Managerial Economics

Teerthanker Mahaveer University

 Block 1
Business Economics
Objectives
You would learn in this lesson
• What constitutes an economic challenge for an individual and society?
• What desires are and how to fulfill them;
• The distinctions between normative and positive economics, with illustrations.
• The differences between the macro and micro branches of economic theory;
• How the decision issue in economics can be explained by PPC;

UNIT 1 ORIGIN & EVOLUTION OF ECONOMICS

Structure
1.1.1 Introduction
1.1.2Unlimited Wants and Limited Means
1.1.3 Defining Economics
1.1.4 Positive versus Normative Economics
1.1.5 Differences between Positive and Normative Economics
1.1.6 Significance of Economics
1.1.7 Micro and Macro Economics
1.1.8 Micro Economics
1.1.9 Significance of Microeconomics
1.1.10 Macro Economics
1.1.11 Significance of Macroeconomics
1.1.12 Comparison between Macro Economics and Micro Economics
1.1.13 The Economic Problem
1.1.14 Three Basic Economic Questions
1.1.15 Production Possibilities Curve (PPC)
1.1Summary
1.2 Keywords
1.3Self Assessment Test
1.4References
 Unit-1

1.1.1 INTRODUCTION
The study of economics is a very broad field. Because economics encompasses a wide
range of topics and has a broad scope, it is difficult to define or interpret it precisely. Many
academics and writers have attempted to define its goals and significance ever since it first
appeared as a distinct field of study within social science. It must be said that the definition
of economics has evolved along with civilization and time. For many authors and scholars
of the late eighteenth and early nineteenth centuries, the science of wealth is economics.
The term "classical thinkers" refers to these scholars.
They believed that the study of economics focused on the phenomena of wealth, including
its origins and nature, as well as how individuals and nations create money. Decision-
making is essential to economics. Every day, we have to make a variety of decisions. How
much should I spend on gas? Which way is best to get to work? Where ought we to eat
dinner? Which profession or line of work should I pursue? Which is better: landing a job
or starting the next great Internet startup? What are the benefits and drawbacks of
graduating from college? Which roommate ought to do the dishwashing? Can I keep the
dog as a pet? When and if I should get married and start a family are important questions.
When every politician says they can boost the economy or make my life better, which one
should I vote for?
Many people assume that economics is all about money when they hear the phrase. Money
is only one aspect of economics. It involves considering the pros and cons of various
options. Money is a factor in some of those significant decisions, but not in
most.Economics is applicable to most of your daily, monthly, and life decisions even if it
has nothing to do with money. Examples of economic decisions are whether you and your
roommate should do the dishes or clean up after yourself, if you should give a small
amount via phone to a worthy organization or give an hour each week, and if you should
get a job to support your parents, siblings, or yourself in the long run.
Economics is a separate academic discipline.Economics describes a man's use of his finite
resources to satisfy his limitless desires. Man is finite in both time and money. It is best
for him to use his time and money wisely so that he gets the most satisfaction possible. A
guy desires clothing, food, and shelter. He needs money to be able to afford these items.
To get the money, he must put in a lot of effort. Satisfaction follows effort. Therefore, in
 a primitive society where there is a direct correlation between desires, efforts, and
satisfaction, the main topics of economics are wants, efforts, and satisfaction.

1.1.2 LIMITED MEANS AND UNLIMITED WANTS

Human needs, wants, and desires are the basis of economics. All human people have needs
and goals, regardless of the stage in which their society has developed historically. In
order for life to exist in this world, some demands, like the need for food, clothes, and
shelter, are biological in nature. Therefore, needs have a biological genesis.A significant
portion of our requirements are met by the existence of human society. The culture of a
certain community is one of many intricate aspects that determine these kinds of needs.
At each given point in the history of that nation, the culture of that society has an impact
on even biological necessities, such as food. As a result, we see that needs arise from the
biological urge to maintain life, and that the shape, nature, and structure of needs are
determined by the presence of human civilization. People's needs, wants, goals, and
aspirations are now realized, and human actions are focused on making this happen.
Economics deals with the aims, objectives, and ends that people (individually and
collectively) seek to achieve and actualize through the use of available resources or means.
If you want a cold drink, for instance, you must be able to buy one. To cultivate wheat,
you'll need a piece of land, seeds, fertilizer, and water for irrigation. A house needs bricks,
cement, steel, glass, wood, and other materials. In these situations, what are the means
(resources) and what are the aims (ends)? Consider an alternative scenario: since your
objective is to purchase a new car, you may drive to work in order to acquire there, you
may arrive at work with the intention of receive money (purchasing power), and you may
make money. These make it abundantly evident that one needs means or resources in order
to achieve goals, objectives, and ends.

1.1.3AN ECONOMICS DEFINITION

The name "economics" comes from the Greek word "Oikonomia," which is composed of
two parts: oikos, which means "home," and nomos, which means "management".
Economics was therefore formerly called "home management," where the head of the
household used his small income to meet the needs of the family members. Economics is
a social science that focuses on the general patterns of human behavior. Economics'
primary goal is to investigate how individuals, families, companies, and nations utilize
their finite resources to generate the greatest amount of profit. Some economists believed
 that economics was the study of wealth, while others believed that it was the study of
problems like unemployment and inflation.

Economics' Definition of Wealth

This conventional definition of economics was offered by Adam Smith, who is recognized
as the father of modern economics. “Economics is the study of the nature and causes of
nations.”
Economics’ Definition of Welfare
Alfred Marshall provided this neo-classical explanation of economics.
“It is the study of mankind in the ordinary business of life. It enquires about his source of
income and his spending habits. In one view, it is a study of wealth and on other hand it
is part of study of man.”
Economics’ Definition of Scarcity
Robbins gave a pre-Keynesian definition of economics in his 1932 book "Essays on the
Nature and Significance of the Economic Science.“Economics is a science which studies
human behaviour as a relationship between ends and scarce means which have alternative
uses.”
Economics' Definition of Growth
“Economics is the study of how man and society choose with or without the use of money
to employ the scarce productive resources, which have alternative uses, to produce
different commodities over time and allocating them to different individuals or social
groups in society for consumption, however or in the future..”

1.1.4 NORMATIVE ECONOMICSAND POSITIVE ECONOMICS

The term "what is" economics is occasionally used to describe positive economics. It deals
with the understanding of what is and has occurred in order to define the ideal structure
for the economy's base. The study of an economy's future based on its past and current
resources is known as positive economics. Stated differently, positivist economics is an
objective area of study in economics that is independent of moral judgments. It uses all
available data to describe future conditions based on existing data. Positive economic data
has useful facts supporting it, and it can be verified for correctness.

Positive economics does not offer guidance or prescriptions. It is merely the facts as they
are represented. Positive economics can thus be validated, and its conclusions can be
combined with normative economics to ascertain the goals and objectives of policy.In
order to create economic presentations, it also addresses reason-and-effect theories and
economic relationships. Positive economics can be seen of as the basis upon which a more
comprehensive economic system is built, since behavioral economics operates under the
tenet that individuals will create opinions based on the information at their disposal. Fact-
based behavioral finance is the foundation of positive economics.

Advantage: Positive economics has several benefits, one of which is that its decisions are
supported by real data. As such, they can be used to practical issues instead of arbitrary
decision-making. Positive economics does not make value judgments; hence developing
practical policies is a preferable option. Because the realities of positive economics are
fact-based, people can use it to make better financial decisions.

Disadvantage: One problem of positive economics is that people regularly make

judgments based more on feelings than on facts. The area of positive economics is so often
ignored. Moreover, the reality of past or present occurrences does not ensure that facts
will remain the same in the future. Positive economics is therefore not a perfect predictor
of economic outcomes.

Normative Economics makes decisions based on facts that reflect "what is." Certain
branches of economics, however, base their conclusions on "what ought to be." The study
of economic principles based on evaluations of the values connected to financial
perspectives, economic advancement, and claims is known as normative economics.
Normative economics is neither fact-based nor driven by cause-and-effect theories. Its
ideological foundations describe the situation of the economy at the moment when new
public policies are put into effect. Unlike positive economics, normative economics
cannot be independently verified. As its name implies, normative economics is the study
of what should go on rather than what actually does. As a result, it offers fixes for
ideologically charged economic circumstances. It is possible to believe of normative
economics as the ideas rather than the economics of facts because normative economic
concepts cannot be independently validated. What should be or what should be the norm
is a question posed by normative economics to individuals. As a result, normative
economics is a subjective discipline. Normative economics deals with concepts whose
claims can only be understood and not independently validated, whereas positive
economics can substantiate its facts and assertions.
 Advantage: One of normative analysis's benefits is that it offers you flexibility. It is not
required for economists to make 100% precise decisions because normative economics is
an idea-based field.

Disadvantage: In some circumstances, the above mentioned aspect may also be viewed
as a drawback. The excessive number of deviations from actual circumstances and the
impractical factors that are inapplicable to real life are drawbacks.

1.1.5 Differences between Positive and Normative Economics

Positive Economics Normative Economics
A range of economic phenomena are The appeal of the outcomes of economic
described by positive economics. activity is the focus of normative
economics.
The foundation of positive economics The field of normative economics can be
consists of verifiable facts. characterized as ideological rather than
factual.
Positive economics merely forecasts future Conversely, normative economics deals
conditions using historical and current with equity and the significance of
facts. It has nothing to do with justice or the economic concepts.
well-being of individuals and society as a
whole.
In order to establish assumptions, positive Normative economics establishes
economics looks for behavioral presumptions and allows economists to
assessments that can be relied upon based satisfy them when the appropriate
on facts and data. moment comes.

1.1.6 Significance of Economics

Economics plays a crucial role in shaping societies and influencing decision-making at
individual, societal, and governmental levels. The significance of economics can be
understood through various perspectives:

• Resource Allocation: Economics facilitates the effective distribution of limited

resources. It offers a framework for comprehending the distribution and use of
resources, including labor, capital, and natural resources, to satisfy the needs and
desires of people and society.
 • Decision-Making: Individuals and businesses make decisions based on economic
considerations. Economic principles guide choices related to consumption,
production, investment, and saving, influencing personal and corporate strategies.

• Policy Formulation: Governments use economic principles to formulate policies

that deal with issues like unemployment, inflation, taxation, and public spending.
Economic analysis helps policymakers make informed decisions to promote stability
and growth.

• Wealth and Income Distribution: Economics explores the distribution of wealth

and income within a society. It examines factors that contribute to inequality and
provides insights into policies that can promote a more equitable distribution of
resources.

• Market Functioning: Economics helps explain how markets function, including

the forces of supply and demand, competition, and pricing mechanisms. This
understanding is essential for businesses, policymakers, and consumers in
navigating market dynamics.

• Global Interactions: In an increasingly interconnected world, economics provides

insights into international trade, finance, and cooperation. It helps nations
understand the implications of global economic events and formulate strategies for
economic development and cooperation.

• Incentives and Behavior: Economics studies how individuals and firms respond to
incentives. This understanding is valuable for predicting and influencing behavior,
whether in the context of consumer choices, labor markets, or business strategies.

• Social Welfare and Well-being: Economics contributes to discussions on societal

well-being by assessing factors such as standard of living, quality of life, and access
to goods and services. Policies informed by economic analysis aim to improve
overall welfare.

• Forecasting and Planning: Economic analysis helps in forecasting economic

trends, which is crucial for businesses, investors, and policymakers. This
information aids in planning and mitigating risks associated with economic
fluctuations.

1.1.7 MICRO AND MACRO ECONOMICS

Micro Economics: The word "micro" is derived from the Greek word "mikros," which
meaning "small." Individual businesses, people, prices, earnings, income, industries, and
commodities are all studied in microeconomics. Price theory research is another name for
microeconomics. The study of an individual's or small group's economic behavior is known as
this. The study of the financial behavior of specific businesses or consumers within an
economy is known as microeconomics. Additionally, supply and demand patterns as well as
the determination of individual market prices and output are the main topics of
microeconomics. A company's resource choices, output targets, and product pricing are all
vital factors that are emphasized in microeconomics.

As stated by Ackley: "Microeconomics deals with resource allocations among

competing groups as well as the split of total outputs among industries, products, and
enterprises. It takes income distribution issues into consideration. The relative costs of
specific commodities and services are of interest to it.”

"Microeconomics is the study of a particular firm, a particular household, individual

price, wages, income, industry, and particular commodity," states Professor Boulding.

"Microeconomics is the theory of the behavior of small units, like the consumers,
producers, and markets," Claims Watson.

Prof. Leftwitch states that "the economic activities of economic units as consumers,
resource owners, and business firms" are the focus of microeconomics.”

1.1.8 Significance of Micro Economics

• Determination of Price: Microeconomics is crucial in determining prices as well

as production volume, resource allocation, etc.

• Aids in the Aggregate Analysis of Economic Issues: The economy is made up of

numerous smaller entities. Thus, it is easier to understand the problem of the entire
economy after studying smaller parts. While microeconomics analyzes small units
to aid in understanding the economy and the aggregate study of larger concerns,
economics investigates economic problems.

• Different aspects of International trade: Theories of microeconomics provide an

explanation for a wide range of characteristics of international commerce, including
 its origins, character, and benefits; how exchange rates are determined; how tariffs
affect prices; and more.

• Supports Personal Choices: Microeconomics examines the individual

components. As such, it can facilitate the easy making of economic decisions
pertaining to certain units. The amount and price at which a commodity is purchased
are decisions that the customer may make. Analogously, a company or sector might
decide on output levels at different levels while accounting for production expenses.

• Teaches the Art of Economizing: Microeconomic concepts focus on how to use

limited resources effectively. Similar to the law of substitution, microeconomic law
demonstrates how a customer can optimize his or her level of happiness by
comparing the costs of different commodities that they purchase to their respective
marginal utility. When their marginal products diverge, there is also optimal use of
the factors of production.

• It helps in the Formulation of Regional Policies: Microeconomics makes it

feasible to investigate a specific area or application. Its assistance allows
recommendations to be made in relation to issues facing any industry that is
connected through policy analysis. For instance, the issue facing the textile business
might be examined; taking into account government policies, and appropriate
recommendations could be made.

• It serves as a Foundation for Business Decision-Making: For instance,

understanding price theory is important for making practical business decisions and
helps businesses decide on their pricing strategies. It directs the user toward
achieving maximum productivity by making the best use of the resources at hand.

• Useful for Formulating Economic policy: Microeconomics is a valuable tool in

the formulation of economic policy. The government's different economic policies
are justified based on how each one affects individual units.
 1.1.9 Macroeconomics: The word "macro" comes from the Greek word "makros,"
meaning "large." Studying "aggregates or the entire economy such as total employment
& unemployment, national income, total consumption, total savings, total supply &
demand, and general price-level, wage-level, interest rates and cost structure" is known
as macroeconomics. This study is also known as the "theory of income & employment."
conversely, deals with wide aggregates such as national income, national expenditure,
aggregate investment, aggregate consumption, employment, general price level, and so
forth. It examines the behavior and determination of various aggregative variables, and
how the economy is affected by the interconnections of these broad aggregates. The
study of the collective economic behavior of different units is the focus of the field of
macroeconomics. In order to better understand how an economy grows generally,
macroeconomics studies a number of economic aggregates, including aggregate supply
and demand, employment trends, GDP, overall pricing levels, and inflation.

As per Gardna Ackley, "Macroeconomics deals with variables like the overall amount
of an economy's output, the degree to which its resources are utilized, the amount of
national income, and the overall level of prices."

Macroeconomics, in the words of Professor K. E. Boulding, "deals not with individual

quantities as such but with aggregates of their quantities, not with individual incomes
but with national income, not with individual prices but with price level, not with
individual output but with national output."

Macroeconomics is the study of the economy as a whole or a significant portion of it,

according to M.H. Spencer. Problems with the nation's overall output, the rate of
inflation, the unemployment rate, and other issues are the main emphasis of
macroeconomics.

1.1.10 Significance of Macro economics

• A clearer image of the global economy is provided by macroeconomics, which aids

in understanding how economic systems operate.

• It makes different economic policies possible for countries to create.

• Through the provision of diverse economic ideas, it aids economists in the solution-
finding process.
 • By facilitating in-depth examination of variations in company activity, it aids in
bringing about price stability.

• It facilitates the identification of corrective actions and the reasons behind the
payment balance deficit.

1.1.11 Comparison between Macro Economics and Micro Economics

Microeconomics:

Focus: Microeconomics deals with the behavior of individual economic agents, such
as households, firms, and industries.

Scope: It examines the specific decisions and interactions of these entities in markets
for goods and services.

Topics: Microeconomics explores issues like supply and demand, pricing, production
costs, market structures, consumer behavior, and the allocation of resources.

Examples: Analyzing how a specific company sets its prices, understanding individual
consumer choices, and studying the impact of government policies on a particular
industry are all examples of microeconomic analysis.

Macroeconomics:

Focus: Macroeconomics looks at the overall performance and behavior of the entire
economy as a whole.

Scope: It studies aggregates like national income, unemployment rates, inflation, and
overall economic growth.

Topics: Macroeconomics examines factors such as gross domestic product (GDP),

unemployment, inflation, fiscal policy, monetary policy, and international trade.

Examples: Analyzing the overall unemployment rate in a country, studying the effects
of government spending on the national economy, and understanding the role of central
banks in controlling inflation are examples of macroeconomic analysis.

1.1.12 THE ECONOMIC PROBLEM

 All civilizations face the fundamental issue of how to meet limitless needs and wants
with finite resources, and this difficulty is known as the economic conundrum. People
and civilizations have to decide how to divide limited resources like labor, capital, and
land. This lack of resources is referred to by economists as scarcity. The real kicker,
though, is that everyone has needs and wants as the world's population grows. Do we
have enough resources to fulfill everyone's desires? When resources are scarce and
society is unable to satisfy all of its desires, scarcity arises.

1.1.13 Three Foundational Economic Questions

• What should be produced?
• How should it be produced?
• Whom should I produce for?

The Economic Problem: What to produce? In order for society to distribute its
resources effectively, this is the first question that must be addressed. Naturally, no
civilization can exist if all of its resources are attentive from food production to defense.
First and foremost, this question aids in identifying a number of necessities for society
to maintain equilibrium.

The Economic Problem: How to produce? In order to make the necessary goods, how
should the factors of production be distributed? Which processes—food preparation and
automobile manufacturing—would be the most efficient? What is a community's work
force size? In what way might these decisions affect the finished product's affordability?
How to manufacture is the single inquiry that incorporates all of these inquiries.

The Economic Problem: For whom to produce? Finally, and maybe most
importantly, it matters to know who will ultimately use the creations. The decisions
made in response to the first of the three inquiries indicate that a specific set of items
was produced using the limited resources. This suggests that there might not be enough
of a particular item for everyone. Suppose that the production of food required a
significant investment of resources. This implies that not every member of that society
is able to own an automobile.

1.1.14 THE PRODUCTIVITY POSSIBILITIES CURVE (PPC)

 The Production Possibilities Curve (PPC), sometimes referred to as the Production
Possibilities Frontier (PPF), is a crucial component of macroeconomics and business
analysis that affects both the financial affairs of nations and individual businesses. A
nation's or business's economy and what should or could be produced with the
resources available can be shown and speculated upon using the curve. In order to show
every potential pairing of two items that can be produced while adhering to resource
constraints, the PPC is created. The
PPC graph makes it simple to assess
whether or not resources are being
used effectively. Two goods have
graphs for the PPC. Because
"television" and "wheat" are made of
distinct resources, it is not possible to
graph their production against each
other. Because the PPC shows that
"production of one good must decrease due to scarce resources as production of one
good increases," it is crucial to compare commodities that use the same resources. This
implies that a nation or a corporation may only create more of one good if it produces
less of another. It can be used by nations and businesses to determine the most
profitable product mix and to distribute resources in an effective and efficient manner
for optimal resource efficiency.

1.1 SUMMARY

Ultimately, the introductory course in economics establishes the foundation for

comprehending the essential ideas that dictate how communities distribute limited
resources to fulfill boundless desires and requirements. People learn about the ways in
which producers, consumers, and politicians make decisions by investigating ideas like
scarcity, opportunity cost, supply and demand, and market equilibrium.

By studying macroeconomics and microeconomics, students get an understanding of

both the larger events and the actions of individual economic agents that influence
national economies. In the end, economics offers a strong framework for analyzing how
resources are allocated sustainably, fairly, and efficiently in various situations. It
provides people with the knowledge and skills necessary to make wise judgments,
 comprehend intricate economic phenomena, and enhance the prosperity and well-being
of society.

1.2 SOME KEY WORDS

Capital: The factor capital includes all man-made, non-labor resources that are
repeatable. It is a part of the output of society that is saved for utilize in future productive
processes rather than being consumed right now. It comprises the stock of actual
physical things manufactured by humans, such as buildings, machinery, plants, and
equipment.

Economics: The term "economics" originates from Greek. Oikos Plus Nomos, or
"Home and Law," The home management principle. Given resources are limited, the
word "economics" refers to the procedure of economizing on the utilization of means to
achieve goals.

Ends: The goal that people pursue when they participate in economic activity.

Enterprise: A company is an entity established with the aim of manufacturing products

(or a company) and services to be marketed. Businesses acquire resources, or inputs,
plan how to employ them in production, and then sell the finished commodities.
Businesses take risks during the process. The division of labor and cooperation
principles forms the foundation of a firm's operations.

Goods: Tangible methods of meeting the needs, wants, and desires of people. In
economics, the phrases goods, products, and commodities are synonymous and can be
used interchangeably.

Labor: Human mental and physical capacities are included in labor as an element of
production.

Land: The element of production includes all unpaid gifts from the natural world and
its resources.

Means: The tools or resources employed to achieve the desired goals.

Normative: Addresses moral dilemmas, concerns, and challenges. For example, should
the unemployed in Economics receive government assistance? Should pricing be
regulated by the government?
 Positive: It addresses concerns and issues related to science. For example, what products
should be created in economics and how should they be produced? It does not impose
value judgments in its analysis or solution of economic issues.

Scarcity: The mismatch between ends and means that results from human needs
surpassing availability is called as scarcity. The concept of scarcity is not absolute;
rather, it is relative.

1.3 SELF ASSESSMENT TEST

1. What do you understand by Economics? Discuss the characteristics and
scope of economics.
2. Distinguish between Micro and Macro Economics
3. Define a production possibility curve along with underlying assumptions.
4. Distinguish between Positive and Normative economics theory.

1.4 REFERENCES
Begg, D.R. Dornbusch, S. Fischer (1991), Macroeconomics (4th Edition), McGraw-
Hill Book Co. New York

Lipsey, Richard (1997), Introduction to Positive Economics (8th Edition), Oxford

University Press (ELBS Edition), London

Nicholson, W. (1995), Intermediate Micro Economics (VIth Edition), Dryden Press,

New York.)

Roychoudhry, Kalyanjit (1999), Modern Microeconomics (II Edition), Book Land,

Delhi

Salvatore D. (1996), Micro Economic Theory (Schaum series 3rd Edition),

McGrawHill Book Co., New York.

Salvatore D. (1995), Micro Economics (2nd Edition), Harper Collins Publishers,

New York Treatment, Timothy (1996), Micro Economics, (Its Edition, 1996)
McMillan, New York
 UNIT 2
Business Economics
Objectives
You would learn in this lesson
• Give an explanation of management economics and its significance for organizational
decision-making.
• to understand the role that business economics plays in management
• to figure out and use managerial economics concepts in order to accomplish company
goals.
• Connect these ideas to resource allocation and managerial decision-making in a
corporate context.
Structure
2.1.1 Business Economics
2.1.2 Nature of Business Economics
2.1.3 Scope of Business Economics
2.1.4 Business Economics and its Relationship with Other Disciplines
2.1.5 Significance of Business Economics:
2.1.6 Economic Concepts of Business Economics
2.1.7 Business Economist
2.1.8 Role of a Business Economist
2.1.9 Responsibilities of a Business Economist
2.1.10 Steps in Decision Making in Business Economics
1.1 Summary
1.2 Some key words
1.3 Self-Assessment Test
1.4 References
2.1.1 BUSINESS ECONOMICS
Managerial Economics is another name for business economics. Business Economics is
the application of economic theory to business operations to facilitate management's
future planning and decision-making. This field of study focuses on how economic
theory is applied to management in the commercial world. It addresses the application
of business decision-making principles and economic concepts. The area of business
economics that deals with how a company organizes and allocates its limited resources
to meet its objectives is known as business economics. The general term "business
economics," often known as "managerial economics," describes the blending of
economic theory and business practice. Business Economics uses the instruments that
the theories of economics provide to describe different concepts like supply, demand,
costs, price, and competition, among others.
A significant part in our everyday financial lives and corporate operations is played by
business economics. Businesses deal with a variety of issues on a daily basis. For
instance, organizations are always focused on maximizing production while using the
least amount of resources. Managers must utilize a variety of economic ideas and
concepts to tackle difficulties of this kind. company economics, often known as
managerial economics, is the study of how economic theories, concepts, and instruments
are applied to company decision-making. The application of economic theories and
procedures to business or organizational decision-making processes is the focus of
managerial economics. It aims to set guidelines and norms to help management achieve
its intended financial objectives.
"Business Economics is the application of economic theory and analysis to practices of
business firms and other institutions," state Hailstones and Rothwell.
Prof. Mansfield states that "business economics attempts to bridge the gap between
the problems of policies that the management must face and the purely analytical
problems that intrigue many economic theories."
Prof. Hague states that the goal of business economics is to apply mathematical,
statistical, and economic reasoning to solve business decision-making problems in an
efficient manner.
Business Economics is "the integration of economic theory with business practice for
the purpose of facilitating decision-making & forward planning by the management,"
Spencer & Siegel Man.
2.1.2 Nature of Business Economics
• Business Economics is a Science: To put it simply, it's a systematic body of
knowledge that can determine the cause and effect of an event. These decision
sciences are combined with economic theory in business economics to create
strategies that assist businesses in achieving their objectives. As such, it employs
scientific methodologies and verifies the accuracy of the findings.

• The foundation is microeconomics: Undoubtedly, a business manager is more

focused on accomplishing the goals of his own company. Ultimately, this aids him
in guaranteeing the company's financial success and sustained existence. It is more
focused on the circumstances surrounding particular establishments' decision-
making. As a result, it is dependent upon microeconomic approaches.

• It's Art: Since business economics relies on using principles and regulations in real-
world situations to accomplish goals, it's an art form. Since business economics
theory is used in a practical manner in M.E., business skills are applied, and art is
the application of skills for the purpose of obtaining some meaningful knowledge,
business economics is an artistic discipline. Business economics is therefore an art.

• Pragmatic Approach: Microeconomics analyzes economic events under

implausible assumptions and is entirely theoretical. However, the methodology of
business economics is practical. It makes an effort to address issues that businesses
actually encounter.

• The Theory of Markets and Private Enterprises Use: The theory of markets and
private enterprises is mostly used in economics. It makes use of the firm and
resource share theories found in private enterprise economies.

• Macro Analysis is Integrated: Despite the fact that every firm prioritizes survival
and profitability. The firm is impacted by various aspects of the external economy,
such as tax laws, employment and income and so forth. The macro economy is made
up of all of these outside variables. Consequently, every such component that could
affect a business manager's environment must be taken into account.

• Multidisciplinary approach: Tools from several different fields, such as statistics,

marketing, accounting, and mathematics, are incorporated into business economics.
is hence interdisciplinary in character.
 • Normative: Both positive and normative aspects exist in economic theory. A
positive science uses a scientific method to examine the cause and effect relationship
between factors. It does not, however, entail any value judgment. Value judgements
are a part of normative science. It offers a plan of action for the particular situation.

2.1.2 Scope of Business Economics

• Demand & Forecasting Analysis: This field examines customer preferences and
the consequences of altering demand factors. The price of the product, the cost of
comparable commodities, the consumer's income, their tastes and preferences, etc.
are also among these drivers. An approach to projecting future demand for an item
or service is called demand forecasting. It also allows them adequate time to plan
ahead and set up several production-related aspects including manpower, raw
materials, equipment, etc.

• Production and Cost Analysis: A business economist's duties in relation to

production include the following: Determine the ideal production size based on the
goals of the company. The company can select the right technology that offers a
technically efficient method of creating the output by using production analysis. On
the other side, cost analysis helps the company to determine how expenses behave
when variables like output, time, and plant size vary. Additionally, by generating
the best product at the lowest feasible cost, a company can maximize revenues by
utilizing both of these studies.

• Inventory Management: By ensuing specific guidelines, businesses can lower the

expenses of keeping raw materials, work-in-progress, and finished goods in stock.
It's also critical to realize that a company's inventory rules have an impact on its
profitability. As a result, economists assist the company in keeping an ideal reserve
of inventories by using techniques like ABC analysis and mathematical models.

• Market Structure and Pricing Policies: Any business must be aware of the type
and intensity of market competition. This information is obtained by a detailed
examination of the market structure. Additionally, this information aids businesses
in developing market management plans for the definite competitive environment.
Alternatively, price theory aids the company in comprehending how prices are set
in various market scenarios. It also helps the company develop its pricing strategies.

• Theory of Capital and Investment Decisions: Among other things, a company has
to make wise capital allocation and investment decisions. There are some theories
 about capital and investments that provide scientific standards for selecting
investment ventures. These theories also assist the company in determining the
capital efficiency. When a company must decide between competing uses for its
funds, business economics helps with the decision-making process.

• Resource Allocation: Business Economics determines the optimum plan of action

for the most efficient use of the resources at hand using sophisticated methods like
linear programming.

• Profit Analysis: A variety of factors, such as shifting market conditions and prices,
affect profits. Under such unpredictable circumstances, firms can measure and
manage profits with the assistance of profit theories. They also aid in the planning
of future earnings.

• Analysis of Risk and Uncertainty: A certain level of risk and uncertainty is present
in most corporate operations. Additionally, by examining these risks and
uncertainties, businesses may make more effective judgments and carry out their
objectives.

2.1.3 Business Economics and its Relationship with Other Disciplines

• Business Economics and Statistics: Quantifiable variables are the focus of both
business economics and general economics. In the field of business economics,
quantification is essential. Consequently, using statistics in business economics
facilitates decision-making in a number of ways. It supports demand function
estimate, which supports demand forecasting. In a similar vein, statistics are helpful
in estimating cost and production functions. Price index estimation mostly relies on
statistical tools.

• Business Economics and Marketing: There are two ways in which managerial
economics supports marketing. First, as a fundamental discipline offering analytical
tools and concepts; and second, as an integrating field offering its opinion on the
ideal sales volume given a firm's cost function, the market structure, and the target
function to be optimized. An economist can decide how much to sell under specific
conditions, while a marketing manager can decide how to sell the desired amount of
output. Selling more than is desired might occasionally be detrimental to the
company's interests.
• Business Economics and Mathematics: Business Economics and Mathematics are
closely related fields of study. Once more, it's because business economics is
measurable. Not only are geometry, calculus, and matrix algebra knowledge
necessary, but so are some mathematical notions. In business and industry, linear
programming is a crucial tool for decision-making since it can be used to solve issues
with optimal product mix, supply distribution, and machine scheduling, among other
things.

• Business Economics and Accounting: Accounting is primarily concerned with the

organized documentation of business organizations' financial statements. For
instance, a company's profit and loss account provides information about how well
the company has performed. A business economist can utilize this information to
shed light on the company's current economic performance and future course of
action. Nowadays, managers view the primary responsibility of management
accountants as supplying the data necessary for them to apply business economists'
theories to solve company problems.

• Business Economics and Personnel Management: An HR manager must address

two main issues: (i) efficiently using human resources in relation to expenses and
output; and (ii) enhancing terms and conditions of employment as a means of
enhancing employee contentment. An HRD manager's primary responsibility is
manpower planning, which helps a company make sure that the right people are
doing the right kinds of work at the right times and in the correct quantities, all while
maximizing their economic contribution.

• Business Economics and Economics: The common understanding of business

economics is the application of economics to business decisions. It can be seen as a
unique area of economics that connects business decisions and economic theory. For
business economists, microeconomics is the primary source of concepts and
analytical instruments. For example, business economists place a great deal of
importance on ideas like elasticity of production, elasticity of demand, marketing
forms, elasticity of demand, and production function.

• Business Economics and Operational Research: Business economics and

operational research are closely connected fields. The use of mathematical methods
to resolve business issues is known as operational research. It offers all the
information needed to make judgments about business and future plans. While
 operational research concentrates attention on the idea of optimization, managerial
economics places particular emphasis on challenges regarding the maximization of
profits and minimization of expenses. A management economics tool for resolving
regular company issues is operational research.

• Business Economics and Production Management: Production is the process of

converting an input into an output in order to provide utility. The word "operations"
is used to indicate a broader definition that includes all economic activity that
generates economic usefulness. Typically, it refers to manufacturing activity.
Achieving quantity supply, meeting deadlines for deliveries, meeting quality
standards, and optimizing production processes.

2.1.4 Significance of Business Economics:

• The areas of traditional economics that are pertinent to real-world corporate
decision-making are covered by business economics. These are changed or adjusted
so that the manager may make better choices. Consequently, the objective of
creating a useful toolkit from classical economics is achieved by business
economics.

• If helpful concepts are determined to be pertinent to decision making, it also

integrates concepts from other fields like psychology, sociology, etc. Actually, other
disciplines that have an impact on business decisions in connection to different
explicit and implicit limitations that must be met in order to maximize resource
allocation are consulted by business economics.

• Business economics acts as an integrator by coordinating the actions in the several

sectors where its operations are carried out, such as finance, marketing, human
resources, and production.

• Business economics examines how a company interacts with society and plays a
crucial role as an agent in accomplishing the objectives of social and economic
wellbeing. It has become apparent that a company has social responsibilities in
addition to its duties to shareholders. These societal responsibilities are the main
emphasis of business economics as the limitations that affect how businesses make
decisions. Via socially conscious business choices, it acts as a tool to advance the
financial well-being of society.
 • In a complex setting, business economics assists in arriving at a range of business
decisions. Here are a few examples:
What goods and services ought to be produced?
Which production method and input should be employed?
What prices should the created goods be marketed for and how much should be
produced?
What are the ideal plant placements and sizes?
When should I replace my equipment?
What is the best way to divide the available capital?

2.1.5 Economics Concepts of Managerial Economics

• The Incremental Concept: The description of incremental thinking is simple.

However, applying it is really challenging. According to T.J. Coyne, the process
entails calculating the effects of various options on expenses and income,
emphasizing the modifications to overall costs and income that arise from
adjustments to pricing, goods, processes, investments, or any other factor that could
be involved in the choice. Incremental cost and incremental revenue are the two
fundamental ideas that underpin incremental analysis. The former speaks of how a
decision affects the overall cost. The latter can also be described as the modification
in total revenue as a consequence of a choice.A decision is surely profita-ble if:

1. It increases revenues more than it increases cost.

2. It reduces some cost more than it increases oth-ers.

3. It increases some revenues more than it de-creases others.

4. It decreases costs more than it decreases reve-nue.

• The Concept of Time Perspective: The long-run and short-run are frequently
distinguished in economics. This distinction is made without reference to any
particular month, quarter, or year in the calendar. It is dependent on how quickly
decisions can be made and how different production aspects can be. The short run is
the time framework that allows for the variation of some parameters but not others.
Nonetheless, the long run is the time frame in which every aspect is changeable.
Even less clear than the cost boundary is the distinction between short- and long-
term revenue (or demand). Ensuring that the long-, short-, and intermediate-term
 runs are appropriately balanced is crucial for managerial decision making. Assume
that a company has transient idle capacity. It now receives a 10,000 unit order. The
potential buyer is prepared to pay Rs. 3 for each unit, or Rs. 30,000 for the entire
collection. Just Rs. 2.50 is the short-term incremental cost, which does not account
for the fixed cost. That means that each unit contributes 50 paise to profit and
overhead (totaling Rs. 5,000).

• The Opportunity Cost Concept: Giving up some options is the opportunity cost of
a choice. When selecting from a range of possibilities, opportunity cost quantifies
the value of the option we have to give up that is the most advantageous. Imagine a
shipbuilder receives a contract, designated as Contract A. He determines an expected
profit of Rs. 25,000 from the deal after accurately assessing the related incremental
expenditures and revenues. It is assumed that during this period, he has been made
aware of two further contracts, B and C. An estimated profit of Rs. 15,000 and Rs.
20,000 is anticipated from these two. He can only take one of these, though, because
his yard can only hold so many. Thus he would accept contract A, which is the most
profitable, if there was no other factor. Substituting the profit for the next best choice
would entail an opportunity cost of Rs. 20,000 for him. The profit that would have
been generated by A if he had selected option B or option C would have been his
opportunity cost.

The following illustrations aid in comprehending the term's meaning:

1. The most profitable alternative that is foregone by operating a machine in its

current capacity is known as the opportunity cost (O.C.) of using the machine.

2. The upside potential of purchasing a color television is the potential return on

investment (O.C.) from the purchase money.

3. The wage that one could make in other occupations is the O.C. of working for
oneself in one's own factory.

• The principle of Discounting: There is a well-known saying that goes, "A bird in
the hand is worth two in the bush." Like many proverbs, there is some truth to this
one. Furthermore, a basic tenet of economic theory is that the value of a rupee
received now is greater than that of a rupee obtained tomorrow. A straightforward
illustration will demonstrate the ratio-nale of discounting. An individual would
undoubtedly prefer the former if given the option to accept a present of Rs. 1,000
 now or Rs. 1,000 to be received in a year (even if there is no doubt about the receipt
of either gift). This is because there is potential to invest Rs. 1,000 at the market
interest rate and accrue interest on the principal in a world where the rate of interest
is not zero. After a year, the $1,000 that you have now will be worth Rs. 1,050 if the
interest rate is 5%. The following is the present value of Rs. 100 that would be
received after a year if the interest rate is 5%:

PV stands for present value, and i for interest rate.

One can calculate how much money will have accumulated at 5% for the year by
multiplying the PV of Rs. 95.24 by 1.05 as a cross check.

A person who can make 5% on their investment should not care whether they receive
Rs. 95.24 now or Rs. 100 in a year.

Thus, Rs. 95.24 is the present value of Rs. 100. Any number of eras can be covered by
the same analysis.

• The Equi-Marginal Principle Concept: The fundamental tenet of economists'

marginal analysis is that investments, endeavors, or productive resources ought to be
distributed in a way that guarantees the marginal utilities, advantages, or value-added
that result from each, are the same across all applications. Moving a unit from one
application to another should not be able to improve the overall benefit or decrease the
overall cost in order to get optimum results. According to the law, when more of one
resource is coupled with fixed proportions of another, the marginal product will
decrease. For instance, increasing amounts of fertilizer are gradually needed to produce
equivalent output gains, even though successive fertilizer treatments tend to enhance
cereal yields per acre. Let us examine a basic scenario in which a company has 100
labor units available to it. The overall wage bill can be calculated in advance if this
stays fixed in the short term. For instance, the monthly payroll will equal Rs. 30,000 if
each employee receives Rs. 300. Let us assume that the plant has five distinct activities:
A, B, C, D, and E. Labor is a necessary input for every activity.

If labor is scarce, one can increase the scope of any one of these activities by hiring
additional workers, but doing so at the expense of other activities. Assume that the total
output increases by, say, ten units when one unit of labor is added to activity A. The
company gains Rs. 50 by selling this output for Rs. 5 a unit on the market. In activity
A, the extra output is valued at "the value of the marginal product (V.M.P.) of labor."
 The marginal product of labor in additional activities, such as B, C, D, and E, can also
be estimated in the same manner. The state of not reaching an optimum is indicated by
a higher V.M.P. in activity A than in another activity. Moving labor from low-marginal
value to high-marginal value usage would now be profitable for the company. The
combined worth of all the products will undoubtedly increase as a result. For instance,
if the V.M.P. for activity A is Rs. 50 and for activity B it is Rs. 55, the company will
be compensated for expanding activity B and decreasing activity A. When V.M.P. is
the same in each of the five activities, the optimal result is obtained. In terms of symbol

VM PLA = VMPLB = … = VMPLE

2.1.6 Business Economist

The work of business economists involves identifying problems that a company is

facing, researching the causes of these problems, analyzing how they affect the
company's operations, and ultimately proposing to management reasonable alternatives
and corrective actions.

2.1.7 Role of a Business Economist

• Study of the business environment: When making policy decisions, any company
must take into relation external elements such as the expansion of the national
income, trade volume, and overall pricing trends. The fundamental components of a
company's business environment are the global and national economic growth trends
as well as the stage of the business cycle that the economy is currently in. The type
and intensity of industry competition that a company operates in is another portion
of the business environment.

• Business strategy & Forecasting: By analyzing the economic climate and

forecasting, business economists can assist management in creating their company
strategy. The business economist's job is to analyze the industrial forecast and
national economic trends and determine how they apply to the company he works
for. In an economy with partial government control, such as India, the business
economist conveys the industry's response to suggested policy changes and
translates government intents into business speak.

• Study of business operations: An economist can assist management in making

decisions concerning a company's internal operations, such as pricing, rate of
operation, investment, and firm growth, all of which can lead to significant
 outcomes. What is the likely sales and profit budget for the upcoming year? What
are the policies regarding inventory and production schedules? What would the
funding sources be?

• Involvement in Public Debates: Business economists take part in public

discussions that are arranged by various organizations. Governments and the general
public consult them. Their observations are validated by their real-world business
and industry experience. He serves as a liaison between the government and business
leaders in the relevant industry in addition to providing his employers with analysis
of current trends and policies.

• Economic intelligence: By giving management access to economic data so they

may participate in seminars and conferences with informed discussion, business
economists also offer general intelligence services. Additionally, they receive the
data and statistics needed to compile the company's yearly reports. The economist
compiles those numbers and information based on his knowledge of the literature
on business operations.

• Specific Functions: Nowadays, business economists also serve as advisors in

relation to certain roles. Demand forecasting, industrial market research, industry
price issues, production plans, investment evaluations, and projections are some of
their specialized tasks. Along with primary supplies and capital projects in the areas
of agriculture, industry, transportation, tourism, and export environment, they also
offer guidance on trade, public relations, and commerce.

2.2.2 Responsibilities of a Business Economist

• Making accurate forecasts: Management must make judgments on the future, which
is unpredictable. Though it cannot be completely eliminated, his employers' exposure
to scientific economic environment forecasts can help to mitigate some of this
uncertainty. Planning a business requires knowing this. The management will highly
value a business economist who can accurately predict business trends. An economist
will occasionally update his projections to reflect new developments in his company.

• Building and Sustaining Relationships: In order to get data for his forecasts and
analyses, the business economist needs to build and maintain relationships with data
sources. He connects with people who are experts in many domains. He needs to
subscribe to periodicals providing him with up-to-date and fresh knowledge and join
 professional associations. Stated differently, his greatest asset in business is his ability
to quickly get information by connecting with the people who can provide it.

• Achieving full status on the management team: A business economist must take part
in strategic planning and decision-making. He has to be able to achieve full status on
the business team in order to do this. He needs to be ready to take on unique project
duties as well. He must be able to communicate effectively in order for his counsel to
be recognized and taken to heart. Lastly, when advising management, he needs to keep
the national perspective in mind while staying in step with industry thought patterns.
Business economists can only become valuable members of the management team if
they are aware of and fulfill their obligations.

2.1.8 Decision- Making

For the purpose of making corporate decisions, managerial economics provides "a link
between traditional economics and the decision making sciences." Facing real-world
choice problems is the greatest method to become familiar with managerial economics
and decision making. Now, the following can be listed as the fundamental traits of
managerial economics:

• Its focus is on "decision making of an economic nature."

• It is "micro-economic" in nature, and it makes extensive use of the set of economic

ideas and precepts referred to as "theory of the firm."

• It is "prescriptive and goal oriented."

• The study of managerial economics is both "metrical and conceptual." It combines

measurement and theory.

Procedure for Making Decisions in Business Economics

• Identifying the problem: Assuming that the goals and objectives are recognized,
the first stage is to properly identify, characterize, and ascertain the problem. To
identify the best solution, one must first perceive the issue. Determining the essential
nature and scope of the issues, as well as the bounds to their resolution, entails
defining the intended outcomes. By characterizing a problem, one should gain a
general understanding of the circumstance. The issue needs to be understood in light
of the organization's overarching objectives.
• Problem Analysis: After the problem has been identified, it needs to be examined
in terms of its impact on the future and the frequency of decisions. The discovery of
limiting or strategic aspects that are important for decision-making is another aspect
of issue analysis. These are the main barriers to reaching the desired outcome; an
analysis of these is necessary to decide who should make the choice. What data must
be collected and how it might be obtained. This is referred to as the problem's
conceptualization. Gathering all the data and information that are relevant to the
choice is essential. The gathered data needs to be carefully categorized and
examined.

• Creating Alternative Solutions: Due to time and financial constraints, it is

imperative to look for and find feasible alternatives in order to make an informed
conclusion. Making a selection and weighing your options takes a lot of creativity,
judgment, and expertise. A decision's quality can never exceed the caliber of the
options that are found. This is where the investigation is at.

• Assessing Alternatives: Following the development of the alternatives, the

following stage is to assess each one's costs, timeliness, viability, and ability to
further the goals. It is important to evaluate alternative solutions in terms of both
tangible and intangible critical or limiting factors. Analyzing alternatives' benefits
and drawbacks using marginal and cost-benefit analyses might be useful. An
alternative can be systematically evaluated by using an analytical operation research
technique. Risk, economy of effort, and scheduling restrictions on resources are the
evaluation factors.

• Choosing the Best Alternative: The relative value of each alternative can be found
by conducting a comparative assessment of them. The option that can contribute the
most net to the goal is chosen. The final decision-making stage is selection. Making
decisions is necessary to choose the most desirable or promising course of action.
The following methods are employed to select the best alternative: analysis,
experimentation, and research.

• Implementing the Decision: Putting the decision into practice entails creating
thorough plans, communicating the decision, getting support and cooperation from
those involved, getting acceptance of the decision, turning it into effective actions,
and creating controls to make sure the decision is being carried out correctly. The
act of promulgating entails announcing and informing subordinates of the decision.
 • Decision Process Evaluation: The last phase in the decision-making process
involves evaluating the choice as well as the decision-making process itself. Follow-
up is a continuous process, and if the evaluation yields unacceptable results, the
choice may be adjusted and the procedure reassessed.

1.1 SUMMARY

Businesses utilize managerial economics to increase their profitability. It is the

application of economics to issues related to business decision-making and the
distribution of limited resources. It speaks about using decision science analytic
methods and economic theory to investigate how an organization may accomplish its
goal most effectively. Different forms of economic analysis concepts, methods, and
procedures are used to analyze managerial decisions. It has connections to many
different academic disciplines.

1.2 SOME KEY WORDS

Decision-making: The process of choosing among alternative courses of action to
achieve organizational objectives.
The Equi-Marginal Principle, which allocates existing resources to obtain the most
advantage, is often referred to as the Principle of most Satisfaction. This theory offers
a foundation for making the most use of all of a company's inputs in order to optimize
profitability.
Marginal Analysis: Evaluation of the incremental costs and benefits associated with
small changes in output or input levels.
Marginal cost is the extra expense incurred by an entity while producing an additional
unit of output. Stated differently, it represents the difference between the total cost of
manufacturing and the additional unit produced.
Marginal revenue: The increase in revenue that comes from selling one extra unit of
output is known as marginal revenue.
Opportunity cost: The cost of forgoing the next best alternative when making a
decision.
Production and Cost Analysis: Examination of the relationship between production
levels and the costs associated with producing goods and services.
Resource Allocation: The process of distributing scarce resources among competing
uses to achieve organizational goals.
1.3 SELF ASSESSMENT TEST
1. Discuss the nature and scope of Business Economics in the context of present business
environment.
2. Explain the role and responsibilities of business economics in present competitive
scenario.
3. Explain the concept of opportunity cost and provide an example in a business context.
4. Evaluate the role of managerial decision models in business. Provide examples and
discuss their limitations.
5. Explain with illustrations, the economic principles essential for managerial decisions.

1.4 REFERENCES
Haynes, W.W. (1979). Managerial Economics: Analysis and Cases (3rd Ed.). Business
Publications, Inc., Texas.
Adhikary, M. (1987). Managerial Economics (3rd Ed.). Khosla Publishers, Delhi.
Baumol, W.J. (1979). Economic Theory and Operations Analysis (4th Ed.). Prentice
Hall India Pvt. Ltd., New Delhi.
Dean, J. (1951). Managerial Economics. Prentice Hall.
Mote, V.L., Paul, S., & Gupta, G.S. (2016). Managerial Economics Concepts and
Cases, Tata McGraw-Hill, New Delhi.
Koutsoyiannis, A. (2018). Modern Microeconomics (2nd Ed.). Macmillan Publishers
India Pvt. Ltd.
Lewis, W.C., Jain, S.K., & Peterson, H.C. (2005). Managerial Economics (4th
Ed.). Pearson.

Block 2
Business Economics
OBJECTIVES
After completion of this unit, you will be able to
 • Explain utility and how it relates to economics.
• Illustrate the relationship between total utility, marginal utility, and average utility.
• Discuss the concept of law of diminishing marginal utility and its assumptions.
• Examine the Law of Equi-Marginal Utility's practical applications in consumer
behavior and business.
UNIT 1 CARDINAL UTILITY THEORY

Structure
2.1.1 Introduction
2.1.2 Concept of Utility
2.1.3 Meaning and Definition of Utility
2.1.4 Characteristics of Utility
2.1.5 Measurement of Utility
2.1.6 Types of Utility
2.1.7 Relationship between TU, MU and AU
2.1.8 Law of Diminishing Marginal Utility
2.1.9 Meaning and Definition of Law of Diminishing Marginal Utility
2.1.10 Assumptions and Importance of Law of Diminishing Marginal Utility
2.1.11 Limitations and Exceptions of Law of Diminishing Marginal Utility
2.1.12 Law of Equi Marginal Utility
2.1.13 Meaning and Definition of Law of Equi Marginal Utility
2.1.14 Assumptions and Importance of Law of Equi Marginal Utility
2.1.15 Limitations and Exceptions of Law of Equi Marginal Utility
1.1 Summary
1.2 Keywords
1.3 Self-Assessment Test
1.4References
Unit- 1
2.1.1 INTRODUCTION
You have studied the basic economic rules, the numerous types of economic systems,
and the fundamental difficulties of the economic system in the preceding sections. This
 unit covers the theory of demand as well as consumer behavior. Some of the most
significant theoretical underpinnings of economic thinking and research fields are laid
out in it. Why would a normal consumer purchase a commodity? Why would he rather
forfeit it than pay a fee for it? At what prices will he purchase how much of this
commodity? The "demand behavior" of the average consumer of the good under
examination is the sum of the responses to these queries. It should be noted that
economists use the idea of utility to help them formulate solutions to these problems.
To some degree, you are already acquainted with this idea. You would gain a better
knowledge of the behavior of a representative buyer and be able to put it in a usable,
standardized manner by learning a little bit more about it in this unit.

As a result, you quickly conclude that a customer will only purchase a good if the price
he pays for it is less than or at most equal to the good's utility for him. As a result, when
prices rise, fewer goods are bought. In this way, you may apply the typical consumer's
behavior pattern to the whole population of consumers of that commodity once you are
able to standardize it using the Law of Diminishing Marginal Utility and Equimarginal
Utility. But before we draw any significant conclusions about the demand for a product,
let's talk about and get some clarification on a few basic issues around the idea.

2.1.2 CONCEPT OF UTILITY

A commodity's utility indicates unrealized consumer satisfaction. The satisfaction is
merely what was expected and anticipated. It therefore carries a certain amount of
uncertainty. It is evident that the level of satisfaction that is truly experienced need not
match the level that is anticipated. Stated differently, utility and satisfaction are not the
same thing. Expected satisfaction is known as utility, while realized utility is known as
satisfaction. However, there is one very crucial point you should be aware of. A
consumer's choice to purchase or not purchase a good is based more on its usefulness
than its satisfaction.

The utility (anticipated satisfaction) is what motivates a buyer to purchase and receive
it. Of course, a consumer's assessment of a commodity's utility can be impacted by a
variety of factors, including his prior experiences, other purchasers' experiences,
advertising and other sales strategies used by the sellers, and more. All things
considered, nevertheless, his assessment of the commodity's usefulness is what
ultimately decides whether or not it is purchased. Only until he truly consumes it will
the customer be satisfied; nevertheless, he must purchase it beforehand.
2.1.3 Meaning and Definition of Utility
"Usefulness" is the simplest definition of "utility." Utility in economics refers to a
commodity's ability to meet demand from people. The ability of a product to fulfill
human needs is known as utility. "Wants satisfying capacity of goods or services is
called Utility." In this sense, usefulness is relative and expressed in monetary terms.
Utility and usefulness are not the same things. The usefulness of a good may not always
depend on how much one desires it.

Prof. Waugh asserts that "utility is the ability of a commodity to satisfy human wants."

Fraser states: "Generally speaking, the broader definition has gained favor in recent
years, and utility is now associated more with desire than with satisfyingness."

2.1.4 Characteristics of Utility:

1. Utilities are psychological: A commodity's usefulness is determined by the
consumer's perception of its ability to fulfill his specific needs. As a result, each person
may find a commodity to be of different utility. From a psychological standpoint, each
customer establishes his own satisfaction threshold and has preferences for products
and services. As an illustration, a customer who enjoys apples may find them to be
more useful than a customer who dislikes them. Similarly, mutton or chicken is useless
to a committed vegetarian.
2. Utility is always personal and situational: A commodity's utility changes depending
on the circumstances, including location and time. At certain times and locations, a
consumer may experience vary levels of utility for the same good. For instance,
wearing woolen clothing may be more practical in the winter than in the summer or in
Kashmir as opposed to Mumbai.
3. Utility Does Not Always Mean Usefulness: Utility is just the capacity to fulfill a need.
A commodity might be helpful, but the consumer might not find it beneficial. For
example, although cigarettes are useful to the smoker, they are harmful to their health.
But rather than being beneficial, a commodity's utility determines demand for it.
Because of their usefulness, many goods—such as cigarettes, alcohol, and opium—are
in demand even though they are bad for people.
4. The Intensity of Want Determines Utility: The intensity of want determines utility.
A person will have a high utility for the commodity in question if their want is
unfulfilled and extremely acute. However, a wan tends to experience a decreased utility
 of the commodity than before when it is happy with the process of consumption. This
is known as the trend of decreased utility seen with an increase in commodity
consumption, and it is a relatively common occurrence. Stated differently, our desire
for an item decreases as its quantity increases.
5. Utility Is Different from Satisfaction: Although they are related, utility and
satisfaction are not the same in a strict sense.
6. Utility Is Not Measurable Objectively: Since utility is a personal experience or
feeling for a customer, it cannot be quantified. Utility therefore cannot be quantified or
measured cardinally. It is not measurable exactly or immediately. But in his demand
analysis, Professor Marshall made the erroneous assumption that utility is measured
cardinally.
7. Utility Is Not the Same as Pleasure: Some commodities, like medicine or injections,
may be useful, but using them may not make the user feel happy. Although an injection
or medication tablet is not enjoyable, the patient must receive it.

2.1.5 Measurement of Utility

According to Alfred Marshall, a neo-classical economist, utility is quantitative and cardinal
like other mathematical variables like height, weight, velocity, air pressure, and temperature.
As a result, these economists created the notion of cardinal utility to quantify the utility
obtained from an item. They created the utils, a unit of measurement for utility. As an
illustration, the cardinal utility notion states that a person receives 20 utils from ice cream and
10 utils from coffee. This idea holds that utility can only be ranked as 1, 2, 3, and so on; it
cannot be quantified mathematically. For example, if someone says they prefer ice cream over
coffee, this suggests that ice cream has rank 1 utility while coffee has rank 2 utility.

Cardinal Utility Concept: The theory of consumption, often known as consumer behavior
theory, was developed by neo-classical economists under the presumption that utility is
cardinal. Units of utility, denoted by the term "util," are used to measure utility. The cardinal
utility concept's underlying presumptions, which economists used to measure utility, are as
follows: One unit of money is equivalent to one util, and the utility of money is constant.
Economists have long believed that it is impossible to measure utility precisely or absolutely,
though. The measuring of utility is fraught with several challenges. The rationale for this is that
a consumer's utility from a good is contingent upon a multitude of circumstances, including
fluctuations in the consumer's mood, tastes, and preferences. It is impossible to quantify and
identify these factors. Consequently, economists have not developed a method of measuring
 utility of this kind. Therefore, utility cannot be quantified in terms of cards. In consumer
behavior analysis, however, the cardinal utility idea is crucial.
Ordinal Utility Concept: The foundation of the ordinal utility method is the reality that utility
cannot be measured exactly or absolutely. To analyze consumer behavior, modern economists
have established the idea of ordinal utility, rejecting the cardinal utility method. They contend
that while accurate utility measurement may not be achievable, it can be described in terms of
more or less helpful good. For example, a customer uses both mustard and coconut oil. The
consumer cannot claim that mustard oil provides 20 utils and coconut oil provides 10 utils in
such a situation. Alternatively, he or she may argue that mustard oil is more useful to them than
coconut oil. Under such circumstances, consumers would rank coconut oil second and mustard
oil first. The ordinal theory of consumer behavior is predicated on this premise. Furthermore,
they thought that studying consumer behavior could benefit from an understanding of cardinal
utility.

2.1.6 Types of Utility

1. Form Utility: This utility is produced by modifying the materials' shape or form. For
instance, a cabinet built of steel that was transformed into wood furniture, and so forth.
Basically, the creation of usefulness comes from the production process.
2. Place Utility: Moving items from one location to another creates this utility. Place
usefulness is thus created in the marketing of commodities from the manufacturer to
the marketplace. Similar to this, location utility is produced when food grains are
moved by grain merchants from farms to the city market. Because of their location
utility, Kashmir apples are more popular and sell for more money in Pune than they do
in Srinagar.
3. Time Utility: It is possible to create time utility for goods by storing, hoarding, and
preserving them over time. Example, by storing or hoarding food grains during a
numerous harvest and selling their stocks during a period of scarcity, traders can profit
from time utility and raise the price of food grains. When a commodity is scarce, its
utility increases.
4. Service Utility: This utility is designed to provide clients with individualized services
from a variety of professions, including bankers, actors, doctors, and teachers.
5. Total Utility: The sum of all consumption units' utilities is known as the total utility.
The total of the marginal utilities related to the consumption of the subsequent units is
known as total utility. As an illustration: Let's say a man eats five pieces of bread at
 once. He receives 20 units of satisfaction from the first bread, 16 from the third, 12
from the fourth, and 4 from the fifth, for a total of 60 units.
6. Marginal Utility: The utility that results from the final or marginal unit of consumption
is known as marginal utility. It refers to the extra utility obtained from an extra unit of
the specified product that the customer purchases, acquires, or uses. It is the net addition
to overall utility that results from using the extra or additional units of the good that are
present in the entire stock. As an illustration, let's say Mr. Shankar is eating bread and
he takes five pieces. He obtains utility from the first unit up to 20; from the second, 16;
from the third, 12; from the fourth, 8; and from the fifth, 2. In this instance, the marginal
utility computed is 2, and the marginal unit is fifth bread. The marginal unit and utility
will be four and eight bread, respectively, if we were to consume only four bread.
7. Average Utility: This is the utility that results from dividing the total number of units
consumed by the total number of units. We refer to the quotient as average utility. The
average utility of three breads, for instance, will be 12 if the total utility of four breads
is 40 and the total utility of three breads is 36, or (36 ÷ 3 = 12).ur bread.

2.1.7 Relationship between TU, MU and AU

Suppose that other things being equal, utility derived by a consumer Mr. X, from
successive bananas is shown in Table. You find from the Table, the first banana has a
utility of 25 units for our consumer: the second banana has a utility of 18 units and so
on. The fifth banana has a utility of only three units. The sixth banana does not bring
any utility for the consumer while the seventh banana has a negative utility or disutility
of two units. It means that the consumer does not expect to get any satisfaction out of
the seventh banana; he thinks that it would cause dissatisfaction to him.
The utility of the last unit of a commodity acquired by a consumer is called its
Marginal Utility (MU). According to Prof. Boulding—”The marginal utility of any
quantity of a commodity is the increase in total utility which results from a unit increase
in its consumption.” It means that while finding out MU of a commodity, it is necessary
to look at the quantity of the commodity acquired by the consumer. Thus look at Table
Column 2. If the consumer buys only one banana, then MU is the utility of that banana
itself, that is, 25 units. In case the consumer buys two bananas, the MU is the utility of
the second banana – in this case 18 units. Similarly, with five bananas, MU of the fifth
banana is 3 units, with six bananas -- MU of the sixth banana is zero, and with seven
bananas, it is minus two units.(The explanation for MU falling with successive
additions of bananas will be found later in this Unit).
Column 1 Column 1 Column 1 Column 1
Units Marginal Utility Average Utility Total Utility
1 25 25 25
2 18 21.5 43
3 12 18.3 55
4 7 15.5 62
5 3 13 65
6 0 10.8 65
7 -2 9 63

Total Utility (TU) represents the sum of utilities of all the units of a commodity
acquired by the consumer. In the example provided in Table 7.1, if the consumer gets
three bananas, then TU is 25+ 18+12= 55 units. The figures of TU for respective
number of bananas can be read from column 4 of Table. You would note that TU is
nothing but sum of successive marginal utilities and MU is nothing but the addition to
TU on account of the last unit of the commodity acquired. Therefore, when MU is zero,
TU remains unchanged. In our example, TU remains 65 units when sixth banana is
added. Also, TU will fall if MU is negative as happens when seventh banana is added.
 Average Utility (AU) is obtained by dividing total utility by the number of units of the
commodity. In table figures of average utility are shown in column 3. Remember that,
generally, change in average utility is sale for at the most equal to) the change in MU.
This happens because the addition to TU caused by MU gets spread over all the units
of the commodity when we consider AU. For example, when third banana is acquired
by the consumer, 12 falls from 18 to 12 units or a fall of 6 units. However, the AU falls
from 21.5 to 18.3 units, or by 3.2 units. Similarly, the reduction in MU is of two units
when seventh banana is acquired, but the fall in AU is by 1.8 units only.

2.1.8 LAW OF DIMINISHING MARGINAL UTILITY

One key aspect of needs that you are already aware of is their ability to be fully satisfied
provided the process is not interrupted in the middle. There exists a limit to every
individual wish, as Marshall states in his well-known book "Principles of Economics."
Recall that a commodity's potential to satisfy needs is what gives it its usefulness. The
result of combining these two concepts is a significant utility-related economic law.
The degree to which a consumer's wish is met decreases as they receive more and more
units of a commodity, all else being equal.

Stated differently, the happiness derived from eliminating the desire continues to
decrease. According to expectations, the satisfaction from each subsequent unit of the
commodity under examination should be lower than that from the one before it. In other
words, as a consumer acquires more units of the commodity, its marginal utility
decreases. The Law of Diminishing Marginal Utility puts this fact into words. In
accordance with this law, "the additional or marginal utility which a consumer derives
from acquiring one more unit of a commodity keeps decreasing with every increase in
the stock of the commodity which he already has, other things being equal." Keep in
mind that the marginal utility decline does not have to occur at a steady pace.

The law of diminishing marginal utility explains a fundamental truth and a typical
occurrence in our day-to-day existence. Take, for instance, the scenario when a person
is really thirsty and is given cups of water one by one to slake his thirst. It is obvious
that he will be more satisfied with the first cup of water than the second; the second
cup will be more useful than the third, and so on. Water will eventually lose all of its
usefulness and his thirst will be completely satisfied. It may even cause disutility if the
user is made to drink one more cup of water.
2.1.9 Meaning of Law of Diminishing Marginal Utility
A key idea in economics is the law of declining marginal utility, which states that the
more we consume of an item or service, the less we get out of it in terms of satisfaction
or utility. "One gets less satisfaction from consuming an additional unit of a commodity
the more of it they consume over any given period of time." When making decisions,
the majority of buyers divide their income across several types of goods. People like a
wide range of commodities since using a single good more and more reduces the
marginal happiness that comes from using it continuously.

According to Alfred Marshall, "the additional benefit that a person derives from a
given increase of his stock of a thing diminishes with every increase that he already
has." It implies that the more of everything one has, the less significant any particular
unit of it is to him.

Example of Diminishing Marginal Utility: The concept of diminishing marginal

utility can be better understood with the help of the following schedule and diagram:

Units of Apples Total Utility Marginal utility

1 25 25
2 42 17
3 54 12
4 60 8
5 60 0
6 55 -5
1
Assumptions of Law of Diminishing Marginal Utility
• Cardinal Measurement of Utility: This approach makes the assumption that a
consumer's level of satisfaction can be expressed as a number, e.g., 1, 2, etc., and that
utility can be measured.

• Monetary Measurement of Utility: The law of diminishing marginal utility makes

the monetary measurement of utility possible.

• Reasonable Quantity Consumption: It is considered that a reasonable amount of the

commodity is consumed. For example, comparing the MU of glasses of juice is a better
comparison than the MU of spoonfuls. If someone is given juice in a spoon to quench
his thirst, each additional spoon will make him more useful. Therefore, the right amount
of the good must be consumed for the law to be true.

• Continuous Consumption: It is taken for granted that consuming occurs continuously.

For example, if you drink one cup of milk in the morning and another in the evening,
the satisfaction you get from the second cup of milk may be higher or equal to that of
the first.

• No Change in Quality: The commodity that is consumed most likely has a stable
quality. The second cup of milk with additional sugar and chocolate can satisfy you
more than the first if the first cup did not include any of those ingredients.

• Rational Consumer: To maximize total satisfaction, a rational consumer computes,

quantifies, and assesses the usefulness of numerous commodities.
 • Independent Utilities: It is considered that every commodity a consumer uses is
independent. As a result, there is no connection between the MU of two commodities.
Moreover, it is presumed that an individual's usefulness remains independent of the
utility of another individual.

• Marginal Utility of Money Remains Constant: After paying for a good, a consumer
has less money to spend on other goods. The consumer's money MU is increased by
this procedure, making the money they have left over more valuable. Such a rise in MU
is disregarded, though. Since the MU of a commodity needs to be expressed in
monetary terms, it is believed that the MU of money is constant.

2.1.10 Limitations of Law of Diminishing Marginal Utility

• Homogenous Units: Each consumer should desire a single commodity with
homogenous units. The commodity should be produced in same weight and quality
units. For instance, if an apple is sweet and the first is sour, the second will satisfy you
more than the first.

• No Change in Tastes: The consumer's tastes, habits, conventions, fashions, and

income shouldn't change in any way. Any alteration to one of them will boost utility
rather than decrease it.

• Continuity: The consumption of the good or service should continue. The commodity
should be consumed in units at a specific time in succession. Randomly selected bread
pieces could improve utility.

• Suitable Size Units: The commodity's units must to be a reasonable size. Spooning out
water to a parched individual will make the future spoonfuls more useful.

• Constant Prices: The cost of the commodity should be the same for all units and
replacements.

• Rational Consumers: A rational consumer is someone who practices economics. The

usefulness of the latter units will increase if he is impaired by alcohol or drugs like
opium. However, this is not entirely the case. The marginal utility of each peg increases
at first, but eventually it starts to decline and can even turn negative when a drunk starts
throwing up.

• Ordinary Goods: The goods ought to be of a typical nature. The rule does not apply
to items that are commodities, such as diamonds and jewelry, or hobby goods, such as
stamps, coins, or paintings. The extra cash can be more useful than the original ones.
2.1.11 Exceptions of Law of Diminishing Marginal Utility
• Consumption of particularly Small Commodity Units: When the size and quantity
of a commodity are extremely small, the law of declining marginal utility is not
applicable. The legislation is not applicable, for instance, if someone who is thirsty is
given water in tiny drips rather than glass water.

• Rare Commodities, Monuments, and Antiques: A person who collects rare

commodities, monuments, antiques, old coins, documents, stamps, etc. is exempt from
the legislation. The marginal usefulness of items that are gathered as a pastime will rise
rather than decrease.

• Classical music, rhymes, poetry, and other literary works: These are exempt from
the legislation. By listening to such rhymes, poetry, and music, the audience will enjoy
themselves more and the law won't be enforced.

• Wine & Harmful Goods: Alcohol-based beverages are exempt from the law. A
drunkard keeps getting more and more satisfied as he drinks more wine. As a result,
the marginal utility of adding more pegs will rise.

• Growing Number of Users or Consumers: Goods and services with growing

numbers of users or consumers are exempt from the law. For instance, the number of
phone connections is growing daily, and in real life, the usefulness is growing rather
than declining.

• Personal Hobbies: Personal hobbies are exempt from the law. For instance, collecting
vintage coins, ancient pictures, vintage stamps, and seashells are common hobbies. In
these situations, having more of these items will satisfy them more and allow the law
to function.

2.1.12 LAW OF EQUI MARGINAL UTILITY

Another important concept in economics is the Law of Equi-marginal Utility. The laws
of substitution and maximum satisfaction are other names for this one. Human demands
are known to be limitless, yet there are only so many resources available to meet them.
Selecting the most pressing needs that a customer can afford to fulfill becomes vital as
a result. He must choose the ideal amount to purchase from among the items he chooses
to buy. Conscientious consumers aim to maximize their satisfaction and utilize their
available funds as efficiently as possible.
2.1.13 Meaning and Definition of Law of Equi Marginal Utility
According to the law of equi-marginal utility, the consumer will allocate his income
among the items so that the utility obtained from the final rupee spent on each good is
equal. Put another way, when the marginal utility of the money spent on each
commodity is the same, the consumer is in an equilibrium situation. The marginal
value of money spent on a good is now calculated by dividing the marginal utility of
the good by its price.

MARGINAL UTILITY MARGINAL UTILITY

UNITS
OF ORANGES OF APPLES
1 10 8
2 8 6
3 6 4
4 4 2
5 2 0
6 2 -2
7 -2 -4
8 -4 -6

Explanation of the law

We carefully consider the satisfaction gained from each rupee "had we spent" in order
to get the most out of the money we have. Spending money on the former good will
continue until the satisfaction from the final rupee spent in both scenarios is equal, if it
turns out that one way is more useful than the other. Stated differently, we replace some
units of a less useful commodity with some units of a more useful commodity Due to
this substitution, the marginal utilities of the two will eventually equalize, with the
marginal utilities of the former falling and the latter rising. The law is sometimes
 known as the Law of Substitution or the Law of Equi-marginal Utility for this reason.
Assume the two goods to be bought are oranges and apples. Assume further that we are
spending seven rupees. Let us buy four rupees worth of apples and three rupees worth
of oranges. And what is the outcome? The fourth unit of apples has a utility of two,
while the third unit of oranges has six. Oranges have a higher marginal utility than
apples, thus we should purchase more of them instead of apples. To make four oranges
and three apples, let's exchange one orange for one apple. At this point, the marginal
utility of apples and oranges is equal, or 4. There is maximal happiness with this setup.
Four oranges would have a total utility of 10 + 8 + 6 + 4 = 28, and three apples would
have a total utility of 8 + 6 + 4 = 18, for a total utility of 46. More satisfaction can be
gained from 4 oranges and 3 apples at a cost of one rupee apiece than from any other
combination of apples and oranges. Under no other circumstances does this utility equal
46.

2.1.14 Assumptions and Importance of Law of Equi Marginal Utility

• Rationality of the Consumer: The legal system is predicated on the idea that all
customers are reasonable individuals who allocate their income in a way that
maximizes their level of happiness.

• Utility Can Be Measured: The law is predicated on the idea that utility can be
measured cardinally. Money serves as the measuring stick for utility, accounting for
both the satisfaction and the sacrifice of cardinal numbers of utility.

• Constant Marginal Utility of Money: The law makes the assumption that as
customers spend their money, the marginal utility of that money stays the same or does
not alter.

• Taste, Preference, and Income of Consumer do not Change: The legal system is
predicated on the idea that consumer income, tastes, preferences, and fashions never
change. They are taken to be continuous throughout the consuming process.

• No Price Change for Related items: The law is predicated on the idea that prices for
related items, such as complementary and replacements, do not fluctuate as a person
consumes them. The legislation will not function if these factors alter.
• Function of the Law of diminishing Marginal Utility: The law of equi-marginal
utility is predicated on the rule of decreasing marginal utility and is predicated on the
idea that the law remains valid when a consumer consumes many units of distinct
commodities.
• Divisibility of Goods: The law functions under the presumption that the commodities
being consumed are divvied. They are able to be broken up into smaller parts and
bought with smaller amounts of money.

Importance of Law of Equi Marginal Utility

• Resource Allocation: The law helps individuals and businesses allocate their limited
resources (such as income or time) among various goods and services in a way that
maximizes overall satisfaction or utility. This is crucial for optimizing the use of scarce
resources.
• Consumer Decision-Making: Understanding the Law of Equi-Marginal Utility aids
consumers in making rational choices. By comparing the marginal utilities and prices
of different goods, consumers can determine the most satisfying combination of goods
given their budget constraints.
• Production Optimization: For businesses, the law is essential in optimizing
production processes. It helps in determining the ideal combination of inputs to
maximize output while minimizing costs. This is particularly relevant in industries
where multiple inputs are used in the production of goods.
• Price Determination: This Law influences pricing strategies. Businesses consider the
marginal utilities that consumers derive from different goods when setting prices. This
can contribute to more competitive and market-driven pricing.
• Consumer Surplus: The law contributes to the concept of consumer surplus,
representing the difference between what consumers are willing to pay for a good and
what they actually pay. Optimized resource allocation under the law can lead to
increased consumer surplus, indicating higher overall satisfaction.

• Efficiency in Consumption: By guiding individuals to allocate resources efficiently,

the law of equi-marginal utility promotes a more efficient use of available resources.
This efficiency is crucial for economic growth and improved standards of living.

• Avoidance of Waste: Rational allocation of resources based on equi-marginal utility

helps in avoiding wastage. Consumers are less likely to spend resources on goods that
provide low marginal utility relative to their prices, reducing waste and promoting
sustainability.
 • Behavioral Economics: The law aligns with principles in behavioral economics by
acknowledging that individuals make choices based on perceived marginal benefits.
This understanding is valuable in explaining and predicting consumer behavior.

• Microeconomic Analysis: The Law of Equi-Marginal Utility is a basic concept in

microeconomics. It provides a framework for analyzing individual choices, market
transactions, and the overall efficiency of resource allocation in a market economy.

2.1.15 Limitations or Exceptions of Law of Equi Marginal Utility

• Indivisibility of Goods: The law is predicated on the idea that the goods being
consumed can be divided into tiny portions and sizes. However, we see that goods are
indivisible in real life. For instance, a television, automobile, radio, or diamond can't
be broken into little bits because if they could, they would no longer be useful.

• Budget Period Is Not Fixed: The legislation presumes that a consumer's income and
expenses are fixed and coincident. Since durables are made to last a long time by nature,
such definiteness is not feasible or viable in their situation. Furniture, watches, fans,
and televisions are a few examples.

• Change in Related Goods' Prices: Although the law presumes that related goods,
such as complementary and replacement items, have constant prices, in practice, we
discover that these prices fluctuate. The consumer's marginal utilities will not be
calculated with the assumption in place.

• Non-Availability of commodities: Although the law presumes that we may maximize

satisfaction by equating the utility and price ratios based on marginal utility, in reality,
a number of helpful commodities are difficult to come by. In this situation, the law is
not relevant.

• Imaginary and Unrealistic Assumptions: The law of equi-marginal utility is

predicated on a number of fictitious and unrealistic assumptions, including the constant
measurability of utility in cardinal numbers, the consumer's income, taste, preferences,
habits, fashion, and the marginal utility of money. We observe that all of these factors
fluctuate in real life.

• Psychological Law: When examining economics, the law is subjective and

psychological in nature, failing to take objectivity into account. Because it is dependent
on psychology and subjectivity, it cannot be classified as an economic law.
 • Ignores Income Effect and Substitution impact: The law of equi-marginal utility is
based on the law of demand, which studies the relationship between quantity desired
and price. However, it is unable to distinguish between the income effect and
substitution impact when a commodity's price changes.

• Customer Ignorance and Laziness: The law makes the assumption that every single
customer is a reasonable person who seeks to maximize his or her happiness by
balancing the pricing and marginal utility ratios of commodities. However, in reality,
not every consumer is logical. They are also indolent and ignorant. Because of this,
individuals are unable to achieve the highest level of satisfaction with the aid of the
law.

1.1 SUMMARY
In summary, utility analysis is a fundamental idea in economics that clarifies the
decisions and actions of consumers. Utility analysis sheds light on how people make
decisions in the face of scarcity by analyzing the pleasure or satisfaction obtained from
consuming commodities and services.
Economists can comprehend preferences, trade-offs, and decision-making procedures
by using the idea of utility. The law of declining marginal utility shows how the
additional satisfaction people receive from each unit of an item or service tends to
decline as they consume more of it. This idea influences consumer decisions and
provides an explanation for why people allocate their resources in particular ways.

1.2 KEYWORDS
Utility: The satisfaction or pleasure derived from consuming goods and services.
Total Utility: The overall satisfaction obtained from the consumption of all units of a
good or service.
Marginal Utility: The additional satisfaction gained from consuming one more unit of
a good or service.
Law of Diminishing Marginal Utility: The principle that states as the consumption
of good increases, the additional satisfaction (marginal utility) decreases.
Consumer Equilibrium: The point at which a consumer maximizes total utility by
allocating income among different goods in a way that the marginal utility per dollar
spent is the same for each good.
 Budget Constraint: The limitation on the amount of goods and services a consumer
can afford, given their income and prices of goods.
Substitution Effect: The change in quantity demanded of a good due to a change in its
relative price, assuming the consumer's level of satisfaction remains constant.
Income Effect: The change in quantity demanded of a good due to a change in the
consumer's real income, considering the impact of changes in prices.
Optimization: The process of allocating resources in a way that maximizes overall
satisfaction or utility.
Equi-Marginal Principle: The concept that consumers allocate their income among
goods in such a way that the ratio of the marginal utility to the price is equal for all
goods.
Resource Allocation: The process of distributing resources among different goods and
services to maximize overall satisfaction or utility.

1.3 SELF ASSESSMENT TEST

1. Define utility and explain its significance in economics.
2. Differentiate between total utility and marginal utility. How are they related in
understanding consumer behavior?
3. Elaborate on the Law of Diminishing Marginal Utility. Provide examples to illustrate
its application in real-life scenarios.
4. Discuss the Equi-Marginal Principle. How does it guide consumers in optimizing
their utility, and what is its role in resource allocation?

1.4 REFERENCES

Dwivedi, D.N.(2008). Managerial Economics, 7th edition, Vikas Publishing House.

Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th edition, 2010.
Hal R. Varian, Intermediate Microeconomics, a Modern Approach, 8th edition, W.W.
Norton and Company/Affiliated East-West Press (India), 2010.
Kumar, Raj and Gupta, Kuldip (2011). Modern Micro Economics: Analysis and
Applications, UDH Publishing House.
Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill education.
 UNIT 2

ORDINAL UTILITY THEORY

OBJECTIVES

• Discuss the concept of an indifference curve and its several assumptions.

• Describe the properties of indifference curves;

• Explain the marginal rate of substitution and its curve.

• Elucidate the meaning of the budget pricing line and its uses;

Structure

2.2.1 Introduction

2.2.2 Indifference Curves

2.2.3 Indifference Curve and Indifference Schedule

2.2.4 Indifference Map

2.2.5 Assumptions of Indifference Curves

2.2.6 Properties of Indifference Curves

2.2.7 Exceptional indifference curve shapes

2.2.8 Marginal Rate of Substitution

2.2.9 Consumer's Equilibrium and Consumer Surplus

2.2.10 Budget Line

1.1Summary

1.2 Key Words

1.3 Self-Assessment test

1.4 References
 Unit- 2

2.2.1 INTRODUCTION
An indifference curve is a graphic and simplified manner of displaying alternative
commodity combinations that, in the consumer's opinion, should result in the same total
satisfaction. An Indifference schedule is a table that presents such combinations; an
Indifference curve is a graphic representation of the same. For the sake of simplicity and
clarity, an indifference curve only considers cases where each group consists of only two
commodities, say X and Y. To better grasp the notion, let's use an imagined example of an
indifference schedule and its related indifference curve.

2.2.2 INDIFFERENCE CURVES

The term "indifference curve" refers to a curve or graphical depiction of the combination
of various commodities that offer the buyer the same satisfaction. A graphical
representation of various consumption bundles or combinations of two commodities or
things that offer the consumer similar levels of utility and satisfaction are called an
indifference curve (IC). In other words, if two bundles produce the same utility, a client is
said to be indifferent to any of them, represented as a point on the curve.

"An indifference schedule may be defined as a schedule of various combinations of goods

that will be equally satisfactory to the individual concerned," according to Prof. A.L.
Mayers. We obtain an indifference curve if we represent this as a curve.

Edge worth defines the "indifference curve" as the path on which a consumer experiences
the same level of satisfaction in each situation when substituting a specific good for another
in any way or quantity.

Prof. J.M. Joshi states that an indifference curve is a collection of points that reflect a
combination of commodities (x and y) in a geometrical manner, with the customer being
apathetic towards any particular combination.

Key Features of Indifference Curves:

• Constant Satisfaction: Each point on the indifference curve represents a combination
of goods that yields the same level of satisfaction to the consumer. Therefore, the
consumer is indifferent between any of these combinations.
• Downward Sloping: Indifference curves typically slope downward from left to right.
This reflects the principle of diminishing marginal rate of substitution, meaning that as
 the consumer gives up some units of one good, they require an increasing amount of
the other good to maintain the same level of satisfaction.
• Convex Shape: Indifference curves are often convex to the origin, indicating
diminishing marginal rate of substitution. This means that the slope (marginal rate of
substitution) decreases as one move along the curve.
• No Intersecting Indifference Curves: Indifference curves for a rational consumer do
not intersect. If they did intersect, it would imply that the consumer is indifferent
between points on different curves, which contradicts the assumption that more is
preferred to less.
• Indifference Map: A set of indifference curves, representing different levels of
satisfaction, is known as an indifference map. Higher indifference curves indicate
higher levels of satisfaction.

2.2.3 INDIFFERENCE CURVE AND INDIFFERENCE SCHEDULE

An Indifference Schedule is a table or schedule that alternates between two
commodities in ways that yet provide the same degree of satisfaction to the customer.
To create an indifference curve, the various combinations of two items are plotted on a
graph using an indifference schedule.

A table or a schedule that shows different combinations of two goods giving the same level of
satisfaction to the consumer is known as an Indifference Schedule. An indifference schedule is
used to plot the different combinations of two goods on a graph for the formation of an
indifference curve. A process of analyzing a simple two-dimensional graph representing two
goods, one on the x-axis and the other on the y-axis is known as an Indifference Curve Analysis.

Combination Number of Oranges Number of Bananas

1 50 2
2 36 3
3 29 4
4 24 5
5 20 6
6 17 7
7 15 8
8 14 9
2.2.4 INDIFFERENCE MAP
When more than one curve is represented on a graph showing different combinations of two
different goods on each curve, it is known as an Indifference Map. Each indifference curve on
that graph shows one satisfaction level all along the curve. In other words, the representation
of consumer preferences by a number of indifference curves is known as an indifference map.

2.2.5 ASSUMPTIONS OF INDIFFERENCE CURVES

• The first assumption used in an indifference curve analysis is that utility is ordinal. It signifies
that the utility derived from the use of a good cannot be quantified in cardinal numbers such as
1, 2, 3, etc. It is therefore measured in ordinal numbers such as first, second, third, and so on.
Cardinal numbers provide for easy comparison of different levels of pleasure by ordering
preferences.
 • A customer only purchases and consumes two products. It is because a graph just has two axes,
and representing two goods is simple.
• The consumer who buys the two commodities is presumed to be reasonable. In other words,
the consumer's primary goal is to increase his or her degree of satisfaction by consuming two
commodities.
• The consumer is fully aware of both goods' market prices.
• The prices for both commodities have already been determined.
• Consumers' tastes, wealth, and habits remain constant throughout time.
• The consumer's choices are transferable. It means that if a consumer chooses Good X
over Good Y and Good Y over Good Z, he or she will prefer Good X over Good Z.

2.2.6 PROPERTIES OF INDIFFERENCE CURVES

• Indifference Curve constantly slopes downwards from left to right: A curve that
provides a customer with an equivalent degree of satisfaction in every possible
combination is known as an indifference curve. It is feasible when a buyer is prepared
to give up a portion of one good in exchange for an extra unit of a different good.
Instead of experiencing equality, a customer will experience greater happiness if they
are receiving more of one benefit without experiencing any decline in another good.
The indifference curve slopes downhill as a result of one good falling in value in order
to obtain more of another one.

• The point of origin of an indifference curve is always convex: An indifference

curve's form is determined by the Diminishing Marginal Rate of Substitution. In other
words, a customer is willing to give up more of one good in order to obtain one extra
unit of another one. As in the case of Nisha (above example), she is willing to give up
 more ice cream units in order to obtain one more unit of chocolate. An indifference
curve has a convex form due to this declining marginal rate of substitution. There are
two extreme possibilities for an indifference curve's form, though. The indifference
curve has a straight line form when two goods are an ideal substitute for one another.
The marginal rate of substitution is constant in this instance. The indifference curve is
L-shaped and convex to the origin when two goods are entirely complimentary to one
another.

• Higher Indifference Curves Indicate Higher Levels of Satisfaction: Alternatively

said, an indifference curve to the right of another indicates higher levels of satisfaction.
Based on the premise of monotonic preference, this indifference curve characteristic
exists. Because it increases their level of satisfaction, a customer with a monotonic
preference will always choose a larger bundle. Stated differently, higher levels of
satisfaction are associated with a larger indifference curve and a consumer who wants
more things.
 • There can be no intersection of two indifference curves: An indifference curve is
made up of several pairings of two commodities that provide a customer with the same
degree of satisfaction. All points on an indifference curve correspond to the same level
of customer happiness. Additionally, distinct indifference curves with varying
satisfaction levels inside each curve make up an indifference map. The concept of an
indifference map is contradicted if two indifference curves overlap because it would
indicate that one location on each curve provides the same degree of enjoyment. Two
indifference curves never meet as a result.

• Never touching any of the axes is an indifference curve. Based on the premise that
a consumer weighs the pros and drawbacks of various pairings of two commodities and
desires both, the indifference curve is used. A consumer cannot possibly be consuming
a single good in its whole, which goes against the assumption if an indifference curve hits
either of the axes. In light of this, an indifference curve never makes contact with either axis.

2.2.7 EXCEPTIONAL INDIFFERENCE CURVE SHAPES

 Indifference curves show pairings of two products that offer a person the same degree
of utility or satisfaction. Certain forms and traits of these curves aid in the
comprehension of customer preferences. The following are some remarkable
indifference curve shapes:
• L-Shaped Indifference Curve: When two items have perfect substitutes, their L-
shaped indifference curve is indicated. In this instance, the buyer doesn't care how the
two commodities are combined as long as the ratio of one to the other doesn't change.
With a constant slope, the indifference curve is a straight line.
• Right-Angled Indifference Curve: When one good is necessary and the other is
optional, there is a right-angled or corner solution indifference curve. For a big quantity
of the luxury good, the consumer is only ready to give up a little bit of the essential
good.
• Kinked Indifference Curve: This type of curve indicates a sharp shift in a customer's
preferences at a specific time. This could occur when a good changes in quality, taste,
or other variables, making it more or less attractive. Where the consumer's preference
shifts is where the curve kinks.
• Perfect Combinations Indifference Curve: The indifference curve has a right-angle
shape when there are perfect complements. This suggests that the consumer is only
satisfied when the two goods are in a particular ratio, and that the consumer will only
be satisfied when the ratio is met.
• Indifference Curve for Perfect Substitutes: This curve has a constant slope and is a
straight line for perfect substitutes. This indicates that the customer is willing to switch
products at a steady rate, and the shape shows a steady degree of happiness in various
configurations.
• Convex Indifference Curve: Declining marginal rates of substitution are represented
by indifference curves with a convex shape. The consumer's readiness to give up units
of one thing declines as they consume more of the other good. This applies to the
majority of standard commodities.
• Concave Indifference Curve: Indifference curves with a concave shape show rising
marginal substitution rates. The customer is more inclined to give up units of one good
when they consume more of the other. Although uncommon, this could happen in
specific circumstances.

2.2.8 MARGINAL RATE OF SUBSTITUTION

When analyzing indifference curves, this idea is crucial. The rate at which a customer
is willing to forgo one unit of Y in exchange for another is known as the marginal rate
of substitution, or MRS, of X for Y. Put differently, the ratio of X's marginal utility to
Y's is always equal to the MRS of X and Y. Therefore, MRS is constantly fluctuating
since the two marginal utilities are. Remember that when we discuss MRS of Y for X
(rather than MRS of X for Y), we are discussing a scenario where the customer
purchases more units of Y (rather than X) and forfeits equivalent amounts of X (rather
than Y). MRS of Y for X is therefore equal to MUY/MUX and ∆ X/∆ Y. The analysis
of indifference curves requires an understanding of this crucial idea. A consumer's
willingness to trade one unit of Y for another of X is gauged by the Marginal Rate of
Substitution (MRS) of X for Y. It is worth noting that the rate in question is simply
∆Y/∆X, which is always equivalent to MUX/MUy, as you may remember from
previously in this unit. It is significant to observe that MRS of X for Y decreases when
X's stock with the consumer rises because this causes MUx and MUY to decrease,
which in turn causes the ratio to decrease. Furthermore, the slope of the tangent to the
indifference curve at the pertinent point of reference serves as a geometric
representation of MRS. Thus, the declining MRS of X for Y and the convexity of the
indifference curve are the same thing. The slope of the successively drawn tangents
decreases as we proceed from left to right along an indifference curve, indicating that
the amount of X is rising at this point. In Figure 8.4, this is demonstrated. The slope of
the tangent drawn to the curve at point A, or the ratio OY1 /OX1, provides the MRS of
X and Y at that point. OY2,/OX2, which is less than OY1,/0X2, represents the MRS of
X for Y at point B in a same way. At point C, the MRS of X for Y is still less than
OY3/OX3, reflecting this.
2.2.9 CONSUMER'S EQUILIBRIUM AND CONSUMER SURPLUS
When a consumer is unable to alter his pattern of consumption by increasing his
income, spending, or number of purchases, he is said to be in equilibrium. When a
product's price equals its marginal utility (MU), a rational consumer will typically
purchase it up until that point. The customer will either purchase more or less if the
aforementioned requirement is not met. The MU will decrease when customers make
larger purchases, and a time will come when product prices will surpass MU. In order
to avoid negative utility or discontent, the customer will cut back on consumption,
which will cause MU to rise once more until the price reaches MU. In the alternative
scenario, the consumer will purchase more to satisfy his need if marginal utility is
higher than the paid price. As a result, MU will gradually decline until it is equal to the
price. Consequently, customers might reach a point where the product's price equals
MU by buying more or less of the product. We refer to this as the consumer equilibrium
point.
Assumptions
• The consumer's scale of preferences for items X and Y, which remains constant
throughout this study, forms the basis of his indifference map for them.
• He receives a fixed and given amount of money. He spends 10 rupees on the two items
in question.
• The costs of the two commodities, X and Y, are fixed and provided as well. Each unit
of X costs Rs. 2, while each unit of Y costs Rs. 1.
• X and Y are homogenous and divisible goods. Throughout the analysis, the consumer's
preferences and routines remain unchanged.
• The market in which he acquires the two commodities is characterized by complete
competition. Because the buyer is logical, he maximizes his delight with the gaining of
the two items.

CONSUMER SURPLUS
The consumer surplus, often known as the buyer's surplus, is an economic measure of
the customer's excess benefit. In an economy, a consumer surplus occurs when a
customer is willing to pay more for a product than the market price. Consumer surplus
is an important research in economics. Here, we will present insights into "What is
Consumer Surplus?", the process of determining the excess, and other significant
 aspects of the topic. Consumer surplus is a method for measuring consumer welfare,
and it is defined as the excess of a product's social value above the actual price paid.

CONSUMER AND PRODUCER SURPLUS

While discussing the consumer and producer surpluses, it is critical that we understand
some fundamental notions employed by economists to explain the interrelationship
between them. The demand curve or marginal benefit curve, as well as the supply curve
or marginal cost curve, can be used to graphically represent both consumer and
producer excess. So, consumer surplus refers to the monetary advantage obtained when
a buyer purchases a product for a lower price than they would normally be ready to
pay. On the other hand, producer surplus refers to the price difference between the
lowest cost of supply to the market and the real price that customers are ready to pay.
The point where the demand and supply curves intersect is designated as the
equilibrium price, which is 50. The blue-shaded area above the supply curve and below
the equilibrium price represents the product surplus (or PS). The portion below the
demand curve and above the equilibrium price is shaded in green and is known as the
consumer surplus (or CS). To calculate consumer surplus, use the formula ½ (base)
(height), taking into account the demand and supply curves.

Assumptions of Consumer Surplus:

• The utility is a measured-type entity: According to the consumer surplus theory, the
value of utility needs to be measured. Utility in Marshallian economics is represented
by a numerical value. For example, ice cream has a utility value of 10 units. Thus, it is
assumed that Consumer Surplus also includes this explanation of Utility.
• There are no alternatives offered in the explanation: No alternatives are offered
when comprehending the consumers' surplus.
• Ceteris Paribus: This suggests that under no circumstances will the tastes, preferences,
or income of the customers alter.
• Marginal utility of money is constant: Another assumption is that the utility obtained
from a consumer's income remains constant. The amount of money possessed by a
consumer remains constant, as does the amount of utility derived from it. This element
is significant since money cannot be used to calculate utility without the assumption.
• Law of diminishing marginal utility: The law of DMU, or Diminishing Marginal
Utility, is also applied here, which asserts that the more a product or service is
consumed, the lower the marginal utility received from consuming each additional unit.
Independent marginal utility: The marginal benefit received from the consumed product is
unaffected by the marginal utility derived from the consumption of related commodities or
services. For example, if you consume a pastry, the utility received from it is unaffected by the
benefit derived from a muffin.

2.2.10 BUDGET LINE: MEANING, PROPERTIES, AND EXAMPLE

A budget line is a graph that shows every possible pairing of two goods that may be
purchased for a certain amount of money and at a given price, all of which have the
same degree of satisfaction. The requirement is that any combination's cost must be
less than or equal to the customer's monthly income. A budget line, to put it simply, is
the location of different pairings of two things that a customer purchases and whose
price is equivalent to his income. Price Line, Price Opportunity Line, Budget Constraint
Line, and Price Income Line are some other names for the budget line.

A consumer, for instance, with 10 in income, would like to spend it on two

commodities, let's say X and Y, each costing 5. The consumer can now choose how to
spend his money among three possibilities. The first choice is to purchase two
commodities X units. Purchasing two units of commodity Y is the second choice;
purchasing one unit each of commodity X and Y is the third. This indicates that the
following bundles could exist in this scenario: (2, 0); (0, 2); and (1, 1). Now, when all
of these three bundles are represented on a graph, a downward-sloping straight line is
formed which is known as a budget line. Let's say a customer has 40 in total that he can
use to purchase different combinations of Good X and Good Y. A single unit of Good
X costs 8, while a single unit of Good Y costs 4.
The consumer now has a potential selection of combinations to choose from: Good X
and Good Y are shown on the X and Y axes, respectively, in the graph. The buyer can
spend their entire income of ₹40 to purchase 5 units of Good X at Point E, the extremity
of the graph. At the opposite extreme of the graph, or Point J, the consumer can spend
their whole income on Good Y in order to buy 10 units of the product. Other
combinations exist between these two extreme points, namely Points F, G, H, and I.
The Budget Line, often referred to as the Price Line, is created by linking the points
from E to J to make a straight line, or "AB." Consequently, the Budget Line in the graph
above is represented by AB, and the Budget Set by OAB. Additionally, each point on
the Budget Line represents a distinct bundle of Good X and Good Y that the customer
can buy at the listed prices of the items by using all of his ₹40 income.
 The slope of Budget Line AB is downward. It is because more of one thing can be
purchased by reducing the quantity of the other good. The budget line includes bundles
whose costs are exactly equal to the consumer's monetary income, such as combos E
to J. Bundles with a cost less than the consumer's money income, such as combination
D, indicate under spending by the consumer. These bundles fall inside the budget.
Bundles that cost more than the consumer's money income, such as combination C,
display unattainable combinations, or combinations that the consumer does not have
access to. These bundles fall outside the budget. Budget Line is more relevant than
Budget Set when determining Consumer Equilibrium since it assumes that the
consumer spends his entire money.

Algebraic Expression of Budget Line

The Budget Line can be expressed as an equation:

M = (PX x QX) + (PY x QY) Where,
M = Individual’s Income
PX = Price of Commodity X Qx = Quantity of Commodity X
PY = Price of Commodity Y QY = Quantity of Commodity Y
The Budget Line AB show those bundles whose cost is exactly equal to M.

1.1 SUMMARY
 The utility approach to consumer behavior analysis has several fundamental flaws
related to the irrational presumptions that underpin it. The ability to measure utility in
cardinal terms, the presumption of constant money's marginal utility, the potential for
interpersonal utility comparisons, the incapacity to explain the behavior of demand for
subpar goods, the income impact, and other issues are some of these limitations. The
indifference curves method seeks to eliminate these flaws. The basis of the indifference
curves approach is the notion of scale of preference. Presumably, a customer can
categorize every potential combination of the two commodities, X and Y, into groups
so that every group includes every combination that gives the customer the same level
of satisfaction overall. Additionally, based on their level of satisfaction, customers can
arrange various groups for themselves.

An indifference curve is a visual depiction of a set of potential pairings of goods X and

Y, each of which is anticipated to provide him with an equal level of enjoyment. The
same collection of combinations is known as an indifference schedule when presented
in tabular form. The assumptions that underpin the drawing of indifference curves are
as follows: (i) utility can be measured cardinally; (ii) there are only two commodities,
X and Y; (iii) commodity Y may be money or a composite commodity; (iv) both X and
Y have positive marginal utilities; (v) both X and Y are subject to the law of
diminishing marginal utility; and (vi) both X and Y are perfectly divisible. These
presumptions give rise to several characteristics of indifference curves, including (i) a
negative slope, (ii) convexity to the origin, (iii) continuity, (iv) the inability of two
indifference curves to intersect, (v) the possibility of a system with many indifference
curves, and (vi) a curve with a greater total utility that is farther from the origin.

1.2 KEYWORDS
Budget Price Line (BPL): This is a line that displays the many combinations of
commodities X and Y (or X and money) that the market allows a customer to own for
a specific price of commodity X and a specified money income.
A Composite Good (Commodity) is a conceptually composed set of goods
(commodities) or all goods other than X such that all non-X goods (commodities) are
contained in the same quantity in each unit of the Indifference Curves Analysis of the
Composite Good. Money, which is the universal purchasing power, is typically used to
symbolize such composite goods.
 Income Effect: A shift in consumer demand for a good or service due to changes in
their income without affecting the good or service's price.
Customer's Surplus: The difference between the amount a customer is willing to pay
and what he actually pays for a specific quantity of X, if he chooses not to forgo it.
Goods/Commodities That Are Related: Goods/Commodities that are not
independently demanded due to their utility. These products can be extras or
replacements.
An Indifference Curve: An indifference schedule is graphically represented by an
indifference curve.
An Indifference Schedule is a tabular representation of all the combinations of X and
Y that result in the same level of satisfaction.
Marginal Rate of Substitution: MRS of X for Y is the amount of Y that the buyer is
willing to forfeit, at the margin, in exchange for one more unit of X. It is equivalent to
MUX/MUy and has the ratio AY/A X.
Pricing Effect: A commodity's shift in demand as a result of a price adjustment.

1.3 SELF ASSESSMENT TEST

1. What are the assumptions of indifference curves approach?
2. State the properties of indifference curves and derive them from the assumptions upon
which indifference curves are drawn.
3. What do you mean by marginal rate of substitution? Why does marginal rate of
substitution of X for Y fall when quantity of X is increased?
4. Show that a budget price line is tangent to one and only one indifference curve.

1.4 REFERENCES
Dwivedi, D.N.(2008) Managerial Economics, 7th edition, Vikas Publishing House.
Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th edition, 2010.
Samuelson, P & Nordhaus, W. (1st ed. 2010) Economics, McGraw Hill education.
Salvatore, D. (8th rd. 2014) Managerial Economics in a Global economy, Oxford
University Press.
http://www.learncbse.in/important-questions-for-class-12-economicsindifference-
curve indifference-map-and-properties-of-indifference-curve/
https://www.businesstopia.net/economics/micro/indifference-curveanalysis-concept
assumption-and-properties
 Block 3
Business Economics

OBJECTIVES
• Describe demand and the factors that influence it.
• Determine the variations between the market demand curve and the firm's demand
curve.
• differentiate the difference between demand and desire;
• explain the law of demand using a demand curve and a demand schedule;
• Determine the shift and movement of the law of demand curve
UNIT 1 DEMAND & LAW OF DEMAND
STRUCTURE
3.1.1 Introduction
3.1.2 Meaning and Definition of Demand
3.1.3 Demand Characteristics
3.1.4 Individual Demand Schedule & Curve
3.1.5 Market Demand Schedule & Curve
3.1.6 Demand Function
3.1.7 Classification of Demand
3.1.8 Determinants of Demand
3.1.9 The Law of Demand
3.1.10 Law of Demand Schedule and Curve
3.1.11 Assumptions of Law of Demand
3.1.12 Exceptions of Law of Demand
3.1.13 Why does a Demand Curve Slope Downwards?
3.1.14 Movement along Demand Curve and Shift in Demand Curve
1.1 Summary
1.2 Key Words
1.3 Practical Questions
 1.4References

Unit-1

3.1.1 INTRODUCTION

A consumer's willingness and ability to buy things in different quantities at different

prices throughout a specific time period is referred to as demand. Your ability to make
a purchase—that is, your financial capability—is a prerequisite for your demand to
have market value. You undoubtedly have a great deal of things that you would want
to get, but you might not actually be able to demand them because you lack the funds
to do so.

In order for demand to be successful, a customer must also be prepared to buy. You
may not want to spend your money on many of the things that you could purchase, even
though you are capable of purchasing them. Every individual possesses a distinct
viewpoint regarding their personal contentment and the elements that could perhaps
augment it. The crucial thing to remember is that you won't be willing to pay for a good
or service if you don't think using it would make you happier. As such, even though
you might be able to purchase them, you do not have a demand for such items.

Demand is always defined as the amount of goods purchased during a specific time
frame. You may have a weekly need for soft drinks, for instance. Four soft drinks every
week is what you require if you are willing and able to purchase them for Rs 5.00 per.
Here, it's crucial to remember that when we talk about a person's demand for a product,
we often imply that desire over a suitable time frame, not necessarily throughout the
entirety of that person's life.

A further explanation for something's lack of market value could be its lack of utility.
In other words, having or utilizing it just does not provide individuals any satisfaction.
The quantity of money that each of us has available to us for products and services is
finite. From person to person, the limit is different. In contrast to a successful
investment banker, a school teacher usually has significantly less money to spend. A
skilled worker can exchange more money for goods and services than an unskilled one.
Nevertheless, the quantity of money that each of us has available to us to purchase
items that will satisfy us is limited. Therefore, each of us must decide how much money
to borrow, save, or spend.This suggests that the way we decide to spend our money
affects the demand for different products and services in the economy.
3.1.2 MEANING AND DEFINITION OF DEMAND
A commodity's quantity that consumers are able and willing to purchase at different
prices throughout a specific time period is its demand. Therefore, in order for a
commodity to be in demand, a customer needs to be willing to purchase it, have the
means to do so, and be able to do it on a daily, weekly, monthly, or annual basisA
consumer's desire can only develop into an "effective desire" or "demand" under the
following circumstances:
• the desire to own the good;
• the ability to pay for it with money; and
• the willingness to give up the ability to do so.
Prof. Mayer’s states that the schedule of quantities that consumers would be prepared
to buy at all prices at every given moment in time represents the demand for goods.
Prof. Benham states that the quantity of something that will be purchased at a
particular price per unit of time is known as the demand.
Prof. Bober states that "demand is defined as the different quantities of a given product
or service that consumers would buy in one market at different prices, at different
income levels, or at different prices of related goods in a given period of time."

3.1.3 Demand Characteristics

• Dynamic in nature: The nature of demand is dynamic. It indicates that there is
fluctuation in the demand for a given good or service. A company must take into
account all relevant aspects in order to meet the current demand from customers, as
several factors might impact the market for a certain commodity.
• Stated in relation to a time frame: The desire for a good is stated in relation to a time
frame. A commodity's price may not change throughout the course of an hour, day,
month, or year, despite changes in demand.
• Sensitive to competition: Market competition has an impact on the demand for a
commodity. When a manufacturer controls the entire market share for a product,
demand for that product will be at its highest point, allowing them to set their own price
for it. On the other hand, there would be fierce competition and a decline in the market
value of the product if there are many makers.
• Depends on price: A commodity's demand is contingent on its price. It implies that
when a commodity's price fluctuates, so too will their demands. The price and demand
 of a commodity typically have an inverse relationship. Demand for a commodity will
decrease as its price rises and vice versa.
• Relies on supply: A commodity's supply and demand are inversely correlated, much
like its price. People are willing to pay any amount to obtain the thing when there is a
limited supply.
3.1.4 Individual Demand Schedule & Curve
Individual Demand Schedule: The Individual Demand Schedule is a tabular
statement that provides the various amounts of a commodity at varying price points
that a consumer is willing and able to buy within a certain time frame.

Individual Demand
Curve: This shows the quantity that each family is willing to pay for at different prices.
It is also possible to refer to it as the graphical representation of the schedule for each
individual demand. It can be created by tracking how customers behave when prices
fluctuate.
3.1.5 Market Demand Schedule & Curve
Market Demand Curve: The horizontal total of the various demand curves is
represented graphically by the market demand curve. The company can comprehend
the whole market, not simply specific clients, with the aid of market demand.

3.1.6 Demand Function:

The Demand Function describes the link between the quantity demanded of a specific
commodity and the factors that influence it. It might apply to a single customer (Individual
Demand Function) or to the entire market (Market Demand Function).
Individual Demand Function: The Individual Demand Function refers to the functional
relationship between the individual amount desired of a certain commodity and the factors that
influence it. The equation is Dx = f (Px, Pr, Y, T, F),
Where Dx represents demand for commodity x,
Px represents the price of the commodity,
Pr represents the prices of related goods,
 Y represents the consumer's income,
T represents tastes and preferences, and
F represents the future price expectation.
Market Demand Function: The Market Demand Function is the functional relationship
between a commodity's market demand and the factors that influence it. As previously stated,
all of the elements that influence individual demand also have an impact on market demand.
In addition to these characteristics, it is affected by population size and composition, season
and weather, and income distribution.
It is expressed as: Dx = f (Px, Pr, Y, T, F, Po, S, )
Where,Dx represents Demand for Commodity x,
Pxrepresents Price of Commodity x,
Prrepresents Prices of Related Goods,
Yrepresents Consumer Income,
T represents Tastes and Preferences, and
F represents Expected Price Change in the Future.
Po represents population size and composition, and
S represents seasonal and weather conditions,

3.1.7 Classification of Demand

• Individual and Market Demand: The term "individual demand" describes a
consumer's desire for products and services; on the other hand, "market demand" refers
to the demand for a product from all of the consumers who purchase it. As a result, the
total of each individual's demand is the market demand.
• Total Market & Market Segment Demand: The total market demand is the sum of
the demands of all the consumers in the market who buy a particular type of goods.
Furthermore, demand can be further segmented into market categories based on factors
such as customer size, age, sex, price sensitivity, and geographic locations.
• Derived and Direct Demand: Derived demand is the term used to describe situations
in which the want for one product or outcome is linked to the desire for another. On the
other hand, direct demand refers to a situation in which the desire for a product or
outcome exists independently of the need for another product.
• Industry Demand and Company Demand: The term "industry demand" describes
the overall combined need for a given industry's products, such as the demand for
cement in the building sector. However, the product that is unique to the company and
 a part of that industry is what the corporation is requesting. As in the case of the demand
for Goodyear tires.
• Short- and Long-Term Demand: Short-term demand is more elastic, meaning that
shifts in income or price have an instantaneous impact on the quantity sought. On the
other hand, long-term demand is inelastic, indicating that changes in price, marketing
tactics, consumption trends, and other factors lead to variations in the demand for
commodities.
• Price Demand: This type of demand is referred to as a price demand since it is
examined in relation to price. How much a commodity is willing to be purchased for at
a specific price is known as the price demand. The consumer's income, tastes, and
preferences, as well as the pricing of other relevant commodities, are assumed to remain
constant while analyzing demand.
• Income Demand: This is the willingness of an individual to purchase a specific amount
at a particular income level. The income and the demand are positively correlated. The
desire for the good rises in bike with income growth and vice versa.
3.1.8 Determinants of Demand for a Product
1. Price of a commodity: Commodity prices have a significant impact on product
demand. The price of a product is inversely proportional to the quantity desired. The
demand for a product diminishes when its price rises, while other factors remain
constant, and vice versa. For example, consumers prefer to buy a large amount of a
product when the price is low. The price-demand connection plays an important role in
oligopolistic markets, when an organization's performance is determined by the
outcome of a price war between it and its competitors.
2. Income of Consumer: Income from consumers is a significant factor of demand. A
consumer's income affects his or her purchasing power, which determines product
demand. A rise in a consumer's income will automatically raise his or her demand for
products, while other parameters remain constant, and vice versa. For example, if Mr.
X's pay rises, he may increase the pocket money of his children and purchase luxury
things for his family. The income-demand relationship can be examined by
categorizing products into four types:
• Essential or Basic Consumer Goods: Items that are eaten by everyone in society.
Examples include food grains, soaps, oil, cooking fuel, and clothing. The quantity
requested for essential consumer products increases with a consumer's income, but
only up to a certain point, whereas other aspects remain constant.
 • Normal Goods: These are goods whose demand rises in response to an increase in
consumer income. For example, as consumer income rises, the demand for products
such as clothing, vehicles, and food increases. The demand for ordinary items varies
according to the rate of increase in consumers' income.
• Inferior commodities: These are commodities whose demand declines as
consumer income rises. For instance, if a consumer's income increased, they would
rather buy cooking gas instead of kerosene and wheat and rice instead of millet. In
this scenario, kerosene and millet are subpar products for the customer.
• Luxurious goods:Luxurious goods are those whose demand rises as consumer
income rises. The purpose of luxury items is to make people feel good about them.
For instance, pricey jewelry, fancy automobiles, vintage wines and paintings, and
flying trips.
3. Price of Related Goods: State that the price of related goods has a higher impact on
demand for a particular product than it does. Two categories of related products exist:
complementary goods and substitutes, which are described as follows:
• Substitute Goods: A substitute is a product that meets the same requirement as a
substitute but costs a different amount. Tea and coffee, jowar and bajra, and
groundnut oil and sunflower oil, for instance, can be substituted for one another.
An increase in the price of a good causes a rise in the demand for its less expensive
equivalent. As a result, when the cost of a specific good increases, buyers typically
choose to buy a substitute.
• Complementary Goods: Goods that are consumed concurrently or in combination
are referred to as complementary goods. Put differently, complementary
commodities are used in tandem with one another. Pen and ink, for instance,
automobile and gasoline, tea and sugar. As a result, the demand for complementary
products fluctuates concurrently. The relationship between the complimentary
commodities is inverse. For instance, if gas prices rose, fewer people would be
driving.
4. Consumer Preferences and Tastes: A wide range of elements, including age, sex,
standard of living, lifestyle, conventions, and common behaviors, influence consumer
preferences and tastes. Consumer tastes and preferences alter in response to changes in
any one of these criteria. As a result, customers increase their consumption of new
products while decreasing their use of outdated ones. Customers would favor new and
advanced products over outdated ones, for instance, if fashion changed, as long as price
 disparities were commensurate with income. For example, if there are more women
than men in a given location, there will be a greater demand for feminine products like
makeup kits and cosmetics.
5. Customer Expectations: It is implied that consumer expectations regarding potential
price adjustments for a product will have an immediate impact on demand for that
product. For instance, if customers anticipate that gas prices will rise over the course
of the next week, demand for gas will rise now. Conversely, when it comes to non-
essential things in particular, buyers would postpone buying items whose costs are
anticipated to drop in the future. In addition, the expectation of higher income by
customers could lead to a rise in the demand for specific products. Furthermore, a
particular product's scarcity in the future would raise its demand in the here and now.
6. Effect of Advertisements: This is one of the key elements in figuring out how much
demand there is for a product. Powerful commercials serve a variety of purposes,
including drawing in viewers, alerting them to a product's availability, showcasing the
qualities to prospective buyers, and convincing them to buy the goods. Because they
occasionally become attached to commercials supported by their favorite celebrities,
consumers are extremely sensitive to commercials. The demand for a product rises as
a result.
7. Population Growth: The market demand for a product is significantly influenced by
the growth of the population. Customers' ability to consume goods and services will
rise in tandem with the market's customer base. The demand for various products would
therefore rise in response to rapid population expansion.
8. Government Policy: One of the main elements influencing a product's demand is its
government policy. For instance, the price of a product would increase if the tax rate
was high. This would lead to a decline in a product's demand. In a similar vein, a
nation's credit policies influence the demand for a given good. One way to boost
demand for products would be to provide consumers with a sufficient amount of credit.
9. Climatic Circumstances: The demand for a product is largely influenced by climatic
conditions. For instance, people prefer tea and coffee in the winter, whereas ice cream
and cool drinks are more popular in the summer. In comparison to plains, mountainous
regions have a higher demand for several things. People therefore have varying needs
for things depending on the climate.

3.1.9 The LAW OF DEMAND

 Customers will often buy more units of most goods at a lower price than at a higher
one. The rule of demand refers to the widely observed inverse relationship between
price and the quantity that customers will buy. The law of demand states that, if all
other things remain equal, consumers will purchase more goods at reduced costs than
at higher ones. According to the rule of demand, when all else is equal, buyers are
willing and able to buy more units of an item or service at a lower price than at a higher
one.

According to the Law of Demand, all other things being equal, or ceteris paribus, there
is an inverse relationship between the price and quantity desired of a good. It is
sometimes referred to as the First Law of Purchase. The quantity of an item that is
demanded depends on a number of other criteria in addition to its price. Therefore, it is
imperative that the other elements remain constant in order to comprehend the distinct
influence of one aspect affecting the demand. Therefore, it is presumed that other
components remain constant under the Law of Demand.

Marshall states that: "The amount demanded increases with a fall in price and
diminishes with a rise in price; in other words, the greater the amount to be sold, the
smaller the price at which it is offered in order to find purchasers."
In Robertson's words, "Other things being equal, a man will be more willing to buy
something if the price is lower."

3.1.10 Law of Demand Schedule and Curve

Law of Demand Schedule: The Law of Demand Schedule is a tabular statement that
provides the various amounts of a commodity at varying price points that a consumer
is willing and able to buy within a certain time frame.

Price of Wheat/Kg Wheat Demanded (In Kg)

15 2
14 3
13 4
12 5
11 6
10 7
9 8
Law of Demand Curve: This shows the quantity that each family is willing to pay for at
different prices. It is also possible to refer to it as the graphical representation of the schedule
for each individual demand. It can be created by tracking how customers behave when prices
fluctuate.

3.1.11 Assumptions of Law of Demand

• No change in income: For the law of demand to be effective, the consumer's income
must either stay the same or not change. It is expected that income would not change
because an increase in income could encourage consumers to purchase more things,
increasing demand even in the face of rising commodity prices.
• No change in population size: The second principle states that a nation's overall
population should remain constant. Stated differently, there must be no net increase or
decline in the population. Since an increase in population would therefore result in an
increase in demand for commodities even in situations when their prices are greater, it
is believed that both the size and composition of the population must remain constant.
• No change in related products prices: The law of demand's third evidence holds that
related goods prices—that is, the prices of complementary and substitute items—
remain constant. Here, it is expected that the prices of complementary goods (like cars
and gasoline) and substitute goods (like tea and coffee) shouldn't fluctuate. It is thought
to be this way because the law of demand becomes invalid and inapplicable when a
customer's preferences or choices change.
• Not anticipating a future price change: In order for Demand Law to continue to hold
true, it is necessary to reject the notion that commodity prices will ever alter or fluctuate
 in the future. Since future price changes will impact the current demand for goods, it is
expected that there will be no expectation of such changes. As an illustration, if
consumers anticipate that the costs of some things will grow in the future; this will also
raise demand for such goods now and vice versa.
• Consumer preferences and tastes should not change: The fourth premise of the law
of demand holds that consumer preferences and tastes, as well as habits and fashions,
should not change. Since doing so would violate the operation or applicability of the
law of demand, it is considered that the consumer's taste, preference, habit, style, and
so forth should remain unchanged.
• No change in the climate: The sixth premise of the law of demand is that a region's or
area's climate should constantly remain the same. The assumption that the climate
would remain constant is necessary since seasonal variations affect people's basic
requirements. When it rains, for instance, there is a greater need for umbrellas than
there is in other seasons.

3.1.12 Exceptions of Law of Demand

• Giffen Goods: Giffen Goods are a particular class of goods that customers spend a
significant portion of their earnings on. When the price of these commodities rises,
demand rises as well, and declines when the price drops. Giffen's Paradox is the name
given to these occurrences, which was first noticed by Sir Robert Giffen. For instance,
wheat is a normal good whereas rice is a lower-class good. Therefore, if rice prices
drop, consumers will start purchasing more wheat and spend less on rice.

• Fear of Shortage: Customers will begin purchasing more of a good now even if its
price goes up if they anticipate it being scarce in the near future. This is due to their
fear of the good becoming scarce and their expectation that its price would rise in the
future. For instance, during the early stages of COVID, customers sought more basic
goods—like wheat, pulses, and other items—even at a higher cost because they were
afraid of future shortages and general uncertainty.

• Status Symbol or Goods of Ostentation: Goods used as status symbols by individuals are
another category in which the law of demand is broken. People purchase items like antique
paintings, for instance, in order to uphold their status symbol. The only reason they demand
ancient artworks is because of their high cost. This implies that consumers will no longer view
ancient artworks as status symbols and will decrease their desire if their price drops.
 • Ignorance: Occasionally, buyers are not aware of a product's current market price. In these
situations, they purchase more goods—even at a premium.

• Necessities of Life: Regardless of price fluctuations, goods that are essential to human survival
are in greater demand. For instance, even if the price of necessities increases, demand will still
rise for products like wheat, pulses, medications, etc.

• Weather Changes: Despite price increases, demand for some commodities varies when the
weather changes. For instance, even if their price increases, there is a rise in demand for
raincoats during the rainy season.

• Fashion-related goods: Despite their high price tags, fashion-related goods are increasingly
in demand. For instance, even if the price of a particular mobile phone model increases, people
will still purchase it if it is in style.

3.1.13 Why does Demand Curve for a Commodity Slope Downward?

• Law of diminishing marginal utility: The law of demand follows logically from the
law of diminishing marginal utility, which is the foundational psychological law.
According to this law, a commodity's marginal utility is high when quantity demanded
is low and low when quantity demanded is high. When making huge purchases, the
price must be cheap because a low quantity will be demanded. It demonstrates how the
law of diminishing marginal utility is the direct source of the law of demand. Actually,
a commodity's marginal utility tells us the highest price a customer is willing to pay for
it. Marginal utility steadily decreases as a commodity is consumed more.
• Substitution effect: The substitution effect is the initial element that explains rising
consumption in the event of a price decline. When a product's relative price changes,
consumers may choose to replace it with another, a phenomenon known as the
replacement effect. Good X's relative appeal will rise with a decrease in price, provided
that the prices of other goods stay the same. This will encourage customers to replace
some of the new, relatively more costly things in their budgets with good X. Coffee
looks significantly more expensive if its price rises while other prices—like the price
of tea—stay the same. Tea will be drunk more often and coffee less frequently as coffee
prices rise relative to other goods.
• Income effect: In addition, a decrease in the market price of a commodity that can be
purchased corresponds to an increase in a consumer's real income or purchasing power
when their money income is fixed. More precisely, the income effect denotes how a
change in price affects a customer's actual income. A decrease in the price of a good or
 service corresponds to an increase in the actual income of a consumer whose money
income remains constant. The term "income effect" describes how variations in product
prices might affect a consumer's actual income. A good's demand typically increases
when its price decreases. Real income effect is used in part for this (i.e., income
adjusted for price changes to represent current purchasing power). Given a price of Re.
1 and an income of, say, Rs. 10, a consumer can purchase 10 units of the commodity.
He will just need to pay Rs. 5 to get the same 10 units if the price of the commodity
drops to 50 paise. Now, the customer has an additional Rs. 5 to spend on purchasing
more of good X and other items.
• Various Uses: A commodity may have a variety of uses, some of which are more
significant than others. Customers limit the usage of these commodities to their most
essential uses as their prices rise, which boosts demand for those uses while decreasing
demand for the commodity's less essential uses. On the other hand, people will utilize
the commodity for anything, regardless of importance, if its price drops. One can utilize
milk, for instance, to make cheese, butter, candies, and other things. The price increase
of Ghee is likely to limit its usage by customers to the essential function of drinking.
• More Customers: When a commodity's price drops, a number of new buyers who
were previously unable to acquire it because of its high cost are now able to do so. Due
to the decrease in price, not only will new consumers start requesting more of the
product, but existing or past consumers will as well. For instance, if pizza's price drops
from Rs. 200 to Rs. 150, many new consumers who previously couldn't afford it will
now be able to buy it as a result of the price decrease. Additionally, the ability to request
extra pizza has increased the overall demand for the food.

3.1.14 Movement along Demand Curve and Shift in Demand Curve

A customer's willingness and ability to buy a certain quantity of a good at any given
time and at any price is referred to as demand. Crucial elements of demand are
highlighted in the definition above: Commodity quantity, willingness to purchase,
price, and duration are the first four factors. It is important to distinguish between the
concepts of quantity demanded and demand for a commodity. The former is contingent
upon fluctuations in the commodity's price, while the latter is contingent upon shifts in
variables unrelated to commodity prices.
Variation in Quantity Demanded (Movement along Demand Curve)
When a commodity's price fluctuates while other elements stay the same, the quantity
demanded of the commodity varies. This is known as a change in quantity demanded.
It appears visually as a shift along the same demand curve. Along the same demand
curve, there are two situations that are moving. It could be moving upward (contraction
of demand) or downward (expansion of demand expansion). The movement of the
demand curve (DD) is depicted in the graph below. Quantity demanded at OP pricing
is known as OQ. The demand curve shifts upward or downward in response to changes
in price.

• Upward Movement: Along the same demand curve DD, there is an upward
movement from A to C when the price rises from OP to OP2. This is also referred
to as the contraction of demand, which occurs when the amount required falls from
OQ to OQ2.
• Downward Movement: In contrast, lowering the price from OP to OP1 generates
an increase in quantity required from OQ to OQ1 (also known as demand
expansion), resulting in a downward movement along the same demand curve DD
from A to B.
Expansion in Demand: Expansion in demand refers to the rise in quantity desired of
an item due to a decrease in price while maintaining other variables constant. Along
the same demand curve, expansion in demand causes a downward movement. Another
name for it is an extension of demand or an increase in the quantity demanded.
 Price Quantity
10 150
8 200

Contraction in Demand: Contraction in demand occurs when the quantity of a good

wanted decreases due to an increase in price while maintaining other variables constant.
The same demand curve rises in response to a contraction in demand. It is often referred
to as a Decline in Demanded Quantity.

Price Quantity
10 150
15 100

Change in Demand (Shift in Demand Curve)

Assuming all other variables stay constant, a demand curve illustrates the relationship between
the price of a good and the amount demanded. Other variables will inevitably change, though,
sooner or later. The demand curve varies when any of the other factors are altered.
Assume, for example, that the consumer's income increases. Customers may get more
interested in a commodity even when its price hasn't altered. A product whose price has not
changed cannot have such a rise in demand as shown by the initial demand curve. The demand
curve will change as a result.

Rightward Shift: When demand rises from OQ to OQ1 (sometimes referred to as an

increase in demand) at the same price as OP, the demand curve moves from DD to
D1D1. Other names for it include upward, forward, and outward shifts.

Leftward Shift: When demand falls from OQ to OQ2 (also referred to as a reduction
in demand) at the same price as OP, the demand curve moves to the left from DD to
D2D2. Other names for it include downward, backward, and inward shifts.

A rise in demand: An increase in demand for a commodity occurs when the quantity
requested of it rises for any reason other than its price. To put it simply, as other factors
change, the demand for a commodity rises at the same price. The demand curve shifts
to the right when demandrises.
 Price Quantity
10 150
10 200

Decline in Demand
A decrease in demand for a commodity occurs when the quantity requested of it
falls for any reason other than its price. To put it simply, as other conditions
change, the demand for a commodity declines for the same price. The demand
curve shifts left when demand declines.

Price Quantity
10 150
10 100
Reasons for Demand Change
Other factors that contribute to its occurrence include changes in:
(i) the cost of complementary goods;
(ii) the cost of substitute goods;
(iii) consumer income;
(iv) tastes and preferences;
(v) the expectation of future price changes;
(vi) population changes;
(vii) changes in the distribution of income; and
(viii) variations in the weather and season.

1.1 Summary
Demand analysis is an important informative input into the corporate decision process
since it fundamentally dictates what is produced and at what price. As a result, business
economists employ demand analysis to identify the numerous elements influencing
demand for a specific product or service.
According to the law of demand, provided all other factors remain constant, customers
are willing and able to buy more units of an item or service at a lower price than at a
higher one. When the price of a particular commodity is altered, two things happen that
lead to the creation of the law of demand: income and substitution. According to the
income effect, a product price increase reduces the amount of money available for other
purchases within a certain budget. According to the replacement effect, people
frequently choose less expensive products over more costly ones.
The horizontal total of all consumer demands in the market is the market demand curve.
Assuming that all other prices, the total income of consumers in that market, the
distribution of that market, consumer preferences, and other influencing factors remain
constant, the market demand curve links the total amount demanded of a product to its
own price. The price of the commodity being offered, the pricing of all other products,
the income of the people purchasing in that market, the distribution of income among
the people, tastes, and a host of other influencing factors all affect the total quantity
required in any given market.

1.2Key Words
 Changes in demand: A price adjustment does not cause a change in demand.
However, a change in a factor other than price, such as income and the prices of similar
commodities causes a shift in demand. In that situation, the change in demand causes
a shift in the demand curve. A decrease in demand changes the demand curve to the
left, whereas an increase in demand shifts the curve to the right.
Complements: Products that work well together are called complements.
Demand: The quantity of a good or service that an individual is willing and able to
purchase at any given price.
Demand curve: A graph that depicts demand, with prices on the vertical axis and
quantities demanded on the horizontal axis. The demand curve slopes downward due
to a negative relationship between price and quantity desired.
Demand Schedule: A table that displays the quantity of an item or service that is
desired at various pricing points is called a demand schedule.
Giffen Goods: A Giffen good is a lower quality product whose demand grows as its
value rises, violating the demand law.
Inferior Goods: Lower-quality, low-cost substitute items are commonly referred to as
inferior goods. When their budget is tight, consumers with lesser salaries frequently
choose subpar products.
Law of demand: When a good's price increases, fewer people want it, and vice versa,
all other things being equal.
Market demand: The entire amount that each individual consumer in an economy
wants to purchase is known as the market demand.
Normal Goods: In contrast, normal goods are products whose demand increases as
consumer income increases and decreases as consumer income decreases.
Substitute: Product that can be used in lieu of another product is called a substitute.
1.3 Practical Questions
1. Describe the key determinants that influence a commodity's market demand.
2. Use a demand curve and a demand schedule to illustrate the law of demand.
3. What is the Law of Demand? State and explain the main assumptions underlying the
Law of Demand.
4. Using the contrast between income effects and substitution, describe the exceptions to
the Law of Demand.
5. What causes a shift in the demand curve, as well as movement along it? Explain.
1.4 REFERENCES

• Case, Karl E. and Ray C. Fair, Principles of Economics, Pearson Education, New Delhi,
2015.
• Stiglitz, J.E. and Carl E. Walsh, Economics, viva Books, New Delhi, 2014.
• Hal R. Varian, Intermediate Microeconomics: a Modern Approach, 8th edition,
W.W.Norton and Company/ Affiliated East-West Press (India), 2010.

UNIT 2

ELASTICITY OF DEMAND

OBJECTIVES

• Give an explanation of the idea of demand elasticity.

• Determine the elasticity of demand for price, income, and cross-elasticity
• Explain the various approaches to calculating price elasticity of demand.
• Describe the significance of demand price elasticity.
• Enumerate the variables that affect demand's price elasticity.

STRUCTURE

3.2.1 Introduction
3.2.2 Meaning and Definition of Elasticity of Demand
3.2.3 Meaning and Definition of Price Elasticity of Demand
3.2.4 Types of Price Elasticity of Demand
3.2.5 Determinants of Price Elasticity of Demand
3.2.6 Measuring Price Elasticity of Demand
3.2.7 Meaning and Definition of Income Elasticity of Demand
3.2.8 Meaning and Definition of Cross Elasticity of Demand
1.1 Summary
1.2 Key Words
1.3 Practical Questions
 1.4 References

Unit-2

3.2.1 INTRODUCTION

Both the demand function and the law of demand were covered in the last unit of study.
We may determine the direction of change in any independent variable's value by
utilizing the demand function and the law of demand. However, they provide no
information regarding the extent of the alteration. We know that demand for a given
amount of a good will rise if, for instance, its price drops. We're not sure how much,
though. We apply another idea in order to quantify the shift. Demand Elasticity is the
term for this. The amount to which a commodity's price, consumer income, and the
prices of other commodities affect a commodity's quantity desired will be covered in
this unit. Demand Theory, pricing consumer behavior, and the elasticity of demand—
including income elasticity of demand and cross-elasticity of demand—will all be used
to help you study this. The notion of price elasticity of demand and its significance in
different government policies will be studied, as well as the factors that determine a
commodity's price elasticity of demand.

3.2.2 MEANING AND DEFINITION OF ELASTICITY OF DEMAND

The responsiveness of a dependent variable (demand) to a change in independent
variables (the price of a commodity, consumer income, or the price of a commodity
other than the commodity) is known as the elasticity of demand. A percentage or
proportionate change in the dependent variable relative to a specified percentage or
proportionate change in the independent variable is how elasticity is always calculated.
The degree to which the amount desired of a commodity responds to a shift in any one
of the demand determinants, or one of the variables influencing demand, is measured
by the concept of elasticity of demand. Each influencing variable's response to change
is quantified by a different elasticity notion.
 Alfred Marshall, a British economist: "The elasticity (or responsiveness) of demand
in a market is great or small according as the amount demanded increases much or little
for a given fall in price, and diminishes much or little for a given rise in price" .

3.2.3 PRICE ELASTICITY OF DEMAND

The relative change in quantity requested of a good as a result of a certain (percentage or
proportionate) change in its price is measured by price elasticity of demand. This may
alternatively be defined as the relative responsiveness of the quantity demanded of a good
to changes in the good's price. This is known as price elasticity of demand. Another
approach to put this would be to say that the price elasticity of demand is the ratio of the
proportionate or percentage change in the quantity of a good that is desired to the
proportional or percentage change in the good's price.

In the words of Alfred Marshall:"Elasticity of demand may be defined as the percentage

change in quantity demanded to the percentage change in price."

"The elasticity of demand for a commodity is the rate at which quantity bought changes
as the price changes," states A.K. Cairncross.

J.M. Keynes states that "the elasticity of demand is a measure of the relative change in
quantity to a relative change in price."

3.2.4 Types of Price Elasticity of Demand:

• Perfectly Elastic Demand: The Price Demand elasticity equals infinity (Ped = When
the price of a commodity changes sharply, this is referred to as perfectly elastic
demand. In completely elastic demand, a tiny increase in price can reduce demand for
the good to zero, but a small decrease in price can boost demand to infinite. The
elasticity of demand influences the slope and shape of the demand curve. As a result,
looking at the slope of the demand curve allows us to determine demand elasticity. A
flatter slope indicates a stronger elastic demand. As a result, the demand curve slope
for completely elastic demand is horizontal.

• Perfectly Inelastic Demand: The price Elasticity of demand is zero. A perfectly

inelastic demand is one that does not fluctuate in response to price changes. Like
perfectly elastic demand, the concept of perfectly inelastic is theoretical and has no
practical application. However, demand for necessities is the most closely related case
of perfectly inelastic demand. The PED formula produces a numerical value of zero for
perfectly inelastic demand. The demand curve for perfectly inelastic demand is a
vertical line with a slope of zero.
• Unitary Elastic Demand: The price elasticity of demand (Ped = 1) is equal to one.
Unitary elastic demand occurs when the proportionate change in the quantity sought
for a good is equal to the proportionate change in the commodity's price. Unitary elastic
demand has a numerical value of 1. For unitary elastic demand, the demand curve is
shown as a rectangular hyperbola.

• Relatively Elastic Demand: Relatively elastic demand occurs when the proportional
change in demand exceeds the proportional change in the price of the good. The
numerical value of moderately elastic demand varies from one to infinity. Unlike the
other categories of demand, relatively elastic demand has a practical application
because many commodities respond in the same way when prices vary. The demand
curve for relative elastic demand is gradually sloping. For example, a 10% decrease in
the price of excellent chocolate may result in a 30% increase in the quantity demanded
of chocolate. In this situation, the answer is 3
 • Relatively Inelastic Demand: The price elasticity of demand is larger than zero but
less than one (Ped>0 < 1). The proportionate change in the amount demanded for a
product is always less than the proportionate change in the price in a relatively inelastic
demand. For instance, if a good's price decreases by 10%, the proportionate change in
demand for that commodity will not exceed 9.9..%; if it does, the demand change is
referred to as unitary elastic demand. Relatively inelastic demand is characterized by
a demand curve that slopes quickly and a numerical value that is always less than 1.

3.2.5 Determinants of Price

Elasticity of Demand

1. Commodity nature: A commodity's elasticity of demand is determined by its nature.

A commodity can be a luxury, a comfort, or a need for an individual.
• The demand for necessities, such as food grains, vegetables, medicines, etc., is typically
inelastic since they are necessary for human survival and do not alter in value
significantly.
• The demand for a comfort-related commodity, such as a refrigerator or fan, is typically
elastic since consumers can put off using it.
• The demand for luxury commodities—such as air conditioning, DVD players, etc.—is
typically more elastic than the demand for comforts.
• The word "luxury" is ambiguous because any given item, such as an air conditioner,
may be a luxury for the impoverished but a need for the wealthy.

2. Availability of substitutes: A commodity's demand will be more elastic if there are

more alternatives available. The rationale is that consumers will choose its
replacements if its costs even slightly increase. For instance, an increase in Pepsi's price
promotes consumers to purchase Coke, and vice versa. The availability of near
alternatives thereby increases the sensitivity of demand to price changes. Conversely,
 commodities such as salt and wheat that have few or no replacements have lower price
elasticity of demand.

3. Income Level: Generally speaking, higher income groups have less elastic demand for
any given commodity than do lower income groups. It occurs as a result of wealthy
people being less affected by fluctuations in the cost of products. Yet, changes in the
cost of products have a significant impact on the poor. Demand for lower income
groups is therefore quite elastic.

4. Price level: The price elasticity of demand is also influenced by price level. Expensive
items with very elastic demand are those whose demand is highly sensitive to price
fluctuations, such as laptops and plasma TVs. However, because changes in the prices
of these items do not significantly alter demand, the demand for inexpensive things like
needles, matchboxes, etc., is inelastic.

5. Delay in Consumption: Non-emergent commodities, such as biscuits and soft drinks,

have a highly elastic demand since consumers can put off consuming them in the event
of price increases. But because they are needed right away, goods with urgent demand,
like life-saving medications, have inelastic demand.

6. Number of Uses: The demand for the commodity in question will be elastic if it has
multiple uses. A commodity's price increase usually results in its being used for more
pressing purposes, which lowers demand for it. Demand increases when prices decline
and are used to satisfy even less urgent demands. For instance, electricity is a resource
with several uses. A significant increase in demand will arise from a decrease in price,
especially for applications (such as air conditioning, heat convection, etc.) where its
high cost previously prevented its usage. Conversely, the demand for a commodity with
few or no substitute uses is less elastic.

7. Share in Total Expenditure: The percentage of a consumer's money allocated to a

certain good or service affects how elastic demand is for that good or service. The
elasticity of demand for a commodity increases with the percentage of income spent on
it, and vice versa. Since customers only spend a small percentage of their income on
items like salt, needles, soap, match boxes, etc., the demand for these kinds of
commodities is typically inelastic. Consumers continue to buy about the same amount
of these things even when their prices vary. On the other hand, demand for a commodity
will be elastic if a significant percentage of income is allocated to it.
 8. Time Period: There is always a relationship between price elasticity of demand and
time. A day, a week, a month, a year, or a span of several years can pass. Demand
elasticity changes in direct proportion to time. Generally speaking, demand is inelastic
within the short term. It occurs as a result of consumers' inability to quickly alter their
behavior in response to a change in the cost of the particular good. Demand is more
malleable in long-term investments, nevertheless, because it is relatively simpler to
switch to alternative options should the commodity's price increase.

9. Habits: The demand for commodities is less elastic since they are now considered
essential by consumers. It occurs when the buyer considers such a good to be necessary
and keeps buying it even when the cost goes up. Cigarettes, alcohol, and tobacco are a
few examples of products that can become habits. Ultimately, it may be said that a
variety of factors influence a commodity's elasticity of demand. It is challenging to
identify a single component or set of factors that specifically determines flexibility.
Everything is dependent on the specifics of each instance.

3.2.6 Measuring Price Elasticity of Demand:

• Point approach: Marshall also proposed this approach, which considers a straight line
demand curve and analyzes elasticity at various places along the curve. This technique
has grown in popularity as a means of determining elasticity. We use a straight line
demand curve in this case, connecting it to the axes OX and OY. The amount demanded
is shown on the OX axis in the diagram, while the price is shown on the OY axis.

Case (i) Linear Demand Curve: The demand

curve is linear. The initial demand is OQ or PA,
and the price is OP or QA. The demand is OQ' at
the increased price of OP. The following formula
can be used to calculate the elasticity of demand at
point R.

Linear Demand Curve in Case (i):A straight line

demand curve is shown. The initial demand is OQ or
PA, and the price is OP or QA. The demand is OQ'
at the increased price of OP. The following formula
can be used to calculate the elasticity of demand at
point R.
• Total Expenditure Method: The Total Expenditure Method is a technique developed
by Dr. Marshall to quantify the price elasticity of demand. This method allows one to
calculate the elasticity of demand by taking into account changes in price together with
the ensuing adjustments to the total quantity and total cost of products purchased.
Price x Demanded Quantity = Total Outlay
a) The elasticity of demand is greater than one, or ED > 1, if the total expenditure rises
in response to a decline in price (demand grows) or lowers in response to a rise in
price (demand falls).
b) The demand will be unitary elastic, or ED = 1, if the overall expenditure stays the
same notwithstanding a rise or fall in price (demand rising or falling, respectively).
c) The demand is considered less classic or the elasticity of demand is less than one
(ED < 1) if, in response to a decline in price (Demand increases), the total
expenditure likewise lowers, and in response to a rise in price (Demand falls), the
total expenditure similarly rises.
• Revenue Method: This approach has been provided by Mrs. Joan Robinson. She
claims that average revenue and marginal revenue can be used to calculate the elasticity
of demand. As a result, a company's revenue is the money it makes from the sale of its
goods. Nonetheless, average revenue is obtained by dividing total income by the
quantity of units sold. Conversely, marginal revenue is the amount that is added to the
total revenue by selling an additional unit of the commodity. Consequently, EA = A/A-
M is the formula that can be used to calculate the elasticity of demand.
• Proportionate Method: Dr. Marshall's name is also connected to this approach. "Price
elasticity of demand is the ratio of percentage change in the amount demanded to the
percentage change in the price of the commodity," according to this technique. It is also
referred to as the Arithmetic Method, Ratio Method, Flux Method, and Percentage
Method. The following is its formula:
Significances:
a) When there is a very slight variation in the quantity and price requested, this
approach should be applied.
b) The price elasticity of demand coefficient is consistently negative. This is due to
the fact that demand shifts in the opposite direction when prices do. However,
unfavorable signs are typically ignored.
c) Demand elasticity is a relative concept. It is expressed in terms of percentages or
infractions instead of any specific unit.
 • Arc Elasticity of Demand: Arc elasticity is a measure of the average responsiveness
to price change exhibited by a demand curve over some finite stretch of the curve. Arc
elasticity is the elasticity at the mid-point of an arc of a demanded curve. When
elasticity is computed between two separate points on a demand curve, the concept is
called Arc elasticity.

3.2.7 Meaning and Definition of Income Elasticity of Demand

The relative responsiveness of a commodity's quantity demanded to changes in the
income of the customer requesting it is known as income elasticity of demand. It is
calculated by dividing the proportionate or percentage change in the quantity of a good
that customers demand by the proportionate change in their income. Let's use symbols
 to indicate income elasticity of demand (Yed), where ed is the elasticity of demand and
Y is the income.

Income elasticity of Demand for a commodity indicates how much a consumer's

demand fluctuates as his income changes. It demonstrates how responsive a consumer's
commodities purchases are to changes in income. It is defined as follows: "As the ratio
of proportionate change in the quantity demanded of the commodity to a given
proportionate change in the income of the consumer."

EY = Proportionate change in the quantity demanded /

Proportionate change in the income
In the words of Stonier and Hague, "Income elasticity of demand shows the way in
which a consumer's purchase of any good changes as a result of change in his income”.
"Income elasticity of demand means the ratio of the percentage change in the quantity
demanded to the percentage change in income." Watson
"The responsiveness of demand to change in income is termed as income elasticity of
demand." Richard G. Lipsey

3.2.8 Types of Incomes Elasticity of Demand:

• Zero Income Elasticity of Demand: This is the circumstance in which an increase in
consumer money income causes no rise or decrease in the quantity demanded of the
commodity. Despite an increase in the consumer's income, the amount purchased of
the commodity remains unchanged, and so does Total Expenditure. The zero income
elasticity of demand is written as Ey = 0.
• Negative Income Elasticity of Demand: This is the circumstance in which a rise in
the consumer's money income is followed by a decrease in the quantity requested of
the commodity. This occurs in the case of economically inferior items. The total
spending decreases as income increases. Negative income elasticity of demand is
denoted as Ey< 0.

• Unitary Income Elasticity of Demand: This is the circumstance in which the

proportion of the consumer's income spent on the commodity in issue remains constant
both before and after the increase in income. The income elasticity of demand here is
equal to one. Total expenditure rises at a constant rate proportional to income growth.
The unitary income elasticity of demand is represented as Ey = 1.
 • Income elasticity of demand Greater than Unity: This refers to a condition in which
the customer spends a larger proportion of his money-income on the commodity in
question as he becomes wealthier and more wealthy. In the case of luxuries, the income
elasticity of demand exceeds unity. In this case, total expenditure grows faster than
income. Symbolically, it is written as Ey> 1. If the value of Ey is greater than one, the
income elasticity of demand is considered very elastic.
• Income elasticity of demand Less than Unity: This refers to the circumstance in
which the consumer spends a smaller proportion of his money-income on the
commodity in question as he becomes more wealthy and prosperous. In the case of
necessities, the income elasticity of demand is less than unity, meaning that expenditure
increases in a smaller proportion as the consumer's money income rises. It is denoted
as Ey< 1. If the value of Ey is less than one, the income elasticity of demand is
considered poor.

3.2.9 Meaning and Definition of Cross Elasticity of Demand

Cross Elasticity of Demand is an economic term that measures how the quantity
requested of one commodity responds to changes in the price of another good. It is also
known as cross-price elasticity of demand. It is computed by dividing the percentage
change in quantity required for one commodity by the percentage change in price for
another. e.g. Cheaper aircraft tickets mean fewer rail tickets, and vice versa.This
demand ratio represents the proportionate change in the amount requested of a
commodity X in response to a given proportionate change in the price of a related
commodity Y.

The cross-elasticity of demand refers to the relative responsiveness of the quantity

demanded for a given commodity. It is the proportionate or percentage change in the
amount demanded of a commodity (X) divided by the proportional or percentage
change in the price of a related commodity (Y).

Cross elasticity of demand of X and Y = Proportionate change in the amount

demanded of X / Proportionate change in price of Y

According to Leibhafsky, "the cross elasticity of demand is a measure of the

responsiveness of T to changes in the price of X."

As defined by Ferugson, "the cross-elasticity of demand is the proportional change in

the quantity of good-X demanded resulting from a given relative change in the price of
the related good-Y."

Substitute commodities: A group of commodities that can be used in lieu of one

another and those roughly meet similar needs are known as substitute goods. Coffee
and tea are two examples of replacement items with positive cross-price elasticity’s of
demand. As coffee costs rise, more people will drink tea, therefore when coffee prices
rise, people will hunt for alternatives like tea, which is relatively inexpensive.
 Complementary Goods:Complementary products are those that work together to offer
a sense of accomplishment or add value to another good. Complementary goods have
negative cross-price elasticity’s, which indicates that raising the price of one good will
affect consumption, demand, or the price of another. For example, if sugar is more
expensive, people will consume less tea. The rising cost of blades will very surely affect
the price of Razor.

Importance of Cross Elasticity of Demand: Understanding the idea of cross elasticity

of demand is essential for predicting how changes in an item's pricing will affect
demand for complementary and substitute commodities. As a result, it assists in
determining how much a good will cost by tracking changes in the demand for
complementary and substitute commodities.In addition, the cross elasticity of demand
aids in identifying the type of relationship that exists between two goods—that is,
whether they are complete opposites, complements, or substitutes for one another.
Furthermore, it allows an organization to predict the level of market monopoly intensity
as well as the scope and kind of competition.

1.1 Summary
Demand's responsiveness to a change in an independent variable, like as the product's
price, the consumer's income, or the price of a related commodity, is known as elasticity
of demand. The responsiveness of demand to a specific proportional change in the
commodity's price is known as price elasticity of demand. Demand for a good or service
is sensitive to changes in the consumer's income. This is known as income elasticity of
demand. Demand's responsiveness to a change in the price of a commodity other than
 the one under consideration is known as price cross-elasticity of demand. The price
elasticity of demand coefficient is often negative. However, the price cross-elasticity
of demand and the co-efficient of income might both be positive or negative. The point
approach, which is applied whenever variations in price and amount desired are
extremely tiny, can be used to calculate price elasticity of demand.

1.2 Key Words

Complementary Commodity: A commodity whose demand is closely tied to the
demand of the commodity under consideration.
Cross-Elasticity of Demand refers to how a commodity's demand responds to a
proportional change in its price relative to another commodity.
A dependent variable is one that only varies in response to changes in the independent
variable.
Elasticity of Demand: This term measures the degree to which the quantity of a good
or service demanded is correlated with its price, consumer income, or the price of a
comparable good or service.
Income Elasticity of Demand: The response of demand to a given proportional change
in the consumer's income.
An independent variable is one that can change independently.
Price Elasticity of Demand: This is the responsiveness of demand to a change in the
commodity's price.
Substitute Commodity: A commodity whose demand is inversely proportional to that of the
commodity in issue.

1.3 Practical Questions

1. Define price elasticity of demand, income elasticity of demand, and price cross-
elasticity of demand.
2. Describe how the demand for a substitute and a complement is cross-elasticity.
3. What are the key determinants of elasticity of demand?
4. What are the various methods to measure the elasticity of demand?
5. Differentiate between substitute goods and complementary goods.

1.4 REFERENCES

Perloff, Jeffrey M, 2001. “Microeconomics”, Second Edition, Pearson Education Asia.

Chrystal, Alec and Richard Lipsey, 1997. “Economics for Business and Management”,
Oxford University Press.

Alper, Neil O., Robert B. Archibald, and Eric Jensen. 1987. “At What Price Vanity?
An Econometric Model of the Demand for Personalized License Plates.” National Tax
Journal 40 (March): 103-109.

Beaman, Jay, Sylvanna Hegmann, and Richard DuWors. 1991. “Price Elasticity of
Demand: A Campground Example.” Journal of Travel Research 30 (Summer): 22.

Perloff, J.M.(2014). “Microeconomics”, Second Edition, Pearson Education Asia.

Chrystal, K.A., & Lipsey, R.G. (1997). Economics for Business and Management.
Oxford University Press.

Unit 3
 Demand Forecasting

Objectives:
• Understand the various concepts and objectives of Demand Forecasting.
• Understand the various steps to be followed in forecasting of demand.
• Various methods that can be used for Estimation and Forecasting of
Demand of a product.
STRUCTURE

3.3.1 Introduction
3.3.2 Meaning and Definition of Demand Forecasting
3.3.3 Significance of Demand Forecasting
3.3.4 Objectives of Demand Forecasting
3.3.5 Factors influencing Demand Forecasting
3.3.6Process of Demand Forecasting
3.3.7 Methods of Demand Forecasting
3.3.8 Criteria of a Good Forecasting method
1.1Summary
1.2 Key Words
1.3 Practical Questions
1.4 References

Unit-3
3.3.1 INTRODUCTION
An event's future probability is estimated in a forecast. At every level of an
organization, the majority of administrative choices are either directly or indirectly
predicated on some kind of future projection. If the environment had been steady and
changed at a minimal or predictable rate, there would be no need for a forecast. These
days, our environment's social, economic, political, and technological components are
changing so quickly and in so many different ways that it is difficult to make
predictions, let alone for the near future. Forecasting is now a crucial task that is
integrated into the planning process in practically every aspect of human endeavor,
particularly in the production of goods to meet a wide range of demands.

3.3.2 MEANING AND DEFINITION OF DEMAND FORECASTING:

Demand forecasting is an effort to predict the level of demand in the future based on
information and experience from the past and present in order to prevent both
underproduction and overproduction. It can be predicated on projections of the
industry's total demand potential. Every marketing control attempt uses the demand
forecasting as a point of reference.
Douglas, Evan J. "Demand estimation, often known as forecasting, is the process of
determining values for demand in upcoming time periods.”
According to Cundiff and Still, demand forecasting is the process of estimating sales
for a certain future time using a planned marketing plan along with a number of specific
uncontrolled and competitive elements.

3.3.3 Importance of Forecasting Demand:

• Fulfilling goals: Suggested that each company unit begins with a set of predetermined
goals. Demand forecasting facilitates the achievement of these goals. After estimating
the market's present need for its goods and services, a company takes action to meet its
objectives.
• Budget preparation: Estimating expenses and anticipated income is a critical step in
creating a budget. One company, for example, predicted that 10, 00, 00 units of its
product, which sells for Rs. 10, would be demanded. This means that the total
anticipated revenue would be 10 * 100,000 = Rs. 10, 00, 000.
• Stabilizing employment and production: Aids in the management of an
organization's hiring and production processes. A firm can prevent resource waste by
 producing in accordance with projected product demand. This further aids a company
in hiring personnel in accordance with needs.
• Expanding organizations: Suggested that determining whether to expand an
organization's operation is aided by demand forecasting. The company may want to
grow even more if the anticipated demand for its products is higher. Conversely, if a
decline in product demand is anticipated, the company might reduce its business
investment.
• Making Management Decisions: Aids in making important choices, such determining
the capacity of the plant, the amount of raw materials needed, and guaranteeing the
availability of personnel and capital.
• Performance Evaluation: Assists in rectifying. For instance, if a company's product
demand is lower than expected, it may raise demand by raising the price of its ads or
improving the quality of its products.
• Assisting the Government: Makes it possible for the government to organize
international trade and coordinate import and export operations.

3.3.4 Objectives of Demand Forecasting:

A. Short-term Objectives:
• Creating a manufacturing policy: Assists in filling the gap in the product's supply
and demand. Demand forecasting aids in projecting future raw material
requirements, enabling the maintenance of a steady supply of raw materials. Because
activities are scheduled in accordance with forecasts, it also contributes to the best
possible use of resources. Demand forecasting also makes it simple to meet needs
for human resources.
• Developing price policy: One of the main goals of demand forecasting is mentioned
here. A company determines the price of its goods based on consumer demand. For
instance, there is a decline in product demand when an economy enters a recession
or depression. In this situation, the company sets low prices for its goods.
• Managing sales: Assists in establishing goals for sales, which serve as the
foundation for assessing sales success. An firm estimates demand for several
locations and sets sales goals correspondingly for each.
• Arranging finance: This suggests that demand forecasting is used to estimate the
enterprise's financial needs. This aids in maintaining appropriate liquidity inside the
company.
 B. Long-term Objectives:
• Determining production capacity: This suggests that an organization can ascertain
the size of the plant needed for production with the aid of demand forecasts. The plant's
size should match the organization's requirements for sales.
• Long-term activity planning: It follows that demand forecasting aids in long-term
planning. For instance, if the firm anticipates a strong level of demand for its products,
it may decide to invest in a number of long-term expansion and development initiatives.

3.3.5 Factors or Elements Affecting Demand Prediction:

• Types of Goods: It has a greater impact on demand forecasts. Produced commodities,
consumer items, or services can all be considered goods. Aside from this, fresh and
established commodities are both possible. Products that have already been brought to
the market are known as new products, while established goods are ones that are
already available.
• Degree of Competition: It has an impact on the demand forecasting procedure.
Demand for items is influenced by the quantity of rivals in a market that is extremely
competitive. Additionally, there is always a chance of new entrants in a highly
competitive sector. It becomes hard and complex to forecast demand in such a situation.
• Price of Goods: It has a significant impact on how demand is forecasted.
Organizations' demand predictions are significantly impacted by changes to their
pricing strategies. It is challenging to determine the precise level of product demand in
such a situation.
• Technology Level: It plays a significant role in generating accurate demand
projections. Rapid technological advancement could render current items and
technology outdated. For instance, since compact disks (CDs) and pen drives were
introduced as alternatives for computer data storage, the market for floppy disks has
significantly decreased.
• Economic Perspective: It plays an important part in obtaining demand projections.
For example, if an economy experiences favorable growth, such as globalization and
increased investment, organizations' demand predictions will improve.

3.3.6 Demand Forecasting Steps:

 a) Setting the Objective: This is the first and most important step in the process. Demand
forecasting must have a clear aim before it can be started by an organization. The
following are involved in setting the demand forecasting objective:
• Selecting the forecasting period: Whether an organization should use long-term or
short-term forecasting
• Choosing whether to predict market demand for a product as a whole or just for the
company's own products
• Selecting whether to project demand for the entire market or just a certain market sector
• Selecting whether to project the company's market share
b) Establishing Time Period: This entails selecting the demand forecasting time
perspective. It is possible to forecast demand for a short or long time. The factors that
determine demand may not alter much or may even stay the same in the near term, but
they do vary dramatically over time. As a result, an organization bases the duration on
the goals it has established.
c) Choosing a Demand Forecasting Method: This is one of the most crucial stages in
the demand forecasting procedure. There are several ways to forecast demand.
Depending on the goal of the prediction, the time span, the type of data needed, and its
availability, demand forecasting techniques vary from company to company. To ensure
the accuracy of the data and to save time and money, the right approach must be chosen.
d) Data Collection: Needs to obtain either primary or secondary data. When researchers
gather data for a specific study through observation, interviews, and questionnaires, it's
referred to as primary data. Conversely, secondary data is information that was
gathered in the past but is still relevant to the current situation or study project.
e) Estimating Outcomes: This entails estimating the anticipated demand for a range of
years. The results ought to be presented in an understandable manner and be simple to
interpret. The organization's management or readers should be able to easily understand
the results.

3.3.7 Methods of Demand Forecasting

1. Opinion Polling Method: This approach allows for the collection of opinions from
experts, salespeople, and consumers in order to identify a new market trend. There are
three types of opinion polling techniques used in demand forecasting:
a) Method of Consumer Survey or Survey of Buyer Intentions: Using this strategy,
buyers are asked directly about their future purchase plans. This is the direct approach
 to short-term demand estimation. In this, the buyer bears the increased forecasting
burden. The company can request a full count or only a sample of the surveys.
• Whole Enumeration Survey: All of the local households must be contacted in order
for the company to conduct a door-to-door survey during the forecast period. This
method's main drawback is how much time, labor, and resources it takes.
• Test marketing and sample surveys: Using this approach, a sample of representative
households is randomly picked, and their opinions are interpreted as the opinions of the
general public. Underlying this approach is the fundamental presumption that the
sample accurately represents the population. Other than that, this is a less expensive
and labor-intensive procedure.
• End Use or Input-Output Method: This approach is very helpful for sectors where
the primary product is produced. This method bases the demand survey of the industries
using the product under consideration on the product's sales, meaning that the end user's
demand for the intermediate product used in the production of the final product equals
the demand for the final product.
b) Collective opinion method: Another name for this approach is the sales force method.
With this approach, salespeople's opinions are sought out rather than those of
customers. Because it is a bottom-up technique and each salesperson in the organization
must create a unique forecast for their specific sales territory, it is frequently referred
to as the "grass roots approach." Together with the sales manager, these individual
projections are discussed and decided upon.
c) Expert Opinion Method: This investigative approach is often referred to as the
"Delphi Technique." A panel of experts is needed for the Delphi method, and they are
questioned using a series of questionnaires, each of which is created using the answers
to a previous questionnaire. The technique is employed in long-term forecasting to
project prospective sales of new goods. Two requirements are assumed by this method:
First and foremost, the panelists need to have a wealth of experience and understanding.
Second, its conductors carry out their duties impartially. The time and resource savings
offered by this technology are unique.
2. Statistical Method: Demand forecasting has shown statistical methods to be incredibly
helpful. The statistical approaches are employed to preserve objectivity, which is
achieved by taking into account all ramifications and looking at the issue from an
outside perspective.
 a) Trend Projection Method: An established business will have its own historical sales
data. When presented in a chronological order, these data are called "time series." A
time series displays historical sales along with the effective demand for a specific
product under typical circumstances. For additional analysis, such data may be
provided in tabular or graphic form.
• Graphical Method: This is the simplest way to determine a trend. All output or sale
data from various years are shown on a graph, and a smooth free-hand curve is
constructed through as many points as possible.
• Least Squares approach: Using statistical methods like least squares regression, a
trend line can be fitted to time series data using the least squares approach. When a
straight line show the sales trend over time, the equation for this line looks like this:
y = a + bx.
Σ y = na + b ΣX
b) Barometric Method: A barometer is a change-measuring device. The idea that "the
future can be predicted from certain happenings in the present" is the foundation of
this approach. Put differently, the foundation of barometer methods is the notion that
specific current events can be utilized to forecast future changing trends.
c) Regression Analysis: It seeks to examine the relationship between at least two
variables (one or more independent and one dependent), with the goal of predicting the
dependent variable's value based on the independent variable's specific value. In
general, previous data is used to make this prediction. This strategy is based on the
notion that two variables have a basic relationship.
d) Econometric Models: An extension of the regression technique, econometric models
include solving a set of independent regression equations. Three categories apply to the
requirements for a proper use of the econometric model in forecasting: variables,
equations, and data. Model construction is the proper process for using econometric
tools for predicting. Econometrics aims to quantify the influence of one economic
variable on another in order to forecast future events and to represent economic theories
in mathematical terms that can be validated by statistical techniques.

3.3.8 Criteria of a Good Forecasting method

• Accuracy: The obtained forecast needs to be precise. How can a forecast be so
accurate? It is crucial to compare the accuracy of previous forecasts against current
 performance as well as current projections against future performance in order to get
an accurate forecast. Exact measurement cannot decide accuracy; only judgment can.
• Durability: Unfortunately, a demand function based on prior experience can be quite
costly and fall apart quickly as a forecaster. The long-term forecasting capability of a
demand function is determined in part by the logic and simplicity of the functions fitted,
but mostly by the stability of previously observed understanding correlations. Of
course, the level of durability influences the forecast's acceptable cost.
• Flexibility: It is possible to think about flexibility as an alternative to generality. A
long-term structure based on fundamental natural forces and human motivations could
be established. A group of variables whose coefficients could be periodically changed
to more practically adapt to shifting circumstances while preserving the standard
forecasting process.
• Availability: Finding appropriate approximations to relevance with delayed data is a
constant source of frustration for forecasters, as it requires immediate access to
information. The methods used ought to yield significant outcomes in a timely manner.
Decisions made by managers will suffer from a delay in results.
• Economy: The cost factor should be carefully balanced with the projections'
significance to the company's operations. One may wonder how much funding and
administrative work are necessary to achieve a high degree of predicting accuracy.
Here, the economic factor serves as the criterion.
• Simplicity: Although unbearably complex, statistical and economic models are
undoubtedly useful. These techniques might seem like Latin or Greek to executives
who are afraid of numbers. Therefore, the process have to be straightforward and
uncomplicated so that management can recognize and comprehend the rationale for the
forecaster's adoption of it.
• Consistency: The forecaster must manage a number of independent components. He
would obtain an overall result that would seem consistent if he did not modify one
element to align it with a forecast of another.

1.1 Summary
Forecasts are essential for creating production schedules and figuring out what
materials are needed to make inventories. You have learned about the significance of
demand forecasting in business in this unit. The foundation for coordinating plans for
activity in different departments within a firm is provided by forecasting. It gives the
 business important information. As a result, caution should be used while predicting
anticipated value. It's not easy to develop a forecasting system. Since forecasting is
essential to all planning, it must be done. The foundation of corporate long-term
planning is forecasting. Predictions serve as the foundation for cost control and
budgetary planning in the functional domains of accounting and finance. Forecasts are
used by staff members in production and operations to help them make regular
decisions about facility layout, capacity planning, and process selection.

1.2 Key Words

Barometric Method: A barometer is a change-measuring device.
Demand forecasting is a prediction or estimation of the future demand.
Expert Opinion Method: A panel of experts is needed for the Delphi method, and
they are questioned using a series of questionnaires, each of which is created using the
answers to a previous questionnaire.
Regression makes use of both economic theory and estimation techniques to generate
forecasts from historical data.
Trend Method is a forecasting technique, where the time series data on thevariable
under forecast are used to fit a trend line or curve either graphically or bymeans of a
statistical technique known as the Least-Squares method.

1.3 PRACTICAL QUESTIONS

1. Explain the term demand forecasting and its various objectives.
2. What are the various methods of demand forecasting? Explain with suitable examples.
3. What are the different criteria for a good forecasting method?
4. Explain the procedure for demand forecasting with suitable illustrations.
5. What are the factors influencing the forecasting of demand?

1.4 REFERENCES

• Buffa E. S. and Sarin, R. S., (2000), Modern Production/Operations Management, John

Wiley.
• Calley, John L. et. al., (1977), Production Planning and Control, Holten Day Inc.
• Greene James H., (1970), Production and Inventory Control Handbook, McGraw Hill.
 • Krajewski Lee J., (2000), Operations Management : Strategy and Analysis, Addison-
wesley.
• Taha Hamdy A. and Ritzman Larry L., (2000), Operations Research : An Introduction,
Prentice Hall of India.
• Starr Martin K., (1976), Production Management : Systems and Synthesis, Prentice
Hall of India.

Block 4
Business Economics
OBJECTIVE
• Define the factors of production, such as land, labor, capital, and organization;
• Describe the production function or the relationship between inputs and outputs;
• Explain the link between of total product, average product, and marginal product;
• Understand the law of variable proportions and recognize the three stages of
production.
UNIT 1 THEORY OF PRODUCTION
Structure
4.1.1 Introduction
4.1.2 Meaning and Definition of Production
4.1.3 Factors of Production
4.1.4 Production Function
4.1.5 Features of Production Functions
4.1.6 Assumptions for Production Function
4.1.7 Types of Production Function
4.1.8 Law of Variable Proportion
4.1.9 Assumptions for the Law of Variable Proportion
4.1.10 The phases of the Law of Variable Proportion
4.1.11Reasons for Variable Proportion:
4.1.12 Law of Returns to Scale: Definition and Stages
4.1.13 Increasing Returns to Scale:
4.1.14 Decreasing Returns to Scale
4.1.15 Constant Return to Scale
4.1.16 Relationship between TP, MP, and AP
4.1.17 What is Supply Law?
4.1.18 Law of Supply assumptions
4.1.19 Supply Schedule and Supply Curve
4.1.20 Exceptions to the Law of Supply
1.1 Summary
1.2 Keywords
1.3 Self-Assessment Questions
1.4 References

Unit- 1
4.1.1 INTRODUCTION
Production is the process of transforming various material and immaterial inputs into
consumable outputs. The production process promotes economic well-being. The
production determines the satisfaction of demands. Production is the consequence of
the cooperation of four production components (land, labor, capital, and organization).
In economics, production means the creation or addition of value. It simply transforms
 inputs into outputs. Production may be at different levels. The scale of manufacturing
affects the cost of production. All manufacturers understand that when a commodity is
produced on a greater scale, the average cost of production is lower. This is why
entrepreneurs are interested in increasing the size of production for their products. They
will benefit from the associated economies of scale. There is also the prospect of
making their items available in the market at a lesser cost.

4.1.2 MEANING AND DEFINITION OF PRODUCTION

In economics, production is sometimes defined as the generation of utility or the
development of demands - goods and services that satisfy customers. It is stated that
just as man cannot destroy matter, he cannot create it. Production in Economics is a
critical economic activity. As we all know, any firm's survival in a competitive market
is dependent on its capacity to produce goods and services at a competitive price. In
economics, production is the transformation of tangible and intangible inputs into
goods or services. Raw resources, land, labor, and capital are tangible inputs, while
ideas, information, and knowledge are intangible inputs. These inputs are sometimes
called production factors.

James Bates and J. R. Parkinson: In economics, production is defined as the

organised process of transforming physical inputs (resources) into outputs (finished
products) that meet the demands of society.

J.R. Hicks: In economics, production is any activity, physical or mental, that is geared
toward satisfying the desires of others through exchange.

4.1.3 FACTORS OF PRODUCTION

In economics, factors of production are the inputs utilized to produce the final output
with the goal of making a profit. The primary components of production are land, labor,
capital, and entrepreneurs. Each aspect is significant and plays a unique role in the
structure.
1. Land: Land is nature's gift, consisting of the earth's dry surface and natural resources like
woods, rivers, and sunlight. Land is used to generate income known as rent. Land is
available in set quantities and so has no supply price. This suggests that a change in land
prices has no effect on supply. Rent is the monetary return on land.
Characteristics that qualify a certain component to be considered land:
• Nature provides land as a free gift.
 • It is permanent and has indestructible properties.
• It is a passive factor.
• Land is immovable, multi-use, and heterogeneous.

2. Labour: Labour refers to the physical and mental efforts of humans involved in the
producing process. It comprises unskilled, semi-skilled, and skilled labour. The price
change has an impact on the supply of labour. It rises in response to pay increases. Wages
and salaries are the terms used to describe the compensation for labour.
Labour characteristics include:
• Human effort.
• Labor is perishable.
• It is an active factor.
• It is inseparable from the laborer.
• Labor power varies by laborer.
• Not all labor is productive.
• Labor has low bargaining power.
• Labor supply does not quickly adjust to demand.
• Laborers can choose between working and leisure hours.

3. Capital: Capital refers to the wealth created by humans. It is a crucial aspect in the
production of all types of goods and services since production cannot occur without the
involvement of capital. Capital is an outcome from one production process that is used as
an input in another. Capital as a factor of production is separated into two parts: physical
capital and human capital. Physical capital refers to tangible resources such as buildings,
machineries, tools, and equipment. Human capital refers to the information and abilities
that human resources acquire via education, training, and experience. The return on capital
is known as interest. Capital types include fixed, circulating, real, human, tangible,
individual, and social capital.

4. Entrepreneurship: Entrepreneurship involves three primary functions: coordination,

management, and oversight. An entrepreneur is a person who establishes an enterprise. The
entrepreneur's efficiency determines whether the venture succeeds or fails. An enterprise
is a company that conducts commercial activities or business operations with an emphasis
on delivering goods and services. An enterprise is made up of people and physical assets
 that work together to generate profits. An entrepreneur's responsibilities include starting a
business, coordinating resources, managing risks and uncertainties, and driving innovation.

4.1.4 PRODUCTION FUNCTION:

The Production Function refers to the link between physical inputs (such as land, labor,
and capital) and physical outputs (amount produced). It is a technical relationship that
examines material inputs and outputs. Material inputs encompass both variable and fixed
components of production. In a conventional equation, Q represents the production
function, L represents labor (the variable), and K represents capital (the fixed element).
Q = f (L, K)
Production is the process by which businesses convert inputs into outputs. Production is
the process of converting inputs into outputs that people can utilize to meet their needs.
Production is essentially the translation of inputs into outputs. Input refers to anything used
in the manufacture of a commodity, whereas output refers to what is generated at the end
of the process. The Production Function defines the relationship between the inputs and
outputs.
According to Watson's definition, the "Production Function is the relationship between
a firm's production (output) and the material factors of production (input)."

4.1.5 Features of Production Functions

1. Complementary: A producer must integrate the inputs to make outputs. Outputs
cannot be formed without inputs.

2. Specificity: For each given result, the possible input combinations are explicitly
described. Before production begins, it is clearly stated what types of variables are
required for the manufacture of a specific product.

3. Production Period: The duration of the manufacturing process is explicitly

communicated to the production unit. Each stage of production is allocated a set time.
Production is typically done over a long period of time.

4.1.6 Assumptions for Production Function

• The inputs and outputs are divisible.
• There are only two factors of production: land (variable) and capital (fixed).
• Factors of production are imperfect replacements.
• Technological advancements are ongoing.
4.1.7 Types of Production Function
Production functions are separated into two groups based on time period: short run
production functions and long run production functions. In these production functions,
variable and fixed components combine and behave differently.

1. Short-Run Production Function: A short run is a period of time during which output can
only be adjusted by adjusting the level of variable input. In the short run, certain factors
are flexible while others are fixed. Land, capital, plant, machinery, and so on are all fixed
components that remain constant in the short run. Production can be increased by simply
raising the level of variable inputs such as labour. As a result, the circumstance in which
output is increased solely by raising the variable elements of input while keeping the fixed
variables constant is referred to as the Short Run Production Function. This link is
explained by the 'Law of Variable Proportions.'

2. Long Run Production Function: The long run is a period of time in which output can be
enhanced by increasing all production factors, whether fixed (land, capital, plant,
machinery, etc.) or variable (labor). The long run allows for enough time to change all of
the production parameters. Long-term variability is claimed to exist for all causes. As a
result, the Long Run Production Function refers to the circumstance in which output is
increased by increasing all inputs at the same time and in the same proportion. This link is
explained by the 'Law of Returns to Scale.'

In the graph above, the X-axis shows inputs used in the production process, while the Y-
axis represents products created. Q represents the production function. Variables are factors
that can be adjusted in the short run. Variable factors fluctuate according to the degree of
output. An increase in variable factors leads to increased output and vice versa. When there
is no production, the use of variable factors is unnecessary. Variable factors include labor,
power, fuel, and so forth. Fixed factors are those that cannot be changed in the short term.
Even with zero production, the number of fixed factors remains constant. Fixed factors
include land, capital, buildings, and so on.
4.1.8 WHAT IS THE LAW OF VARIABLE PROPORTIONS?
Consider a farmer who cultivates wheat solely by employing increasing amounts of labor
in a situation where land is a fixed factor and labor is variable. Here's a critical question:
Will each additional unit of labour used in the given region generate an equal amount of
wheat? In other words, will the MP of labor remain constant with each new unit of labor
used? Never say, "Maybe." This is not possible. If the MP of labour remained constant, a
country like India could have produced more and more wheat by employing more and more
labour on the same plot of land. There would not have been a food scarcity. The reality is
that MP will eventually diminish.

The reason is simple: there is always some ideal ratio of the factors of production. The
ideal ratio can only be maintained by modifying L if both L (Labour) and K (Capital) exist
and K is a constant. MPL should be at its maximum value to correlate to the best K:L ratio.
However, after the appropriate ratio is achieved, any increase in L indicates excessive
utilization of the variable component.

Alternatively, it would suggest a decrease in fixed factor availability for each unit of the
variable component. It could also mean overusing the fixed factor. As a result, MPL must
begin to decline. It is possible that adding a new labor unit (on the same area) will
eventually have no effect on overall output. This indicates that MPL reaches zero. As
previously indicated, MP may even turn negative in certain instances. This is how the Law
of Returns, often known as the Law of Varying Proportions, works.
Returns to Factor: The Law of Variable Proportions
Returns to a Factor relate to the increase in total product that follows from raising only one
factor while keeping the others unchanged. In the near run, the firm's production follows the
Law of Variable Proportions when one input is variable and the others are fixed.

Statement on the Law of Variable Proportion

According to the Law of Variable Proportions, increasing the quantity of only one input while
keeping the other inputs constant causes the total product to increase initially at an increasing
pace, then at a decreasing rate, and finally at a negative rate.

According to the law of variable proportions, changes in TP and MP can be divided into three
phases:
• Phase 1: TP rises at an increasing rate, and MP increases.
• Phase 2: TP rises at a decreasing rate, MP decreases and is positive.
• Phase 3: TP falls, and MP becomes negative.

4.1.9 Assumptions for the Law of Variable Proportion

• It acts in the short term because the factors are classified as variable and fixed.
• The law applies to all fixed factors, including land.
• The law of variable proportions allows for the combination of many variable units and fixed
elements.
• This law is largely applicable to the production sector.
• It is simple to calculate the impact of a change in output due to a change in variable factors.
• It is believed that after a certain point, components of production become imperfect
substitutes for one another.
• This law assumes that the state of technology will remain constant.
• All variable elements are believed to be equally effective.

Example of Law of Variable Proportions

Assume a farmer owns one acre of land (fixed factor) and wishes to use labor (variable factor)
to increase rice production. The output increased at first at an increasing rate, then at a declining
rate, and then at a negative rate as he employed more and more units of labor. The following
table shows the output behavior in this scenario.
4.1.10 The phases of the Law of Variable Proportion
Phase I: Increasing Returns to a Factor (TP increases at an increasing rate)
During the first stage, each additional variable component increases total production by an
increasing amount. This suggests that the MP of each variable increases, as does the TP. It
happens when the initial variable input quantity is too low in relation to the fixed input.
Because of the division of labor, efficient utilization of the fixed input during production boosts
the productivity of the variable input. According to the schedule and diagram, one laborer
produces 5 units, while two laborers produce 20 units. It means that MP rises until it reaches
its maximum at point P, which marks the conclusion of the first phase, but TP climbs at a faster
pace (up to point Q). Point of Inflexion: The point of inflexion is when the slope of the TP
curve changes. TP grows at an increasing pace until it reaches the point of inflexion, after
which it decreases.

Phase II: Decreasing Returns to a Factor (TP increases at a decreasing rate)

Each additional variable in the second phase raises the output by a decreasing amount. This
shows that when the variable factor increases, MP lowers and TP climbs at a decreasing pace.
This stage is referred to as declining returns to a factor. This occurs as a result of pressure on
fixed inputs, which causes a decrease in variable input productivity after a given level of
output. When MP is zero (point S) and TP is at its maximum (point M) of 40 units, the second
phase ends. The second phase is critical because a rational producer will always try to produce
during this time since MP and TP are both positive for each variable element.

Phase III: Negative Returns to a Factor (TP Falls).

The third phase exhibits a decrease in TP due to the usage of more variable elements. MP has
now become negative. As a result, this stage is known as "negative returns to a factor." It occurs
when the amount of variable input surpasses the fixed input by a significant margin, causing
TP to fall. The third phase in the graph above starts after points S on the MP curve and M on
the TP curve. During the third phase, MP for each variable factor is negative. As a result, no
company would consciously want to operate during this phase.

4.1.11 Reasons for Variable Proportion:

A. Reasons to Increase Returns to a Factor (Phase I)

• More Effective Use of Fixed Factors: Initially, a lot of fixed components are available,
but there are insufficient variable factors. The fixed factor is thus not fully utilized. When
variable factors are raised and integrated with fixed factors, the fixed factor is more
effective, and output increases at a faster rate.

• Improved Efficiency of Variable Factor: To make better use of the fixed factor, the
variable factors must be multiplied and merged. Furthermore, there is a high degree of
specialisation and enhanced collaboration among the many units of the variable factors.
• Fixed Factor Indivisibility: In general, fixed elements that are combined with variable
components are not divisible. It signifies that these elements cannot be subdivided into
smaller units. As additional units of the variable components are provided, the utilisation of
the fixed factor improves following an investment in an indivisible fixed factor. As long as
the appropriate level of variable and fixed component combination is achieved, growing
returns are possible.

B. Reasons for Decreased Returns to a Factor (Phase 2)

• Over-utilization of Resources: As the variable factor increases, the fixed component

eventually hits its limits and begins to produce diminishing returns.

• Optimum Factor Combination: There is only one optimal combination of a variable and
a fixed factor that maximizes the overall product. After the fixed component has been used
to its full capacity, the variable factor's marginal return begins to decline. For example, if a
machine (fixed factor) is being used to its full potential with four workers, adding a fifth
worker will only slightly boost TP while decreasing MP.

• Imperfect Substitutes: Fixed and variable factors are imperfect substitutes for one another,
resulting in diminishing returns. One factor of production can be substituted for another
only to a certain extent. For example, until a certain point, capital may be utilized instead of
labor, or labor may be employed in place of capital. After a certain point, they begin to lag
behind each other and produce falling returns. Fixed and variable factors are unsatisfactory
substitutes for one another, resulting in decreasing returns on a factor. There is a degree to
which one factor of production can be substituted for another. For example, until a certain
point, capital can be employed instead of labor, or vice versa. Beyond a certain point, they
begin to lag behind one another, producing falling results.

C. Reasons for Negative Returns to a Factor (Phase 3)

• Limitations of Fixed Factors: Some production factors have negative returns because they
are fixed in nature and cannot be raised in the short run while the variable factor increases.

• Lack of Coordination: When the variable factor outweighs the fixed factor, they interfere
with each other. It leads to a lack of coordination between the fixed and variable factors. As
a result, overall output decreases rather than increases, and marginal product becomes
negative.
• Variable Factor Efficiency Decrease: As variable increase, the benefits of specialization
and division of labour tend to wane. It increases inefficiencies in variable components,
which contributes to negative returns.

4.1.12 LAW OF RETURNS TO SCALE: DEFINITION AND STAGES

Returns to scale relate to the change in output caused by changing the factor inputs in the
same proportion over time. Changing the quantity of all inputs throughout time alters the
scale of production for the goods. Watson, "Returns to Scale is related to the behaviour of
total output as all inputs are varied in same proportion and it is a long run concept."
Koutsoyiannis, a Greek economist: "The term returns to scale refers to the changes in
output as all factors change by the same proportion."
According to Leibhafsky, "Returns to scale relates to the behaviour of total output as all
inputs are varied and is a long run concept".

4.1.13 Increasing Returns to Scale:

When all production components are increased, output
rises faster. This is also known as declining costs. It
means that if all inputs are doubled, the output will
increase at a rate faster than twofold. As a result, it is
said to improve returns to scale. This growth is due to
a variety of factors, including division and external
economies of scale. In Figure, the OX axis depicts an
increase in labor and capital, but the OY axis reflects
an increase in production. When labor and capital rise
from Q to Q1, output increases from P to P1, which
exceeds the factors of production, i.e. labour and capital.
4.1.14 Diminishing Returns to Scale
The term "diminishing returns to scale" refers to a
production situation where increasing all factors of
production in a fixed percentage results in a lesser
rise in output. It signifies that doubling the inputs
will result in an output that is less than doubled. If a
20% increase in labor and capital is followed by a
10% rise in output, this is an example of diminishing
returns on scale. The primary cause of diminishing
returns to scale is that internal and external economies are smaller than internal and external
diseconomies.

4.1.15 Constant Returns to Scale:

Constant returns to scale, also known as
constant cost, refers to a manufacturing
situation where output increases according to
the growth in factors of production. Simply
said, doubling the factors of production
doubles the output. In this situation, internal
and exterior economies are identical to internal
and external diseconomies. This occurs when,
after reaching a particular level of output,
economies of scale are balanced by
diseconomies of scale. This is known as a homogenous production function..

4.1.16 RELATIONSHIP BETWEEN TP, MP, AND AP

Consumers and producers both play important roles in the smooth operation of an economy.
A producer employs a variety of inputs to create goods and services. Production is an
important economic activity because it converts the product into the form that consumers
require, therefore improving its utility. The term "product" refers to the quantity of items
produced by a firm or industry over a specific time period. The product concept can be
viewed from three perspectives:

Total Product (TP):

 Total Product (TP) is a firm's total quantity of items produced in a specific time period and
number of units. For example, if five workers produce 6 kg of wheat, the total output is 30
kg. A corporation can boost TP in the short term by focusing on the variable components.
However, both fixed and variable factors can be raised gradually to raise TP. Other names
for Total Product are Total Physical Product, Total Return, and Total Output.

Average Product (AP):

Average Product (AP) measures output per unit of a variable input. For example, if the
overall product is 30 kg of wheat produced by 5 labourers (varying inputs), the average
product is 30/5, or 6 kg. To compute AP, divide TP by the variable factor units.
Marginal Product (MP):
Marginal Product (MP) is the increase in total product when one more unit of a variable
factor is used. It computes the additional output for each additional unit of input while
keeping all other inputs constant. Other names for marginal product include marginal
physical product (MPP) and marginal return.
4.1.17 WHAT IS SUPPLY LAW?
Economists have examined the actions of sellers as well as purchasers. As a result of their
research, the law of supply was developed. When all other factors stay constant, or ceteris
paribus, the relationship between price and quantity supplied is described by the law of
supply.One of the main determinants of a commodity's supply is its price. An increase in price
of a commodity also results in an increase in its supply on the market, and vice versa. The law
of supply is used to study this producer behavior.

4.1.18 Law of Supply assumptions

• Other goods always have the same price.
• Technology is still in the same state.
 • Factors of production have a fixed cost.
• The tax code is still in effect.
• The producer's goals never change.

4.1.19 Supply Schedule and Supply Curve

Key information regarding the Law of Supply:

• Assuming all other variables stay constant, the law of supply describes the positive
relationship that exists between the quantity supplied and the price of a good.

• Since the law of supply only shows changes in the direction, not the magnitude, of the
quantity supplied of a good or service. It's regarded as a quantitative assertion.

• There is no proportionate link established by the law of supply between a change in the
quantity provided of a commodity and its corresponding price change.

• There is a bias in the law of supply. The reason for this is that the legislation primarily
addresses how price changes affect a commodity's supply, not how supply changes affect a
commodity's price.

Why the Law of Supply Exists

• Profit Motive: When producers provide a good or service, their main objective is to
maximize earnings. When a commodity's price increases without corresponding changes in
costs, their profits increase. Therefore, producers raise the supply of the good by raising
production. On the other side, because low prices translate into smaller profit margins,
supply likewise decreases when prices fall.
• Shift in the Number of Firms: Potential producers are enticed to enter the market and
create the good in order to profit when the price of a certain commodity rises. As more
enterprises enter the market, the supply of goods increases. But, some companies who don't
think they can profit at a low price can reduce or cease manufacturing if the price starts to
drop. The supply of a certain commodity reduces as the number of enterprises in the market
declines.

• Change in Stock: Sellers are happy to supply more items from their stocks when the price
of an item increases. But the manufacturers don't offer a large portion of their inventory for
a much lower price. In preparation for future price rises, they strive to grow their inventory.

4.1.20 Exceptions to the Law of Supply

The supply curve often has an upward slope, indicating that as a commodity's price
increases, so does the quantity supplied. Nonetheless, there might be instances in which the
price and supply of a good are not positively correlated. The following are these cases:

Future Expectations: If sellers anticipate a price decline in the future, the law of supply is
not applicable. In this case, the vendors will be open to selling more, even for a lower price.
On the other hand, vendors that anticipate a price increase in the future will lower their
supply in order to deliver the goods later and for a higher price.

Agricultural Goods: Since agricultural products are generated in response to climatic

conditions, they are free from the rule of supply. Even at higher prices, supply cannot be
increased if unanticipated weather patterns result in low agricultural production.

Perishable Goods: Despite declining prices, sellers are nevertheless prepared to offer a
greater variety of perishable goods, such as fruits, vegetables, and other consumables. This
happens because vendors are unable to hold such items for a long time.

Rare Articles: Artistic, rare, or precious products are exempt from the law of supply. For
instance, the quantity of rare objects, such as the artwork of Mona Lisa, cannot be raised,
even if the price does.

Backward Countries: In economically backward nations, output and supply cannot be

increased due to resource constraint.

1.1 SUMMARY
As we've seen, a number of variables must come together for any production process to
occur. There are variables and fixed factors among the factors. The components are divided
 into four categories: capital, labor, land, and entrepreneurs or organizations. The production
function is the relationship between the inputs (different production parameters) and the
output. The highest output that may be achieved with a certain combination of inputs is
specified by a production function. The production manager must select the best input-
output combination for the given cost in order to maximize earnings. We have demonstrated
in this section how a production manager seeks to maximize profit by minimizing costs
associated with a given output. It has also been observed that the total amount of whatever
that a company produces is referred to as its Total Product, and the additional product that
is generated, all other things being equal, with each additional variable input is referred to
as its Marginal Product. We also discovered that the drop in this Marginal Product—that is,
the point at which a rise in input actually lessens an increase in output—explains the rule of
diminishing returns. Production analysis involves the systematic examination and
evaluation of the processes and factors influencing the creation of goods or services within
an economic system.

1.2KEYWORDS
Average Product: The product obtained by dividing the total product by the quantity of
input used.

Constant returns to scale (CRS) is an economic concept that describes a situation in which
the proportional increase in inputs results in an equivalent increase in output. In other words,
if all inputs are increased by a certain percentage, the output will also increase by the same
percentage.

Diminishing Returns to Scale: When output increases proportionately less than input, this
is referred to as having diminished returns to scale.

Factors of Production: All the elements that go into making something.

Increasing Returns to Scale: This is the situation where output increases proportionately
faster than inputs.

Law of supply is a fundamental principle in economics that describes the relationship

between the price of a good or service and the quantity that producers are willing to offer
for sale in a given period.

Marginal product refers to the additional output or production that results from using one
more unit of a variable input while keeping all other inputs constant. In other words, it
 measures the change in output associated with a one-unit change in the quantity of a specific
input.

Production Function: The relationship between inputs and output expressed

mathematically as Q = f (x1, x2, x3, n) where x1, x2, n represents the various inputs and Q
represents the maximum output, which can be the quantity of rice, fish, computers, cars, or
pens produced.

Production management is the process of organizing, staffing, running, maintaining, and

centralizing a manufacturing organization's operations. It is in charge of the real conversions
of raw resources into finished products that can be sold.

Production Manager: The individual tasked with overseeing the production process is
known as the production manager.

Supply Curve: A graph that illustrates the relationship, with other influencing factors being
constant, between the price of a good and the quantity supplied over a specific time period.

Supply Schedule: A table with two columns that displays the commodity's various prices
in one column and the quantities provided at each of these prices during a specified time
period in the other.

Total product refers to the overall quantity or total output of goods or services produced
by a firm during a specific period using various combinations of inputs, such as labor and
capital.

1.3 SELF-ASSESSMENT QUESTIONS

1 What do you understand by the term Production? Explain the various factors of
Production.
2 What is the production function, and how does it relate to the concept of inputs and
outputs in economics?
3 Explain the law of increasing and diminishing marginal returns. How does this concept
influence the short-run production decisions of a firm?
4 What is the difference between total product, average product, and marginal product in
the context of production analysis? How are these measures related?
5 Explain the difference between Supply Cuve and Supply Schedule. What are exceptions
of Law of Supply?
6 What conditions or assumptions are necessary for the law of variable proportions to hold
true in a given production scenario?

1.4REFERENCES
Adhikary, M (1987), Managerial Economics (Chapter V), Khosla Publishing House,
Delhi.

Maddala, G.S., and Ellen Miller (1989), Micro Economics: Theory and Applications
(Chapter 6), McGraw-Hill, New York.

Maurice, S.C., Thomas, C.R., and Smithson, C.W (1992), Managerial Economics:
Applied Microeconomics for Decision Making (Chapter 9), Irwin Inc, Boston. Mithani,
D.M .1982. Modern Economic Analysis, Himalaya Publishing House, Bombay

Mote, V.L., Samuel Paul, and G.S. Gupta (1977), Managerial Economics: Paul A.
Samuelson and William D. Nordhaus. 1990. Economics. McGraw-Hill, Inc

Concepts and Cases (Chapter 3), Tata McGraw-Hill, New Delhi.

Ravindra H. Dholakia and Ajay N. Oza (1996), Micro Economics for Management
Students (Chapter 8), Oxford University Press, Delhi.

UNIT 2
OBJECTIVE
• Being familiar with some of the cost ideas that are regularly applied in managerial
decision-making;
• Identify the short-run cost function & Long run cost function; and
• Recognize the ways in which the short-run cost and Long run cost function is applied
to managerial decision making.

THEORY OF COST & THEORY OF REVENUE

Structure
4.2.1 Introduction
4.2.2 Meaning and Definition
4.2.3 Types of Costs
4.2.4 Cost Function
4.2.5 Relationship of Cost Function
A. Short-term cost-output relationship
B. Long-term cost-output relationship
C. Cost Control & Cost Reduction
4.2.6 Economies and Diseconomies of scale
A. Internal Economies of Scale
B. External Economies of Scale
C. Diseconomies of Scale
D. Internal Diseconomies of Scale
E. External Diseconomies of Scale
4.2.7 Meaning and Definition of Revenue
4.2.8 Relationship between TR, MR and AR
1.1Summary
1.2 Keywords
1.3 Self-Assessment Questions
1.4 References
 Unit-2
4.2.1INTRODUCTION
Cost analysis is crucial to the study of managerial economics because it forms the
foundation for two critical decisions that managers must make: (a) whether or not to
produce, and (b) how much to create after production is decided upon. Short-term and
long-term cost analyses are the two different forms of cost analysis.This unit will cover
a number of significant cost ideas that are pertinent to managerial choices. We discuss
how accountants and economists approach various cost ideas differently, as well as the
fundamental distinctions between these two schools of thought. Our topic of discussion
will be the short run cost function and how managers use it to make decisions. To
determine the best combination of inputs to meet a specific output goal for a company,
managers might use the short-term cost estimates.

4.2.2 MEANING AND DEFINITION

Cost is the sum of money that a business spends developing or producing a good or
service. Cost is the term used to describe the out-of-pocket costs associated with
providing goods and services to customers. Cost is the sum of money required to
produce or carry out an action. In this context, "cost" refers to the overall amount of
money required for a firm. When managers must choose between several options for
action, costs are a crucial factor to consider. It assists in defining different options
according to their numerical values. The whole amount of money required to produce
a specific amount of product is referred to as the cost.
Wallace and Gulhrie: "Cost of production has a unique meaning in the field of
economics. It all comes down to the payments or expenses necessary to obtain the
labor, capital, land, and managerial factors of production required making a good. It
represents the monetary expenses that must be paid in order to obtain the production
ingredients.
According to Campbell, "Production costs are the expenses that resource owners
should essentially bear in order to assume that they will continue to supply them in a
given period of time."

4.2.3 TYPES OF COSTS

• Fixed cost: The term "fixed cost" refers to an expense that remains constant
regardless of how much a company produces. Because fixed costs are not
 influenced by production variables like volume, they are less manageable than
variable costs. Two instances of fixed costs are salaries and rent.

• Variable cost: This kind of cost is defined as one that will fluctuate in response to
shifts in production levels. Variable costs rise or fall in proportion to an
organization's production volume. The price of labor, raw materials, and other
expenses are some instances of variable costs.

• Average Cost: The average cost per unit of production is calculated by dividing
the total cost by the total output. Per unit cost of production takes into account all
fixed and variable costs when computing the average cost. Thus, it is often referred
to as Per Unit Total Cost. The average cost is represented symbolically as: AC =
TC/Q.

• Marginal Cost: The extra expense incurred when producing an extra unit of output
is known as the marginal cost. The process of calculating the amount of change in
aggregate costs resulting from an increase of one unit over the current level of
production is known as marginal costing. It results from the creation of new output
increments as a result.

• Total Cost: The term "total cost" describes the production's entire cost, comprising
both fixed and variable expenses. The cost necessary to manufacture a good is
referred to as the whole cost in economics.
Total Costs = Variable Cost + Fixed Cost

• Opportunity costs: Alternative costs are referred to as opportunity costs.

Organizations allocate the few resources they have to the most productive option,
forgoing the revenue that would have been generated by the second-best option.
The return from the firm's second-best use of its limited resources is known as
opportunity cost. Let's say that an organization has two different courses to choose
from and a capital resource of $1,000. Either a photocopier or a printing machine
with a 12-year productive life cycle can be purchased with it.

• Actual Cost: The term "actual cost," also known as "outlay cost" or "absolute cost,"
refers to the actual sum of money spent on creating or purchasing a good or service.
These are the expenses that are noted in the books of accounts for financial or cost-
related reasons, such paying salaries, buying raw materials, covering other costs,
etc.
• Shut-down costs: These are expenses that would arise if plant operations were
suspended but that could have been avoided if they had gone forward, such as costs
associated with storing exposed property. When activities are resumed, more costs
might need to be paid.

• Abandonment Costs: Costs connected with completely retiring a facility from

service are known as abandonment costs. When operations are completely stopped,
abandonment occurs. When management must decide whether to keep running the
current factory, pause operations, or close it down completely, these expenses start
to matter.

• Direct cost: Direct costs are those associated with using different manufacturing
inputs that are paid for in cash. In order to generate his goods and services, the
producer really pays money. The costs associated with producing a commodity
directly include labor, materials, overhead, selling and distribution costs, and
administrative costs. It is true to its nature.

• Indirect cost: An alternative production element is hired by the company at the

expense of other costs, which are let go of or sacrificed. These expenses represent
the variables of production's opportunity costs. Imputed cost is another name for
implicit cost. There is no cash outflow in this instance.

• Past Cost: Expenses that were really incurred in the past are known as past costs,
and income statements usually include them. In essence, their measuring is a
record-keeping exercise. These expenses can only be noted and assessed after the
fact.

• Future Cost: Expenses that are anticipated to be incurred in the future are referred
to as future costs. These costs must be estimated because the future is unpredictable,
therefore it is not reasonable to expect them to be precisely correct. Projecting
future expenses is based on past costs. The two cost notions are very different
during inflation and deflation.

• Sunk Costs: As a result of a prior choice or contractual arrangement, sunk costs

are expenses that have already been incurred or that will need to be paid in the
future. Sunk cost include, for instance, the money paid for inventory, machinery,
and equipment as well as future warehouse rental payments that are required as part
of a long-term leasing arrangement.
• Incremental Costs: The whole additional expense incurred in carrying out a
managerial decision is referred to as an incremental cost. Incremental expenses
include things like changing distribution routes, adding or replacing machinery,
altering the product line, and altering the output level. Incremental expenses are
occasionally referred to as preventable or escapable costs.

• Out-of-pocket costs: These are expenses that supplement the present monetary
payments made to third parties. One type of out-of-pocket expense is the salary and
wages paid to the employees. Other instances of expenses that must be paid out of
pocket include rent, interest, transportation fees, etc.

• Postponable costs: These are expenses that, if they are not incurred on time, have
no impact on the company's ability to operate efficiently. Maintenance charges are
one example.

• Book costs: Book costs are those business expenses that are recorded in the books
of account but do not need payment in cash. This allows the books of account to
account for the costs in profit and loss statements and to claim tax benefits. The
manager's salary is a book expense if it is not paid. Other examples of book costs
are depreciation and owner's fund interest costs.

• Explicit costs: Explicit costs are those that need to be paid to third parties in person.
Thus, the monitory payment that a company pays for using an input that is owned
or controlled by someone else is an explicit cost. Accounting expenses are another
name for explicit costs. For instance, if a company hires 15 workers for ten days at
a rate of Rs. 100 per day, the firm will specifically incur Rs. 15,000. The cost of
renting a building, buying raw materials, running an advertisement, and other
expenses are examples of additional explicit costs.

• Implicit costs: These expenses do not need a cash payment; rather, they reflect the
worth of missed possibilities. Though commonly disregarded due to their lack of
obviousness, implicit costs are equally as significant as explicit ones. As
demonstrated by the example we used earlier, a manager who owns his own
company forfeits the compensation that he could have made working for someone
else. Accounting statements typically do not account for this implicit cost.

• Prime Cost: The whole of the direct expenses incurred in a product's

manufacturing is its prime cost. These expenses cover direct labor expenditures as
well as raw material costs. Expenses directly related to every manufactured item
 are referred to as prime costs. Typically, these expenses include the following:
Direct labor, direct materials, and direct costs.

• Historical Costs and Replacement Costs: An asset's historical cost, often known
as its original cost, is the amount that management originally paid to acquire it. On
the other hand, replacement costs are the expenses a company faces when
purchasing or replacing the same asset. The difference between the replacement
cost and the historical cost is the outcome of price fluctuations over time. In the
event that a company purchases a machine for $20,000 in 1990 and it now costs
$40,000. The replacement cost is $40,000, while the historical cost is $20,000.

• Urgent Costs: The term "urgent costs" refers to expenses that management must
incur out of necessity in order to maintain business operations. If important
expenses are not paid for on time, the company's operational effectiveness declines.
For instance the price of fuel, labor, and materials.

4.2.4 COST FUNCTION

The link between input costs and output is referred to as the cost function. The cost
function, to put it simply, is the functional connection between cost and output. The
writing is as follows:
C = f(q)

Where,

C = Cost of Production; q = Quantity of Production; and

f = Functional Relationship

• A key idea in microeconomics is the cost function, which is used to examine the
connection between the cost of producing products & services and the quantity
produced.

• When a commodity or service is produced, three main kinds of costs are incurred.
These three figures are the total, average, and marginal costs.

• Businesses utilize cost functions to decide how much to produce, how much to charge,
and how to allocate their resources.

• The cost function is used with the intention of minimizing expenses and optimizing the
company's earnings.
4.2.5 RELATIONSHIP OF COST FUNCTION
A. Short-Term Cost-Output Relationship
In the short term Marginal Cost and Average Cost: When costs are stated as costs per
unit, they take on greater significance. It is possible to calculate cost per unit using
fixed, variable, total, and marginal costs. The relationship between these notions is
shown in the following diagram:
Fixed cost (FC): The term "fixed cost" refers to an expense that remains constant
regardless of how much a company produces. Because fixed costs are not influenced
by production variables like volume, they are less manageable than variable costs. Two
instances of fixed costs are salaries and rent.

Variable cost (VC): This kind of cost is defined as one that will fluctuate in response
to shifts in production levels. Variable costs rise or fall in proportion to an
organization's production volume. The price of labor, raw materials, and other expenses
are some instances of variable costs.

Total Cost (TC): The term "total cost" describes the production's entire cost,
comprising both fixed and variable expenses. The cost necessary to manufacture a good
is referred to as the whole cost in economics.

Total Costs = Variable Cost + Fixed Cost

Average Fixed Cost (AFC): The TFC is divided by the quantity of units produced to
get the average fixed cost. As a result, AFC = TFC/Q, where Q is the manufacturing
quantity.

Average Variable Cost (AVC): The TVC is divided by the quantity generated to get
the Average Variable Cost. Consequently, AVC = TVC / Q

Average Total Cost (ATC): The TC is divided by the quantity of units generated to
get Average Total Cost, or just Average Cost. Consequently, ATC = TC / Q

Marginal Cost (MC): A one-unit increase in output results in a corresponding increase

in TC, which is known as marginal cost (MC). Stated differently, it represents the
expenses incurred in generating an extra output unit. The extra expense incurred when
producing an extra unit of output is known as the marginal cost. The process of
 calculating the amount of change in aggregate costs resulting from an increase of one
unit over the current level of production is known as marginal costing.

Marginal Cost and Average Cost Relationship

 The connections between the several marginal and average cost curves. The normal
AFC, AVC, ATC, and MC curves are depicted in the image, which is not scaled to
the data. AVC and ATC are both reduced to a minimum by the MC. The rate of AVC
decline will be slower when both the MC and AVC are lowering. When the AVC and
MC are both rising, the MC will climb more quickly. MC will therefore reach its
minimum prior to the AVC.Put otherwise, if MC is higher than AVC, then AVC will
rise, and if MC is lower than AVC, then AVC will fall. This implies that where MC is
above AVC, AVC will rise, and vice versa, as long as MC is below AVC. As a result,
AVC has not yet started to increase at the crossing point where MC = AVC; it has
only recently stopped falling and reached its minimum.

Likewise, at the minimum point of the ATC curve, the MC curve intersects it. This is
due to the fact that MC is the addition that one extra output unit produces to either TC
or TVC. But since MC and AFC are unrelated—MC, by definition, only contains
expenses that vary with output, whereas FC, by definition, is output-independent—
there is no such relationship between the two.

B. Long-Term Cost-Output Relationships:

A long duration allows business managers enough time to adjust even the production scale.
Every production factor is erratic. There are no set expenditures; instead, every expense is
variable. Because the scale of production and its factors of production may be altered, the
supply of commodities can be adapted to their demands. The long run marginal cost curve and
long run average cost curve are available for analysis in the long term.
Long Run Average Cost (LAC): Over an extended period of time, all production
variables are subject to variation, and the company is presented with a range of options
for choosing the size of its plants and the production factors it will utilize. The many
plant sizes that a corporation can choose from are represented by different short run
average cost curves. With the aid of all the short run average cost curves, we can obtain

the long run average cost curve. All of the short run average cost curves are included
in the long run average cost curve. Another name for it is a "Planning Curve" or
"Envelope Curve."
 Long
Run

Marginal Cost (LMC): When a new unit of a commodity is created, the long run
marginal cost is added to the long run total cost. It is computed in the same way as the
short-term marginal cost. The long-term marginal cost curve is similarly U-shaped,
but it rises and falls gradually rather than brusquely.

C. COST CONTROL & COST REDUCTION

Cost Control: The goal of the cost control process is to employ competitive analysis
to keep overall costs under control. Maintaining the real cost in line with set guidelines
is the goal of this strategy. A series of steps are involved in cost control: first, the budget
is prepared in relation to the operation; next, the performance is evaluated; still later,
the differences between the actual and budgeted costs are computed and the reasons for
them are investigated; and lastly, the appropriate corrective measures are put into place.
Standard costing and budgetary control are the two main methods of cost control.

Cost Reduction: Cost reduction is the process of using new and improved methods
and procedures to lower the unit cost of a manufactured good or a service provided
without compromising its quality. It finds other ways to lower a unit's cost. It
guarantees reductions in cost per unit and optimization of the company's earnings. The
goal of cost reduction is to eliminate needless expenditures that arise throughout the
creation, storage, marketing, and delivery of the good.

4.2.6 ECONOMIES AND DISECONOMIES OF SCALE

A firm's production efficiency rises in tandem with its increased capacity for
production. Low average total costs result from its ability to draw more output per unit
of input. Economies of scale are the word for this situation. Because a firm can produce
more with the same amount of inputs, economies of scale save money for the company.
Due to the fact that overall expenses are distributed throughout the higher production,
higher output levels translate into lower average costs.Economies of scale are the cost
advantages that a business can eventually attain by increasing its output. It is an idea
with a long term. Gaining economies of scale is possible when an organization's sales
rise. As a result, the organization's savings rise, further enabling it to buy raw materials
in large quantities. This facilitates the organization's access to savings. We refer to these
advantages as economies of scale.

A. Internal Economies of Scale

Internal Economies of Scale are the savings that a company realizes as a result of its
own expansion. Internal economies of scale are attained by an organization when costs
are decreased and production is increased. When a company increases its capacity, it
can achieve lower costs per unit, which is known as internal economies of scale.It refers
to actual economies that result from an organization's growth in plant size. The
expansion of the organization itself gives rise to these economies. The following are
some instances of internal economies of scale:

• Technical economies: They happen when businesses spend money on pricey,

cutting-edge technologies. Because of the organizations' increased technical
efficiency, these economies are enjoyed. An business can generate a huge quantity
of things quickly thanks to sophisticated technologies. Consequently, economies of
scale are achieved when production costs per unit decrease.

• Marketing economies: The distribution of a major organization's marketing budget

over a substantial amount of work. Through branding, advertising, and bulk
purchasing, marketing efficiencies are realized. Big businesses gain from
advertising because they can reach a wider audience. Small businesses do not
receive any discounts on advertising expenditures; instead, they must pay the same
advertising charges as large businesses.

• Managerial economies: When big businesses use specialized personnel to carry out
various duties. These employees, who are professionals in their domains, leverage
their expertise and understanding to optimize the company's earnings. To ensure
accurate estimation of all expenses and revenues, the organization's accounts and
research departments are established and run by seasoned professionals.
• Commercial economies: Commercial economies are those in which businesses
profit from decreased costs associated with purchasing raw materials and selling
completed commodities. Large companies benefit from lower transportation costs,
easier bank credit, and faster product delivery to clients since they purchase raw
materials in bulk.

• Financial economies: Small firms are frequently thought to be riskier than larger
companies with a solid track record. Thus, larger companies find it easier to identify
potential lenders to raise money at lower interest rates, while smaller companies
struggle to acquire financing at affordable rates. The production scale is further
increased with this capital, resulting in low average total costs.

B. External Economies of Scale

The efficiencies in production that a company attains as a result of the expansion of the
industry in which it works are known as external economies of scale. Beyond a
company, inside an industry, external economies of scale take place. As a result,
external economies of scale are stated to have been reached when an industry's
operational scope grows. These economies are found in the sectors that help
organizations. Better infrastructure, transportation, and other amenities may become
available to companies as their sector grows. This aids in bringing down an
organization's expenses.
For instance, external economies of scale arise from the development of a better
transportation network, which lowers the transportation costs of a company involved
in that business.

• Economies of Concentration: These are the economies resulting from improved

financing, transportation infrastructure, and the availability of trained labor.

• Economies of Information: Refers to benefits obtained from trade and commercial

publications. Organizations obtain their knowledge from the central research
institutions.

• Economies of Disintegration: These are the economies that emerge when

businesses divide their operations into distinct functional areas.

C. Diseconomies of Scale
These are the drawbacks that result from a company's capacity being expanded, which
raises the average cost of production. Diseconomies of scale can also be divided into
internal and external categories, much like economies of scale. Diseconomies of scale
arise when an organization's average long-term costs rise. It could occur if a company
expands too much. Larger companies have to pay more to create goods and services
due to diseconomies of scale. Internal and external diseconomies are the two categories
of diseconomies on a scale, and they are explained as follows:

D. Internal Diseconomies of Scale

The term "internal diseconomies" describes the losses a company experiences as a
result of its expansion. Due to these scale-related diseconomies, the firm's output
declines and its long-term average cost rises.

• Ineffective management: As a company grows its output, it also has to enhance

planning and control. This necessitates increased efficiency from the administration.
Lower level employees are frequently given managerial tasks since managing a
larger company can be challenging. These employees might not have the necessary
experience to take on the challenge, which could lead to low output at a greater cost.

• Labor inefficiency: As a company grows, its workspaces may get more congested,
making it difficult for each employee to do their job well. Furthermore, in a larger
company, overspecialization and labor division result in an excessive reliance on
employees. Under such circumstances, there is a rise in the average cost of
production over the long term due to labor absenteeism, lethargy, and service
discontinuation.

E. External Diseconomies of Scale

The drawbacks that result from an industry's overproduction brought on by a growth
in the number of enterprises are known as external diseconomies of scale.
Diseconomies of scale externalities: Talk about the economic conditions that restrict
the growth of a company or sector. The lack of competent labor, the high cost of
production, and the shortage of raw materials are the issues that prevent expansion.
Diseconomies of scale can result from a number of factors, including the following:

• Improper Communication: An organization's overproduction or production may

result from improper communication of its production goals and objectives to its
workforce. There could be a loss of scale as a result.

• Lack of Motivation: Employees in huge organizations may experience a decline in

motivation as a result of feeling alone and underappreciated for their efforts. Poor
 communication makes it more difficult for businesses to engage with staff members
and foster a sense of community. Due to a lack of motivation, this causes the
productivity levels of output to decline.

• Loss of supervise: In a huge organization, it becomes difficult and expensive to

monitor and oversee every employee's job. It is more difficult to discern whether
every worker in a company is pursuing the same objective. In huge businesses,
managing subordinates becomes challenging for managers.

• Cannibalization:It refers to a scenario in which a company faces competition from

its own merchandise. Products from other companies compete with those of small
businesses, while occasionally the products of major businesses find themselves in
direct competition with one another.

4.2.7 Concept of Revenue

The sum of money that an organization receives from the market sale of a specific
quantity of a good or service is known as revenue. is, to put it simply, the sum of money
that a manufacturer gets paid for the sales proceeds. For instance, if a company sells
100 tables for ₹20,000, its income will be ₹20,000.
When analyzing an economy, the concept of revenue is crucial. Revenue is directly
impacted by sales volume. It implies that revenue will rise in tandem with an increase
in sales. Profit and revenue are not the same thing. Profit is the amount of income over
expenses, whereas revenue is the earnings from sales.
Revenue – Expenses = Profit
4.2.8 Relationship between TR, MR & AR
Total Revenue is the sum of the proceeds from the sale of a certain quantity of a good
or service. To put it simply, total revenue is the amount of money a business makes
overall. It is calculated by multiplying the quantity of a good sold by its price. The
equation for the total revenue is
Price x Quantity = Total Revenue
For instance, a company's total revenue would be 100 x 200 = ₹20,000 if it sells 100
tables for ₹200 each.

Average Revenue is the amount of money received for each unit of a commodity sold.
It is computed by dividing the total revenue by the quantity of a commodity that is sold.
The following is the formula for average revenue:
 Revenue on Average = Total Revenue/Quantity
For instance, if a business sells 100 tables for ₹20,000, its total revenue would be ₹20,000;
therefore, its average revenue would be ₹200.
Marginal revenue is the extra money made from the sale of an extra unit of output. To put it
simply, it's the difference in Total Revenue resulting from selling an additional unit of a good.
The Marginal Revenue formula is,
MRn = TRn - TRn-1.
Whereas
MRn stands for Marginal Revenue for Unit n.
TRn stands for Total Revenue (n units).
Total Revenue from n-1 Units = TRn-1

1.1 SUMMARY
Cost concepts are crucial for decision-making, but when it comes to decision-making,
neither the economic nor the accounting approaches are entirely appropriate.
Depending on the decision at hand, costs must be taken into account in different ways.
 In their conceptions of costs, classical economists and accountants have a tendency to
be somewhat dogmatic. To assist in making wise judgments, all cost concepts must be
taken into account. The decision maker is not always constrained by conventional
conceptions created for other purposes; instead, the decision maker should attempt to
ascertain the "relevant" costs by questioning what costs are important to a specific issue
at hand.
The short-term total cost is made up of both variable and fixed expenses. The additional
variable cost incurred by a company for every additional unit of output is known as its
marginal cost. The total variable cost divided by the quantity of output units yields the
average variable cost. Specifically, the marginal product of the variable input and the
marginal cost of production are inversely related. The U-shaped curves represent the
average variable cost and average overall cost. The average total cost curve and average
variable cost curve are both cut off at their minimum points by the short run marginal
cost curve, which rises beyond a certain point.

1.2 KEYWORDS
Average cost is the total production cost divided by the number of units produced.
Cost control aims to reduce the total cost of production, whereas cost reduction aims
to reduce the per-unit cost of a product. Cost control is a transient process in nature.
Unlike
Cost reduction is a permanent process. When the given objective is met, the cost-
control process will be complete.
Diseconomies of scale occur when production expenses per product rise as the
business.Economies of scale arise when the cost per unit of a product falls as the
business grows.
Fixed costs: These costs, often known as start-up costs, are constant regardless of the
quantity of things produced or the amount of service provided.
Marginal analysis is a method of approximating change used in economics. The rates
at which cost, revenue, and profit fluctuate in proportion to the number of units
produced or sold are referred to as marginal cost, marginal revenue, and marginal
profit.
Total variable cost (TVC) is the cost that varies with the level of output.
Total cost (TC) is calculated by adding total fixed and variable fixed costs.

1.3 SELF-ASSESSMENT QUESTIONS

 1. How do fixed costs differ from variable costs?
2. Distinguish between economic and accounting costs?
3. Define and differentiate between explicit and implicit costs.
4. How important is opportunity cost while making managerial decisions?
5. What is analysis of short-run costs? What kinds of decisions is it helpful for?
6. What is analysis of short-run costs? What kinds of decisions is it helpful for?
7. Distinguish between Cost Control and Cost Reduction.
8. Explain the concept of economies and diseconomies of scale related to cost functions.
9. What do incremental and marginal costs mean? What distinguishes these two cost
theories from one another?
1.4 REFERENCES
Adhikary, M (1987), Managerial Economics (Chapter V), Khosla Publishing House,
Delhi.
Maddala, G.S., and Ellen Miller (1989), Micro Economics: Theory and Applications
(Chapter 6), McGraw-Hill, New York.
Maurice, S.C., Thomas, C.R., and Smithson, C.W (1992), Managerial Economics:
Applied Microeconomics for Decision Making (Chapter 9), Irwin Inc, Boston.
Mote, V.L., Samuel Paul, and G.S. Gupta (1977), Managerial Economics: Concepts
and Cases (Chapter 3), Tata McGraw-Hill, New Delhi.
Ravindra H. Dholakia and Ajay N. Oza (1996), Micro Economics for Management
Students (Chapter 8), Oxford University Press, Delhi.
 Block 5
Business Economics
OBJECTIVES
• Identify the various market forms.
• Recognizing various market structures and their effect on competition;
• Explain the equilibrium conditions of industry under various structures.
• Differentiate between the perfect competition, monopoly, monopolistic, and oligopoly
short- and long-term equilibrium.

UNIT 1 MARKET AND MARKET STRUCTURES

Structure
5.1.1 Introduction
5.1.2 Meaning and Definition of Market
5.1.3 Features of Market
5.1.4 Classification of market
5.1.5 Market Structures Meaning and Definition
5.1.6 Perfect Competition - Meaning and Definition of Perfect Competition
A. Features of Perfect Competition
B. Determination of Price and output equilibrium under Perfect Competition
5.1.7 Monopoly- Meaning and Definition of Monopoly
A. Features of Monopoly
B. Causes of the Monopoly's Emergence
C. Determination of Price and output equilibrium under Monopoly
5.1.8 Monopolistic- Meaning and Definition of Monopolistic
A. Features of Monopolistic
B. Determination of Price and output equilibrium under Monopolistic
5.1.9 Oligopoly- Meaning and Definition of Oligopoly
A. Features of Oligopoly
B. Types of Oligopoly
C. Determination of Price and output equilibrium under Oligopoly
1.1 Summary
1.2 Keywords
1.3 Self Assessment Test
1.4 References

Unit- 1
5.1.1 INTRODUCTION
Market structures are the arrangements that bring buyers and sellers together. The
market for a product can also refer to the entire territory where customers and suppliers
of that commodity are spread out and there is so much free competition that one price
for the product prevails throughout the region. Whether a firm is considered
competitive is determined by a number of criteria, including the number of firms in the
industry, the degree of competition, the degree of product homogeneity, economies of
scale, and the ease with which a firm can join and exit the market.Based on these
features, particularly the degree of competition, a market can be categorized as
perfectly competitive, monopoly, oligopoly, or monopolistic competition. This unit
aims to investigate the characteristics of perfectly competitive markets, monopolies,
oligopolies, and monopolistic competition.

5.1.2 MEANING AND DEFINITION OF MARKET

A marketplace is a location where products are exchanged. Alternatively put, a market
is a gathering place for the buying and selling of products. Producers and consumers
conduct sales and purchases on the market, which serves as the economic life's central
nerve system. When it comes to the exchange of goods, a market in economics is an
area where buyers and sellers are not required to gather at a particular location. Rather,
it is necessary for them to communicate with one another by every available channel,
including phone, email, mail, and the internet.

A market is often understood to be a physical place where vendors and consumers come
together to exchange commodities. A market, according to economists, is a group of
buyers and sellers who exchange goods and services regarding a specific good or
service.The term "market" describes the entire area where commodity buyers and
sellers interact to influence the commodity's purchase and sale.

According to Cournot, the "market" is defined as "the whole of any region in which
buyers and sellers are in such free intercourse with one another that the prices of the
 same goods tend to be at equality easily and quickly, rather than any specific market
place in which things are bought and sold."

"A market is made up of all potential customers who share a specific need or want and
who may be willing and able to engage in exchange to satisfy that need or want," Philip
Kotler.

5.1.3 FEATURES OF MARKET

• Buyers and Sellers: The existence of buyers and sellers is another feature of a market.
In the market, buyers and sellers need to communicate with one another. It does not,
however, mean that they must meet in person; they can communicate via phone, email,
the internet, and other contemporary channels.

• Area: In economics, a market isn't tied to a single location; rather, it's a broad region
that serves as a hub for interactions between producers, or sellers, and customers, or
consumers. Modern communication methods and technological advancements have
expanded a product's market reach.

• One commodity: While in economics a "market" does not refer to a specific location
per se, it does refer to a market for a commodity or commodities, such as a wheat, tea,
or gold market, among others. In everyday life, a market is understood as a place where
commodities are bought and sold at retail or wholesale price.

• Perfect Competition: There must be perfect competition between buyers and sellers
in the market. However, contemporary economists believe that because imperfect
competition also prevails in the market, both conditions must exist.

• Price: Products should be priced at acertain level in order to be profitable. Some

economists think that the price of a specific product should be determined equally
across the market through competition among buyers & sellers. However, in reality,
prices for the same product may change in the market due to imperfect competition
between buyer and seller, as well as the seller's monopoly on definite products.

• Transfer of Ownership:In the market, the buyer takes ownership of the product from
the seller. Money serves as a medium of exchange for ownership transfers. Hence,
there should be features such as buyers and sellers, or demand and supply, commodities
or services, determined price, a certain region, ownership transfer, etc. to be market.
 • Perfect Market Knowledge: Buyers & sellers must have a thorough understanding of
the market, including client demand, habits, tastes, styles, and so on.

• Relationship between buyers and sellers: In order for a market to exist, buyers and
sellers must have a perfect relationship. Even in cases where they are not physically
present in the market, the commercial connection needs to continue.
5.1.4 CLASSIFICATION OF MARKET
1. On the Basis of Geographical Spread:

• Local markets sell perishable items such as seafood, eggs, and vegetables. These
markets cover a rather narrow geographical area.

• National market for non-perishable goods with logicalcarrying costs for their price.
The national market is expanded across the entire country. The pricing of goods sold
in this market are decided by demand and supply across the country.

• International market for items produced within a country & sold both domestically
and internationally. In addition, some goods are produced in the country solely for
export to other countries. Traditional foreign markets for Indian goods include those
produced in the jute, sugar, cotton textile, and leather sectors, as well as tea.
2. On the Basis of the Product Purchased and Sold:The jute market, for instance, is the
name given to the market for jute goods. A market for sugar, gold, labor, fish,
vegetables, shares, bonds, and so forth might exist similarly. These markets could be
local, regional, or national in addition to some being nationwide.

3. On the Basis of the Duration:

• Very Short-Period Market: This market's name makes it obvious that there is
extremely little time given for any essential modifications. For instance, a very short-
period market for the good can be defined as the activity of buyers and sellers in the
market during the few hours of a day's morning.

• Market for a Short Period: In comparison to the extremely short period, the short-
period market lasts longer. During a brief period, the company can use more or less of
its variable inputs, such as labor, fuel, and raw materials, to increase or decrease the
supply of its product.

• Long-term Market: The length of time in the lengthy period allows the firm to
increase the quantities of both variable and fixed inputs. As a result, if demand for the
 good increases and prices rise in the short term, supply may increase sufficiently in the
long run, and the majority of the price increase may be reversed later.

• Very Long-Term Market: The extended amount of time may result in a change of
age. In the new age, there may be a noticeable change in the country's population, as
well as a significant change in people's tastes, preferences, and habits; there may also
be a qualitative change in technology, social institutions, and organizations.

5.1.5 MARKET STRUCTURES

Market structure refers to the variety and quantity of businesses that operate in an
industry, as well as the kind and intensity of rivalry that exists in the market for products
and services.The type and intensity of competition in the market for goods and services
is referred to as market structure. The type of rivalry that exists in a given market shapes
the structures of both the commodities and service (factor) markets. Market structure
is the system used to classify and differentiate various industries according to the
degree and kind of competition for products and services. An enterprise operates inside
an economic environment, which is referred to as a market structure. It describes the
industry's competitiveness by looking at things like how hard it is to get into the market
and how many sellers are there.

According to Samuelson and Nordhaus, market structure includes "the number of

buyers and sellers in the market, the degree of product differentiation, and the ease of
entry and exit from the market."

Stiglitz and Walsh define market structure as "the market characteristics that influence
the behavior of buyers and sellers and affect the level of competition in the market."

According to Michael Porter, market structure is "the underlying economic structure

of an industry, which includes its size, degree of concentration, and the nature of
competition."

Features of Market Structures

• Number of Sellers and Buyers: The quantity or number of buyers and sellers in a
commodities market has a significant impact on the commodity's price. A single buyer
or seller cannot affect the price of a commodity in a market with a large number of
participants. On the other hand, a single seller, like in the case of railroads, has
extensive control over the price of the good.
 • Nature of the Commodity: The commodity's nature greatly influences its price. If a
commodity is homogeneous in nature (e.g., pen, paper), it is priced uniformly in the
market. If a commodity is heterogeneous in nature (non-identical, completely separate
commodities, such as multiple toothpaste brands), it may be sold at varying prices.
However, goods with no near replacements, such as railways, might command a greater
price from customers.

• Freedom of Movement for Businesses: Market price stability is the outcome of

business entrance and exit freedom. Restrictions on the admission of new enterprises
or the departure of current ones, however, may cause the enterprises to control the cost
of goods and services since they will not be afraid of competition from other
companies, either new or old.

• Knowledge of Current Market Conditions: A uniform price for products and

services will prevail in the market if both buyers and sellers are fully informed about
the state of the market. On the other hand, merchants may charge varying prices to their
consumers if neither the buyers nor the sellers are aware of the state of the market.

• Mobility of goods & factors of production: The free movement of manufacturing

elements from one location to another leads in market prices that are uniform. However,
if the movement of factors of production is not free, prices may vary.

5.1.6 PERFECT COMPETITION - MEANING AND DEFINITION OF

PERFECT COMPETITION
A market situation where a large number of buyers and sellers deal in a homogeneous
product at a fixed price set by the market is known as Perfect Competition.
Homogeneous goods are goods of similar shape, size, quality, etc. In other words, in a
perfectly competitive market, the sellers sell homogeneous products at a fixed price
determined by the industry and not by a single firm. In the real world, the situation of
perfect competition does not exist; however, the closest example of a perfect
competition market is agricultural goods sold by farmers. Goods like wheat, sugarcane,
etc., are homogeneous and their price is influenced by the market.A market is said to
be perfect when all the potential buyers and sellers are promptly aware of the prices at
which the transaction take place. Under such conditions the price of the commodity
will tend to be equal everywhere.”
 Mrs. Joan Robinson stated that "perfect competition prevails when the demand for
each producer's output is perfectly elastic" in relation to this.

According to Boulding,A Perfect Competition market, is characterized by a large

number of participants who are all involved in the purchase and selling of goods that
are identical to one another, who are in close proximity to one another, and who freely
buy and sell among themselves.

A. Features of Perfect Competition

• A large number of Sellers and Buyers: In a market with perfect competition, there
are a lot of sellers and buyers. It indicates that there are so many buyers in a market
with perfect competition that the participation of any one buyer in the overall purchases
is negligible; as a result, one customer cannot affect the price of a product in the market.
In a similar vein, there are so many sellers that the contribution of a single seller to the
economy's overall supply is negligible; as a result, one seller cannot affect a product's
price on the open market.

• Homogeneous Product: Under perfect competition, businesses sell homogeneous

products. It denotes that every aspect of the goods—including size, shape, color, and
quality—is the same. Because the products are interchangeable, the buyer has no
special preference amongst sellers because they are all the same. Customers are only
willing to pay the same price for products from every company in the business since
the products are homogenous. In addition, it guarantees price parity in the market by
prohibiting any one company from raising the price at which they sell their goods.

• Freedom of Entry and Exit: In a market with perfect competition, sellers are free to
enter and leave the market. It denotes the absence of fictitious limitations or obstacles
to the entrance of new businesses or the departure of current ones. The new businesses'
freedom of entry under shows that there are no obstacles preventing them from joining
the market. In a market with perfect competition, the current firms' freedom of exit
suggests that there are no obstacles preventing them from leaving the sector. When
businesses experience losses, they typically leave the industry, which lowers the
amount of goods available on the market and raises the price of those commodities.

• Perfect Knowledge between Buyers and Sellers: In a market with perfect

competition, both buyers and sellers are fully aware of the market value of the goods.
It implies that no business or seller may demand a price that differs from what its clients
 are willing to pay and that no buyer would ever pay more than the going rate. Put
otherwise, it leads to a standardization of a product's market pricing. In addition, the
product's vendors are quite knowledgeable about the input marketplaces. It denotes that
all businesses have equal access to the resources and technologies needed to produce
goods, leading to a consistent cost structure. Additionally, just as a product's cost and
price are consistent, so are the businesses' earnings.

• Absence of Selling Costs: A product's selling cost is the price of its advertisement.
The homogenous nature of the goods under perfect competition means that selling
expenses are not included. It is simple for businesses to sell things without incurring
selling costs because buyers and sellers have perfect information of the product.

• Absence of Transportation Costs: It is considered that in a perfect market, there

would be no transportation costs in order to maintain price uniformity. Stated
otherwise, it is presumed that a producer has the freedom to sell the product anywhere,
and that consumers can buy it from any vendor of their choosing.

B. Determination of Price and output equilibrium under Perfect

Competition
Reducing the quantity of a product produced by a firm is not possible in a market with
perfect competition. These conditions also include input and cost. Thus, without
affecting the product's pricing, the company can adjust the amount of production it
produces. The firm's cost and revenue conditions determine when a firm is in
equilibrium, and this is when we know its earnings are at their highest. In the short and
long terms, these factors can change. The demand curve for a product under perfect
competition will be examined before we look at the equilibrium states.
Demand Curve of a Product in a Perfectly Competitive Market: Using the supply
and demand curves of the market, let's calculate the firm's demand curve. The price in
a market with perfect competition is set by the equilibrium between supply and
demand.

Price is on the Y-axis and quantity is on the X-axis in the above graphic. The industry
is shown on the left side of the picture, while a firm's case is on the right. Market supply
is represented by curve SS, and market demand by curve DD. Moreover, the
equilibrium point is where the supply and demand curves of the market cross. At this
point, the quantity and price is both equal and represent the equilibrium values.
The following are known to be both sufficient and essential for a firm to be in
equilibrium:
MR = MC
The MC curve cuts below the MR curve.
Put otherwise, the MC curve needs to cross the MR curve from below and then lie
above the MR curve following the intersection. Put another way, the company needs to
maintain increasing its output as long as MR>MC.
This is so because higher output boosts profitability by bringing in more money than it
spends. Furthermore, if the firm finds that even with increased output, MC falls short
of MR even if MC=MR, it will need to continue increasing output.

Three Short-Run Possibilities

A company may make a normal profit, a super-normal profit, or a loss in a completely
competitive market. The company is making a typical profit at the equilibrium quantity
if the average cost and average revenue are identical.In contrast, the company is losing
money if the average cost exceeds the average income. On the other hand, if average
costs are lower than average revenue, the company is turning a supernormal profit.

Normal Profit
Normal Profits:When the average
revenue for a given output equals the
average cost of production, a business
makes normal profits. The MC curve
crosses the MR curve at equilibrium point,
as displayed in the figure.Moreover, at a
location that corresponds to the same
point, the AC curve intersects the AR
curve. As a result, the company makes
typical profits.
Super Normal Profits:When the average
cost of production for a certain output is
lower than the average revenue, a company
makes super-normal profits As a result; the
company is making more money while
spending less. The profit per unit in this
instance is
PP' = OP - OP'

Loss: When the average cost of production

exceeds the average income for the same
output, a company experiences a loss. The
average cost curve for the same quantity is
shown above the average revenue curve in
the above graphic.. Sometimes, in the near
term, a monopolist will decrease prices and
suffer losses in order to deter new businesses
The long-term equilibrium of a firm in a
perfect market competition: The long term is the time frame during which the
company can change all of its inputs. Because there are no fixed costs, the Average
Fixed Cost (AFC) curve disappears. ATC, or average total cost, is represented by the
Average Cost (AC) curve as well. Additionally, because it can change all of its inputs,
the company is free to close and exit the market. As its short-run AC curves produce
the long-run AC curve, we know that it too has a U-shaped shape. Thus, the firm
experiences increasing returns up to a certain point, at which point the AC curve slopes
downward.There is a period of time after which there are constant returns, meaning
that the AC curve stays flat. Decreasing returns to scale phase, during which the AC
curve dips upward, then begins. Over time, new businesses may also enter this sector.
This characteristic, has two consequences.
 • The company is free to exit the industry and is not required to continue operating at
a loss.
• No company is able to make supernormal earnings. This is due to the fact that super-
normal profits draw in new businesses to the sector. This causes the supply to rise,
which in turn drives down prices and returns to normalcy.

The process of determining long-run equilibrium under perfect competition is shown

in the image. It is evident that the costs are shown along the Y-axis and the output is
measured along the X-axis. The company is a price taker as well. Moreover, the MR
curve coincides with the X-axis, and its AR curve runs parallel to it.

5.1.7 MONOPOLY - MEANING AND DEFINITION OF MONOPOLY

Monopoly is a wholly different type of market, derived from the Greek words monos
(meaning solo) and polus (meaning seller). Monopoly refers to a market condition in
which just one vendor sells a product with no close substitutes. For instance, Indian
Railways. In a monopolistic market, there are different barriers on new firms entering
and current ones exiting. In addition, price discrimination is possible in a monopoly
market.

In a monopoly market structure, a single company dominates a specific industry. But

from a regulatory perspective, monopoly power occurs when one company owns at
least 25% of a specific market. De Beers, for instance, is reputed to control a monopoly
in the diamond sector.
 "A monopoly is a market situation when there is only one seller. There are no close
substitutes for the commodity produced, and there exist entry hurdles." –
Koutsoyiannis

"Under absolute monopoly, there is only one seller in the market. Monopolistic demand
is market demand. The monopolist is a price setter. "Pure monopoly implies no
substitute situation." A. J. Braff

A. Features of Monopoly
• Single Seller: In a monopoly market, a single seller is the only one offering the product
for sale. It indicates that in this type of market, the industry and the monopoly firm are
the same? The monopolist has complete control over the product's supply and pricing
because there is only one seller. In contrast, a monopoly market has a huge number of
buyers, meaning that no single buyer can affect the price of a product in the market.

• Absence of Close Substitutes: The product is sold by a single seller in a monopolistic

market; hence there are no close alternatives. As a result, monopoly enterprises do not
fear new or current competitors entering the market. There isn't a close replacement for
Indian Railways' transportation services, for instance. But, there are more remote
services available, such as metro.

• Restrictions on Entry and Exit: In a market with a monopoly, there are significant
barriers that prevent new businesses from entering and prevent established businesses
from leaving. It implies that over time, a monopoly corporation may experience
unusual losses and gains. Legal constraints, such as those pertaining to patent rights,
licensing, and the like, or constraints in the form of company cartels may be one of the
causes of the hurdles.

• Price Maker: In a market with a monopoly, there is only one seller, and the company
and industry is the same thing, thus the seller has complete control over the product
price. As a solitary vendor, the monopolist has control over the supply of commodities
in the market and can set their own prices.

• Price Discrimination: Price discrimination refers to the ability of a monopolist, who

is a single seller in the market, to charge varying prices to distinct customers at the
same time.

B. Causes of the Monopoly's Emergence

• Government Licensing: A company must apply for and receive a license from the
government in order to enter a certain industry. A company can ensure basic
competency standards with the use of licensing. As a result, the government
occasionally refuses to license new businesses in order to ensure that there is only one
business operating in the market.
• Control over Raw Materials: Sole ownership or control over the necessary raw
materials needed in a particular industry is another factor contributing to the
establishment of monopolies. For instance, De Beers can affect the market because it
controls a sizable portion of the global diamond production.
• Cartel: To maintain their uniqueness and coordinate their price and output strategies
in order to function as a monopoly, some businesses form cartels. Additionally, they
decide among themselves to limit their overall productivity to the extent that it will
allow them to maximize their combined profits. OPEC, or the Organization of
Petroleum Exporting Countries, is one of the most well-known instances of a cartel
within a monopoly.

• Patent Rights:A lot of large private corporations engage in risky research and
development; if these efforts are successful, they may produce new technologies or
products. As a return for taking a risk on R&D, the government gives them patent
rights. The government gives a company or manufacturer a patent right, which allows
them to use or sell their innovation for a set amount of time. Patent life refers to the
length of time that companies or manufacturers are given patent rights.

C. Determination of Price and output equilibrium under Monopoly

Short-Term Equilibrium in Monopoly
A firm's equilibrium in monopoly can occur in one of three ways, much like in perfect
competition. They are as follows:
• If average costs equal average revenue, then the company makes normal profits.
• It makes supernormal profits if average revenue below average cost.
• If the average expenditure is more than the average revenue, losses result.

Normal Profits: When the average revenue for a given output equals the average cost
of production, a business makes normal profits. The MC curve crosses the MR curve
at equilibrium point E, as shown in the above figure. Additionally, at a location that
corresponds to the same point, the AC curve intersects the AR curve. As a result, the
company makes typical profits.

Super Normal Profits:When the average cost of production for a certain output is
lower than the average revenue, a company makes super-normal profits.. As you can
see in the above picture, OP = QA equals price per unit. Moreover, OP' is the cost per
unit. As a result, the company is making more money while spending less. The profit
per unit in this instance isPP’ = OP - OP'
Loss: When the average cost of production exceeds the average income for the same
output, a company experiences a loss. The average cost curve for the same quantity is
shown above the average revenue curve in the above graphic. OP represents average
income, and OP' represents average cost. Consequently, the company is losing money
on average of PP', for a total loss of PP'BA. Sometimes, in the near term, a monopolist
will decrease prices and suffer losses in order to deter new businesses.

The Long-Term Equilibrium of a Firm in Monopoly

Over time, a monopolist has the ability to change every input. Thus, the AC and MC
cost curves are the only two we need to find the firm's equilibrium. Furthermore, the
demand curve must lie to the right and cross the AC curve twice, or it must be tangent
to the curve because the monopolist leaves the market if he is running at a loss.In the
 long run, the companies make extraordinary profits because of the constraints on
entering and leaving the monopoly market. Additionally, the firm's demand curve, or
AR curve, slopes downward as a result of the firms' ability to sell more outputs by
lowering the price of the product; as a result, the MR curve also slopes negatively.

The long-run average cost curve (LAC) and the long-run marginal cost curve (LMC)
are represented in the above graph, respectively. The requirements to reach equilibrium
are as follows: i) MR = LMC ii) At the OQ output level, the LMC curve cuts the MR
curve from below. The company will make anomalous profits of PBAP1 if its produce
is priced at OP1 and LAC at OP.

5.1.8 MONOPOLISTIC - MEANING AND DEFINITION OF

MONOPOLISTIC

A Monopolistic Competition Market has the characteristics of both Perfect

Competition and Monopoly Market. Monopolistic competition refers to a market
environment in which a large number of enterprises sell closely related but
 differentiated products. Monopolistic rivalry produces products such as toothpaste,
shampoo, and soap. For example, the soap market is fully competitive with several
brands and has freedom of entry, demonstrating the characteristics of a perfect
competition market. However, each soap has its own unique property, allowing
companies to charge varying prices for them. It illustrates the characteristics of a
monopoly market.

A market with perfect competition and monopoly combined is known as monopolistic

competition (monopolistic competition = monopoly along with competition).A
company that operates in monopolistic competition is the only manufacturer of a
certain brand or product. Put another way, the companies subject to monopolistic
competition have a monopoly position with regard to a certain brand. However, as the
company faces fierce rivalry from other businesses in the industry, the presence of near
substitutes in the market affects the company's dominant position.

Prof. J. K. Mehta states that an increasing number of people have realized that every
trading situation involves a situation that could be classified as a partial monopoly,
which is viewed as an imperfect competition scenario. Both the monopoly and the
competitive elements are blended in every scenario.
In the words of Prof. Leftwich, "Monopolistic Competition (or imperfect
competition) is that condition of the industrial market in which a particular commodity
of one seller creates an idea of difference from that of the other sellers in the minds of
the consumers."

A. Features of Monopolistic

• Many Sellers: In monopolistic competition, a multitude of businesses offer a wide

range of closely related but distinct products. Under this market structure, each
company operates independently and has a finite share of the market, which implies
that each company's ability to influence the product's market price is restricted. But
with so many businesses in the market, there is fierce competition.

• Product Differentiation: Under monopolistic competition, each company has some

degree of exclusivity in the market despite the high number of suppliers. The
companies' exclusivity is enforced by their unique product offerings. It indicates that
while a company's product is comparable to that of another company, it is not an exact
match. Customers in a monopolistic market structure distinguish between goods
 produced by several companies and are prepared to pay varying rates for the same
differentiated good made by various companies. The main advantage of product
differentiation is that it grants a company monopoly power, allowing it to easily control
the price at which its product is sold.

• Freedom of Entry and Exit: In a market with perfect competition, sellers are free to
enter and leave the market. It denotes the absence of fictitious limitations or obstacles
to the entrance of new businesses or the departure of current ones. The new businesses'
freedom of entry under shows that there are no obstacles preventing them from joining
the market. In a market with perfect competition, the current firms' freedom of exit
suggests that there are no obstacles preventing them from leaving the sector. When
businesses experience losses, they typically leave the industry, which lowers the
amount of goods available on the market and raises the price of those commodities.

• Selling costs: Products in markets with monopolistic competition are unique. The
selling costs of the products provide the consumers with information about these
variances. In order to influence consumers to purchase a certain brand of product over
a rival's brand, businesses tack on selling expenses to their offerings. Consequently,
selling expenses are included in the total cost of a product in monopolistic competition.
The price spent on the product's marketing, sales promotion, and advertisement is
known as the selling cost.

• Pricing Decision: In monopolistic competition, the companies are neither price

providers nor price consumers. However, each company has some control over the
product's price because they each make distinctive and differentiable products from one
another. The degree of a customer's brand loyalty determines how much influence a
company has to regulate a product's price.

• Lack of Perfect Knowledge: In a market with monopolistic competition, buyers and

sellers are not fully informed about the state of the market. The inclusion of selling
expenses in the overall cost of a product produced by a dominant company gives buyers
a false sense of superiority, which hinders their ability to compare and contrast various
products on the market. Customers like expensive products over cheaper ones because
they lack complete information and believe that one is superior to the other, even while
cheaper products offer comparable quality.
 • Non-Price Competition: Non-price competition is a feature of monopolistic
competition in addition to price competition. Competing with other businesses by
giving those presents, better credit conditions, etc. is known as non-price competition.
The companies carry it out without raising the cost of the goods.

B. Determination of Price and output equilibrium under Monopolistic

Short-Term Equilibrium in Monopolistic Competition

The revenue curves under monopolistic competition slope downward, just like they do
during monopoly. This is due to the fact that the company must lower the price in order
to increase sales.
In a monopolistic competitive environment, a company may experience losses, super-
normal profits, or normal profits. A company makes super-normal profits if there is a
huge demand for its product, just like in a monopoly.
Additionally, new businesses are unable to join the group in the short term and improve
the product group's supply. As a result, they are unable to steal the company's
supernormal profits. Additionally, a company has some fixed costs in the near term.
These may comprise expenses related to both manufacturing and sales.
A firm's equilibrium in monopolistic competition can occur in one of three ways, much
like in perfect competition. They are as follows:

• If average costs equal average

revenue, then the company makes
normal profits.
• It makes supernormal profits if
average revenue below average
cost.
• If the average expenditure is more
than the average revenue, losses
result.

Normal Profits: When the average revenue for a given output equals the average cost of
production, a business makes normal profits. The MC curve crosses the MR curve at
equilibrium point E, as shown in the above figure. Additionally, at a location that corresponds
to the same point, the AC curve intersects the AR curve. As a result, the company makes typical
profits.

Super Normal Profits: When the average cost of production for a certain output is lower than
the average revenue, a company makes super-normal profits.. As you can see in the above
picture, OP = QA equals price per unit. Moreover, OP' is the cost per unit. As a result, the
company is making more money while spending less. The profit per unit in this instance isPP’
= OP - OP'

Loss: When the average cost of production exceeds the average income for the same
output, a company experiences a loss. The average cost curve for the same quantity is
shown above the average revenue curve in the above graphic. OP represents average
income, and OP' represents average cost. Consequently, the company is losing money
on average of PP', for a total loss of PP'BA. Sometimes, in the near term, a monopolist
will decrease prices and suffer losses in order to deter new businesses.

The Long-Term Equilibrium of a Firm in Monopolistic Competition

Over time, a monopolist has the ability to change every input. Thus, the AC and MC
cost curves are the only two we need to find the firm's equilibrium. Furthermore, the
demand curve must lie to the right and cross the AC curve twice, or it must be tangent
to the curve because the monopolist leaves the market if he is running at a loss.In the
long run, the companies make extraordinary profits because of the constraints on
entering and leaving the monopoly market. Additionally, the firm's demand curve, or
AR curve, slopes downward as a result of the firms' ability to sell more outputs by
lowering the price of the product; as a result, the MR curve also slopes negatively.
The long-run average cost curve (LAC) and the long-run marginal cost curve (LMC) are
represented in the above graph, respectively. The requirements to reach equilibrium are as
follows: i) MR = LMC ii) At the OQ output level, the LMC curve cuts the MR curve from
below. The company will make anomalous profits of PBAP1 if its produce is priced at OP1
and LAC at OP.

5.1.9 OLIGOPOLY - MEANING AND DEFINITION OF OLIGOPOLY

"Oligi," which means few, and "polein," which means to sell, are the roots of the word
"oligopoly." Oligopoly refers to a market structure in which there are more buyers than big
sellers of a certain good. In an oligopoly market, vendors offer either homogeneous or
distinctive goods. Because there are fewer sellers in this market, the decisions made by one
seller regarding pricing and output affect those of the other sellers as well. Put otherwise, there
is a significant degree of dependency among commodity sellers. Luxury car manufacturers,
such as BMW, Audi, Ford, and so forth, are examples of an oligopoly market because there
are fewer dealers and more customers of these vehicles. "Competition among the few" refers
to the situation in which there are oligopoly markets with a small number of sellers. Each seller
is impacted by other sellers and in turn influences them.
A.Features of Oligopoly

• Few Firms: In an oligopoly market, the precise number of firms is not known.
However, a sizeable portion of the overall output is produced by each of the companies
in this industry. In an oligopoly market, every company engages in fierce competition
with one another, trying to outwit one another by manipulating the volume and price
of its products. Additionally, because there are so few companies in the market, the
actions of one company have an impact on the competitors. As a result, every company
monitors the behavior of its competitors. For instance, India's car industry is an example
of an oligopoly market.

• Non-Price Competition: In an oligopoly market, the firms have the ability to affect
the product's price, but they attempt to avoid doing so because it could spark a price
war, which none of the firms wants. Put another way, if a company tries to lower the
price of its goods, other companies would inevitably have to do the same, and vice
versa. As a result, the company may lose clients, which would ultimately lead to an
increase in price. Consequently, these businesses favor non-price competition since
they adhere to the price rigidity strategy. Thus, in addition to price, the businesses
compete with one another through a variety of strategies like promotion and after-sale
services.

• Interdependence: In an oligopolistic market, the activities of individual enterprises

have an impact on those of other firms. Before determining the price and level of output
for their products, every company in this market takes into account the actions and
responses of its competitors. Other businesses in the same market respond differently
when a company modifies its price or output. For instance, if Maruti decides to change
the price of its automobiles, its competitors, including Tata, Hyundai, and others, will
also need to adjust their business practises accordingly.

• Barriers to Firm Entry: Because of the obstacles preventing new businesses from
entering this market, there are only a small number of firms operating under an
oligopoly. The high capital requirements, patent requirements, and numerous other
barriers deter new businesses from entering the oligopoly market. As a result, new
businesses that are able to overcome these obstacles enter the market and eventually
make abnormal profits.
 • The Role of Selling Costs: Selling costs comprise the expenses incurred for product
marketing, sales promotion, and advertising. Due to intense rivalry and
interdependence, businesses rely on selling expenses to assist them promote their goods
in the marketplace. As a result, businesses operating in oligopolistic markets
concentrate more on their advertising and other methods of promoting sales. Selling
expenses play a larger part in the selling of goods than they do in a market with
monopolistic competition.

• Product Nature: In an oligopolistic market, companies may create homogeneous or

distinctive goods. Pure oligopolies are businesses that produce identical goods.
Conversely, companies that manufacture a variety of goods are referred to as imperfect
oligopolies.

• Group Behavior: Because the companies in an oligopoly market are totally dependent
on one another, changes in one firm's output and price have an impact on the other
firms that are in competition. As a result, these businesses would rather reach a
consensus on the product's pricing in order to prevent price wars and maximize profits
for all of them. In this context, group behavior refers to how the companies in this
market act as if they are a single entity, despite maintaining their individual
interdependencies.

• Intermediate Demand Curve: In an oligopoly market, it is impossible to pinpoint a

producer's exact behavior pattern. As a result, in an oligopoly market, the firms' demand
curve is ambiguous or intermediate. Due to the interdependence of the companies in
this market, a decision made by one company has a significant impact on those made
by competitors. As a result, in an oligopoly market, the demand curve is constantly
shifting and changing.

B. Types of Oligopoly

• Pure or Perfect Oligopoly: An oligopoly market is referred to as pure or perfect if the

participating firms produce identical goods. While homogenous product oligopoly
enterprises are uncommon, pure oligopoly applies to industries such as steel, cement,
aluminum, etc.

• Imperfect or Differentiated Oligopoly: An oligopoly market is said to as imperfect

or differentiated if the enterprises inside it produce differentiated goods. Talcum
 powders, for instance, are manufactured by several companies and have unique
qualities, but they are all nearly identical alternatives to one another.

• Collusive Oligopoly: Also referred to as cooperative oligopoly, collusive oligopoly is

a market structure in which various enterprises collaborate to set the price, the output,
or both.

• Non-Collusive Oligopoly: An oligopoly market is referred to as non-collective if the

firms in it engage in competition with one another.

C. Determination of Price and output equilibrium under Oligopoly

Analysis of Kinked Demand Curves in the Paul Sweezy Model: Professor Paul M.
Sweezy, together with Professors R. C. Hall and C. J. Hitch, created this concept
separately. This model operates under the following assumptions:
• An oligopolistic market consists of a small number of enterprises.
• The companies are making products that are close substitutes.
• The companies don't invest in promotion, and the product quality stays the same.
• The product's pricing have already been decided upon and are currently the going
rates in the market.
• Every company thinks that if it lowers the price of its goods, the competition would
follow suit; yet, if it raises the price, the competitors won't. All they would do is
maintain their current prices. We would soon observe that each firm's demand curve
would have a kink at the going rate for its product due to the asymmetric pattern of
response of the competitors.

Why Does the Demand Curve Kink?

Two straight line demand curves with negative slopes, denoted as dd' and DD', are
depicted in the figure. Compared to DD', dd' is a more flat curve. Now, the company's
demand curve will be significantly flatter like dd', i.e., the magnitude of the change in
the demand for its product as its price changes would be substantially bigger, when one
specific firm in the industry changes the price of its product while all other companies
maintain their prices constant.
This is because, when the company lowers or raises the price of its product, the prices of other
companies' products stay the same, making the company's product comparatively less
expensive or more expensive than those of the other companies. As a result, this firm's demand
curve will become flatter. Conversely, office firms will not raise their prices in response to a
company that does so. Thus, the opponents' responses will be asymmetrical.
When one company lowers its prices, others tend to follow suit or else they risk losing business
to this company. Others won't raise their prices if one does, as they anticipate losing some
business to this company. The demand curve kinks as a result of these reactions together.
Assume for the moment that the firm's product has an initial price of p1 or Op1, and that there
is q1 or Oq1 demand for the product. Assumption (v) of this model states that competing firms
would maintain their prices if the firm were to raise its price from p1.In this scenario, the
demand for the company would decline along the somewhat more elastic demand curve dd''s
segment Rd. On the other hand, assumption (v) states that if it continues to lower its price from
p1, its competitors will likewise do the same.
In this scenario, the segment RD' of the somewhat steeper demand curve DD' will see an
increase in the quantity demanded of the company's goods. The firm's demand curve would
therefore be dRD' at price p1. The segment dR of this demand curve would obviously be more
flat or elastic than the segment RD' (and the segment RD' would be more steep or less elastic
than the segment dR) due to assumption (v).Consequently, the demand curve in this scenario
would be kinked, with a kink at the prevailing price (p1), or at point R on the firm's demand
curve (d RD').
Kinked Demand Curve Model Analysis
 Particular attention is given to the characteristics of the kinked demand curve and its
importance in the oligopoly model under study. Firstly, the firm's MR curve cannot be
derived as a continuous curve since its demand or average revenue (AR) curve has a
kink. Thus, we may start by discussing the characteristics of the kinked demand curve's
MR curve.
DRD' is the firm's kinked demand curve in Fig. 12.3. This curve has a kink at point R
(p1, q1) because it is made up of two segments: RD', which is part of the steeper curve
DD', and dR, which is part of the flatter curve dd'.
Thus, in the instance of the kinked demand curve dRD', the firm's MR curve would be
the segment NB associated with the segment RD' of the demand curve for q > q1, and
up to q = q1 would consist of the MR curve dM associated with the dR segment of the
kinked demand curve.

1.1 SUMMARY
Economic theory suggests that there lies a continuum of market structure that
comprises of perfect competition at one end and monopoly at the other. Between these
two extremes lie monopolistic competition, oligopoly, and duopoly. With regard to
structure, markets are classified as perfectly competitive market, monopolistic
competitive market, monopoly, and oligopoly. The price determination differs in
different market structures, both in the short and long run.
Since the price is set at market prices, the enterprises must decide how much needs to
be produced. In a market with perfect competition, a company may experience short-
term profit or loss. A monopoly occurs when there is just one vendor and no close
 substitutes for their goods. In this instance, admission is not free. Businesses that
engage in monopolistic competition sell unique goods and make their own decisions.
They could experience losses in addition to supernormal or normal gains. An oligopoly
occurs when there are a limited number of dominant sellers. The element of
interdependence exists in this market. To avoid price wars, the oligopoly firms may
decide to collude. There are several strategic options available for gaining a sustained
competitive edge. The companies employ a variety of pricing techniques. Price lining,
limit pricing, stay-out, psychological, skimming, and penetration pricing techniques are
some examples of these.

1.2 KEYWORDS
Abnormal profit occurs when a company's total sales income exceeds its total
production costs, resulting in a profit that exceeds the normal profit level.

Cartel: A cartel is a legal agreement among producers of an item or service to control

supply or regulate or operate prices. Cartels often set pricing, define trading terms, and
give trade or market sharing rules in order to gain economies of scale.

Collusion is a cooperative and often covert agreement or understanding between

competitors in an industry to coordinate their conduct, usually with the objective of
manipulating market circumstances.

Economic equilibrium is the condition or state in which economic forces are balanced.
In the absence of external influences, economic variables maintain their equilibrium
values. Economic equilibrium is also known as market equilibrium.

Heterogeneous products can be quite different and require considerations other than
price.

A homogeneous product is one that cannot be distinguished from competing products

from different suppliers.

A kinked demand curve is one that is not linear but exhibits varying degrees of
elasticity at different price points. It exhibits stronger elasticity for pricing above the
market price and lower elasticity for prices below the market price.

Market the process through which products and services are exchanged as a result of
buyers and sellers coming into contact with one another, either directly or via
intermediaries like organizations or agencies.
 Market structure is the number and size distribution of buyers and sellers in a market
for products or services.

A monopoly is defined as the production of a product or service by a single entity.

Monopolistic competition is defined by a large number of sellers of a differentiated

product.

Non-collusive behavior is defined as competitive measures taken by enterprises in the

market without formal agreement or cooperation with competitors. It demonstrates
independent decision-making and the pursuit of personal interests.

Normal profit is an economic phrase used to describe a situation in which a company's

total revenues equal its whole costs in a completely competitive market.

Oligopoly situations have fewer sellers, whether or not there is product differentiation.

Perfect competition is a market in which a large number of buyers and sellers trade
nearly identical products. Each is so insignificant that all members are 'price takers'.

Pure monopoly: A market structure in which one firm dominates the market because
of its large market share.

Price discrimination occurs when a company charges different rates to different

customers for an identical good/service with no variances in manufacturing costs.

Super normal profit is also known as abnormal profit, it is when a firms total sales
revenue exceed the total costs of production i.e. they are earning a profit above and
beyond the level of normal profit.

1.3 SELF ASSESSMENT QUESTIONS

1. Differentiate between market structures and their impact on competition.
2. What are the characteristics of a perfectly competitive market?
3. How does a firm determine its level of output in a perfectly competitive market?
4. What are the key characteristics of an oligopoly market?
5. Define a monopoly and outline the key features of a monopoly market structure.
6. How do firms in an oligopoly interdependently make pricing and output decisions?
7. What are the distinguishing features of monopolistic competition?
8. Explain how product differentiation is a key aspect of monopolistic competition.
9. Discuss the long-run equilibrium in a monopolistically competitive market.
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