Академический Документы
Профессиональный Документы
Культура Документы
[ Microeconomics
for Business ]
[ACeL]
[Amity University]
consumers are able and willing to buy at each possible price during a given period of time, other things being equal.]
PREFACE
Economics has proved itself as a basic discipline; its applications have a wide range. New and newer areas are being discovered where the logic of economic reasoning and the use of economic tools and techniques come very handy. In particular, the business applications of economics are so numerous in number and varied in forms, that without a basic knowledge and understanding of economics, no business, government, nation, any international body or for that matter any organization, including the NGOs can function in todays world. There is, thus, a need for basic training in economics followed by applications in evaluating the rationality and optimality of business decisions taken by any agent. The emphasis of this e-book is on relating principles of economics at the firm level and help in analyzing demand, cost, production, pricing, output and investment decisions so common in corporate world. I am grateful to Amity, Dr.Shipra Maitra and all those who have directly or indirectly helped me in preparing this course material. I sincerely believe that there is always scope for improvement. Therefore I invite suggestions for further enriching the study material.
Table of Contents
PREFACE ........................................................................................................................................................ 2 Chapter -1- Demand Analysis....................................................................................................................... 5 1.1 Meaning of demand ................................................................................................................................ 5 1.2 Demand Classification: ............................................................................................................................ 6 1.3 Law of demand........................................................................................................................................ 7 1.4 Demand Function (Demand Determinants) ........................................................................................... 9 1.5 Individual Demand ................................................................................................................................ 10 1.6 Movement along demand curve (Change in Demand) ......................................................................... 11 1.7 Concept of Elasticity of demand .......................................................................................................... 14 End Chapter Quizzes ................................................................................................................................... 17 Chapter -2 :- Supply Analysis ..................................................................................................................... 19 2.1 Meaning of supply................................................................................................................................. 19 2.2 The law of supply................................................................................................................................ 19 2.3 Determinants of the supply .................................................................................................................. 21 2.4 Concept of elasticity of supply .............................................................................................................. 22 2.5 Market Equilibrium .............................................................................................................................. 23 End Chapter Quizzes ................................................................................................................................... 25 Chapter -3: Theory of Consumer Behaviour .............................................................................................. 27 3.1 Marginal utility theory .......................................................................................................................... 27 3.2 Indifference curve theory ..................................................................................................................... 29 3.3 Consumer surplus ................................................................................................................................. 34 End Chapter Quizzes ................................................................................................................................... 37 Chapter 4 :- Theory of Production and Cost ........................................................................................... 39 4.1 Meaning of Production ......................................................................................................................... 39 4.2 Production Function.............................................................................................................................. 39 4.3 ISOQUANTS OR EQUAL PRODUCT CURVE ............................................................................................ 40 4.4 Law of Variable proportion ................................................................................................................... 46 4.5 The law of returns to scale.................................................................................................................... 48 4.6 THE COST CONCEPT .............................................................................................................................. 50
4.7 Short run theory of cost ........................................................................................................................ 51 4.8 CONCEPT OF ECONOMIES AND DIS-ECOMNOMIES OF SCALE ............................................................. 54 End Chapter Quizzes ................................................................................................................................... 57
Chapter -5 Market Organisation and Pricing .......................................................................................... 59
5.1 PERFECT COMPETITION ........................................................................................................................ 59 5.2 Price Taking Behaviour:- ...................................................................................................................... 59 5.3 MONOPOLY .......................................................................................................................................... 66 5.4 PRICING UNDER MONOPOLY ................................................................................................................ 68 5.5 PRICE DISCRIMINATION ....................................................................................................................... 71 End Chapter Quizzes ................................................................................................................................... 82 Chapter -6:- Pricing under Oligopoly ................................................................................................. 84 6.1 MEANING OF OLIGOPOLY ..................................................................................................................... 84 6.2 CHARACTERISTICS/FEATURES OF OLIGOPOLY MARKET. ..................................................................... 84 6.3 KINDS OF OLIGOPOLY ........................................................................................................................... 85 6.4 Oligopoly Models .................................................................................................................................. 86 End Chapter Quizzess.................................................................................................................................. 98 Chapter -7:- Theory of Factor pricing ....................................................................................................... 100 7.1 MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION:- .................................................................... 100 7.2 WELFARE ECONOMICS ....................................................................................................................... 105 7.3 PARETO CRITERION OF SOCIAL WELFARE ........................................................................................... 105 End Chapter Quizzes ................................................................................................................................. 110 BIBLIOGRAPHY.......................................................................................................................................... 113
Clothing
Demand is said to exist provided three conditions are satisfied: 1. Desire to possess the commodity 2. Ability to purchase the commodity 3. Willingness to part with the means (money) for purchasing the commodity There are three additional features of demand: 1 Demand in economics is always at the price
2 Demand is always in reference to the particular period of time. In the words of Prof. Benham the demand for anything at the given price is the amount of it which will be bought per unit of time at that price. 3 Demand is a flow concept i.e. it can be measured over a period of time rather than at a particular point of time.
It states that people demand a larger quantity of goods and services only at a low price than at a higher price, ceteris paribus( ceteris paribus means all other factors affecting the demand such as income of the buyer, tastes of the buyer, prices of substitute and complementary goods ,are kept constant). Why demand curve slopes downwards? a) Law of Diminishing Marginal Utility: This law states that as the consumption of a commodity by a consumer increases, the satisfaction obtained by consumer from each additional unit (i.e., marginal utility) of the commodity goes on diminishing. For e.g. a thirsty man gets too much satisfaction by drinking a glass of water. But, the second glass of water will not be as much satisfying to him, as the first glass of water. The satisfaction derived from the third glass will even be lesser. b) Income effect: A fall in price of a commodity increases the purchasing power (or the real income) of the consumer. The money so saved because of a fall in the price of the commodity can be spent by the consumer in any way he likes. He will spend a part of this money on buying some more units of the same commodity, whose price has fallen. Thus, a fall in the price of this commodity increases its demand. This is called income effect.
c) Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other commodities, whose prices have not fallen. So the consumer substitutes this commodity for other commodities, which are now relatively dearer. This is known as substitution effect. The sum of income effect and substitution effect is called price effect. The demand curve slopes downward, as a fall in price of a commodity causes more of it to be demanded and vice - versa. d) Diverse uses of a commodity: Many commodities can be put to several uses. A commodity having several uses is said to have a composite demand. For e.g.- electricity can be used for lighting, cooking and so on. At a higher price, electricity may not be used for all of these purposes, i.e. the use of electricity may be restricted to lighting only. But, if price of electricity falls, people may afford to use it for other purposes also. Thus the demand of electricity at a lower price will increase.
Exceptions to the law:a) Giffen goods - These are a special type of inferior goods (named after the economist Sir Robert Giffen who made this proposition popular) such that a rise in their price leads to an increase in quantity demanded for these goods, and vice- versa. So, in the case of Giffen good, demand curve slopes upward and the law of demand does not operate. Example: Cheap bread, cheap vegetables, etc. b) Conspicuous consumption- A few goods are purchased by rich and wealthy sections of the society because the prices of these goods are so high that they are beyond the reach of the common man. More of these commodities is demanded when their prices go up very high. Veblen has termed it as conspicuous consumption. Example: Fancy diamonds, fancy cars, high priced shoes, pens, ties etc. c) Future changes in prices- Households also act as speculators. When the prices are rising, households tend to purchase larger quantities of the commodity, out of apprehension that prices may go up further. Likewise, when prices are expected to fall, a reduced price may not be a sufficient incentive to induce households to purchase more. Example-Shares of good corporate at the stock exchanges etc. d) Emergencies: In a situation like that of war or a famine, households behave in an abnormal way. Households purchase more of the commodities even when their prices are going up. This only worsens the situation. Similarly, during depression, no fall in price is a sufficient inducement for consumers to demand more. e) Change in fashion: When the commodity goes out of fashion, no reduction in its price is a sufficient inducement for a buyer to purchase more of it. Example- Old edition of text book on Indian economy, Big-sized handsets.
6 Other factors-Other factors like composition of population, distribution of income, size of population also influence consumers demand.
Individual demand is defined as the quantity of a commodity that an individual is willing to buy (backed by the ability to purchase it) at a given price, during a given period of time. Demand schedule for an individual consumer for a single commodity Price per unit(in Rs ) Quantity demanded ( in units)
70 60 50 40 30 20 10 Market Demand
Definition of Market Demand
2 5 12 25 45 70 95
Market demand refers to the total quantity of a commodity that all individuals are willing and able to purchase at the given price, during a given period of time. It is also called aggregate demand.
Market (consisting of two individuals) Demand Schedule Price per unit(in Rs) 70 60 50 40 30 20 Quantity demanded by a( in units) 2 5 12 25 45 70 Quantity demanded by b (in units) 0 4 10 18 35 45 Market demand(in units ) 2 9 22 43 80 115
When the price of the commodity raises the quantity demanded contracts this is known as contraction of demand. In both the above cases the movement is along the demand curve.
Increase of Demand
An increase in demand means an upward shift in the demand curve (it may have been caused by an increase in consumers income). Increase in demand thus takes place when the same quantity is demanded at a higher price or more units are demanded at the same price.
Decrease in Demand A decrease in demand means a downward shift in the demand curve (This may be caused by the change in tastes of the consumer away from the product). A decrease in demand means that fewer units are demanded at the same price or the same quantity is demanded at a lower price.
Factor changing demand Increase in the consumer money income Decrease in consumer money income Increase in tastes and preferences for the commodity Decrease in the tastes and preferences for the commodity
increase
Rightward
Decrease
Leftward
Elasticity= Symbolically,
Y X E= ------ -----Y X
Where, E= Elasticity Y = Quantity of the dependent variable X=Quantity of the independent variable = the change in
demand of a particular commodity to the changes in prices of another commodity, ceteris paribus
Ec=
Percentage change in the quantity demanded of commodity X -------------------------------------------------------------------------Percentage change in the price of commodity Y
QX PY Ec= --------- --------PY QX where subscripts X and Y refer to commodity X and Y respectively.
Q 7 Income elasticity of demand is same as Price elasticity of demand (a) True (b) False (c) May be (d) May be not Q 8 If a product is a Veblen good: a) Demand is inversely related to income b) Demand is inversely related to price c) Demand is directly related to price d) Demand is inversely related to the price of substitutes Q 9 Extension of demand is said to have existed, if (a) Price falls along the downward sloping demand curve (b) Price rise along the downward sloping demand curve (c) Rightward shift of demand curve (d) Leftward shift of demand curve Q 10 If demand is Pizza what would be the corresponding need (a) Fooding (b) Clothing (c) Medication (d) None of the above
a) Law of Diminishing Marginal Productivity: As we produce more and more beyond a certain limit, the additional return to the variable factor diminishes. Marginal and average cost of production increase as a result. This implies that more quantity of the commodity can be produced and supplied only at a higher price so as to cover higher cost of production. b) Profit maximization-Producers supply a commodity to secure maximum profits. An increase in the price of a commodity raises the level of profit, with conditions of cost remaining same. So producers increase the supply of the commodity by releasing big quantities from their stocks. Exceptions to the law of supply a) Non Maximisation of profits: Sometimes, the goal of firm is not to maximize the profits, but to maximize the sales. In that case, the quantity supplied may increase even when price does not rise. This usually happens when firm is interested in the maximization of long term profits. b) Subsistence farming: In underdeveloped countries , where agricultural farms are in subsistence rather than commercial , as prices of food grains rise , marketable surplus of food grains fall rather than rising, resulting in backward sloping supply curve. With rise in the prices of food grains, farmer can get the required amount of income by selling less and keeping the balance for their own consumption than before. c) Factors other than price not remain constant: The law of supply is stated on the assumption that factors other than price of the commodity remain constant. The quantity supplied of a commodity may fall at a given price, if, prices of other commodities show a rising trend. The change in a state of technology can also bring about a change in the quantity supplied even if the
price of that commodity does not undergo a change. Similarly, expectations of rise in the price in the future may induce the sellers to withhold supplies so as to get greater profits later on.
Attracted by the profits earned by existing firms, if new firms enter the industry and start production, supply will increase. Generally the greater the number of sellers, the better shall be the supply position. g) Government policy The government policy with respect to the certain commodities in specified quantities, levy of the excise duty on some commodities, subsidy policy etc all influence the supply of that particular commodity on which that policy is applicable. For example, when the government imposes an excise duty on the good its cost will increase and it may be passed on to consumers in terms of higher prices or less quantity may be supplied at the old price.
Es
Percentage change in quantity supplied of a commodity -------------------------------------------------------------------Percentage change in the price of the commodity
Q
Es Where Es =Elasticity of supply P=Change in price Q=Change in quantity = ------
P
------
Factors affecting Elasticity of supply a) Nature of commodity: On the basis of the nature, commodities may be classified as (i) perishable and (ii) durable. Perishable goods cannot store and thus, entire stock of such goods must be disposed of within very short period, whatever may be price. Hence their supply is inelastic in nature. On the other hand, durable goods can be stored and their supply responds to the changes in their price. Thus their supply is generally elastic.
b) Behaviour of costs and output varies: Total cost rises at a falling rate in the beginning, then at a constants rate and finally at rising rate. If total cost rises at falling rate there is more stimuli to expand output in response to rise in price and accordingly, supply will tend to be more elastic. On the other hand, if total cost rises at rapid rate, supply will be less elastic. c) Techniques of production: Simple techniques of production are by and large expensive in nature. In such case, the production and supply of commodities can be easily increased. Thus, supply of such commodities is generally elastic in nature. On the other hand, if the techniques of production of a commodity are complex and time consuming, it may not be possible to change the supply in response to change in price. Supply of such commodities would generally be less elastic. d) Future of price expectations: If the producers expect that the prices will rise in future, they may hoard the stock and may supply less quantity in the market. Supply in such case will be inelastic. On the other hand, if the prices are expected to fall in the future, supply will be more elastic
The market equilibrium is established where the market demand curve intersects the market supply curve.
The market equilibrium is established where the equilibrium price is P* and the equilibrium quantity is Q*. At the price above P*supply is in excess of the demand. This will exert a downward pressure on the price such that finally the equilibrium is established at the (P*, Q*). Similarly, at the price below P* the demand is in excess of the supply , as the result there will be an upward pressure on the price such that finally the equilibrium is established at the (P*,Q*).
7 Supply of a commodity is always in reference to a particular: a) Price, time period and market b) Price and time period c) Time period d) Price and market 8 There is a direct and positive relationship between price and quantity supplied; explained by the law of supply a) True b) False c) Cant say e) None of the above
9 If demand increases in a market this will usually lead to: a) b) c) d) A higher equilibrium price and output A lower equilibrium price and higher output A lower equilibrium price and output A higher equilibrium price and lower output
10 If the price of commodity X increases then the quantity supplied of commodity Y also increases, then a) X and Y both are complimentary b) X and Y both are substitutes c) Both (a) and (b) d) None of the above
As the consumer goes on consuming more units of a particular commodity, the additional utility that a consumer derives from the consumption of that commodity goes on diminishing i.e. as consumption increases, the utility goes on progressively diminishing.
The law of diminishing marginal utility is also called the law of satiable wants. Kenneth. E. bounding defines the law of diminishing marginal utility as As a consumer increases the consumption of any one commodity, keeping constant the consumption of all other commodities the marginal utility of the variable commodity must eventually decline.
THE FOLLOWING TABLE WOULD ILLUSTRATE THE LAW OF DIMINISHIONG MARGINAL UTILITY
5. The consumer is more unwilling to give up a commodity that is scarce as compared to situation when it is plentiful. 6. The consumer tastes, habits, remain unchanged.
As an example, consider the diagram above. Consumer would be most satisfied with any combination of products along curve U3. Consumer would be indifferent between combination Qa1, Qb1, and Qa2, Qb2.
Indifference curve is defined as the locus of various combinations of two commodities that would provide the consumer with the same level of satisfaction. Every point on the given indifference curve represents an equal amount of satisfaction to the consumer.
1.An indifference curve always slopes downwards from left to right ; i.e., it has a negative slope-It means that if the quantity of one commodity (say Y) decreases, the quantity of the other (X) must increase, if the consumer is to stay on the same level of satisfaction. This is due to the non-satiety requirement. 2. Indifference curve are convex to the origin.- Convexity of indifference curves is due to the assumption of the diminishing marginal rate of substitution. 3. Indifference curves do not intersect each other-If they did, the point of their intersection would supply two different levels of satisfaction, which is impossible. This is due to the assumption of transitivity. 4 Higher indifference curves represent higher level of satisfaction-an indifference curve, which is nearer to the point of origin represents smaller combinations of the two commodities, while an indifference curve farther from the point of origin represents larger combinations. Larger combination of the two commodities provides greater satisfaction to the consumer. This can be represented by following diagram.
Important term in the indifference curve theory Marginal rate of substitution (MRS) Marginal rate of substitution of good x for good y is defined as the number of units of good y that the consumer is willing to forego for an additional unit of good x so as to maintain the same level of satisfaction.
Marginal rate of substitution of good x for good y MRS xy = (change of units of good y) / (change of units of good x)
As one moves along the indifference curve from left to the right the marginal rate of substitution goes on diminishing. Combinations A B C D Units of biscuits 8 5 3 2 Increase in units of MRSxy (between tea cups tea and biscuits) 2 3 3:1 4 2:1 5 1:1
APPLICATION OF INDIFFERENCE CURVES TO THE TAX CHOICE (DIRECT TAX VERSUS INDIRECT TAX)
Direct tax is demanded from the person who it is intended or desired should pay it. Whereas, Indirect tax are those which are demanded from one person in the expectation and intention that he shall indemnify himself at the expense of the other. In other words, Direct tax is paid by the person on whom it is imposed, whereas if the tax is paid by some person and the final burden is borne by some other person the tax would be an Indirect tax.
Examples of Direct tax include income tax and that of Indirect tax includes sales tax, custom duty or commodity tax. To resolve the conflict of choosing between levying a direct tax or an indirect tax for raising revenues indifference curves may be helpful. Let us assume that there is a single consumer faced with the choice between two goods good x measured on X-axis and the money income measured on the Y-axis With the given money income OM the price of good CX the consumer can purchase OA units of x by spending his entire income on the purchase. Thus MA is the budget line faced by the consumer. The consumer is initially in equilibrium at point E3 where the budget line MA becomes tangential to the indifference curve IC3. The state now imposes an indirect tax on good x causing the producers of good x to raise their prices to the extent of the indirect tax levied on them. Due to rise in the price of good x, the budget line M A, pivots inward to the position MB and the consumer reduces the quantity demanded of good x. the consumer reaches equilibrium at point E1, where the budget line MB becomes tangential to the indifference curve IC1. The consumer purchases only OX units of good x and keep an amount of OD income with himself. He therefore pays MD amount to purchase ox units of good x. If the state has not imposed the indirect tax the consumer would have purchased ox units of good x for MF amount of money income. Therefore the indirect tax imposed on the consumer is equal to MD-MF= FD (FD is equal to GE). Imposition of the indirect tax on the good x has caused the consumer to move to a lower indifference curve IC3. His level of satisfaction has therefore been reduced. Suppose instead of imposing an indirect tax on good x the state collects the same amount of indirect tax FD inform of a direct tax say income tax. With the imposition of the income tax of the amount FD the budget line MA will shift parallel downward from MA to M1A1. since the same amount of revenue FD has to be raised through income tax as with the indirect tax the budget line M1A1 passes through point E1 (parallel to MA) with M1A1 as the budget line the consumer reaches equilibrium at point E2 on Ic2. The consumer welfare at equilibrium point E2 is higher than e1. Therefore imposition of an income tax leaves the consumer on the higher indifference curve IC2 than the imposition of an indirect tax of an equal amount. This is because the indirect tax has both an income and substitution effect reducing the consumers quantity demanded, which reduces the quantity demanded only to the extent of income effect.
Points of comparison Money income retained by the consumer Units of good x Equilibrium established on IC Final analysis
Indirect tax E1x1 OX1 E1 on ic1 Consumer is better off when the direct tax is imposed as he is on the higher indifference curve IC2
Prof. Marshal defined consumer surplus as the excess of price which a consumer will be willing to pay rather than go without the commodity over that which he actually does pay is the economic measure of this surplus satisfaction In other words consumer surplus is the excess of what the consumer is ready to pay over what they actually pay. According to the Marshallian concept of consumer surplus- At the consumption of the nth unit of the commodity the consumer willingness to pay is equal to what he actually pays. But for the all pre-marginal units which he derives from the commodity is greater than what he actually pays. Each pre-marginal unit gives him a surplus of utility. The sum total of such surplus is the consumer surplus
Units of commodity 1st 2nd 3rd 4th 5th Total units purchased=5
The above analysis of consumer surplus is based on the Marshallian analysis of consumer surplus the assumption of which includes:
1. 2. 3. 4. 5.
Utility is cardinally measurable. Marginal utility of the money is constant. Market price of the commodity is given. The demand for the price is independent of the price and the quantity of the other goods. There is no close substitute for the commodity.
Mathematically the consumer surplus is given by: Consumer surplus = total utility derived total amount spent Consumer surplus can also be expressed as total utility derived (price * number of units of commodity. As shown in the diagram above the consumer surplus at the level of the Q1th unit of the commodity is ST whereas actual price paid for the Q1th unit is TQ1.
Usefulness of the Concept of Consumer Surplus a) The concept gives an assessment of enjoyment of real income, i.e., total utility derived from the consumption of a commodity is always more than the paid for it. b) The higher the consumer surplus, the more advanced is an economy. Thus, the concept tells us the state of an economy. c) The concept is widely used in determining monopoly prices, i.e., in discriminating monopoly the monopolist charges according to the consumer surplus of the consumers. d) The concept helps in finding out the relative merit of different types of taxes. A tax raises the price and reduces consumer surplus. e) It explains the paradox of value. Adam Smith posed paradox of value in his book. The Wealth of Nations. The paradox of value is: how is it that water which is essential to life has little value while diamonds which are generally used for conspicuous consumption, has more value. Limitations of the Concept of Consumer Surplus a) Utility or satisfaction cannot be measured in money units. b) It is difficult to find the amount a consumer is willing to pay. In a calamity, consumer may be willing to pay more. c) The consumer surplus derived from a commodity is affected by the availability of substitutes.
Q8 Law of Diminishing Marginal Utility is also called a) Law of satiable wants b) Law if insatiable wants c) Law of demand d) Law of supply Q9 Law of Diminishing Marginal utility is based on a) Rational Consumer b) Irrational consumer c) Both a and b d) None of the above Q10 Indifference curve are a) Convex to origin and negatively sloped b) Concave to origin and positively sloped c) Convex to origin and positively sloped d) Concave to origin and negatively sloped
Types of Production Function a) Short run production function:-A SR production function shows the maximum quantity of a good or service that can be produced by a set of inputs, assuming that the amount of at least one of the inputs used remains constant. b) Long-run production function:-A LR production function shows the maximum quantity of a good or service that can be produced by a set of inputs, assuming that the firm is free to vary the amount of all the inputs being used. Long-run does not refer to a long period of time. The distinction has no direct connection with time at all. When changing the scale of production, the firm must operate under short-run conditions until its most-fixed input becomes variable. E.g. Assembly of an automobile production. Fixed inputs: land and building, assembly lines, computerized plant and equipment. Variable inputs: worker-hours, component parts, energy. Terminology: Inputs: Factors, Factors of production, Resources Output: Quantity (Q), Total Product (TP), Product Q = Total product = f (X, Y) Marginal product of X (MPX) = Q / X, holding Y constant
Average product of X (MPX) = Q / X, holding Y constant Marginal product is the change in total product resulting from a unit change in a variable input. Average product is the total product per unit of input used.
curve cannot measure satisfaction in physical units. All combinations providing the same level of output lie on the same equal-product curve.
10 6 4 3
5 10 15 20
Table shows different combinations of labour and capital inputs which jointly produce 100 units of output. For example, 10 units of capital and 5 units of labour provide the same total product as 3 units of capital and 20 units of labour input. The firm is free to choose any one of these combinations to get 100 units of output. All these combinations when depicted through a diagram provide us an isoquant or equal product curve. This diagram shows such an equalproduct curve which represents 100 units of output. The various combinations of factor inputs have been represented by points A, B, C and D on the equal product curve. These points have been drawn by joining those combinations of labour and capital inputs which yield the same amount of total product.i.e, 100 units.
Properties of Isoquants
As we have already said the isoquant analysis is based upon the indifference curve analysis. Therefore, all the properties of indifference curves are also to be found in the isoquants. There are three main properties of isoquants which are as follows: 1. An isoquant slopes downwards to the right: - An isoquant has a downward slope from the left to the right. In other words, it has a negative slope. The implications of such a slope is that if a firm wants to employ more of one factor input it shall have to employ less of another factor input in order to attain the same level of output. It would, however, be conceivable only when there exists a technical substitution between the two inputs. It means that one factor input must be substituted by another factor input. 2. Isoquants are convex to the origin point: - The convexity of the isoquant indicates that curve is relatively steep along the Y-axis and relatively flat along the X-axis. The convexity of isoquants depends upon the diminishing marginal rate of technical substitution (MRTS). If we denote labour by L and capital by K, then the marginal rate of technical substitution between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. Mathematically, MRTSLK = K L Where K is the change in capital and L is change in labour.
The ability to use one factor (or input) in place of another is measured by the marginal rate of technical substitution. If we look back to the table we find that for successive units of labour input lesser units of capital input are sacrificed. Diminishing marginal rate of technical substitution can be explained by means of an adjoining diagram. This figure shows the diminishing marginal rate of technical substitution between labour and capital. In order to employ L1L2 additional unit of labour, the firm forgoes K1K2 unit of capital.Then, the firm is prepared to sacrifice a lesser amount of capital, i.e, K2K3, and finally, for the additional unit of labour L3L4, the firm is prepared to give up only K3K4 amount of capital. In this figure L1L2=L2L3=L3L4 but K1K2>K2K3>K3K4. It means that in order to get the same amount of total product as the firm raises the units of labour, lesser units of capital are required to sacrifice for each successive unit of labour. It is because of the diminishing MRTS that the isoquants are convex to the origin.
3.
Isoquants representing different level of output never cut each other. If they did , there would be a logical contradiction. It will mean that isoquants representing different levels of output are showing the same amount of output at the point of intersection, which is not true.
Producers are generally rational and are guided by the objective of profit maximization. As the result the producers are concerned with attainment of optimal combination of factors of production such that the cost of production would remain the least. There are various key terms involved in the analysis of how he producers could attain the optimal combination of factors of production they are:-
Iso-cost line
This represents the various combinations of factors of production that can be employed with a given amount of money. For example- if a firm has Rs.200 to spend on labor (L0 and capital (K) and that the price of capital is Rs. 10 per unit and the price of the labor is Rs. 20 per unit, then the equation for the Iso-cost line is given by 200=10K+20L.
The above equation of the Iso-cost line represents various combinations of both the factors of production that could be combined with the given level of money to be spent on them. The Iso-cost line would shift parallel on with the change in the money to be spent on the factors of production. The diagram of Isocost line is as follows:
Fig:-The slope and intercept of Isocost Line Above diagram shows this line when the X good is cooks and the Y good is mixers. Just like the budget line, the isocost line will shift out along the X axis when the price of the X good falls and shift in along the X axis when it rises, and shift out along the Y axis when the price of the Y good
falls and shift in along the Y axis when it rises. Note that the isoquant and isocost line contain completely separate type of information. Just as the isoquant does not tell us anything about the cost of production, the isocost line does not tell us anything about the production function or the techniques available: It only tells us how much it will cost to use a particular set of inputs, not that these inputs are the slightest bit useful.
A given level of output is represented by a given Isoquant. A map of various possible Iso-cost lines are drawn on the graph with the same given prices for the labor and capital at the different level of money to be spends on them. Then the given Isoquant is superimposed on the Iso-cost line map. The point at which the given Isoquant is tangent to one particular Iso-cost line such that at the point of tangency the Isoquant has the downward trend with the increase in the level of factor of production represented on the X- axis, is the point of producers equilibrium exhibiting the point f optimal combination of the factors of production in the production of a given level of output.
B) Maximization of output subject to a given cost of the production Under this it is assumed that the producer is given with a Iso-cost line. A map of different Isoquant representing different level of output is then superimposed on the graph (drawn on the same scale) of the Iso-cost line, the point of tangency that would be obtained in between the given Iso-cost line and one of the various Isoquant from the Isoquant map would represent the point of optimal combination of the factors of production.
The given table below illustrates the law of variable proportion Fixed factor Variable factor Total product Average Marginal (land or capital) (labor) product product 20 1 8 8 8 20 2 20 10 12 20 3 36 12 16 20 4 48 12 12 20 5 55 11 7 20 6 60 10 5 20 7 63 9 3 20 8 64 8 1 20 9 64 7.11 0 20 10 60 6 -4
Average product of an input is total product divided by the amount of the input used to produce the total product, whereas marginal product of an input is the addition to the total product attributable to the additions of one unit of the variable input to the production process, the fixed input remaining unchanged.
As per the law of variable proportion there are three stages of the production Stage 1 1. It is called the stage of increasing returns 2. The total product increases at an increasing rate up to a point the marginal product of the labor MP is increasing and reaches its highest point vertically downward to that point. 3. Beyond point of maximum of the marginal product of labor the total product increases but at the diminishing rate. Marginal product curve correspondingly starts falling but continues to be positive. 4. In this stage the average product of the labor continues to rise. 5. The stage comes to an end when the average product curve is the highest and is equal to the marginal product of the labor.
Stage 2 1. The total product continues to increase but at the diminishing rate but eventually becomes highest 2. Both average product curve and the marginal product curve diminishes but are positive 3. The stage comes to an end when the total product curve is the highest 4. Throughout this stage average product curve remains above the marginal product curve. Stage 3 In this stage the total product curve declines in the absolute terms The marginal product curve becomes negative Average product curve continues to diminish. To summaries, the returns to the variable factor may be increasing, diminishing or negative. A rational producer will prefer to operate in the range of diminishing returns described by stage II. The law of diminishing returns implies a declining marginal product.
According to this law if given a certain combination of factors of production, producing a given output, all the factors are increased in the same proportion and the output increases in the same proportion, returns to scale are constant. If the output increases more than proportionately, there are increasing returns to scale, and when the output increases than proportionately there are decreasing returns to scale.
Increasing returns to scale If all the factors of the production are increased in a particular proportion and the output increases more than proportionately, then the production function is said to exhibit increasing returns to scale. Factor labor 1 2 3 Capital 1 2 3 Total product 10 24 42 Average product 10 12 14
Constant returns to scale If the factor of production is increased in the particular proportion and the output increases in the exact proportion ten the production function is said to exhibit constant returns to scale. Factors of labor Capital Total product Average product 1 1 10 10 2 2 20 10 3 3 30 10
Decreasing returns to scale It implies that a proportionate increase in the factors o the production results in a less than proportionate increases in the output. Labor 1 2 3 Capital 1 2 3 Total product 10 15 21 Average product 10 7.5 7
Law of returns to scale Long run All factors are variable but in fixed proportion Fixed
Factor proportion Varying Reasons for the operation of law Phase 1 Stage of increasing returns Increasing returns to scale Phase 2 Stage of diminishing returns Stage of decreasing returns
b)Opportunity cost The opportunity cost is defined as the next best alternative that could be produced instead by the same factors or by the equivalent group of factors, costing the same amount of money. c)Explicit Cost vs. Implicit Cost Explicit cost or direct cost is the actual expenditure incurred by a firm to purchase or hire the inputs it needs in the production process. This includes wages, rent, interest etc. Implicit cost or imputed cost is the cost of inputs owned by the firm and used by the firm in its own production process. It include payment for owned premises, self invested capital etc.
Total fixed cost It refers to the total obligations incurred by the firm per unit of time for all fixed inputs. For example property tax, insurance fee, payment of factory rent etc.
Total variable cost They are the cost incurred on the employment of variable factors, whose amount can be altered in the short run. Variable cost varies directly with the change in output level. For example cost of raw materials, cost of labor, cost of fuel and electricity.
The postulates of short run costs includes:1. Total variable cost curve is an inverse s- shaped curve 2. In the short run average variable cost(AVC) average cost(AC) and marginal cost (MC) are U-shaped curves 3. The marginal cost curve cut the average cost curve average cost curve at their minimum points fro below 4. At the point of minimum of the average cost curve the combination of fixed and variable factors is optimal
Where ATC= average total cost curve AVC= average variable cost curve MC= marginal cost curve Average total cost is total cost divided by total units of the product Average variable cost is total variable cost divided by the total units of product Marginal cost is additional cost incurred on the production of each additional unit of the product
Introduction to the long run theory of cost In the long period, no factors of production remain fixed. The firm can alter the size and the scale of plant to meet the changed demand conditions. In other words, the firm has no fixed costs in the long run. Key terms in the explanation of the long run theory of the cost Long run average cost curve:
The long run average cost curve is defined as total cost per unit output when the entrepreneur has the time to vary all the factors of production so that he has the most profitable size of the plant and the best proportion of fixed and variable factors for any given output.
Characteristics of the long run average cost curve 1. They are called the envelope curve as it envelops the short run average cost curve (SAC) 2. No portion of the LAC curve be above any portion of SAC curves 3. The firm chooses that short run plant which allows it to produce the expected output at the minimum cost in the long run. therefore LAC helps the firm in the decision making 4. Each point on the LAC is a point of tangency with the corresponding SAC curve.
When the economies of scale are fully expected and the diseconomies of scale is yet to set in the LAC curve reaches its minimum point. At its minimum the firm is employing the optimal plant size and operating this plant at full capacity. If the plant size increases further than the optimal size there will be dis-economies of scale and cause the LAC to turn upwards. The LAC curve is U-shaped but the sides are more flat than the u-shaped SACs.
Managerial economies The manager for each of the various departments would results in the improvement of the productive efficiency of each and every worker across the organization. Financial economies Large firms command goodwill in the market and could have accessibility to the cheap finance from the commercial banks, development banks and also from the general public by issue of shares and debentures. Economies of in-house research and development This tend to reduce the cost of consultancy and would contribute to the making of the production system an efficient one. Economies of employees welfare schemes This tends to improve the motivational aspect of the workers. Provision for the housing facilities, medical facilities and the educational facilities for the employees and their family are covered under the employees welfare schemes. External economies of large scale production They are the benefits which accrued to the firm because of the growth of the whole industry. Such benefits cannot be monopolized by a single firm when it grow in size, but are conferred on it when some other firms grow larger. Types of external economies of large scale production Economies of concentration When the industry develops in a particular region it brings with it all the advantages of concentration such as availability of skilled manpower, transportation and communication facilities, banking and insurance and marketing services Economies of ancillarisation Ancillary industry may develop in and around industrial townships manufacturing inputs such as parts of machinery, nuts and bolts, raw materials etc.
Dis-economies of scale They are broadly categorized into internal and external dis-economies of scale Internal economies of the scale They are the demerits which are internal to the firm and accrue to the firm when it over expands its scale of production such as distortion in flow of the information due to complexity bin the managerial hierarchy
External dis-economies of scale They are these disadvantages which are generated outside the firm with the expansion of the industry as a whole such as increase of input price in course of keen competition among the firms for the limited factors of the production, increasing pressure on the infrastructure as in the form of bottlenecks and delays.
When internal economies of scale occur: a) Total costs fall b) Marginal costs increase c) Average costs fall d) Revenue The shape of AFC curve is a) U shaped b) Inverted u shape c) Rectangular hyperbola d) None Cost function shows the relationship between a) Cost and input b) Cost and output c) Both a) and b) d) None Which of following is not a fixed factor a) Raw materials b) Land c) Machinery d) All
6 Total cost is the sum total of a) TFC + AFC b) TVC+AVC c) TFC+TVC d) AFC+AVC 7 Which of the following curve is known as envelop curve?
a) SAC b) LMC c) LAC d) LTC 8 --------------refers to the transformation of resources into products a) Consumption b) Production c) Savings d) Investment Q9 If all the factors of the production are increased in a particular proportion and the output increases more than proportionately, then the production function is said to exhibit a) b) c) d) Increasing returns to scale. Decreasing return to scale Constant returns to scale None of the above
Q10 The substitutability of one factor for another is given by the slope of the isoquant, and is known as a) b) c) d) MRS MRTS LAC SMC
PERFECT COMPETITION : - Perfect competition is a market in which there are many firms selling identical products with no firm large enough relative to the entire market to be able to influence market price. The price of the product is determined by industry with the forces of demand and supply.
FEATURES OF PERFECT COMPETITION:1) LARGE NUMBER OF BUYERS & SELLERS: - It means there are large number of buyers and sellers in the market. Thus no individual buyer or seller can affect the price. 2) HOMOGENEOUS PRODUCT: - It assumes that all sellers sell homogeneous product. 3) PERFECT KNOWLEDGE: - It means that, there is perfect knowledge of the market and about the nature of the product being sold and the price charged on the part of buyers and sellers. 4) FREE ENTRY AND EXIT:- Under perfect competition, firm can enter into or exit from the industry. 5) PROFIT MAXIMIZATION:-All firms have a common goal of profit maximization. Thus, there is absence of social welfare of the general masses 6) PRICE-TAKER: - An individual firm is a firm-taker. It must passively accept the ruling market price. Prices are determined by supply and demand.
5.2 Price Taking Behaviour:Market supply and market demand collectively set up the market price i.e. the price at which the product will be sold in the market.
Market supply curve has a positive slope, while market demand curve will have a negative slope as shown in the figure above. In the given market, OQ quantity would be offered for sale and demanded by buyers at OP price per unit. Quantity supplied and the quantity demanded are equal at this price OP.OP is the equilibrium price and OQ is the equilibrium quantity. Thus the industry is in equilibrium. A firm that is operating in a perfectly competitive market will be a price-taker. A price-taker cannot control the price of the good it sells; it simply takes the market price as given. The conditions that cause a market to be perfectly competitive also cause the firms in that market to be price-takers. When there are many firms, all producing and selling the same product using the same inputs and technology, competition forces each firm to charge the same market price for its good. Because each firm in the market sells the same, homogeneous product, no single firm can increase the price that it charges above the price charged by the other firms in the market without losing business. It is also impossible for a single firm to affect the market price by changing the quantity of output it supplies because, by assumption, there are many firms and each firm is small in size.
Short Run Price and Output for the Competitive Industry and Firm
In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown below, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximizes profits when marginal revenue = marginal cost. In the diagram below, the profit-maximizing
output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.
Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximizing level of output, the firm is making an economic loss (or sub-normal profits).
Short run equilibrium of a firm is attained at a level of output which satisfies the following two conditions:1) MC=MR 2) MC cuts MR from below When it is in short run equilibrium, a perfectly competitive firm may find itself in any of the following conditions:1) It earns super normal profits 2) It suffers losses 3) It breaks even. 1) SUPER NORMAL PROFITS:A firm would earn super normal profits if at equilibrium output AR>AC.
In the above diagram, the given price is P1. The firm wants to maximise profits, so it produces at the level of output where MC = MR. This occurs at point A. Drop a vertical line to find the firm's output (Q1). At Q1, AR > AC and the difference between average revenue and average cost is the distance AB. This is the profit per unit. To find the total super normal profit, we must multiply the profit per unit per the number of units. In the diagram, this is the area ABCP1 .
2) LOSSES:A firm suffers losses, if at the equilibrium level of output, its average cost (AC) is more than its average revenue (AR) i.e. AC>AR.
In the above diagram, the given price is P2. In this case, it is clear that the firm will not be making a profit. The AC curve is above the AR curve at all levels of output. The firm will still want to minimise its losses, though. This can be done, again, with the formula, MC = MR. This occurs at point D giving output Q2. At Q2, AR < AC and the difference between average revenue and average cost is the distance DE. This is the loss per unit. To find the total losses, we must multiply the loss per unit per the number of units. In the diagram, this is the area DEFP2. 3) BREAK EVEN (NORMAL PROFIT):A firm breaks even when at the equilibrium level of output its AR=AC.
In the above diagram, at the bottom, the given price is P3. Again the firm will produce the level of output for which MC = MR. This occurs at point G, giving a level of output of Q3. Notice that at this point, AR = AC, so the firm is making normal profit. The three diagrams show the three situations in which a firm could find itself in the short run. NOTE:i. ii. The main thing is that the prices P1, P2 and P3 are determined by market demand and market supply. In all three diagrams, the MC curve cuts the AC curve at its lowest point.
are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.
Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximising output level Q2 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established
LONG-RUN EQUILIBRIUM OF INDUSTRY:Long-run equilibrium of competitive industry must satisfy the following three conditions:-
All the firms in the industry are maximizing profit. No firm has incentive either to enter or exit the industry because all the firms are earning zero economic profit. The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by the consumers. The key to long run equilibrium in a perfectly competitive industry is entry and exit of firms.
o o o
New firms entering the industry shift the short-run supply curve to the right, causing price to fall. Existing firms leaving the industry shift the short-run supply curve to the left, causing prices to rise. Adjustments occur until economic losses are eliminated and economic profits equal zero in the long-run.
The conditions for long-run perfectly competitive equilibrium can be expressed as equality: P = MR = SRMC = SRATC = LRAC P = Price MR = Marginal Revenue SRMC = Short-Run Marginal Cost SRATC = Short-Run Average Total Cost LRAC = Long-Run Average Cost
5.3 MONOPOLY
MONOPOLY is a market situation in which there is a single seller. There are no close substitutes of the commodity it produces, there are barriers to entry.
FEATURES OF MONOPOLY:a)ONE SELLER & LARGE NUMBER OF BUYERS:- The monopolists firm is the only firm, it is an industry. But the number of buyers is assumed to be large. b) NO CLOSE SUBSTITUES: - There shall not be any close substitutes for the natural or artificial restrictions on the entry of firms into the industry, even when the firm is making abnormal profits. c) PRICE-MAKER: - Monopolist has full control over the supply of the commodity. But due to large number of buyers, demand of any one buyer constitutes an infinitely small part of the total demand. Therefore, buyers have to pay the price fixed by the monopolist. d)DIFFICULTY OF ENTRY OF NEW FIRMS:- There are either natural or artificial restrictions on the entry of firms into the industry, even when the firm is making abnormal profits.
e) MONOPOLY IS ALSO AN INDUSTRY: - Under monopoly there is only one firm which constitutes the industry. There is no difference between firm and industry comes to an end. e.g. Public utilities: gas, electric, water, cable TV, and local telephone service companies, are often pure monopolies. Monopolies may be geographic. A small town may have only one airline, bank, etc. Monopolist will be in equilibrium when two following conditions are fulfilled i.e., i. ii. MC=MR MC must cut MR from below. The study of equilibrium price according to this analysis can be conducted in two time periods:1. THE SHORT RUN 2. THE LONG RUN
SOURCES OF MONOPOLY:1) NATURAL FACTORS: - A firm can acquire power because of the natural factors. If a transport company in plying buses on a particular route exclusively, it will assume monopoly power. Similarly, if a firm has full control over the localized raw materials or minerals it will have absolutely monopoly power. 2) LEGAL FACTORS: - A firm can legally procure monopoly power. An author may have copyright of his book; a firm may patent a particular design, etc.
3) COST FACTORS: - A firm may produce at such a large scale that it may receive enormous economies of scale. The firm is in position to sell off its product at a low price. Rival firms entry is prohibited by low cost competition 4) MARKET FACTORS: - Sometimes the nature of the market is such that it cannot attract and accommodate more than a single seller. The firm in existence has a relative advantage of experience. Sometimes, different firms join hands to maintain their existence. 5) HEAVY INVESTMENT: - Certain industries like iron, steel, cement, locomotives, etc. require heavy investment. Heavy investment will restrict number of producers and the possibility of the entry of new firms becomes bleak.
6) TARIFF POLICY: - When the Government imposes heavy taxes on imports, these will fall considerably. In the absence of foreign competition, the domestic producers will form their associations to maximize profits. It is often said, Tariff is the mother of trusts. 7) PROTECTION OF PUBLIC RIGHTS:- In order to safeguard the interests of the public and them from exploitation, public monopolies are formed. Railways, Posts and Telegraph, Electricity and Water Supply, etc, are a few examples of the public monopoly.
SHORT-RUN EQUILIBRIUM:In the equilibrium situation, in the short-run, a monopoly firm is likely to be faced with any of the following three situations: 1) It may be earning abnormal profits, i.e. at the equilibrium output, its AR>AC. 2) It may be incurring losses, i.e. at the equilibrium output, its AR>AC. 3) It may only break- even, or earn only normal profits, i.e. at equilibrium output AR=AC.
1) PURE PROFITS:-If the price determined by the monopolist is more than AC, he will get super normal profits.
2) LOSSES:A monopoly firm will incur losses if at the equilibrium output its AR<AC.
3) NORMAL PROFITS:-
normal profits.
LONG RUN EQUILIBRIUM UNDER MONOPOLY:THE LONG RUN EQUILIBRIUM OF THE MONOPOLY FIRM IS AGAIN ATTAINED WHERE THE MARGINAL COST (MC) = MARGINAL REVENUE (MR). A monopoly firm in the long run will necessarily receive abnormal profits. There are mainly two reasons for the emergence of abnormal profits in the long run. 1. The entry of the new firms is difficult. 2. If the monopolist does not receive profits he will have no attraction to stay in the market.
Definitions:
Price discrimination exists when the same product is sold at different prices to different buyers. -Koutsoyiannis Price discrimination refers strictly to the practice by a seller of charging different prices from different buyers for the same good. -J.S. Bain Price discrimination is the act of selling the same article produced under single control at different price to different buyers. - Mrs. Joan Robinson Price discrimination refers to the sale of technically similar products at prices which are not proportional their marginal cost. - Stigler
1. Difference in Elasticity of Demand: Price discrimination is possible only when elasticity of demand will be different in different markets. The monopolist will fix higher price where demand is inelastic and low where the demand will be elastic. In this way, he will be able to increase his total revenue. 2. Market Imperfections: Generally, price discrimination is possible only when there is some degree of market imperfections. The individual seller is able to divide his market into separate parts only if it is imperfect. 3. Differentiated Product: Price discrimination is possible when buyers need the same service in connection with differentiated products. For example, railways charges different charges for the transportation of coal and copper. 4. Legal Sanction: In some cases price discrimination is legally sanctioned. As Electricity Board charges lowest for electricity for domestic use and highest for commercial houses. 5. Monopoly Existence: Price discrimination is also called discrimination monopoly. It is evident that price discrimination is possible only under conditions of monopoly.
5. Geographical Discrimination: Price discrimination may be possible on account of geographical situations. The monopolist may discriminate between home and foreign buyers by selling at lower price in the foreign market than in the domestic market. Geographical discrimination is possible because no unit of the commodity sold in one market can be transferred to another. 6. Difference in Elasticity of Demand: - A commodity may have different elasticity of demand in different markets. Thus the market of a commodity can be separated in the basis of its elasticity of demand. Hence, a monopolist can charge different prices in different markets classified on the basis of elasticity of demand, low price is charged where demand is more elastic and high price in the market with the less elastic demand or inelastic demand. 7. Artificial Difference between Goods:- A monopolist may create artificial differences by presenting the same commodity under different names and labels, one for the rich and snobbish buyers and other for the ordinary customers. For instance, a biscuit manufacturer may wrap small quantity of the biscuits, give it separate name and charge a higher price. Thus, he may charge different price for substantially the same product. He may charge RS.2 for 100gms. Wrapped biscuits and RS.1.50 for unwrapped biscuits.
more complex: the customer may try to influence the price, e.g. by pretending to like the product less than he or she really does, and by "threatening" not to buy it. This form exists when a seller is able to sell each quantity of a good for the highest possible price that buyers are willing and able to pay. In other words, ALL consumer surplus is transferred from buyers to the seller.
ALL CONSUMER SURPLUSES IS TRANSFERRED FROM BUYERS TO THE SELLER. 2. Second Degree Price Discrimination:
In Second Degree Price Discrimination, the price varies according to quantity sold. Larger quantities are available at a lower unit price. The buyers are divided into different groups and from different groups different price is charged which is the lowest demand price of that group. This type of price discrimination would occur if each individual buyer had a perfectly in-elastic demand curve for a good below and above a certain price.
1.
2.
Output under discriminating monopoly will be larger as compared to pure monopoly, thus, it reduces the deadweight loss of monopoly.
Maximization of Total Revenue: A multi-price monopolist can discriminate between two markets by charging different prices. The firm will allocate its output in two markets so that marginal revenue from the two markets is equalized. If marginal revenue is not equal, the monopoly firm can increase its total revenue by selling a unit less in the market with lower marginal revenue and selling one more unit in the market with the higher marginal revenue. A Price Discrimination monopolist has the choice to classify buyers into two categories. From one set of buyers, the firm will charge a price more than the marginal cost and from another equal to marginal cost, and thus, can maximize its total revenue.
1.
2. Output under Discriminating Monopoly will be larger as compared with Pure Monopoly:
A single-price monopoly firm maximizes profits by selling less at a high price. It has no incentive to expand its output. But a price discriminating monopoly firm has the incentive to expand its output, selling a part of its output at a high price and selling the remaining quantity at a price greater than or equal to marginal cost. 1.6
Monopolistic Competition
Monopolistic competition refers to a market structure in which there are many sellers selling similar but differentiated products and there is existence of free entry and exit of firms. Its features can be stated as follows: FEATURES OF MONOPOLISTIC COMPETITION
i) Large Number: The number of firms operating under monopolistic competition is sufficiently large which implies that the firms are small in comparison to the entire market. Although they have some power over price (to the extent that their products are differentiated), they do not have sufficient power to retaliate if another firm changes its price. Moreover there is freedom of entry. There are no quantitative restrictions or differences in market conditions. However, each firm differs from its rivals in some qualitative respect. ii) Close Substitutes: In case of a monopoly there are no substitutes available. Under monopolistic competition firms produce very close substitutes. Chocolates of one company may serve a similar purpose as that of some other firm. The only difference may be of some variation in the quality of the product.
iii) Group: Firms under monopolistic competition together form a group. They cannot be called an industry. This is because their products are somewhat dissimilar and not homogenous as under competitive industry.
iv) Entry to market: No barriers to entry or exit exist in monopolistic competition. However, the need to make one's product differentiated may require nonprice action, which, if unsuccessful, would drive the firm out of the market. v) Demand: The demand of a firm in monopolistic competition is down sloping because of the preference of customers for the features of the differentiated product. However, because there are many close (if not perfect) substitutes readily available, the demand is highly elastic. Graphically, this means that the demand in monopolistic competition is flatter than in monopoly i.e. is more elastic. vi) Product Differentiation: Under monopolistic competition products are differentiated. This is the outstanding feature of this form of market. Otherwise monopolistic competition closely resembles perfect competition. The fundamental difference between the two is that products are no more homogenous. Goods produced are deliberately differentiated. By differentiation we mean the goods are made to appear somewhat different and superior to those produced by other firms. Product differentiation may be real or apparent. By real differentiation we mean that a difference is maintained in some physical or chemical composition of a product or in the taste and appearance of that product. This is easily done with the help of attractive packaging; or some extra services are rendered. A product can also be marketed as superior using local advantage. When products are differentiated more buyers are likely to be attracted. Thereby the firm gains extra control over demand and market conditions. (vii) Selling (Advertising) Cost: Selling Cost (SC) is another outstanding feature of a monopolistic competitive market. This is in the form of advertisement expenditure. Selling Cost and Product Differentiation together enable the producer to maintain some control over market conditions and influence the shape of the demand curve. Both features are interdependent. Whenever a product is differentiated it is necessary to inform buyers; and advertisement is the only medium through which buyers can be told about superiority of that product. Selling Cost by itself is apparent product differentiation. When a product does not contain any genuine qualitative difference, buyers can be made to treat a product differently through advertisements. So whenever products are differentiated and advertised, the market becomes a monopolistic competition. These are the hallmarks of this form of market. The presence of selling cost increases the firms cost of production. In order to recover it, firms have to charge a higher price. The net effect of a monopolistic competitive market is pricing goods at a higher rate. Consumers have to bear this extra expenditure. (viii) Lack of Perfect Knowledge: The buyers and sellers do not have perfect knowledge of the market. There are innumerable products each being a close substitute of the other. The buyers do not know about all these products, their qualities and prices. Likewise, the seller does not know the exact preference of buyers and is, therefore, unable to get advantage out of the situation.
(ix) Less Mobility: Under monopolistic competition both the factors of production as well as goods and services are not perfectly mobile. (x) Economic Welfare: Under monopolistic competition the total level of production is low, and the price is higher than the marginal cost. The consumers get very little amount of consumers surplus. Firms are of smaller size, they do not get economies of scale; therefore the cost of production is high. Both efficient and inefficient firms can maintain their existence under monopolistic competition. The unprecedented waste and misuse of the resources minimise the economic welfare.
Normal Profits: If under monopolistic competition, the price of the product is equal to AC, the firm will be earning normal profit. In the Fig. MC is equal to MR, this is the point of equilibrium where equilibrium output is OQm and equilibrium price is equal to aQm. At this point, AC is aQm and AR is also aQm i.e. AC=AR. Thus firm will be earning only normal profits.
Sustaining losses: However it is also possible that the demand may not be favorable to the firm under monopolistic competition, i.e. it may or may not be able to attract the consumers towards its product, if it fixes price below AC. But it is compelled to sell its product at the price which is less than even its short period average cost. Hence, it may incur losses. Such firm in long run may leave the industry, if it is not possible for it to change its demand relative to its cost conditions trough product differentiation and advertisement. In the fig the shade area represents the losses incurred.
Long Run Equilibrium Long run refers to that time period in which each firm can change its production capacity by changing the fixed as well as variable factors. News firms can enter the industry and old firms can exit it. Basically the firms in the long run will get normal profits. If the existing firms are making super normal profits, it will attract some of the new firms in the industry. The entry of new firms will result into over production which will have a depressing effect on price. Hence all the firms in the long run get normal profits.
In the Fig. output is measured on X-axis whereas price is measured on Y-axis. LRAC is the long run average cost and LRMC is the long run marginal cost curve. The firm is equilibrium because MR=MC. the equilibrium output is OQL and the price is OPL. Since, at this equilibrium average revenue is tangent to long run average cost curve; hence the firms are earning normal profit.
Question 2: In perfect competition: a) The price equals the marginal revenue b) The price equals the average variable cost c) The fixed cost equals the variable costs d) The price equals the total costs Question 3: A profit maximising firm in perfect competition produces where: a) Total revenue is maximised b) Marginal revenue equals zero c) Marginal revenue equals marginal cost d) Marginal revenue equals average cost
4 The marginal revenue curve in monopoly: a) Equals the demand curve b) Is parallel with the demand curve c) Lies below and converges with the demand curve d) Lies below and diverges from the demand curve
5 In monopoly when abnormal profits are made: a) The price set is greater than the marginal cost b) The price is less than the average cost c) The average revenue equals the marginal cost d) Revenue equals total cost
6 In monopoly in long run equilibrium: a) The firm is productively efficient b) The firm is allocatively inefficient c) The firm produces where marginal cost is less than marginal revenue
7 In a monopoly which of the following is not true? a) Products are differentiated b) There is freedom of entry and exit into the industry in the long run c) The firm is a price taker d) There is one main seller
8 In monopolistic competition: a) Firms face a perfectly elastic demand curve b) All products are homogeneous c) Firms make normal profits in the long run d) There are barriers to entry to prevent entry
9 In monopolistic competition: a) Demand is perfectly elastic b) Products are homogeneous c) Marginal revenue = price d) The marginal revenue is below the demand curve and diverges
10 In monopolistic competition firms profit maximize where: a) Marginal revenue = Average revenue b) Marginal revenue = Marginal cost c) Marginal revenue = Average cost d) Marginal revenue = Total cost
significant entry barriers into the market in the long run which allows firms to make supernormal profits. 5. Indeterminate demand curve: An oligopoly firm can never predict its sales correctly. It can never be certain about the nature and position of its demand curve. Any change in price or output by one firm leads to series of reaction by the rival firms. As a result, the demand curve of the oligopoly firm is indeterminate. 6. Role of selling costs: Advertisement, publicity and other sales techniques play an important role in oligopoly pricing. Oligopoly firm employs various techniques of sales promotion to attract large number of buyers and maximise the profits.
This game models a situation in which each firm chooses its output independently, and the market determines the price at which it is sold. Specifically, if firm 1 produces the output y1 and firm 2 produces the output y2 then the price at which each unit of output is sold is P(y1 + y2), where P is the inverse demand function. Denote firm 1's total cost function by TC1(y) and firm 2's by TC2(y). Then firm 1's total revenue when the pair of outputs chosen by the firms is (y1, y2) is P(y1 + y2)y1, so that its profit is P(y1 + y2)y1 TC1(y1); firm 2's revenue is P(y2 + y2)y2, and hence its profit is
P(y1 + y2)y2 TC2(y2). Notice an essential difference between these specifications of the firms' revenues and those for a competitive firm or for a monopolist. The revenue of both a competitive firm and of a monopolist depends only on the firm's own output: for a competitive firm we assume that the firm's output does not affect the price, and for a monopolist there are no other firms in the market. For a duopolist, however, revenue depends on both its own output and the other firm's output. The solution which applies to this game is that of Nash equilibrium. First consider the nature of the firms' best response functions. The firms' best response functions Firm 1's best response function gives, for each possible output of firm 2, the profit-maximizing output of firm 1. Firm 1's profit-maximizing output when firm 2's output is y2 is the output y1 that maximizes firm 1's profit; that is, the value of y1 that maximizes P(y1 + y2)y1 TC1(y1). Differentiating with respect to y1 (treating y2 as a constant), we conclude that the profitmaximizing output y1 satisfies P'(y1 + y2)y1 + P(y1 + y2) MC1(y1) = 0. We'd like to know the shape of firm 1's best response function---i.e. we'd like to know how the value of y1 that satisfies this condition depends on y2. Consider a case in which firm 1's average cost function takes the "typical" U shape. First suppose that y2 = 0. Then firm 1's problem is the same as that of a monopolist. Its best output satisfies the condition MR = MC1, as illustrated in the left panel of the following figure. The corresponding point on firm 1's best response function is shown in the right panel: when y2 = 0, firm 1's best output is b1 (0).
Now increase y2. Firm 2 now absorbs some of the demand, and less is left over for firm 1: the demand curve firm 1 faces is shifted to the left by the amount y2, as in the left panel of the following figure. Firm 1's best output satisfies the condition that its marginal revenue, given the part of the demand function that it faces, is equal to its marginal cost. This optimal output is indicated as b1 (y2) in the left panel of the figure; the corresponding point on firm 1's best response function is shown in the right panel.
As firm 2's output increases, there comes a point where there is no positive output at which firm 1 can make a profit. The critical point is shown in the left panel of the following figure. In this case, the most profit firm 1 can earn by producing a positive output is 0: the AR curve it faces is tangent to its AC curve. The corresponding point on firm 1's best response function is shown in the right panel.
For larger outputs, firm 1's optimal output is zero, as shown in the following figure.
Firm 1's whole best response function is shown in the following figure. The way to read this figure is to take a point on the vertical axis---a value of y2---and go across to the graph, then down to the horizontal axis; the value of y1 on this axis is firm 1's optimal output given y2.
If firm 2's cost function is the same as firm 1's, then its best response function is symmetric with firm 1's, as shown in the following figure.
Whenever a firm's average cost functions is U-shaped, its best response function has a "jump" in it, for the same reason that a competitive firm's supply function has a "jump" in it: the firm either wants to produce outputs close to its efficient scale of production or it wants to produce an output of zero, but it does not want to produce intermediate outputs (for which the average cost is high). A firm's best output does not necessarily decrease as its rival's output increases. Such a relationship seems likely, though it is possible that for some increases in its rival's output, a firm wants to produce more output, not less. Nash equilibrium To find Nash equilibrium, we need to put together the two best response functions. Any pair (y1, y2) of outputs at which they intersect has the property that y1 = b1(y2) and y2 = b2(y1) and hence is Nash equilibrium. The best response functions are superimposed in the following figure.
We see that for this pair of best response functions there is a unique Nash equilibrium, indicated by the small purple disk. (In general, there may be more than one Nash equilibrium.)
The leader sets a price, PL based on their own MC and MR curves, but taking into account the other firms cost curves. The price needs to be high enough to stop other firms making losses, which would attract the competition commission to investigate the market. The models characterize price leadership in terms of industries where the distribution of firm sizes is highly skewed, resulting in a dominant firm that exists alongside a competitive fringe of much smaller firms, typically supplying a relatively standardized product. The fringe suppliers are small individually but may have a significant share of the market collectively. The dominant firm sets its own price on the basis of industry demand not served by the fringe suppliers, thereby providing a price umbrella for the latter. Market performance then depends on relative costs and ease of market entry. If there are barriers to market entry, the dominant firm will be able to charge supra-competitive prices, though this power will be moderated by the presence in the industry of the competitive fringe. Since it acts as price setter, the dominant firms price cuts will be matched by the competitive fringe. On the other hand, if barriers to entry are low, the price leaders ability to exercise market power will be constrained by the entry [or threat of entry] of additional fringe suppliers.
3 CARTELS Cartel Theory of Oligopoly A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum-exporting countries (OPEC) is perhaps the best-known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce. Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oilproducing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward-sloping market demand curve, just like a monopolist. In fact, the cartel's profitmaximizing decision is the same as that of a monopolist, as Figure 1 reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel's profits are equal to the area of the rectangular box labeled abcd in following figure. Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.
Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is a built-in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.
ASSUMPTIONS
The kinked demand curve hypothesis of price rigidity is based o the following assumptions: 1. There are few firms in the market. 2. The product produced by one firm is a close substitute for other firms. 3. The product is of same quality. No product differentiation. 4. No advertising cost. 5. Each sellers attitude depends upon the attitude of its rivals. 6. If one firm raises prices, others will not follow, rather they would stick to the prevailing prices and cater to the customers, leaving the price raising seller behind. Sweezy postulates are as follows: If an oligopolist raises its price, it would lose most of its customers since the other firms in the industry would not match the price increase On the other hand, an oligopolist could not increase its share of the market by lowering its price, since its competitors would immediately match the price reduction.
In these two cases the oligopolist firms have a kink at the prevailing market price, which explains price rigidity. Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve. Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity. The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. This is because competitors will generally ignore price increases, with the hope of gaining a larger market share as a result of now having comparatively lower prices. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases. Firms will often enter the industry in the long run
Above the kink, demand is relatively elastic because all other firms prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and the kink point. While a theoretical model proposed in 1947, it has failed to receive conclusive evidence for support. Like any other market situation, the aim of an oligopoly firm is to maximise its profits. Equilibrium of the oligopoly firm is obtained at the level of output where the cost of producing an additional unit [i.e. ., MC] is equal to the revenue derived from the additional unit sold [i.e. ., MR]. The equilibrium of the firm is defined by the point of kink. At any point to the left of kink MC is below the MR, while to the right of the kink, the MC is larger than MR. The total profits is maximised at the point of the kink. The above figure shows that so long as the MC curves [MC1, MC2, and MC3] intersect the MR curve in the discontinuous portion of MR, the price remains stable. This is also known as PRICE RIGIDITY. It is only when the MC curve intersects the MR curve in the continuous segments that the price will change. The firms, however does not go for a price change because an increase or decrease in price leads to falls in total profits. This implies stable or sticky prices. CHANGES IN COSTS In oligopoly under kinked demand curve analysis changes costs within a certain range do not affect the prevailing prices. It should be noted that with any cost reduction the new MC curve will always cut MR curve in the gap as cost falls the gap continues to widen due to 2 reasons: As cost falls, the upper portion of the demand curve becomes more elastic because of the fact that a price rise by one seller will not be followed by rivals and his sales would be considerably reduced. With the reduction in the costs, the lower portion of the kinked demand curve becomes more inelastic, because of the greater certainty that a price reduction by one seller will be followed by the other rivals. Therefore the chances of existence of price rigidity are greater where there is a reduction costs than there is a risk in costs.
2. Economies of Scale: Oligopoly firms are also able to take advantage of economies of scale that reduce production costs and prices. As large firms, they can "mass produce" at low average cost. Many modern goods--including cars, computers, aircraft, and assorted household products-would be significantly more expensive if produced by a large number of small firms rather than a small number of large firms.
2. Under oligopoly, a few large firms control most of the production and sale of a product because a. economies of scale make it difficult for small firms to compete. b. diseconomies of scale make it difficult for small firms to compete. c. average total costs rise as production expands. d. marginal costs rise as production expands.
3. In an oligopoly such as the U.S. domestic airline industry, a firm such as United Airlines would a. carefully anticipate Delta, American, and Southwests likely responses before it raised or lowered fares. b. pretty much disregard Delta, American, and Southwests likely responses when raising or lowering fares. c. charge the lowest fare possible in order to maximize market share. d. schedule as many flights to as many cities as possible without regard to what competitors do. 4. One of the reasons that collusive oligopolies are usually short lived is that a. they are unable to earn economic profits in the long run. b. they do not set prices where marginal cost equals marginal revenue. c. they set prices below long-run average total costs. d. parties to the collusion often cheat on one another. 5. In a collusive oligopoly, joint profits are maximized when a price is set based on a. its own demand and cost schedules. b. the market demand for the product and the summation of marginal costs of the various firms. c. the price followers demand schedules and the price leaders marginal costs. d. the price leaders demand schedule and the price followers marginal costs. 6. During the 1950s, many profitable manufacturing industries in the United States, such as steel, tires, and autos, were considered oligopolies. Why do you think such firms work hard to keep imports from other countries out of the U.S. market? a. Without import barriers, excess profits in the United States would attract foreign firms, break down existing price agreements, and reduce profits of U.S. firms.
b. Without import barriers, foreign firms would be attracted to the United States and cause the cost in the industry to rise. c. Without import barriers, foreign firms would buy U.S. goods and resell them in the United States, causing profits to fall. d. Without import barriers, prices of goods would rise, so consumers would buy less of the products of these firms.
7. Over the past 20 years, Dominator, Inc., a large firm in an oligopolistic industry, has changed prices a number of times. Each time it does so, the other firms in the industry follow suit. Dominator, Inc., is a a. monopoly. b. perfect competitor. c. price leader. d. price follower.
8. In the kinked demand curve model, starting from the initial price, the demand curve assumed to face a firm is relatively ____ for price increases and relatively ____ for price decreases. a. elastic; elastic b. elastic; inelastic c. inelastic; elastic d. inelastic; inelastic
9. The kinked demand curve model illustrates a. how price rigidity could characterize some oligopoly firms, despite changing marginal costs. b. how price increases and price decreases can elicit different responses from rival firms, in oligopoly. c. why price rigidity may be more common when firms have excess capacity than when operating near capacity. d. the importance of expectations about rival behavior in oligopoly. e. all of the above.
10. Which of the following areas illustrates positive network externalities? a. Telephones b. Software c. fax machines d. the Internet e. all of the above
7.1 MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION:The most significant theory of factor pricing is the marginal productivity theory of distribution. It was propounded by the German economist T.H. Von Thunen but later many economists like Karl Menger, Walras, Wickstead, Edgeworth and Clark etc. contributed for its development. According to this theory remuneration of each factor of production tends to be equal to its marginal productivity. Marginal productivity is the addition tat the use of one extra unit of the factor makes to the total production. So long as the marginal cost of factor is less than the marginal productivity the entrepreneur will go on employing more and more units of the factors. He will stop giving further employment as soon as the marginal productivity of the factor is equal to the marginal cost of the factors. ASSUMPTIONS OF THE THEORY The main assumptions of the theory are:1 PERFECT COMPTITION:-The marginal productivity theory rests upon the fundamental assumption of perfect competition, as it cannot take into account unequal bargaining power between the buyers and the sellers. Since there is perfect competition in the factor market the prices of the factors throughout the market are uniform. This is because when this condition holds good the marginal productivity shall be equal and factor prices shall be uniform. 2 HOMOGENEOUS FACTORS: - This theory assumes that the factors of production are homogeneous. This implies that the different factors of production have the same efficiency. Thus productivity of all workers offering the particular type of labour is the same. In other words, different units of labour have the same productivity. Likewise the productivity of different units of land, capital and organization is the same. 3 RATIONAL BEHAVIOUR:-The theory assumes that every producer desires to reap maximum profits. This is because the organizer is a rational person and he so combines the different factors of production in such a way that marginal productivity from a unit of money is the same as in case of every factor of production. 4 PERFECT SUBSTITUABILITY: - The theory is also based upon the assumption of perfect substitution not only between the different units of same factor but also between the different units of various factors of production. As per this assumption, the various units of labour are not only perfect substitutes of each other but also different units of labour are perfect substitutes of different units of capital.
5 KNOWLEDGE ABOUT MARGINAL PRODUCTIVITY: - Both the producers and owners of factors of production have means of knowing the value of factors marginal product. 6 LAW OF DIMINISHING MARGINAL RETURNS: - It means that as units of a factor of production are increased the marginal productivity goes on diminishing. 7 LAW OF VARIBALE PROPORTIONS:-The law of variable proportions is applicable in the economy 8 LONG -RUN ANALYSIS: - Marginal productivity theory seeks to explain determination of factors remuneration only in the long run period.
EXPLANATION OF THE THEORY:The marginal productivity theory states that under perfect competition, price of each factor of production will be equal to its marginal productivity. The price of the factor is determined by the industry. The firm will employ that number of a given factor at which the price is equal to its marginal productivity. Thus for an industry it is a theory of factor pricing while for a firm it is a factor demand theory. ANALYSIS OF MARGINAL PRODUCTIVITY THEORY FROM THE POINT OF VIEW OF AN INDUSTRY:Under the condition of perfect competition price of each factor of production is determined by the equality of demand and supply. As the theory assumes that there exists full employment in the economy. Therefore supply of the factor is assumed to be constant. So factor price is determined by its demand which itself is determined by the marginal productivity. Thus under such conditions it becomes essential to throw light on the demand curve or marginal productivity curve of the industry. As the industry consists of a group of many firms accordingly .its demand curve can be drawn with the demand curves of all firms in the industry. Moreover, marginal revenue productivity of a factor constitutes its demand curve. It is only due to this reason that a firms demand or labour depends on its marginal revenue productivity. A firm will employ that number of labourers at which their marginal productivity is equal to the prevailing wage rate. The summation of demand curves of all firms shows demand curve of the industry. Since the number of firms is not constant under perfect competitive market, it is not possible to estimate the summation of demand curves of all firms. However one thing is certain that the demand curve of industry also slopes downwards from left to right.
MARGINAL PRODUCTIVITY CURVE OF A FIRM NOTE: RED LINE REPRESENTS ARP (average revenue product) Y AXIS:- WAGES X AXIS:- LABOUR MARGINAL PRODUCTIVITY CURVE OF THE INDUSTRY
The point where demand and supply of a factor are equal, it determines the factor price for the industry. Thus the factor price is determined by the demand for factor i.e. factor price will be equal to the marginal revenue productivity.
SS represents the supply curve in the long run. It is a vertical line which shows the total supply of labour is fixed and it is a condition off full employment. DD the marginal productivity curve which is downward sloping from left to right. The factor price is determined at point where DD cuts SS. ANALYSIS OF MARGINAL PRODUCTIVITY THEORY FROM THE POINT OF VIEW OF FIRM:Under perfect competition the number of firms is very large. No single firm can influence the market price of a factor of production. Every firm acts as a price taker and not as price maker. Therefore it has to accept the prevailing price. No employer would like to pay more than what others are paying. A firm will employ that number of factors t which its price is equal to the value of marginal productivity. Other things remaining constant as more and more labourers are employed by a firm, its marginal physical productivity goes ion diminishing. As price remains constant so when marginal physical productivity of labour goes on diminishing, marginal revenue productivity will also go on diminishing. Therefore in order to get the equilibrium position, a firm will employ labourers up to a point where their respective marginal revenue productivity is equal to their wage rate.
In this diagram number of labourers lies on x axis & wage rate on y .MRP is the marginal revenue product curve. WS is the prevailing wage rate in the market. MRP is downward sloping and cuts WS curve at a point at which we get equilibrium wage rate.i.e. Ol. CRITICISM:1 UNREALISTIC ASSUPMTIONS:-The theory assumes that there exists perfect competition in all the markets. But in reality, perfect competition is only imaginary concept. In modern days, perfect competition does not hold good. 2 ALL FACTORS ARE NOT HOMOGENEOUS:-This theory assumes that all units of a given factor are homogeneous. It is wrong. In reality different units of a given factor are heterogeneous. 3 SHORT-PERIOD IGNORED:-The marginal productivity theory holds good in the long run only while it ignores the short period. As LORD KEYNES stated that in the long run we all are dead. Therefore all problems are needed to be solved in the short run. 4 LEVEL OF EMPLOYMENT AND WAGE RATE:- According to this theory, employment can be increased by wage cut. Moreover, according to KEYNES, the volume of employment is not determined by wage rate but by effective demand. 5 UNREALISTIC ASSUMPTION OF FULL EMPLOYMENT:-The marginal productivity theory assumes that the situation of full employment prevails in the economy. It is a rare phenomenon. But, in reality there exists hardly any country in the world whether advanced or
less advanced which enjoys full employment. Therefore, this theory does not hold good in the real world. 6 VAGUES CONCEPT OF MARGINAL PRODUCTIVITY:- The concept of marginal productivity is vague. Production is the result of the cooperative efforts of all the four factors of production and it is not possible to separate out the contribution of one factor.
4 A producer tries to produce a given output with the least-cost combination of factors. 5 Every individual wants to maximize his satisfaction. 6 Every individual purchases some quantity of all goods. 7 All factors of production are perfectly mobile. Given the above assumption various marginal conditions require for the achievement of Pareto Optimum are explained below. 1. THE OPTIMUM DISTRIBUTION OF PRODUCTS AMONG THE CONSUMERS: EFFICIENCY IN EXCHANGE The first condition relates to the optimum distribution of the goods among the different consumers composing a society at a particular point of time. The condition says The marginal rate of substitution between any two goods must be the same for every individual who consumes them both. i.e. MRSAXY=MRSBXY Marginal rate of substitution of one good for another is the amount of one good necessary to compensate for the loss of a marginal unit of another to maintain a constant level of satisfaction. So long as the marginal rate of substitution (MRS) between two goods is not equal for any two consumers, they will enter into an exchange which would increase the satisfaction of both or of one without decreasing the satisfaction of the other. This condition can be better explained with the help of Edgeworth box diagram in the figure goods X and Y which are consumed by two individuals A and B the composing a society are represented on the X and Y axis respectively. Oa and Ob are origins Ia1, Ia2, Ia3 and Ib1, Ib2 and Ib3 are the indifference curves showing successively higher level of satisfaction of consumers A and B respectively. CC is the contract curve passing through various tangent points Q,R,S of the indifference curve of A and B. MRS between the two goods for individuals A and B are equal on the various points of the contract curve CC. Any point outside the contract curve does not represent the equality of MRS between the two goods for two individuals A and B of the society.
Let us consider point K where indifference curves Ia1 and Ib1 of individuals A and B respectively intersect each other instead of being tangential. Therefore at point K, (MRS) between two goods X and Y of individual A is not equal to that of B. With thee initial distribution of goods as represented by pt. K ,it is possible to increase the satisfaction of one individual without any decrease in that of the other or to increase the satisfaction of both by redistribution of the two goods X and Y between them. A movement from K to S increases the satisfaction of A without any decrease in the satisfaction of B. Similarly a movement from K to Q increases these satisfaction of B without any decrease in As satisfaction. The movement from K to R increases the satisfaction of both because both move to their higher indifference curves. Thus a movement from K to Q or to S or any other point on the segment SQ of the contract curve will, according to Pareto Criterion, increases the level of social welfare. Since the slope of an indifference curve represents the MRS at every point of the contract curve, which represents tangency points of the indifference curve, MRS of the two individual are equal. Thus, every point on the contract curve denotes maximum social welfare. 2. THE OPTIMUM ALLOCATION OF FACTORS: EEFICIENCY IN PRODUCTION The second condition for Pareto optimum requires that the available factors of production should be utilized in the production of different goods in such a manner that it is impossible to increase the output of one good without a decrease in the output of another or to increase the output of one good without a decrease in the output of another or to increase the output of both the goods by any re-allocation of factors of production. This situation would be achieved if the Marginal technical rate of substitution between any pair of factors must be the same for any two firms producing two different products and using both the factors to produce the products. i.e. MRTSXLK=MRTSYLK
This condition can be explained with the help of Edgeworth Box diagram relating to production. This is depicted in the following figure. Let us assume two firms A and B producing goods X and Y by using two factors labour and capital. The available quantities of labour and capital are represented on X and Y axes respectively. OA and OB are the origins for firms A and B respectively. Isoquants Ia1,Ia2,Ia3 and Ib1,Ib2,Ib3 of firms A and B respectively represent successively higher quantities of goods X and Y respectively which they can produce by different combinations of labour and capital. The slope of the isoquant, which is convex to the origin, represents the marginal technical rate of substitution (MRTS) between two factors. MRTS of one factor for another is the amount of one factor necessary to compensate the loss of the marginal unit of another so that the level of output remains the same. So long as the MRTS between two factors for two firms producing goods X and Y is not equal, total output can be increased by transfer of factors from one firm to another. In terms of the following diagram any movement from K to S or to Q raises the output of one firm without any decrease in the output of the other. The total output of the two firms increases when through redistribution of factors between two firms, a movement is made from the point K to the point Q or S on the contract curve. A glance at the figure will reveal that movement from point K of the contract curve to the point R on the contract curve will raise the output of both the firms individually as well as collectively. Therefore, it follows that corresponding to a point off the contract curve there will be some points on the contract curve production at which will ensure greater output of the two firms. As the contract curve is the locus of the tangency points of the isoquants of the two firms, the (MRS) of the two firms is same at every pt. of the contract curve CC. It, therefore, follows that on the contract curve at every pt. of which MRTS between the two factors of two firms is the same, the allocation of factors between the two firms producing X and Y respectively is optimum. When the allocation of factors between the two firms is such that they are producing at a pt. on the contract curve, then no reallocation of factors will increase the total output of the two firms taken together.
3. THE OPTIMUM DIRECTION OF PRODUCTION: EFFICIENCY IN PRODUCT MIX The third condition relates to the technical conditions of production and the state of consumers preferences. This is also called overall condition of Pareto-Optimality or economic efficiency. The marginal condition for a Pareto optimal composition of output requires that the MRT between any two goods be equal to the MRS between the same two goods In the figure, commodities X and Y have been represented on the X and Y axis respectively. AB is a transformation curve between any pair of goods X and Y. This curve represents the maximum amount of good X that can be produced for any quantity of good Y, given the amount of other goods that are produced and fixed supplies of available resources.IC1 is the indifference curve of a representative consumer reflecting the preferences of the society between the two goods of the society. The MRT of the commodity and the MRS of the consumers of the society are equal to each other at the point K at which the transformation curve is tangent to the indifference curve IC1 of the consumers. Point K represents optimum composition of production in which commodities X and Y are being produced. This is because of all the points on transformation curve, pt. R lies at the highest possible indifference curves IC1 of the consumer.
c) None of the above d) Both (A) and (b) 8. Marginal conditions required for the achievement of Pareto Optimum are:a) THE OPTIMUM DISTRIBUTION OF PRODUCTS AMONG THE CONSUMERS b) THE OPTIMUM ALLOCATION OF FACTORS c) THE OPTIMUM DIRECTION OF PRODUCTION d) All the above 9. Pareto criterion can be explained with the help of:a) Ford fuse box diagram b) Edgeworth box diagram c) Lipsey diagram d) Keynes diagram 10. According to Pareto Criterion, a change is good if:a) It leaves no one worse off than before b) It leaves someone better off than before c) It leaves no one worse off and someone better off than before None of the above
Answer Key to Multiple choice questions Chapter 1 1 (c) 2(b) 3(b) 4(b) 5(d) 6(a) 7(b) 8(c) 9(a) 10(a) Chapter 2 1 (b) 2(c) 3(a) 4(b) 5(d) 6(a) 7(a) 8(a) 9(a) 10(a) Chapter 3 1 (b) 2(a) 3(a) 4(c) 5(a) 6(a) 7(a) 8(a) 9(a) 10(a) Chapter 4 1 (d) 2 (c) 3(c) 4 (b) 5 (a) 6 (c) 7 (c) 8 (b) 9 (a) 10 (b) Chapter 5 1 (a) 2(a) 3(c) 4(d) 5(a) 6(b) 7(b) 8(c) 9(d) 10(b) Chapter 6 1 (c) 2(a) 3(a) 4(d) 5(b) 6(a) 7(c) 8(b) 9(e) 10(e) Chapter 7 1 (a) 2(c) 3(c) 4 (d) 5 (c) 6(d) 7 (c) 8 (d) 9 (b) 10 (c)
BIBLIOGRAPHY I.C.Dhingra -Principles of Microeconomics-Sultan Chand & Sons Ahuja, H.L. Advanced Economic Theory (Micro Economics), S. Chand & Co Gupta G.S. - Managerial Economics, Browning & Browning Gould & Lazer Koutsoyiannis, Modern economics Varshney. R and Maheshwari, Managerial Economics-Sultan Chand & Co