whole. Microeconomics analyzes the individual people and companies that make
up the greater economy.

c) The Production Possibility Frontier (PPF) allows us to determine how an economy can
allocate its resources in order to achieve optimal output. Knowing this will lead countries to
specialize and trade products amongst each other rather than each producing all the products it
needs.

d) Demand and supply refer to the relationship price has with the quantity consumers demand
and the quantity supplied by producers. As price increases, quantity demanded decreases and
quantity supplied increases.

e) Elasticity tells us how much quantity demanded or supplied changes when there is a change
in price. The more the quantity changes, the more elastic the good or service. Products whose
quantity supplied or demanded does not change much with a change in price are considered
inelastic.

f) Utility is the amount of benefit a consumer receives from a given good or service.
Economists use utility to determine how an individual can get the most satisfaction out of his or
her available resources.

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g) Market economies are assumed to have many buyers and sellers, high competition and
many substitutes. Monopolies characterize industries in which the supplier determines prices
and high barriers prevent any competitors from entering the market. Oligopolies are industries
with a few interdependent companies. Perfect competition represents an economy with many
businesses competing with one another for consumer interest and profits.

Part - II

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11) Monetary Theory

Money is any object or record that is generally accepted as payment for goods and services
and repayment of debts in a given socio-economic context or country. It is an officially-issued
legal tender generally consisting of currency and coin. The main functions of money are
distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in
the past, a standard of deferred payment. Most modern textbooks now list only three functions,
that of medium of exchange, unit of account, and store of value, not considering a standard of
deferred payment as a distinguished function, but rather subsuming it in the others. Any kind of
object or secure verifiable record that fulfils these functions can be considered money.

Fiat Money

Fiat money or fiat currency is money whose value is not derived from any intrinsic value or
guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has
value only by government order (fiat). Usually, the government declares the fiat currency
(typically notes and coins from a central bank, such as the RBI in India.) to be legal tender,
making it unlawful to not accept the fiat currency as a means of repayment for all debts, public
and private.

Money Supply

The money supply of a country consists of currency (banknotes and coins) and bank money
(the balance held in checking accounts and savings accounts). Bank money, which consists
only of records (mostly computerized in modern banking), forms by far the largest part of the
money supply in developed nations.

In economics, money is a broad term that refers to any financial instrument that can fulfil the
functions of money (detailed above). These financial instruments together are collectively
referred to as the money supply of an economy. In other words, the money supply is the amount
of financial instruments within a specific economy available for purchasing goods or services.
Since the money supply consists of various financial instruments (usually currency, demand
deposits and various other types of deposits), the amount of money in an economy is measured
by adding together these financial instruments creating a monetary aggregate.

Modern monetary theory distinguishes among different ways to measure the money supply,
reflected in different types of monetary aggregates, using a categorization system that focuses
on the liquidity of the financial instrument used as money. The most commonly used monetary
aggregates (or types of money) are conventionally designated M1, M2 and M3. These are
successively larger aggregate categories: M1 is currency (coins and bills) plus demand deposits
(such as checking accounts); M2 is M1 plus savings accounts and time deposits; and M3 is M2
plus larger time deposits and similar institutional accounts. M1 includes only the most liquid
financial instruments, and M3 relatively illiquid instruments.

Another measure of money, M0, is also used; unlike the other measures, it does not represent
actual purchasing power by firms and households in the economy. M0 is base money, or the
amount of money actually issued by the central bank of a country. It is measured as currency
plus deposits of banks and other institutions at the central bank. M0 is also the only money that
can satisfy the reserve requirements of commercial banks.
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Monetary policy

When gold and silver are used as money, the money supply can grow only if the supply of these
metals is increased by mining. This rate of increase will accelerate during periods of gold rushes
and discoveries, such as when Columbus discovered the New World and brought back gold and
silver to Spain, or when gold was discovered in California in 1848. This causes inflation, as the
value of gold goes down. However, if the rate of gold mining cannot keep up with the growth of
the economy, gold becomes relatively more valuable, and prices (denominated in gold) will
drop, causing deflation. Deflation was the more typical situation for over a century when gold
and paper money backed by gold were used as money in the 18th and 19th centuries. Modern
day monetary systems are based on fiat money and are no longer tied to the value of gold.

The control of the amount of money in the economy is known as monetary policy. Monetary
policy is the process by which a government, central bank, or monetary authority manages the
money supply to achieve specific goals. Usually the goal of monetary policy is to accommodate
economic growth in an environment of stable prices. For example, “to promote effectively the
goals of maximum employment, stable prices, and moderate long-term interest rates.

A failed monetary policy can have significant detrimental effects on an economy and the society
that depends on it. These include hyperinflation, stagflation, recession, high unemployment,
shortages of imported goods, inability to export goods, and even total monetary collapse and
the adoption of a much less efficient barter economy. This happened in Russia, for instance,
after the fall of the Soviet Union.

Governments and central banks have taken both regulatory and free market approaches to
monetary policy. Some of the tools used to control the money supply include:

 changing the interest rate at which the RBI loans money to (or borrows money from) the
commercial banks
 currency purchases or sales
 increasing or lowering government borrowing
 increasing or lowering government spending
 manipulation of exchange rates
 raising or lowering bank reserve requirements
 regulation or prohibition of private currencies
 taxation or tax breaks on imports or exports of capital into a country

The Roots of Monetarism

Monetarism holds the money supply is the primary determinant of both short-run movements in
nominal GDP and long-run movements in price. Of course, Keynesian macroeconomics also
recognizes the key role of money in determining aggregate demand. The main difference
between monetarists and Keynesians lies in the importance assigned to the role of money in
determination of aggregate demand. While Keynesian theories hold that many other forces
besides money also affect aggregate demand; monetarists believe that changes in money supply
are the primary factor that determines movement in output and prices.
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The Equation of Exchange and the Velocity of Money

Money sometimes turns over very slowly; it may sit under a mattress or in a bank account for long
periods of time between transactions. At other times, particularly during periods of rapid inflation;
money circulates quickly from hand to hand. The speed of the turnover of money is described by
the concept of the velocity of money, introduced by Cambridge University’s Alfred Marshall and
Yale University’s Irving Fisher. The velocity of money measures the number of times per year that
the average rupee in money supply is spent for goods and services. When the quantity of money
is large relative to the flow of expenditures, the velocity of circulation is low; when money turns
over rapidly, its velocity is high.

The concept of velocity is formally introduced in the equation of exchange. This equation states:
MV = PQ = (p1q1 + p2q2 + ---- )

Where, M is the money supply, V is the velocity of money, P is the overall price level, and Q is
total real output. This can be restated as the definition of velocity of money by dividing both sides
by M:
V = PQ / M

We, generally, measure PQ as total income or output (nominal GDP); the associated velocity
concept is the income velocity of money.

Velocity of money is the rate at which money circulates through the economy. The income
velocity of money is measured as the ratio of nominal GDP to the stock of money.

As a simple example, assume that the economy produces only rice. GDP consists of 50 million
metric ton of rice, each selling at a price of Rs. 20,000 per metric ton; so GDP = PQ = Rs.
1,000,000 million per year. If the money supply is Rs. 50,000 million, then by definition V =
1,000,000 / 50,000 = 20 per year.

12) Inflation and Deflation

In the world of economics, there are two fundamental terms used to describe the price
movements of goods and services over time: inflation and deflation.

Inflation: In economics, inflation is a sustained increase in the general price level of goods
and services in an economy over a period of time. When the general price level rises, each unit
of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the
purchasing power per unit of money – a loss of real value in the medium of exchange and unit
of account within the economy. A chief measure of price inflation is the inflation rate, the
annualized percentage change in a general price index (normally the consumer price index)
over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative.
Negative effects of inflation include an increase in the opportunity cost of holding money,
uncertainty over future inflation which may discourage investment and savings, and if inflation
were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices
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 will increase in the future. Positive effects include ensuring that central banks can adjust real
interest rates (to mitigate recessions), and encouraging investment in non-monetary capital
projects.

Economists generally believe that high rates of inflation and hyperinflation are caused by an
excessive growth of the money supply. However, money supply growth does not necessarily
cause inflation. Some economists maintain that under the conditions of a liquidity trap, large
monetary injections are like "pushing on a string". Views on which factors determine low to
moderate rates of inflation are more varied. Low or moderate inflation may be attributed to
fluctuations in real demand for goods and services, or changes in available supplies such as
during scarcities, as well as to changes in the velocity of money supply measures; in particular
the MZM ("Money Zero Maturity") supply velocity. However, the consensus view is that a long
sustained period of inflation is caused by money supply growing faster than the rate of
economic growth.

Today, most economists favor a low and steady rate of inflation Low (as opposed to zero or
negative) inflation reduces the severity of economic recessions by enabling the labour market to
adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary
policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is
usually given to monetary authorities. Generally, these monetary authorities are the central
banks that control monetary policy through the setting of interest rates, through open market
operations, and through the setting of banking reserve requirements.

Measuring Inflation

In the developed countries, the most common measure of inflation is the Consumer Price
Index. In addition, producer price index and employment cost trends are also considered.

 Consumer Price Index (CPI): this program monitors monthly changes in the prices paid by
urban consumers for a "basket" of goods and services. This basket includes food, clothing,
shelter, fuels, transportation fares, doctor and dental services, and prescription medications.
The CPI is used by a wide variety of organizations to adjust wages, rents, and other items
affected by a change in the cost of living.
 Producer Price Indexes (PPI): a family of indexes aimed at measuring the change in the
selling prices received by domestic producers of goods and services. This is also known as the
Wholesale Price Index, and the measure is a good indication of the cost to produce goods and
services.
 Employment Cost Trends (ECT): also referred to as the National Compensation Survey, this
program publishes quarterly indexes that track labour costs, overtime rates, wages, salaries, as
well as the cost to supply benefits to employees.

Deflation: a consistent decrease in the price of goods and services over time. During
deflationary times, money increases in its "buying" or "purchasing" power, and it takes less units
of currency to purchase the same units of goods or services. Over time, deflation increases the
value of each unit of currency. Before we delve right into the topic of deflation, it should be
noted that the causes and effects of deflation are complex economic forces. In this answer, we'll
simply introduce readers to the concept and explain how it affects investors. Let's take a look at
the different effects of deflation.

One would think that people would be happier if prices were to go down. Everything becomes

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cheaper, and the money that we have seems to go a little further than it used to. However, when
this effect drags on for too long, companies' profits begin to decline. Economic conditions (i.e.
excess supply) force companies to sell their products for even cheaper and subsequently cut
back on production costs, reduce employee wages, lay off workers or even close production
facilities. At this point, unemployment will increase, the economy cannot expand and people
aren't spending their money because their economic future seems uncertain.

Equity prices begin to decline as people sell off their investments, which are no longer offering
good returns, and bonds temporarily become more attractive. Until the government can find a
way to increase consumer and business spending - usually by lowering interest rates to
stimulate the economy - equity prices will take a severe beating.

Now that we know the effects of deflation, we can imagine why it is considered worse than
inflation: in times of inflation, governments curb spending and encourage saving by increasing
interest rates, but as governments will do the opposite to encourage spending during deflation,
they cannot lower the nominal interest rates to a negative level, or below zero. Central banks in
areas affected by deflation can only move the rate by a certain amount.

Fisher Equation

The Fisher equation in financial mathematics and economics estimates the relationship
between nominal and real interest rates under inflation. It is named after Irving Fisher, who was
famous for his works on the theory of interest. In finance, the Fisher equation is primarily used
in YTM calculations of bonds or IRR calculations of investments. In economics, this equation is
used to predict nominal and real interest rate behaviour. Economists generally use the Greek
letter as the inflation rate, not the mathematical irrational number pi (3.14159....)

Fisher proposed a relationship equation as below:

Where, denotes the real interest rate, denotes the nominal interest rate, and denotes
the inflation rate.

CRR, Repo Rate and Reverse Repo Rate

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep
with RBI in the form of reserves or balances .Higher the CRR with the RBI lower will be the
liquidity in the system and vice-versa.RBI is empowered to vary CRR between 15 percent and 3
percent.. As in 2017, the CRR is 4.00 percent.

Repo rate is the rate at which RBI lends to commercial banks generally against government
securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate
and increase in Repo rate discourages the commercial banks to get money as the rate
increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money
from the commercial banks. The increase in the Repo rate will increase the cost of borrowing
and lending of the banks which will discourage the public to borrow money and will encourage
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them to deposit. As the rates are high the availability of credit and demand decreases resulting
to decrease in inflation. This increase in Repo Rate and Reverse Repo Rate is a symbol of
tightening of the policy. As of October 2013, the repo rate was 7.75 % and reverse repo rate
was 6.75%. In 2017, RBI raised repo rate is 6.25 % and reverse repo rate 5.75%.

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