Directorate of Distance Education

UNIVERSITY OF JAMMU
JAMMU

STUDY/REFERENCE MATERIAL
FOR
B.COM SEMESTER - I

COURSE NO. BCG-103 UNIT I-IV

Subject : Micro Economics Lesson No. 1 to 20

Course Coordinator
Rohini Gupta Suri
9419186716

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1
 MICRO ECONOMICS

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2
Course No. BCG-103 Title : Micro Economics
Duration of Exam : 3 Hrs Total Marks : 100
Theory Examination : 80
Internal Assessment : 20

OBJECTIVE : The objective of this course is to develop basic understanding about

the economic concepts, tools and techniques for rational business decisions.

UNIT - I : INTRODUCTION

Nature, scope of micro economics, relevance of managerial economic business decisions;

Fundamental economic concepts — Scarcity of resources, opportunity cost, production
possibility curve; Demand function: Meaning, types and determinants; Law of demand;
Elasticity of demand — Meaning, types and its measurement; Supply function —
Meaning and its determinants, Law of supply.

UNIT - II : CONSUMER BEHAVIOR

Utility analysis and indifference curve analysis; Consumer’s equilibrium under utility and
Indifference curve approaches, Demand forecasting — its significance and techniques.

UNIT - III : PRODUCTION AND COST ANALYSIS

Factors of production, fixed and variable inputs; Law of variable proportions; Law of
returns to scale; Economics and diseconomies of scale; Cost analysis Kinds of costs,
short run and long run cost functions.

UNIT-IV : MARKET STRUCTURES AND PRICE DETERMINATION

Different market structures and their characteristics, short run and long run price —
output decisions under perfect competition, monopolistic competition, monopoly and
oligopoly.

SKILL DEVELOPMENT (SPECIMEN FOR CLASS ROOM TEACHING

AND INTERNAL ASSESSMENT)

* Diagrammatically present production possibility curve.

* Identify products and apply the concept of elasticity on them.

3( i )
* Select any product and apply a technique of demand forecasting.

* Present a case study showing economics and diseconomics of scale.

* Select few products and show how their price is determined under different
market structure.

BOOKS RECOMMENDED

1. ChopraP.N. : Economic Theory, Kalyani Publishers, New Delhi

2. Ahjuja H.L. : Advance Economic Theory, S.Chand New Delhi

3. Mehta P.L. : Management Economics, S.Chand, Delhi

4. Mehta P.L. : Managerial Economics, Sultan Chand & Sons

5. Koutsoyiannis : A Modern Micro Economics, Macmilla Press Ltd.

6. Dwivedi D.N. : Principles of Economics, Vikas Publishing House Pvt. Ltd.,

New Delhi

7. Mithani, D.M. : Micro Economics; Himalaya Publishing House, New Delhi

8. Misra & Puri : Principles of Micro Economics, Himalaya Publishing House,

New Delhi.

NOTE FOR PAPER SETTER

Equal weightage shall be given to all the units of the syllabus. The external paper shall
be of the two sections viz., A&B.

Section-A : This section will contain four short answer questions selecting one from
each unit. Each question carries 5 marks. A candidate is required to attempt all the four
questions. Total weightage to this section shall be 20 marks.

Section-B : This section will contain eight long answer questions of 15 marks each.
Two questions with internal choice will be set from each unit. A candidate has to attempt
any four questions selecting one from each unit. Total weightage to this section shall be
60 marks.

( ii4 )
 MODEL QUESTION PAPER
MICRO ECONOMICS

SECTION - A

Attempt all the questions. Each question carries five marks.

1. Discuss briefly the concept of market equilibrium ?

2. State the characteristic features of indifference curve ?

3. Differentiate between monopoly and monopolistic competition ?

4. State the Law of diminishing return to scale ?

SECTION - B

Attempt any four questions selecting one question from each unit. Each question
carries 15 marks.

1. Discuss the nature and scope of managerial economics ?

OR

Define elasticity of demand. State its application in business ?

2. Briefly discuss the various techniques of demand forecasting ?

OR

How consumer equilibrium is reached under utility analysis and indifference

curve analysis ?

( iii)

5
3. Explain Law of variable proportion ?

OR

State the relationship between short term and long term cost curve ?

4. How price-output is reached under monopolistic competition ?

OR

What is Oligopoly. State its characteristic features ?

(6iv )
B.Com. Part - I Unit-I
C. No. BCG-103 LESSON No. 1
MICRO ECONOMICS

STRUCTURE

1.1 INTRODUCTION

1.2 OBJECTIVES

1.3 NATURE OF MICRO ECONOMINCS

1.3.1 Microeconomics as Price Theory

1.3.2 Microeconomics and Economic Efficiency

1.4 SCOPE OF MICRO ECONOMICS

1.5 IMPORTANCE AND USES OF MICRO ECONOMICS

1.6 RELEVANCE OF MANAGERIAL ECONOMIC BUSINESS DECISIONS

1.7 SUMMARY

1.8 SELF ASSESSMENT QUESTIONS

1.9 SUGGESTED READINGS

7
1.1 INTRODUCTION

Economic analysis is of two types: micro and macro analysis. Like most other
subjects economics is divided into branches and sub-branches. In recent years the
subject-matter of economics has been made to fall into two major branches (i)
microeconomics, which is the study of the economic actions of individuals and well-
defined groups of individuals; and (ii) macroeconomics, which is the study of broad
aggregates such as total employment and national income. The terms were coined by
professor Ragnar Frisch of Oslo University in 1933 and have become current in modern
economic terminology used in economic theory. The division is in a sense artificial, since
aggregates are merely sums of individual figures. However, it is justified by the basic
differences in the objectives and methods of the two branches.

The fundamental difference between microeconomic theory and macroeconomics

is the microscopic versus the macroscopic view of the economy they take. However, this
is not the only difference between the two branches of economics. Before the micro-
macro distinction came into practice, the fundamental distinction was between price theory
and income theory. This distinction was carried over into the micro and macro branches.
In microeconomics, prices play a major role. Here the goal is generally the analysis of
price determination and the allocation of specific resources to particular uses. On the
other hand, the main objects of macro economics generally are the determination of the
levels of national income, total employment of resources and the general price level.

1.2 OBJECTIVES

The objectives of this chapter is:

• To explain the concept of micro economics.

• To know the importance of managerial economics in business decision making.
1.3 NATURE OF MICRO ECONOMINCS

According to Boulding, “Micro-economics is the study of particular firm, particular

household, individual price, wage, income, industry, and particular commodity.”

8
 In the words of Leftwitch, “Micro-economics is concerned with the economic
activities of such economic units as consumers, resource owners and business firms.”

1.3.1 Microeconomics as price Theory

Microeconomics is the analysis of economy’s constituent elements households,

firms, industries and sectors. ‘Micro’is a Greek word meaning ‘small’. As the name suggests,
it is not aggregative but selective; it seeks to explain the working of market for individual
commodities and the behaviour of the individual buyer and seller in those markets. These
markets are broadly classified into two types: commodity (product) markets and factor
markets. These two markets are not, of course, independent of each other. Since the
factors of production earn in the factor markets and spend in the product markets, changes
in the former reflect themselves in changes in the latter. But there are essential differences
in the character and working of the two markets. These differences justify the need for a
separate theory of distribution. The basic, common feature of the two markets is that the
pricing in both the markets is the result of the interplay of supply and demand and their
elasticities. In the product markets (the product market has many sub-markets), the demand
comes from the households and supply from the firms. A whole group of firms producing
the same product constitutes an industry. Therefore, under product pricing, we study the
forces behind individual demand and for that matter also market demand. An individual
household is said to be in equilibrium if it gets the maximum satisfaction from the allocation
of its expenditure on various goods and services. On the supply side, a firm is in equilibrium
if it is getting maximum profits as determined by its marginal costs and marginal revenue.
An industry is assumed to be in equilibrium if there is no tendency among its constituent
firms to either leave the industry or for outside firms to enter it. In studying the processes
of equilibrium of these entities, we are studying by implication, the process of resource
allocation. But we study the factor markets separately because of the different nature of
supply of factors of production and resources and the derived nature of demand from the
product markets. Thus, the subject of study under microeconomics is an individual consumer
and a firm or an industry. Given the level of aggregate output and employment in the
economy, its goal is to study how resources are allocated between different outputs for
their production, how are product prices determined and how is the total production
distributed among the co-operant producing factors. Microeconomics, in other words,

9
involves the study of economic motives and behaviour of individual consumers and
producers and the principles underlying the organisation and operation of firms and industries.

An important fact to be borne in mind about microeconomics is that here we

assume the prevalence of full employment in the economy as a whole. Given this presumption,
we proceed to know as to how a consumer allocated. It studies relative prices of particular
goods and services, how the various economic units act and react to changes in technology,
the output and allocation of resources. Since prices of products and factor units occupy
the central place, microeconomics is also called Price Theory. While the behaviour of a
particular unit is under study, it has to be assumed that the environmental data are given.
For example, in the analysis of price determination in a particular industry, it is assumed
that the price and output in the industry under study are independent of those in other
industries. On account of this ceteris paribus assumption of micro-economics, it is also
called Partial Equilibrium analysis.

1.3.2 Microeconomics and Economic Efficiency

An important extension of micro-economic theory consists of the determination of

conditions for economic efficiency of firms and industries, and through them, the economy.
Now we study the ideal organisation of production and exchange that would satisfy a
community’s broad economic motives. This type of analysis has been the basis of modern
welfare economics that studies the optimal allocation of resources so as to achieve given
non-contradictory but competing goals. Thus, we can say that the Robbinsian problems of
‘scarcity’ and ‘allocation’ of resources are at the heart of micro-economics.

1.4 SCOPE OF MICRO ECONOMICS

Micro economics is concerned with the efficiency of allocation of resources for

achieving the various objectives of the society. The scope of micro economics extends to
the following fields.

(1) Theory of demand- All economic activity originates from a source of demand.
Production of goods is done when there is demand for these. Micro economics studies the
nature and extent of demand for different commodities and services and the way these

10
demands are interrelated. We study the behaviour of demand for a commodity, its elasticity,
and variations in the same over a period of time. Sometimes economists try to forecast the
demand for the product of a firm.

(2) Theory of production- When a commodity is demanded, it has to be produced by

firms for a profit. Firms use the factors of production-land, labour, capital and
entrepreneurship-to produce the output which is most-profitable for them. In order to
study the process of production, we study the laws of production- the behaviour of output
in response to changes in inputs. We distinguish between the laws of production which
operate in the short run and over the long period.

(3) Theory of price determination- Micro economics studies the way in which price
determination of different commodities, the nature and structure of the markets where
buyers and sellers interact and the changes in prices and outputs of the same over the short
period and the long period. The earlier fields of knowledge-the theories of demand and
supply-help us in knowing the process of commodity pricing in the perfect and imperfectly
competitive markets.

(4) Theory of factor pricing- In this part of micro economics, we study the determination
of the rates of return to the four factors of production-rent to land, wages to labour,
interest to capital and profits to entrepreneurship. Rent, wages, interest and profits are the
income shares of the four factors which are supplied by different people. In fact, the factor
markets determine the pattern of income distribution in the economy. We are especially
interested in the share of wages because a large part of the population earns its income
from wages.

(5) Allocative efficiency- Micro economics is specifically being used to study the
efficiency of allocation of the resources available to consumers, firms and industries. It is
usually presumed that consumers try to maximise their satisfaction while firms try to
maximise, therefore, profits by minimising their costs. This ensures allocative efficiency of
the resources used by them. But this is not so in practice. There are inter-dependencics
among consumers, firms and industries which micro units are not able to control. It is in
this area of consumption and production that the market-mechanism is unable to ensure

11
allocative efficiency. Micro economics explores the scope for increasing output by re-
organising the use of resources.

(6) Welfare Economics-The last part of micro economics is what is called welfare
Economics. Here we study the determinants of human welfare, the way the resources of
the society ought to be used to promote the maximum benefit of the maximum number of
people in the society. It studies the ideal ways of production, exchange and distribution.

1.5 IMPORTANCE AND USES OF MICRO ECONOMICS

Microeconomic analysis is applied for solving different economic problems. In

this regard Lord Keynes said, “Microeconomics is a necessary part of one’s apparatus of
thought.” The importance of microeconomics is reflected in the following arguments:

1. Operation of an economy

We get knowledge about the operation of any economy from the microeconomics.
It tells us whether the units of the economy like a consumer or a firm are behaving optimally
or not. According to Prof. Watson, “Micro-economics has many uses. The greatest of
these is the understanding of the operation of the economy.”

2. Basis of the economy as a whole

We know that micro-economics deals with individuals whereas macroeconomics

deals with aggregates. Aggregates are merely the sums of individual figures. Therefore,
microeconomics is the base for clear understanding of macro-economics. The problems
of the economy are analysed on the basis of the analysis of the individual units of the
economy. For example, if we want to study the expenditure habits of an economy, we will
have, to study the family budgets of individuals of the economy. In this way, for detailed
understanding of the working of the economy, the study of individuals is a must.

3. Predictions

The principles of microeconomics are based on predictions. These predictions

are made on some conditions. It explains that if something occurs then a set of results will
follow. For example, micro-economics states that with the fall of demand, prices will also
fall.

12
4. Economic policies

Microeconomics is used while formulating economic policies. With the study of

microeconomics, we can know the effects of Government policies on the allocation of
factors or resources. In fact, microeconomics provides a basis for making economic
policies. For example, when a Government wants to impose new taxes, it can make
necessary changes in it by knowing the reactions of the people regarding the new taxes.
This knowledge of individual reactions can be had from the microeconomics.

5. It is helpful in removing difficulties of a particular firm

There may be some difficulties or complications in the working of an individual

firm or an industry. To remove these complications or difficulties, we need not study the
working of the whole economy. The study of a working of a firm or an industry will suffice.
Therefore, micro analysis is helpful in such situations:

6. It is the basis of welfare economics

The great importance given to microeconomics is due to the fact that it provides
the base for welfare economics. The ultimate aim of all production is consumption. The
main aim of the study of positive economics is the policy implications that can be built out
of its prepositions. In so far as the main aim before us is the optimum allocation of our
scarce resources, the primary purpose of economic theory is to build up hypothesis that
define the ‘optimum’. Price theory or microeconomics helps us exactly in doing this.

The whole structure of welfare economics available to us is built entirely on the

price theory of perfect competition.

1.6 RELEVANCE OF MANAGERIAL ECONOMIC BUSINESS DECISIONS

Business firms also use microeconomics while taking managerial decisions. In this
context, the cost and demand analysis occupy great significance. From the arguments in
favour of microeconomics we can say that it provides a base for analysing the problems of
the economy as a whole.

13
 A business manager is essentially involved in the processes of decision making as
well as forward planning. Decision making is an integral part of management. Management
and decision making are to be considered as inseparable. It is the intellectual process and
a purposeful activity which at varied times takes in hands all the managerial activities, such
as, planning, organising, staffing, directing and controlling. It is the process wherein an
executive, by taking in to consideration several alternatives reaches at the conclusion about
how it should be dealt successfully in a given situation. Thus, being a continuous activity,
decision making is regarded to be the heart of management. Decision making is nothing
but choice-making and the importance of choice-making emerges due to the fact that a
business faces the changes in the conditions in which it operates and there arise unforeseen
contingencies. The survival and the growth of a business in such situations is directly
determined through decision making process. It can be defined clearly as selecting one of
the best alternatives available - that entails being two or more alternatives. According to
George Terry, “Decision making is the selection of a particular course of action, based on
some criteria, from two or more possible alternatives.” Decision making is thus choosing
the best course of action out of the available options while aiming at the achievement of
particular organisational objectives. Since a business organisation has the available
resources, such as, capital, land and labour, a business manager needs to select the best
alternative among others and employ in the most efficient manner so as to attain the desired
results. After a particular decision is made relating to resources, plans about production,
pricing and materials are to be implemented. In this way, decision making and forward
planning go conjointly. The fact that a business entity is influenced by the conditions of
uncertainty about the future and due to the changes in the business environment resulting
complexities in business decisions. Since no information or the knowledge about the future
sales, profits or the costs is available for a business executive, the decisions are to be
made on the basis of past data as well as the approximations being forecasted. In order
that the decision making process is carried out in such conditions in an efficient way,
economic theory is of great value and relevance as it deals with production, demand, cost,
pricing etc. This gives rise to understand the concepts of managerial economics for business
manager so that he may apply the economic principles to the business and appraise the
relevance and impact of external factors in relation to the business.

14
 Having been regarded as micro economic as well as the economics of the firm,
managerial economics is related to the economic theory which is to be applied to the
business with the objective of solving business problems and to analyse business situations
and the factors constituting the environment in which a business is operated. Managerial
economics has been defined by Spencer and Siegelman as, “The integration of economic
theory with business practice for the purpose of facilitating decision making and forward
planning by management.” Managerial economics is very much capable of serving various
purposes and useful for managers in making decisions in relation to the internal environment.
It aims at the development of economic theory of the firm while facilitating the decision
making process with regard to sales and profits etc. Moreover, it enables to take decisions
about appropriate production and inventory policies for the future. It is a branch of
economics that is applied to analyse almost all business decisions. It is meant to undertake
risk analysis, production analysis that is useful for production efficiency. Likewise, it is of
great use for capital budgeting processes as well. In the most positive form, it seeks to
make successful forecasts with the objective of minimising the risks involved. It deals with
the aspects as how much cash should be available and how much of it should be invested
in relation to a choice of processes and projects while making possible the economic
feasibility of various production lines. A business produces goods which are in course of
time to be sold in the market on the basis of demand of consumers. Demand can be
defined in brief as the quantity of goods that the consumers are willing to buy at certain
prices. In this pursuit, the decisions related to demand are of much significance for managers
as the process entails making appropriate estimates with successful forecasts on sales
before the activity of production is to be carried out. It is therefore demand analysis is
essential part of managerial economics since it enables to analyse the demand determinants
and forecasting with a deep involvement of value judgments. Above and beyond, by
considering whether the competitions are likely to increase or decrease, a business manager
with the help of managerial economics applications is able to asses demand prospects as
well as the social behaviour that can result in the expansion or the reduction of the sales of
business products. Further, Managerial economics deals with the cost estimates that are
helpful for management decisions. It is important for a manager to undertake production
analysis and to determine economic cost with the objective of profit planning and cost
control processes. Since the objective of a business entity in general is to generate profits,

15
profit is the chief measure of success in this way. In respect of this, managerial economics
cover the aspects, such as, Profit policies and the techniques of profit planning-Break
Even Analysis-also called as cost volume profit analysis - that assists significantly in profit
planning and cost control methods with a view to maximise profits of the business.
Managerial economics plays a significant role in the business organisations. It is very much
effective to the management in decision making and forward planning in relation to the
internal operations of a business as it gives clear understanding of market conditions as
well as analytical tools through which the competitions prevailing in the markets can be
studied, at the same time the market behaviour can be predicted. It enables to analyze the
information about the business environment in which a business is managed. It is meant to
undertake systematic course of business plans by making possible forecasts. Managerial
economics contributes to the profitable growth of business and effective solutions of the
business problems by changing the economic scenario in to the feasible business
opportunities for business organisations while enabling managers to optimise business
decisions as well as involving them in the activity of forward planning efficiently.

In a civilised society, we rely on others in the society to produce and distribute

nearly all the goods and services we need. However, the sources of those goods and
services are usually not other individuals but organisations created for the explicit purpose
of producing and distributing goods and services. Nearly every organisation in our society-
whether it is a business, non-profit entity, or governmental unit-can be viewed as providing
a set of goods, services, or both. The responsibility for overseeing and making decisions
for these organisations is the role of executives and managers.

Most readers will readily acknowledge that the subject matter of economics applies
to their organisations and to their roles as managers. However, some readers may question
whether their own understanding of economics is essential, just as they may recognise that
physical sciences like chemistry and physics are at work in their lives but have determined
they can function successfully without a deep understanding of those subjects.

Whether or not the readers are skeptical about the need to study and understand
economics per se, most will recognise the value of studying applied business disciplines
like marketing, production/operations management, finance, and business strategy. These

16
subjects form the core of the curriculum for most academic business and management
programs, and most managers can readily describe their role in their organisation in terms
of one or more of these applied subjects. A careful examination of the literature for any of
these subjects will reveal that economics provides key terminology and a theoretical
foundation. Although we can apply techniques from marketing, production/operations
management, and finance without understanding the underlying economics, anyone who
wants to understand the why and how behind the technique needs to appreciate the
economic rationale for the technique. Since the purpose of managerial economics is to
apply economics for the improvement of managerial decisions in an organisation, most of
the subject material in managerial economics has a microeconomic focus. Therefore,
Managerial economics may be viewed as economics applied to problem solving at the
level of the firm. The problems relate to choices and allocation of resources is faced by
managers all the time. Managerial economics is more concrete and situational and mainly
concerned with purposefully managed process of allocation.

1.7 SUMMARY

Microeconomics involves the study of economic motives and behaviour of individual

consumers and producers and the principles underlying the organisation and operation of
firms and industries. Where prices of the products and factor units occupy the central
place, microeconomics is also called Price Theory. An important extension of micro-
economic theory consists of the determination of conditions for economic efficiency of
firms and industries.

Micro economics is concerned with the efficiency of allocation of resources for

achieving the various objectives of the society. The scope of micro economics covers
various fields like theory of demand, theory of production, theory of price determination,
theory of factor pricing, allocative efficiency, and welfare Economics.

Further, microeconomic analysis is applied for solving different economic problems.

We get knowledge about the operation of any economy from the microeconomics. It tells
us whether the units of the economy like a consumer or a firm are behaving optimally or
not. The principles of microeconomics are based on predictions. It is used while formulating
economic policies. With the study of microeconomics, we can know the effects of

17
Government policies on the allocation of factors or resources. The great importance given
to microeconomics is due to the fact that it provides the base for welfare economics.

Also, managerial economics is related to the economic theory which is to be applied

to the business with the objective of solving business problems and to analyse business
situations and the factors constituting the environment in which a business is operated.
Managerial economics has been defined by Spencer and Siegelman as, “The integration
of economic theory with business practice for the purpose of facilitating decision making
and forward planning by management.” Managerial economics is very much capable of
serving various purposes and useful for managers in making decisions in relation to the
internal environment.

1.8 SELF ASSESSMENT QUESTIONS

1. How is micro economics different from macro-economics?

__________________________________________________________

__________________________________________________________

____________________________________________________________

2. Define micro economics. What is its importance?

___________________________________________________________

__________________________________________________________

__________________________________________________________

2. Critically evaluate micro economics. How micro economics is helpful in taking

business decisions?

__________________________________________________________

__________________________________________________________

18
1.9 SUGGESTED READINGS

• Business Economics, Chopra P.N., Kalyani Publishers, New Delhi.

• Managerial Economics, Mehta, P.L., S. Chand, Delhi.

• Micro Economics, Mithani, D.M., Himalaya Publishing House, New

Delhi.

---------

19
B.Com. Semester-I Unit-I
C. No. BCG-103 LESSON No. 2

FUNDAMENTAL ECONOMIC CONCEPTS

STRUCTURE

2.1 INTRODUCTION

2.2 OBJECTIVE

2.3 SCARCITY OF RESOURCES

2.3.1 Robbins’ Scarcity-of-Resources Definition

2.3.2 Main Features of Robbins’ Definition

2.3.3 Merits of Robbins’ Definition

2.3.4 Criticism of Robbins’ Definition

2.4 OPPORTUNITY COST

2.4.1 Relative Nature of Opportunity Cost

2.4.2 Outlay Costs and Opportunity Costs

2.4.3 Choice and opportunity cost

2.5 PRODUCTION POSSIBILITY CURVE

2.5.1 Assumptions

2.5.2 Production Possibility Schedule

20
 2.5.3 Production Possibility Curve Explain

2.5.4 Production Possibility Curve as the Transformation Curve

2.5.5 Increasing Opportunity Costs

2.5.6 Uses of Production Possibility Curve

2.5.7 Shifting of Production Possibility Curve

2.6 SUMMARY

2.7 SELF ASSESSMENT QUESTIONS

2.8 SUGGESTED READING

2.1 INTRODUCTION

Economic theory deals with the problems of economic systems. To understand the
economic problem means to know the purpose and functions of economic system.
Economic problem arises mainly due to two reasons: (i) human wants are unlimited, (ii)
resources to satisfy human wants are scarce.

The problem of scarcity is faced by an individual and a nation. We know from our
daily experience that man has to do many types of work to satisfy his wants. The nature of
human wants is such that they never come to an end. As long as man is alive, his wants go
on increasing. In his life time, a man cannot satisfy or fulfill all his wants. The reason is that
resources required to fulfil these wants are limited i.e., they cannot be increased according
to needs. This is also true for a nation. Productive resources are scarce in relation to
human wants. Thus, unlimited wants and scarce resources lead to the origin of the
basic economic problem in all types of economies, whether they are rich or poor.
Besides the fact of scarcity of productive resources, you also find that resources have
alternative uses. It means that one resource can be put to several uses. For example, coal
is used in factories, in running railway engines, in ovens, etc. So those resources which are
scarce in relation to human wants become more scarce. This character of human resources
gives rise to another problem. This is the problem of choice. The economic problem is to

21
utilise these scarce resources that it satisfies the human wants in the best possible way. In
other words, the problem of choice deals with the utilisation or allocation of scarce resources
in such a way as achieves the greatest possible satisfaction of human wants.

Prof. Lewis has rightly said, “We have economic systems or economies because we
are confronted by the economic problem; all economies irrespective of characteristics or
qualities are fashioned, moulded and maintained solely because this problem exists. To
understand the economic problem is to know the purpose and functions of economic
system.”

The economic problem is pointed out in Robbins’ definition of economics clearly.

He observed, “Economics is the science, which studies human behaviour as a relationship
between ends and scarce means which have alternative uses”.

Because resources are scarce, choices have to be made. There are three main
types of choice which must be made in any society and these are:

• What goods and services are going to be produced and in what quantities, given
that there are not enough resources to produce all things people desire?

• How are things going to be produced, given that there is normally more than one
way of producing things?

• For whom are things going to be produced?

All societies have to make these choices, whether they be made by individuals, by
groups or by the government. These choices can be seen as micro economic choices,
since they are concerned not with the total amount of national output, but with the individual
goods and services which make it up: what they are, how they are made, and who gets the
income to buy them.

2.2 OBJECTIVES

The objectives of this chapter are:

• To provide the idea of economic problem.

22
 • To explain the concept of scarcity of resources and opportunity costs.
• To define production possibility curve and its related concepts.
2.3 SCARCITY OF RESOURCES

2.3.1 Robbins’ Scarcity-of-Resources Definition

Robbins criticised Marshall for his normative view of economics. In his own words,
“Economics is the science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses.” The definition is based on a number of
facts of life: (i) wants are unlimited but, (ii) the means to satisfy the human wants are limited
or scarce, (iii) the means or resources can be put to different uses, (iv) we are faced with
the choice of using the limited means to satisfy this want or that. Much of man’s economic
activity is moving around the problem of scarcity or choice. This is the central idea in
Robbins’ definition.

2.3.2 Main Features of Robbins’ Definition

The definition given by Robbins has the following five main features:

I. Unlimited wants or ends- Robbins calls wants as the ends. Ends are of the
economic or non-economic type. Those concerned with the consumption of goods
and services may be called economic ends. Economic ends are unlimited; as one
want is satisfied, many, others crop up. It is impossible to satisfy all of man’s
wants. Each one of them, of course, may be satisfied separately.

II. Limited or scarce means- Most of the means or resources which can be used to
satisfy wants are limited in supply. Here the word ‘limited’ is used in a relative
sense. We call such a resource as limited whose supply is less than its demand.
Man’s wants are unlimited and the resources available to satisfy them are scarce.
Therefore, we are forced to postpone the satisfaction of many of our wants while
we try to find out more and more resources by working harder and harder.

III. Means have alternative uses- According to Lord Robbins, another important
reason for the existence of the economic problem is the alternative uses of

23
 resources. Some resources have a large number of uses, for example, sugar. Others
have a few uses, for example, wasteland. Man is always faced with the problem
of allocation of limited resources.

IV. Wants are of different intensity- All the wants are not equally urgent. Some
wants are more intense than others. Some need immediate satisfaction, others can
wait. For example, if a man needs medicine as also fruit for his ailing child, he will
try to obtain the medicine first. Thus, a man is forced to choose between wants
due to their different intensity.

V. Problem of choice- According to Robbins, choice making is really an economic

activity. Every man is faced with the scarcity of means and as such is forced to
make a choice in his present and future satisfaction of wants and in his allocation
of resources. The choice problem is the central problem of economics. It forces
us to evaluate different commodities for their satisfaction of man’s wants. If resources
were in plenty and goods free, there would be no such problem. But facts are
always pointing to the scarcity of means.

Robbins’ definition has been approved by a good number of economists like Macfie,
Oscar Lange. Scitovsky has remarked, “Economics is a social science concerned with the
administration of scarce resources.”

2.3.3 Merits of Robbins’ Definition

Robbins has found many admirers. For example, Macfie has showered praise on
his definition in the following words “Whatever he (Robbins) has said cannot be resaid. To
me it appears final within its chosen scope.” We can list the major merits of Robbins’
definition as under:

a) Status of a positive science- Robbins tried to make economics a more exact

science. He defined economics in a way as clearly laid down the central problem
of the science of economics. Therefore, he wanted the subject to be a positive
science, that is, a science which has nothing to do with the goodness or bad nature
of the ends. He wanted to study all economic activities without bringing in welfare.
He succeeded in this to some extent.

24
 b) An analytical definition- Robbins’ definition has made the study of economics
analytical. He provided the reasons for the study of the economic problem which
is the problem of scarcity. Thereby he not only gave a separate identity to the
subject, he pointed to the nature of analysis in it also.

c) Clear conception of human behaviour for economics- Robbins also gave a

clearer view of what human behaviour economists are interested in. He told us
that it is human behaviour for choice between ends and means.

d) Clear on the scope of Economics- This definition has delimited the scope of
economics very well. Wherever a choice problem arises due to the resources
being scarce and the wants being much more, an economic study is called for.
This is the subject matter of economics.

e) A universal definition- Robbins’ definition is applicable everywhere. It is

concerned with unlimited wants and limited resources which is the problem
facing every country. Whether it is rich America or poor Asia, whether an
economy is capitalist or socialist, the problem everywhere is the same.

f) Points out the central problem of Economics- Marshall’s definition, was

defective due to the failure of the definition in identifying the central problem.
Robbins can be credited with removing this defect.

2.3.4 Criticism of Robbins’ Definition

The definition given by Robbins is logical and scientific. But it has been criticised
by some economists on different grounds.

1. Self contradictory. Robbins has contradicted himself by his two views

about choice between ends. In the first place, he contended that economics is neutral as
regards ends. Secondly, he considers economics as the science of choice. These two
contentions are mutually contradictory because choice between ends and the allocation of
resources is simply not possible without a knowledge of the relative importance of different
ends.

2. Concealed concept of welfare. Robbins rejects Marshall’s definition for its welfare

25
content. According to critics, even Robbins’ definition has a concealed concept of welfare.
According to Robbins, economics is concerned with the choice between ends and allocation
of resources. It is understood that there is something to guide the solution of this problem.
I is nothing else than maximisation of satisfaction. Prof. Pigou considered satisfaction as a
sign of welfare. Thus, the idea of welfare has entered Robbins’ definition through the
backdoor.

3. Hazy view of the scope of Economics. Robbins laid down in general terms the
subject matter of economics. It is difficult to decide in particular cases whether it is in the
scope of economics or not. For example, time and space available to us arc limited. The
choice here is so wide that economics alone cannot solve the problem. To what extent is
economics concerned is just not clear in Robbins’ definition.

4. Ineffective attempt to make Economics a positive science. Critics have also charged
Robbins with trying in vain to make economics a positive science. Fraser observed,
“Economics is something more than a value theory or equilibrium analysis.” If economics
is not concerned with material welfare then what is it concerned with? Again a Ruskin can
attack economics. It becomes a dry and dull science. Prof. Pigou also observed that
economics must be a problem-solving science. It is as much an art as it is science.

5. Artificial separation of Economist’s personality. Prof. Eric Roll has criticised

Robbins for dividing the personality of an economist artificially. As an economist, Robbins
wants the analyst to refrain from commenting on ends and means. In the practical life, the
economist is supposed to give his verdict on economic matters. An economist’s personality
cannot be split like this. He is not mechanical-minded as Robbins seems to believe.

6. Impractical definition. If we follow Robbins then economics is merely an intellectual

exercise. It is a study for study’s sake. But all practical men of affairs are interested in a
science only if it can help to solve humanity’s problems. This is particularly true of
economics. Robbins’ definition is removed away from reality.

From the study of Robbins’ definition of economics we can say that it is a scientific definition.
The main shortcoming of this definition is that it considers economics only as theoretical
science. It ignores the realistic side of economics because it ignores the welfare of human

26
beings. The fact is that we cannot separate welfare from economics. Welfare economics is
developing these days. The reason is that the role of state has increased in the economics
activities of nations. Every state aims at pro viding maximum
benefits to its citizens. Thus economists cannot remain silent about the well-being of human
beings. Thus, the fundamental economic problem of every economy is of relative scarcity.
It is so in all types of economic systems whether it is a capitalistic economy, a socialistic
one or a mixed economy. Thereby the principle of economising is given much importance.
Further, modern economists have analysed the nature of fundamental economic problems
with help of the production possibility curve.

2.4 OPPORTUNITY COST

Work to an ordinary man is uncomfortable or even painful if done overtime. In the

same way, responsibility and risk-bearing in business means worry and nervous wear for
the common businessman. Similarly, accumulation of capital whose services are so important
for production is the result of a process of abstinence and waiting. From the social point of
view no real cost may be attributed to the services of natural resources, yet from the point
of view of an individual, land (or other resource) owner, the sacrifice of an opportunity of
using it for some purpose other than the one to which it is being put, constitutes a cost. The
forgone opportunity also taken as cost and is termed opportunity cost.

According to Leftwitch, “Opportunity cost of a particular product is the value of

the forgone alternative product that resources used in its production could have produced.”

It is instructive and analytically helpful to think of production costs as opportunity

costs or alternative costs. The resources (or inputs) used in production generally have
many alternative uses, that is, they are non-specialised. A driver can be used to drive a
taxi, a personal car, a highway truck, a tractor or a road-building bulldozer. He cannot be
put to all these employments at the same time. His employment as a taxi driver means the
loss of an opportunity of employing him as a truck driver. The sacrifice of an alternative
opportunity from the viewpoint of the transport firm is an opportunity cost.

A more interesting example of opportunity cost is the dislocation of family life a

person has to suffer in agreeing to his wife getting employed. Similarly a businessman is

27
generally capable of working in a few industries. A machine can be put to a variety of uses.
Its employment in one of these uses must pay it at least that much which it can get in the
next best employment; it must be priced at least equal to its transfer earnings, which is its
opportunity cost.

2.4.1 Relative Nature of Opportunity Cost

Opportunity cost assumes different magnitudes when looked from different angles:

i. From an individual producer’s viewpoint opportunity cost of a worker is

the wage he can secure by working in another firm within the same industry,

ii. From the industry’s viewpoint, his opportunity cost is the wages he will be paid in
another industry, where he can get the next highest wages. The alternative cost
looked at from the point of industry will be less than that viewed from the individual
firm’s viewpoint. This is because the worker will choose the firm in that industry
where he gets the highest wage. However, the alternative cost of labour of the
worker is entirely different when looked at from the social point of view. Socially,
a worker can be put to an innumerable number of tasks. In this case the alternative
or opportunity cost will be the wage he needs in his lowest paid employment.

We can therefore said that ultimately the real costs of production of a commodity
boil down to the costs that are paid socially, the costs which the society has to pay. A
private entrepreneur reckons his costs of production from his point of view; a society
must, in planning resource allocation, look at costs from its own point of view. This difference
in the viewpoints has also given rise to another cost concept, the social as against private
cost.

According to Ferguson, “The alternative or opportunity cost of producing one

unit of commodity X is the amount of commodity Y that must be sacrificed in order to use
resources to produce X rather than Y.” Opportunity cost has to be stated in relative terms.

2.4.2 Outlay Costs and Opportunity Costs

Outlay costs involve actual outlay of funds on, say, wages, material, rent, interest
etc. Opportunity cost, on the other hand, is concerned with the cost of foregone opportunity;

28
it involves a comparison between the policy that was chosen and the policy that was
rejected. For example, the cost of lending or using capital is the interest that it may earn in
the next best use of equal risk.

A distinction between outlay costs and opportunity costs can be drawn on the.
basis of the nature of the sacrifice. Outlay costs involve financial expenditure at some
time and thus are recorded in the books of account. Opportunity costs relate to sacrificed
alternatives; they are not recorded in the books of account in general.

The opportunity cost concept is very useful, e.g., in a cloth mill which spins its
own yarn, the opportunity cost of yarn to the weaving department is the price at which the
yarn could be sold, for measuring profitability of the weaving operations. Similarly, during
a boom period a decision of the use of scarce capacity for a given product would involve
the use on the opportunity cost of not using it or to make some other product that can yield
profit.

In long-term cost calculation also it is useful e.g., in calculating the cost of higher
education, it is not only the student’s tuition fee and books but also the earning foregone by
him that should be taken into account.

2.4.3 Choice and opportunity cost

Choice involves sacrifice. The more food you choose to buy, the less money you
will have to spend on other goods. The more food a nation produces the fewer resources
will there be for producing other goods. In other words, the production or consumption of
one thing involves the sacrifice of alternatives. This sacrifice of alternatives in the production
(or consumption) of a good is known as its opportunity cost.

The opportunity cost of buying a text book is the new pair of jeans you also
wanted to buy which you have had to go without. The opportunity cost of working overtime
is the leisure you have sacrificed.

29
2.5 PRODUCTION POSSIBILITY CURVE

The relative scarcity of productive resources in relation to needs has caused the
economic problem. Every economy has to decide about what to produce, how to produce,
and for whom to produce. These are the sub-problems. We know the problems which an
economy has to solve from time to time. Prof. Samuelson has analysed these problems
with the help of production possibility curve.

Whatever the nature and type of an economy, it faces the problem of scarcity of
resources in relation to human wants. In other words, in socialistic as well as capitalistic
economies, in rich as well as in poor countries, the basic or fundamental cause of all
economic problems is the scarcity of resources in relation to human wants. Owing to
scarcity of resources, the need of economising is felt. An economy cannot produce unlimited
amounts of goods. Though we use all factors of production for the production of a good,
yet its production cannot go beyond a limit. So by using different-combinations of factors
of production for the production of different goods, we can know the possibilities of
production of the desired goods. This tells us the maximum production that can be possible
with the help of available combinations of factors of production. The curve showing the
possibilities of production of the desired goods in an economy is known as production
possibilities curve. In other words, production possibilities curve depicts the maximum
possible production of different combinations of different goods that can be produced
with the given technology and resources.

According to Samuelson, “Substitution is the law of life in a full-employment

economy. The production possibility curve or frontier depicts society’s menu of choices.”

2.5.1 Assumptions

a) Fixed Factors of Production- It is assumed that the factors of production are given
and they do not change.

b) Full Employment- Factors of production are supposed to be fully employed.

30
c) No change in technology- Methods of production and technology are assumed to
be constant.

d) Based on short run- Production possibility curve is a short period phenomenon. The
reason is that techniques of production and size of factors of production can change in
the long run. So it is a short period concept.

e) Production of two goods- Further it is assumed that the economy is producing only
two goods, rice and butter. So all factors of production arc engaged in the production
of these two goods.

f) Substitution of Factors of Production- Another bold assumption taken here is that

factors of production are substitutable. It means that one factor can be frequently used
in place of another. The assumption implies that factors of production can be reallocated
among different uses.

We know that resources at our disposal are scarce. Further all factors of production
are taken to be fully employed. So if we increase the production of one commodity, it can
be only at the cost of another commodity. The reason is that to increase the production of
one good, we have to put more factors of production to work. This is possible only when
some factors of production are taken away from the other use. Therefore, from the
production possibility curve, we come to know how factors of production are transferred
from one use to another. This curve is also known as “Transformation Curve.”

2.5.2 Production Possibility Schedule

Production possibility schedule shows the various combinations of different goods

which can be produced with the existing resources with the given technology. We have
assumed that the economy is producing only two goods: rice and butter. Various
combinations of the two goods which can possibly be produced using the given factors of
production in different proportions can be listed in a schedule given below:

31
 Table 3.1: Production Possibility Schedule

Production Rice Butter

Possibilities (in tons) (in tons)

A 0 15

B 1 14

C 2 12

D 3 9

E 4 5

F 5 0

The production possibility schedule given above shows that if all the factors of
production are engaged in the production of butter alone, the economy is capable of
producing fifteen tons of butter. On the contrary, when all factor inputs are used for the
production of rice, five tons of rice is produced. These are the two extremes of possibilities
of production of the two goods.

In between these two combinations, there are other combinations of the two goods
showing the different possibilities of production of rice and butter. Production possibility
on combination B is such that 1 ton of rice and 14 tons of butter are produced. Similarly
combination C gives 2 tons of rice + 12 tons butter ; Combination D offers 3 tons rice +
9 tons butter and combination E shows that 4 tons rice + 5 tons butter can be produced
with the given resources and technology.

One thing more is clear from the schedule. That is, as we go on having more and more
quantities of rice or lesser quantities of butter, we are ready to forgo more quantities of
butter to get the same additional units of rice. In other words, the marginal rate of
transformation between rice and butter is increasing. The schedule also shows that more
of rice can be produced only when less butter is produced. In other words, increase in the
production of rice takes place only at the cost of butter.

32
2.5.3 Production Possibility Curve

Production possibility curve is the graphical representation of the production

possibility schedule. In other words, production possibility curve graphically shows the
alternative production possibilities with given resources and technology. It can be explained
as under.

Figure 2.1 shows the graphical representation of the production possibilities

schedule. The curve AF is obtained when the different combinations of the production of
rice and butter as shown in the schedule are plotted on a graph. This curve is called the
production possibility curve. It shows the various combinations of rice and butter which
the economy can produce with given amount of resources. This production possibility
curve like the schedule shows that in an economy where there is full employment, an
increase in the amount of one good is possible only by decreasing the amount of another
good.

O 2 3 4 5
PRODUCTION OF RICE (in tons)

Fig. 2.1 The Production Possibility Curve with a Given Technology

33
 In figure 2.1, combination A shows 15 tons of butter alone because all factors are
used in the production of butter. Similarly point F on the AF curve shows that only 5 tons
of rice is produced when all resources are devoted for its use. In between these two
combinations, there are various points B, C, D and E showing the different combinations
of rice and butter that can be produced with the given technology and factors of production
available to the economy.

2.5.4 Production Possibility Curve as the Transformation Curve

We have already said that production possibility curve is also called transformation
curve. The reason is that when we move from one point to another on the production
possibility curve, one good is transformed into another by transferring resources from one
use to another. Another implication of the curve is that, with the given resources and
technology, the combination of the two goods produced can lie anywhere on the production
possibility curve but not inside or outside it.

As shown in the figure 2.2 the combined output of rice and butter can neither lie at S nor
at P. This is so because at S the economy would not be utilising its resources fully while the
output of the two goods shown by point P is beyond the reach of the economy under the
given technology. In other words, the economy is not having enough resources to produce
the output as shown by the point P. Further, a movement from S to any point B, C, D is
welcome.

RICE
Fig. 2.2 The Transformation curve

34
2.5.5 Increasing Opportunity Costs

The production possibility curve also illustrates the phenomenon of increasing opportunity
costs. But this we mean that when a country produces more of one good, it has to sacrifice
ever increasing amounts of the other, the reason for this is that different factors of production
have different properties. Workers differ in efficiency and lands differ in productivity. Thus,
as a nation wants to produce more and more of one good, it has to start using resources
which arc less and less suitable. In one example given in table 3.1, production of an
additional ton of rice involves sacrifice of one, two, three and four tons of butter for every
additional ton of rice produced. This is called the law of increasing opportunity costs. It is
because of the operation of this law that a normal production possibility curve slopes from
left to the right and is concave to the origin.

2.5.6 Uses of Production Possibility Curve

Production possibility curve helps us to make correct decisions regarding the

analysis and solution of economic problems. It tells what goods ought to be produced.
With the given technology and factors of production, production possibility curve shows
the maximum amount of product that can be produced if the economy is working efficiently.

1. Knowledge of economic efficiency- The answer to the first problem (i.e. whether
there is the full and efficient utilisation of economic resources or not) can be sought
from the transformation curve as shown in figure 3.2. If the real production of the
economy lies on the production possibility or transformation curve, it is said to be fully
utilizing its resources: On the contrary, if the actual production level of the economy
lies below the transformation curve as shown by point 5 in the figure, it means that it
is not fully utilizing its resources. Thereby there is the scope of increasing production
by putting idle resources to work or by removing inefficiencies of production.

2. Distribution of the national product- Production possibility curve also solves another
economic problem. It shows the distribution of the national income between the two
sections of the society known as capitalists and workers. We can know from it as to
how much of the national income is enjoyed by the capitalists and how much goes to
workers. For example, if the economy is producing more televisions than cloth, then

35
 we can say that there is the inequality of the distribution of wealth.

3. Choice of the techniques of production- Another problem concerning the choice of

techniques of production is also illustrated with the help of the production possibility
curve. There are two techniques of production: (i) labour intensive, (ii) capital-intensive.
The choice of techniques depends upon the economic conditions of the country-
availability of capital, size of the population, technological development and training
facilities, etc. Actual choice of techniques can be made only by keeping in mind the
production possibilities. If the needs of the people are more in consumer goods, then
labour-intensive techniques are profitable and suitable. On the contrary, if people
demand more machinery and other capital equipment, then capital-intensive techniques
are advocated.

4. Nature and extent of economic growth- The answer to the problem of economic
growth can also be sought from the production possibility curve. The curve shows the
different combinations of production of two goods with the given technology and
factors of production. The production possibility curve is based on the assumption of
the short period. The reason is that technological developments take place with the
passage of time. When technological improvements occur, it is possible to increase
production even with the old size of factors of production or resources. With the
improvement in technology, the production possibility curve shifts. Therefore, we can
say that if there is a right ward shift in the production possibility curve of an economy,
it shows to that extent, the economic growth of the economy.

2.5.7 Shifting of Production Possibility Curve

Figure 2.3 shows the production of rice in tons on OX axis and that of butter on
OY axis. With the given technology and resources, the economy is producing on the
production possibility curve AF. In other words AF shows the maximum limit of the output
that can be produced with the given resources and technology.

Now we suppose that due to technological improvements which result from technical
growth production possibility of both rice and butter increases in the economy. The possible
rise in the production of the two goods is shown by a shift of the AF curve to a higher

36
position A’B’. When there is such shift of the production possibility curve, we can say that
economic growth has taken place. More of both butter and rice can be produced.

5 YEARS AFTER

F F’
RICE (In tons)
Fig. 2.3 The rightward shift in the Production
Possibility Curve with improvement in technology.

2.6 SUMMARY

We live in a world with scarce resources, which is why economics is a practical

science. We cannot have everything we want. Further, others want the same scarce resources
which we want. Organisations that provide goods and services will survive and thrive only if
they meet the needs for which they were created and do so effectively. Since the organisation’s
customers also have limited resources, they will not allocate their scarce resources to acquire
something of little or no value. And even if the goods or services are of value, when another
organisation can meet the same need with a more favourable exchange for the customer, the
customer will shift to the other supplier. Put another way, the organisation must create value for
their customers, which is the difference between what they acquire and what they produce.

Robbins Defines Economics as the science which studies human behaviour as a

relationship between ends and scarce means which have alternative uses. The main features
of robbins definition are unlimited wants or ends, limited or scarce means, means have
alternative uses, wants are of different intensity, and problem of choice.

This definition by Robbins is logical and scientific. But it has been criticised by
some economists on different grounds, as it is self contradictory, concealed concept of

37
welfare, hazy view of the scope of economics, ineffective attempt to make economics a
positive science, artificial separation of economist’s personality. The main shortcoming of
this definition is that it considers economics only as theoretical science. It ignores the
realistic side of economics because it ignores the welfare of human beings.

Opportunity cost of a particular product is the value of the forgone alternative

product that resources used in its production could have produced. It is concerned with
the cost of foregone opportunity; it involves a comparison between the policy that was
chosen and the policy that was rejected. For example, the cost of lending or using capital
is the interest that it may earn in the next best use of equal risk. The opportunity cost
concept is very useful, e.g., in a cloth mill which spins its own yarn, the opportunity cost of
yarn to the weaving department is the price at which the yarn could be sold, for measuring
profitability of the weaving operations.
Thus, every economy has to decide about what to produce, how to produce, and
for whom to produce. These are the sub-problems which an economy has to solve from
time to time. Prof. Samuelson has analysed these problems with the help of production
possibility curve, which explained that by using different combinations of factors of
production for producing different goods, we know the possibilities of production of the
desired goods. This tells us the maximum production that can be possible with the help of
available combinations of factors of production. The curve showing the possibilities of
production of the desired goods in an economy is known as production possibilities curve.
In other words, production possibilities curve depicts the maximum possible production
of different combinations of different goods that can be produced with the given technology
and resources. This curve is also known as “Transformation Curve.” Therefore, Production
possibility curve is the graphical representation of the production possibility schedule. In
other words, production possibility curve graphically shows the alternative production
possibilities with given resources and technology.

2.7 SELF ASSESSMENT QUESTIONS

1. What is an economic problem? Why does it arise?

___________________________________________________________

38
 __________________________________________________________

__________________________________________________________

2. What is meant by production possibility curve? Illustrate it?

___________________________________________________________

__________________________________________________________

__________________________________________________________

3. Discuss the concept of opportunity costs with an example.

__________________________________________________________

__________________________________________________________

__________________________________________________________

4. Critically evaluate Robbin’s Definition of economics.

__________________________________________________________

__________________________________________________________

__________________________________________________________

2.8 SUGGESTED READINGS

• Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S.

Chand and Company Ltd, New Delhi.

• Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,

New Delhi.

• Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

*****

39
B.Com. Semester-I Unit-I
C. No. BCG-103 LESSON No. 3

DEMAND FUNCTION

STRUCTURE

3.1 INTRODUCTION

3.2 OBJECTIVE

3.3 DEMAND

3.3.1 Definition

3.3.2 Features

3.4 DETERMINANTS OF DEMAND

3.4.1 Demand function

3.4.2 Types of Demand Function

3.5 LAW OF DEMAND

3.5.1 Assumptions

3.5.2 Explanation of the Law of Demand

3.5.3. Demand Curve

3.5.4 Why is the Demand Curve Negatively-Sloped?

3.5.5 Exceptions

40
 3.5.6 Importance

3.6 SUMMARY

3.7 SELF ASSESSMENT QUESTIONS

3.8 SUGGESTED READINGS

3.1 INTRODUCTION

In Economics, we use of the word ‘demand’ is made to show the relationship

between the prices of a commodity and the amounts of the commodity which consumers
want to purchase at those prices. Demand is one of the forces determining price. The
theory of demand is related to the economic activities of a consumer, called consumption.
The process through which a consumer obtains the goods and services he wants to consume
is known as demand.

3.2 OBJECTIVES

The objective of this lesson is to provide information about:

• Demand and its determinants.

• Demand function and Law of Demand.
3.3 DEMAND

3.3.1 Definition

According to Prof. Hibdon, “Demand means the various quantities of goods that
would be purchased per time period at different prices in a given market.” Thus, three
things are necessary for demand to exist; (1) the price of a commodity (2) the amount of
the commodity the consumer or consumers are prepared to buy per unit of time; (3) a
given time. Similarly, Benham wrote down, “The demand for anything at a given price is
the amount of it which will be bought per unit of time at that price.”

3.3.2 Features

41
The definitions given above contain the following characteristics of demand:

a) Difference between desire and demand. Demand is the amount of a commodity

for which a consumer has the willingness and the ability to buy. There is difference
between need and demand. Demand is not only the need, it also implies that the
consumer has the money to purchase it.

b) Relationship between demand and price. Demand is always at a price. Unless

price is stated, the amount demanded has no meaning. The consumer must know
both the price and the commodity and he will tell his amount demanded.

c) Demand at a point of time. The amount demanded must refer to some period
of time such as 10 quintals of wheat per year or six shirts per year or five kilos of
sugar per month. Not only this, the amount demanded and the price must refer to
a particular date.

3.4 DETERMINANTS OF DEMAND

The demand for a product is determined by a large number of factors. It would be

impossible to include all possible determinants of demand in any study. Therefore, a few
factors which underlie the demand for most of the products can be easily spotted. These
factors are price of the commodity, incomes of the buyers’ of the commodity, prices of
related goods, advertising and sales promotion. These factors are found to have a substantial
influence on the sales of a commodity. These are expressed and measured in various
ways. In demand studies, these constitute the controlling variables. The importance of
each determinant varies from product to product. As such the demand for a particular
product has to be analysed only after the importance of each determinant is specified.
Some of these factors are within a firm’s control, others may not be so. For example, a
firm can change the price of the commodity, its promotional expenditure, quality of the
product and sales conditions. Let us discuss all these determinants in brief:

i. Price of the Commodity- The most important factor affecting amount demanded
is the price of the commodity. The amount of a commodity demanded at a particular
price is more properly called price demand. The relation between price and demand

42
 is called the Law of Demand. It is not only the existing price but also the expected
changes in price which affect demand.

ii. Income of the Consumer- The second most important factor influencing demand
is consumer income. In fact, we can establish a relation between the consumer
income and the demand at different levels of income, price and other things remaining
the same. The demand for a normal commodity goes up when income rises and
falls down when income falls. But in case of Giffen goods the relationship is the
opposite.

iii. Prices of related goods. The demand for a commodity is also affected by the
changes in prices of the related goods also. Related goods can be of two types:
(1) Substitutes which can replace each other in use; for example, tea and coffee
are substitutes. The change in price of a substitute has effect on a commodity’s
demand in the same direction in which price changes. The rise in price of coffee
shall raise the demand for tea; (2) Complementary goods are those which are
jointly demanded, such as pen and ink. In such cases complementary goods have
opposite relationship between price of one commodity and the amount demanded
for the other. If the price of pens goes up, their demand is less as a result of which
the demand for ink is also less. The price and the demand go in opposite direction.
The effect of changes in price of a commodity on amounts demanded of related
commodities is called Cross Demand.

iv. Tastes of the Consumers- The amount demanded also depends on consumer’s
taste. Tastes include fashion, habit, customs, etc. A consumer’” taste is also affected
by advertisement. If the taste for a commodity goes up” its amount demanded is
more even at the same price. This is called increase in demand. The opposite is
called decrease in demand.

v. Wealth- The amount demanded of a commodity is also affected by the amount of

wealth as well as its distribution. The wealthier are the people higher is the demand
for normal commodities. If wealth is more equally distributed, the demand for
necessaries and comforts is more. On the other hand, if some people are rich,
while the majorities are poor, the demand for luxuries is generally higher.

43
 vi. Population- Increase in po pulation increases demand for
necessaries of life. The composition of population also affects demand.
Composition of population means the proportion of young and old and
children as well as the ratio of men to women. A change in composition of
population has an effect on the nature of demand for different commodities.

vii. Government Policy- Government policy affects the demands for commodities
through taxation. Taxing a commodity increases its price and the demand goes
down. Similarly, financial help from the government increases the demand for a
commodity while lowering its price.

3.4.1 Demand function

The demand function for a commodity describes the relationship between quantities
of the commodity which consumers demand during a specific period and the factors which
influence its demand. In mathematical symbols the demand function for a good can be
expressed as follows:

Dx =f(Y, Px, P5 , Pc, T; Ep ; N, D, u)

Subject to the condition that

f3, f6, f7, f8 .>0>f2 >f4 and

f3, f5, f9 >< 0

Where

Dx = demand for good x

Y = Consumers’ income

Px = Price of good x

Ps = Prices of substitutes of x

Pc = Prices of complements of x

T = measure of consumer’s tastes and preferences

44
 Ep = consumers’ expectations about future prices

Ey = consumers’ expected future incomes

N = number of consumers

D = distribution of consumers

u = ‘other’ determinants of the demand for x

f= unspecified function, to be read as “function of”

fi = derivative of f with respect to the ith variable

The demand function given above can be easily rationalised and explained and we
can draw the following observations:

a. fx is positive if x happens to be a superior good or and negative if it were an

inferior good. This is because superior goods have a positive income effect while
inferior goods have a negative income effect.

b. f5 is positive if consumers develop taste and preferences in favour of x and f5 is

negative if the consumers have preferences against it.

c. The sign of f9 depends upon the way distribution of consumers undergoes a change.
If the consumers move to the cities, the demand for consumers durable is found to
be favourably affected.

d. The first five determinants affect the demand for all goods. These are y,PX, PX,P5,PC
and T.

e. Ep and Ey exert an influence mainly on the demand for durable and expensive
goods.

f. N and D are arguments only in the demand function for a group of consumers. For
example, religious books are demanded only by a small group of persons having
a religious bent of mind. Hot fiction books are demanded by young readers who
might be town dwellers.

45
 Thus, the demand function for commodities is not generally under the control
of producer firm. But under imperfect competition, firms can change the number of
customers by changing their prices, product quality and service etc. Firms can also
try to tilt the demand in favour of their own brands through well-designed advertising.

3.4.2 Types of Demand function

In the context of the discussion of the demand function, it is important to know

about the distinction between firm demand and industry demand. Although the two demand
functions have similar arguments, the direction and magnitudes of their effects would
presumably be different. Let us take the case of a car producing firm, say Maruti Udyog.
The demand function facing this firm would have rival firm’s product prices as the prices of
substitutes and then ‘other firms’ price would be expected to exert a positive influence on
the demand for a firm’s product. In contrast, for the industry demand function, all firm’s
prices are the argument for the demand function for cars. Therefore, these prices would
exert a negative influence on the demand for the industry product i.e. cars. Likewise, the
advertisement budgets of the ‘other’ car producing firms promoting their brands of cars
would adversely affect the demand for the Maruti cars. But the advertisement budgets of
all the firms taken together would favourably affect the demand for cars.

Another difference between company demand function and industry demand

function is about the effect of consumers’ income. Consumers’ income in the company
demand function would have a smaller co-efficient than that in the industry demand function.

3.5 LAW OF DEMAND

Experience tells us that ordinarily if the price of a commodity falls, the amount
demanded goes up and vice-versa. There is an inverse relationship between the price of a
commodity and the amount demanded. In Economics, this relationship is known as the
Law of Demand.

Statement of the Law

Some popular statements of the Law of Demand are as follows:

According to Bilas, “The Law of Demand states that other things being equal, the

46
quantity demanded per unit of time will be greater, the lower the price and smaller, higher
the price.”

Prof. Samuelson writes, “Law of Demand states that people will buy more at
lower prices and buy less at higher prices, other things remaining the same.”

In Ferguson’s words, “According to the Law of Demand, the quantity demanded

varies inversely with price.”

3.5.1 Assumptions of the Law of Demand

According to Prof. Stigler and Boulding, the main assumptions of the law are:

i. No change in tastes and preferences of consumers.

ii. Consumer’s income must remain the same. Marshall assumed that money income
should not change. Milton Friedman thinks that real income should remain constant.

iii. The prices of the commodities related to the commodity in demand should not
change.

iv. There should be no change in the wealth of the consumers.

3.5.2 Explanation of the Law of Demand

The relationship between the price of a commodity and the amount demanded is
dependent on a large, number of factors, the most important being the nature of a commodity.
The response of amount demanded to changes in price of a commodity is known as the
demand schedule. It summarises the information on prices and quantities demanded. The
table 3.1 showing the prices per unit of the commodity and the amount demanded per
period of time.

The Demand Schedule may be the Individual Demand Schedule which refers to
the prices and amount demanded of the commodity by an individual.

In Price Theory we are mainly interested in the Market Demand Schedule. A

market consists of all those individuals who want to purchase a given commodity. Therefore,
“Market Demand Schedule is defined as the quantities of a given commodity which all

47
consumers will buy at all possible prices at a given moment of time.” It should be clear that
the Individual Demand Schedules when added give us the Market Demand Schedule.

The following table shows the Individual Demand Schedules of buyers A and B
and the Market Demand Schedule where there are only two buyers.

Table 3.1
Price per Amount Amount Demand Total Market
Quintal (Rs.) Demanded by by buyer B Demand
buyer A
50 5 10 15
40 15 20 35
30 25 30 55

3.5.3 Demand Curve

If we show the demand schedule graphically, we get a Demand Curve. The demand
curve shows the maximum quantities per unit of time that consumers will take at various
prices. According to R.G. Lipsey, “This curve, which shows the relation between the price
of a commodity and the amount of that commodity the consumer wishes to purchase, is
called Demand Curve.”

Like the demand schedules, there can be an Individual Demand Curve and
Market Demand Curve. (1) Individual Demand Curve is the graphical representation of
Individual Demand Schedule and Market Demand Curve is the horizontal summation of
the Individual Demand Curves in the Market. The following diagram shows the Individual
Demand Curves for consumers.

48
 15 25 20 30
A’S DEMAND B’S DEMAND

Figure 3.1 Individual and Market Demand Curves

A and B are the Market Demand Curve. It is assumed here that there are only two
MARKET DEMAND

consumers in the market. They face the same price of the commodity but purchase according
to their needs. The Market Demand Curve sums up the amounts demanded by the two
consumers at different prices. The Individual Demand Curves show the prices and quantities
of the Demand Schedules given in the Table 5.1. The Individual Demand Curves-slope

49
from left down to the right. That is, they have a negative slope. As a result, the Market
Demand Curve DD is also negatively sloped.

3.5.4 Why is the Demand Curve Negatively-Sloped?

There are some reasons given for the inverse relationship between price and amount
demanded in case of ordinary commodities. These reasons are as follows:

1) Law of Diminishing Marginal Utility. Writers who believe in cardinal utility

approach to consumer’s demand believe that diminishing marginal utility for the
consumer in case of the commodity is the fundamental cause of the Law of Demand.
As the price of the commodity falls, consumer purchases more of the commodity
so that his marginal utility from the commodity also falls to equal the reduced
price. If the price rises, the opposite happens.

2) Substitution Effect. Another group of writers who believe in ordinal utility

(Indifference curves) consider the substitution effect of the change in price as the
major cause for the application of the Law of Demand. When the price of
commodity falls, it becomes cheaper as compared to the other commodities which
the consumer is purchasing. As a result the consumer would like to substitute this
cheaper commodity for other commodities whose prices remain the same. For
example,-with the fall in price of tea, coffee’s price remaining the same, tea will be
substituted for coffee. In other words, the demand for tea would go up. This is
nothing but the application of the Law of Demand.

3) Income Effect. Another cause behind the Law of Demand is known as Income
Effect. As the price of a commodity is reduced, the consumer has to spend less
amount of money income for the same amount of the commodity. This may be
taken to be a rise in his real income. It is the Income Effect of a fall in price. Part
of the increase in his real income can be used to purchase more of the cheaper
commodity while the other part may be spent on other goods. Thus, when the
price falls, amount demanded rises and vice-versa.

4) New Consumers. When the price of a commodity is reduced then many other

50
 consumers who were not consuming the commodity earlier will start purchasing it
now because it is within their reach now. For example, radio sets have become
cheaper and even poor people can easily buy a set. The amount demanded of the
radio-sets has gone up with a fall in their price. The opposite would happen with
a rise in prices.

5) Different uses of the commodity. Commodities have many uses. If their price
rises, they are used only for the more important purposes. As a result, their demand
will go down. On the contrary, when the price is reduced, the commodity will be
put to many other uses where it was not being used earlier. Its demand will go up.

3.5.5 Exception

Many times people behave contrary to what we expect according to law of demand.
In these exceptional cases, the demand curve is positively sloped. These are as under:

(1) Special Type of Inferior Goods or Giffen goods- There are some
commodities of consumption which are inferior from the consumer’s viewpoint.
There are others which are superior. Sir Giffen pointed out to the economist,
Marshall, that in the case of English workers the Law of Demand does not
apply to bread. He could practically show that with a fall in the price of bread
its amount demanded was reduced rather than being more than before. Marshall
admitted that this was an exceptional case to the Law of Demand. It is now
clear as to why the English workers behaved contrary to the Law of Demand.
They had two main items of consumption: (1) Bread, (2) Meat. As the price of
bread fell in the market, they could purchase the same amount of bread with
less money. The money income saved thereby was not spent on purchasing
more bread. Rather it was spent on purchasing pore of meat, a superior
commodity for the English workers. In short, there was no Substitution Effect
in favour of bread. The Income Effect of the fall in price of bread was also in
favour of meat. This reduced the demand for bread as its price went down.
Therefore, bread was a special type of inferior good whose amount demanded
changed directly with change in its price and not inversely as expected from
the Law of Demand.

51
 In India, such food grains as Jowar and Bajra are Giffen goods, wheat and rice
being the superior goods.

(2) Articles of Distinction- This exception was first explained by the American
economist, Veblen. According to him, the demand for articles of distinction like
diamonds and jewellery is more when their price is high. This is because a rich
man’s desire for distinction is satisfied better when the articles of distinction are
highly-priced and the poorer man cannot buy them. On the other hand, the demand
for articles of distinction falls with a fall in their price.

(3) Expectation of Rise and Fall in Price in Future- There are many commodities
whose prices are expected to go down or rise in future. In such cases consumers
may behave opposite to the law of demand. If people expect a rise in price in
future, they will rush to purchase more of the commodity at the present price. If
they expect the price to fall, they will purchase less of the commodity to derive
benefit from the fall in price later on.

(4) Ignorance on the Part of Consumers about Quality- It happens many times
that consumer’s judge the quality of a commodity from its price. In such cases, a
lower-price commodity may be considered inferior and purchasers buy lesser
amount of it. But when its price is more they consider it to be superior and may
purchase more of the commodity than before.

3.5.6 Importance of Law of Demand

The law has some theoretical as well as practical advantages. These are as follows:

i. Price determination. A monopolist gets the help of the Law of Demand in fixing
his price. He is able to know how much amount demanded for his commodity
shall go up or down with change in prices. The Demand Schedule tells him the
demand at different prices in the whole market. He is able to decide the most
profitable amount of output for himself.

ii. To the Finance Minister. The Finance Minister also takes the help of the Law
of Demand. The Finance Minister can know the effect of his taxes on the amount

52
 demanded for different commodities. If increasing the rate of taxation of a commodity
reduces its sale to a large extent, it is not good policy to tax this commodity. Only
such commodities should be taxed as have relatively inelastic demand.

iii. To farmers. How far a good shall or bad crop affect the economic condition of
the farmer can be known from the Law of Demand. If there is a good crop and
demand for it remains the same, price will definitely go down. The farmer will not
have much benefit from a good crop, but the rest of the society will be benefited
from it.

iv. In the field of planning. Demand Schedule has great importance in planning for
individual commodities and industries. In such cases it is necessary to know whether
a given change in the price of the commodity will have the desired effect on the
demand for commodity within the country or abroad. This can be known from a
study of the nature of demand schedules for the commodity.

3.6 SUMMARY

Demand is one of the forces determining price. The theory of demand is related to
the economic activities of a consumer, called consumption. The process through which a
consumer obtains the goods and services he wants to consume is known as demand. In
Economics, use of the word ‘demand’ is made to show the relationship between the
prices of a commodity and the amounts of the commodity which consumers want to
purchase at those prices.

The demand for a product is determined by a large number of factors, viz.,

price, income, prices of related goods, tastes, preferences, population etc. There is
an inverse relationship between the price of a commodity and the amount demanded.

In Economics, this relationship is known as the Law of Demand. The demand

curve is negatively sloped just because of law of diminishing marginal utility, substitution
effect, different uses of the commodity, and because of income effect.

As we know that the demand curve is negatively sloped form left to right, but in
some cases it is positively sloped like in case of inferior or giffen goods, expecting rise or

53
fall in the prices of goods in future, due to ignorance of consumers etc.

Law of demand is important to determine price of a product, budget fixing by

finance minister, How far a good shall or bad crop affect the economic condition of the
farmer can be known from the Law of Demand and also in planning for individual
commodities and industries.

3.7 SELF ASSESSMENT QUESTIONS

1. Define Demand. State the factors affecting demand for a commodity by a

consumer?

__________________________________________________________

__________________________________________________________

__________________________________________________________

2. What is demand curve? Why does demand curve slope downwards? Are

there exceptions to it?

_________________________________________________________

__________________________________________________________

__________________________________________________________

3. State the law of demand and explain its assumptions?

__________________________________________________________

__________________________________________________________

__________________________________________________________

3.8 SUGGESTED READINGS

54
• Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S.
Chand and Company Ltd, New Delhi.

• Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,

New Delhi.

• Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

--------

55
B.Com. Semester-I Unit-I
C. No. BCG-103 LESSON No. 4

ELASTICITY OF DEMAND

STRUCTURE

4.1 INTRODUTION
4.2 OBJECTIVES
4.3 MEANING AND TYPES OF ELASTICITY OF DEMAND
4.4 PRICE ELASTICITY OF DEMAND
4.4.1 Degrees
4.4.2 Factors Affecting
4.4.3 Importance
4.5 INCOME ELASTICITY OF DEMAND
4.5.1 Types
4.5.2 Importance
4.6 CROSS ELASTICITY OF DEMAND
4.6.1 Classification of Commodities
4.7 MEASUREMENT
4.7.1 Total Expenditure Method
4.7.2 Mathematical Method
4.7.3 Graphic Method
4.8 SUMMARY
4.9 SELF ASSESSMENT QUESTIONS
4.10 SUGGESTED READINGS

56
4.1 INTRODUCTION

We have studied in the previous chapter that when price of a good falls, its quantity
demanded rises and when price of it rises, its quantity demanded falls. This is generally
known as law of demand. This law of demand indicates only the direction of change in
quantity demanded of a commodity in response to a change in its price. This does not tell
us how much or to what extent the quantity demanded of a good will change in response
to a change in its price. This information as to how much or to what extent the quantity
demanded of a good will change as a result of a change in its price is provided by the
concept of price elasticity of demand. Quantity demanded of a good will change as a
result of change in any of these determinants (price, income, price of related goods etc.) of
demand. The concept of elasticity of demand therefore refers to the degree of
responsiveness of quantity demanded of a good to a change in its price, consumers’ income
and prices of related goods.

4.2 OBJECTIVES

After reading this chapter, you will be able:

• To understand the concept of elasticity of demand.

• To define different types of elasticity of demand.
• To explain how elasticity of demand is measured.
4.3 MEANING AND TYPES OF ELASTICITY OF DEMAND

Elasticity of demand is the measure of the degree of change in the amount demanded of
the commodity in response to a given change in price of the commodity, prices of some
related goods or changes in consumers’ income. This is the general definition of the term
“Elasticity of Demand”.

It should be clear from the above definition that elasticity of demand can be mainly of three
types:

(1) Price elasticity is responsiveness of demand to changes in prices.

57
(2) Income elasticity is the responsiveness of demand to changes in consumers income.

(3) Cross elasticity is the responsiveness of demand for a commodity A to changes in the
price of a related commodity B.
4.4 PRICE ELASTICITY OF DEMAND

Price elasticity of demand is commonly called the elasticity of demand. This is because
price is the most changeable factor influencing demand. Some popular definitions of the
price elasticity of demand are:

In the words of Kenneth Boulding “Elasticity of demand measures the

responsiveness of demand to changes in price”.

Alfred Marshall define elasticity as, “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 rise in price.

Proportionate change in Demand

Elasticity of Demand =
Proportionate change in Price
Suppose, sugar is Rs. 5 per kg and its demand is 15 quintals in a small market. If
the price falls to Rs 4 per kg the amount demanded goes up to 30 quintals. Here change in
demand is 15 quintals, the original demand was also 15 quintals. So the proportionate
change in demand is 15/15= 1. Now let us find out the proportionate change in price. The
absolut e change in price is fro m Rs. 5
to Rs. 4; this means ‘-1’.The original price Rs 5. So the proportionate change
in price is -1/5. Now, we can calculate the price elasticity of demand.

Elasticity of Demand = Proportionate change in Demand

Proportionate change in Price

=1/ (-1/5) =1* -5 = -5

-5
Thus, the demand for sugar is highly elastic. With 1 percent change in its price there is a 5
per cent change in its demand. The elasticity of demand with regard to price of the commodity
is always having a minus sign. This shows that price and demand are inversely related. The

58
negative sign is not ordinarily used in writing the price elasticity of demand. The sign is
understood.
4.4.1 Degrees of price Elasticity of Demand
Elasticity of Demand for different commodities is different. Some commodities
have more elastic demand while others have relatively inelastic demand. Elasticity of demand
may have a value from zero to infinity. Some particular values of elasticity of demand show
graphically as under:
1. Completely inelastic demand is shown by a straight line demand curve which is
parallel to vertical axis showing price. This means that whatever the changes in
price may be, the amount demanded remains the same. In the case, price elasticity
of demand is equal to zero.
2. Perfectly elastic demand is one in which a small change in price will cause an
infinitely large change in amount demanded. A small rise in price on the part of the
seller reduces the demand to zero. A small reduction in price leads to such a big
expansion in demand that no seller is able to satisfy this demand at the reduced
price. This case of infinite elasticity of demand is shown by a straight line demand
curve parallel to the horizontal axis.
3. Unitary elasticity of demand. This is a particular case of elasticity of demand in
which a given percentage change in price leads to exactly the same percentage
change in amount demanded. According to Marshall, a commodity has elasticity
equal to one if the total expenditure of the consumers on the commodity remains
the same even when the price changes.
A demand curve that subtends equal-area rectangles over the X and Y axis has
unitary elasticity of demand. Such a demand curve is known in mathematics as a
rectangular hyperbola. This curve is shown in panel C of the diagram 4.1. The two
sides of the curve are such that they approach the two axes but never meet them.
We can call this curve as a constant-total-outlay curve. In the diagram (Figure 4.1
panel C) when the price is OT and the amount demanded OM, the total expenditure
is OT X OM which is the area of the rectangle OMPT. At price OL, total
expenditure is the area of the rectangle ONKL. According to Marshall when total

59
 expenditure remains the same with changes in price, elasticity of demand is equal
to one.
4. Relatively elastic and inelastic demand. Those demand curves which have
elasticity between zero and infinity are closely classified as relatively inelastic and
relatively elastic. We may say that demand elasticity between zero and one may
be termed relatively inelastic. A higher value of elasticity than one may be called
relatively elastic. On the basis of the sign and value of the price-elasticity of demand
for a commodity, it is usually classified as a necessity, a comfort and a luxury.
Necessities of life like wheat, or rice have price elasticities less than one. Comforts
have slightly higher values of price elasticity. Luxuries have the highest values of
price-elasticity. In all these cases the sign of price elasticity is minus. All these
commodities obey the Law of Demand.

D
PRICE PRICE PRICE
D P
T K
L D

O D DEMAND O DEMAND O M N DEMAND

Figure 4.1 Demand Curves with different Elasticities

4.4.2 Factors Affecting price Elasticity of Demand

Price elasticity of demand depends upon a number of factors. The main factors are as
follows:

1. Availability of Substitutes- If a commodity has close substitutes available at

reasonable prices, then the demand for the commodity will be quite price elastic.
The demand for Campa-Cola is elastic because a substitute, Thumbs-up is easily
available at a competitive price.

60
2. Nature of the Commodity- Price elasticity for necessaries of life is low while
that for luxuries is quite high. The amount of demand in case of’ food grains does
not change much because it is a necessity. The demand for butter and eggs is quite
price-elastic because these are luxuries for the poor common man.

3. Number of uses of a Commodity- The greater the number of uses to which a

commodity is put, the higher is the elasticity of demand. For example, coal is used
for many purposes. If its price rises, the less important users will not purchase coal
and the amount demanded will fall appreciably. Contrary to this, ordinary women’s
Jewellery has no other use and, therefore, its demand is relatively inelastic.

4. Possibility of Postponing the Purchase of a Commodity- Price elasticity is

also affected by the possibility or otherwise of the postponement of the purchase
of a commodity; for example, if woolen clothes become costlier, the middle class
people try to get their old suits repaired and postpone the purchase of new woollen
clothes. As a result, elasticity will be high in this case.

5. Level of Income of the Consumers of the Commodity- Price elasticity of

demand for a commodity also depends upon the income of the consumers of the
commodity. Price elasticity of demand from the high income class for high quality
mangoes is low because the expenditure on mangoes for this class forms only a
minor part of the total expenditure. On the other hand, price elasticity for high
quality mangoes from the poorer classes is very high.

6. Habitual Necessities- Those commodities whose consumption is a habit with

consumers have low price elasticity. For example, the prices of cigarettes and
liquor are rising but their demand has not diminished. It is price-inelastic.

7. Place of the Commodity in the Consumer’s budget- The demand for a

commodity is less elastic, lesser is the proportion of expenditure on the commodity
by the consumer: such items as shoe-polish, newspaper, tooth paste and tooth
powder have inelastic demand. If their prices rise, the consumer is not worried
about his budget and, therefore, does not seek substitutes. On the other hand,
demand for durable commodities claiming a good deal of income of the consumer

61
 is quite elastic. Examples are television, steel-almirahs etc.

8. Prevailing Price level of the Commodity- Price elasticity of demand also

depends upon whether the price prevailing in the market is relatively high or low
from the viewpoint of common consumers. Highly priced commodities such as
diamonds and low-priced commodities such as salt have low price elasticity because
a change in their price has very little effect on their consumers. But commodities
having price in the middle range are quite price-elastic because their consumers
are quite conscious of their price; examples are radios, transistors, etc.

9. Time Period Under Consideration- Price elasticity in the short period is low
while in the long period it will be relatively higher. This is because it is possible for
consumers to change their consumption habits in favour of cheaper substitutes
and against the expensive commodities. Therefore, in the long period, elasticity is
generally higher for all the commodities.

10. Joint Demand- Price elasticity for a commodity is also dependent upon the nature
of price elasticity of jointly-demanded commodities. If the demand for cars is
inelastic the demand for petrol will also be inelastic. The elasticity of demand for
ink depends directly on the nature of elasticity of demand for pens.

4.4.3 Importance of Price Elasticity of Demand

Price elasticity of demand is a very useful concept for producers, farmers, workers
and the Government. Lord Keynes considered price elasticity to be the most important
contribution of Marshall. The practical importance of this concept should be clear from
the following applications.

1) Determination of price and output: Every producer has to decide his volume
of output and the price at which he has to sell it. In these decisions, elasticity of
demand is one of the very relevant informations. If the demand is less elastic price
will be higher. If the demand is elastic, a lower price is fixed.

2) Price discrimination: A monopolist adopts a price discriminatory policy only

when the elasticity of demand from different consumers or sub-markets is different.

62
 Those consumers whose demand is inelastic can be charged a higher price than
those with more elastic demand.

3) Price determination in cases of joint supply: Jointly supplied goods are those
which are the products of the same production process; for example, wool and
mutton. The price determination of these joint products becomes a little difficult
due to joint costs of production. In such cases, the concept of price elasticity of
demand comes to our help. If the demand for wool is inelastic as compared to the
demand for mutton, a higher price for wool is charged and a lower price for
mutton.

4) Determination of sale policy for super markets: Super markets are a combined
set of shops run by a single organisation. These markets are supposed to sell
commodities at lower prices than are charged by shopkeepers in the bazaar. The
costs of marketing have also to be covered. Therefore, the policy adopted in the
super bazaar is to charge a slightly lower price for goods whose demand is quite
elastic. As a result of the greater sales, the costs are easily covered.

5) Use of the concept in factor pricing: The idea of price elasticity is helpful in
explaining the relative share of factors of production in the production process.
The factors having price-inelastic demand for the goods they produce can obtain
a higher price than those with elastic demand. For example, workers producing
petro-products having inelastic demand can easily get their wages raised.

6) Importance in taxation policy: The finance minister often taxes those

commodities whose demand is price-inelastic. This increases total expenditure on
the commodity and taxation revenue. Similarly in levying indirect taxes, the finance
minister taxes those commodities which are having inelastic demand from the rich
class. That way, the burden of taxation falls on the richer class.

7) Pricing policy for public utilities: Such enterprises as provide services of

mass consumption like water, electricity, postal services, railways and
communication are known as public utilities. A suitable price policy for these
enterprises is to charge 2 consumers according to their elasticity of demand for

63
 the public utility. Household consumers are charged a higher rate of electricity
than industrial consumers because the demand for electricity from households is
less elastic compared to that from industrial consumers.

4.5 INCOME ELASTICITY OF DEMAND

The percentage change in amount demanded as a result of a given percentage

change in income of a consumer is called Income Elasticity of demand.

According to Watson, “Income elasticity of demand rneans the ration of the

percentage change in the quantity demanded to the percentage change in income. Income
elasticity measures the responsiveness of demand to change in income. It gives us an idea
of the sensitivity of demand for a commodity as consumer’s income changes.

Proportionate change in demand

Ey =
Proportionate change in income

@q @y
B
q y
y @q
W
q y
Where Ey is income elasticity of demand, q is the change in demand, q is original demand,
y original income and y change in income.

Suppose a consumer’s income is Rs.100, and he purchases 10 kilos of sugar. If

his income goes up to Rs. 110, he is prepared to purchase 12 kilos of sugar. We can find
the income elasticity of demand here as,

= =2

Since, Y= Rs.100

q = 10 kilos

64
 
@y = Rs. 110-100 100 2
10 10
= Rs.10

@q = 12-10 = 2 kilos.

Thus, the demand for sugar is 2 which is quite income-elastic.

4.5.1 Types of Income Elasticity

An income demand curve shows the changes in amount demanded in response to

changes in income. The response of demand to income changes is classified into three
categories:

I. Positive income elasticity of demand. When the amount demanded of a

commodity increases with increase in income and vice-versa, the income demand
curve will be shown as positively-sloping from left upwards to the right. In this
case the commodity is shown on the horizontal axis and income on vertical axis.
The commodity is normal. It has a positive income-elasticity as shown in part (a)
of the figure 4.2 given below.

II. Zero income elasticity. When the demand for a commodity does not respond to
changes in income, it is said to be completely income inelastic. Examples are salt,
kerosene oil and post cards. In these cases, the income demand curve is shown as
a straight line parallel to the vertical axis, as shown in part (b) of the figure 4.2.

III. Negative income elasticity. When the amount demanded of a commodity

diminishes with an increase in income of the consumer, the commodity is
said to be an inferior one. In this case, the income demand curve will be
shown as sloping from left downwards to the right as shown in part (c) of
the 4.2 figure. The food grains such as Jowar and Bajra are inferior goods.

65
 gi.

Fig. 4.2 Types of Income-demand curves and Income elasticity

4.4.4 Importance of Income Elasticity

The concept of income elasticity of demand is of theoretical and practical importance.

1) Use in Capitalist Economies. Income elasticity concept occupies an important

place among the analytical tools applied for business research. In the U.S.A. the
department of commerce has evolved another concept intimately related to income
elasticity. This concept is of income sensitivity of consumption expenditure. The
main point of difference between the two concepts is that while income elasticity
concerns physical units of the commodity purchased, income sensitivity tells us
about changes in dollar expenditures. Income sensitivity has a coefficient which
measures the pe7clntage~increase in dollar expenditure associated with a one
percentage change in disposable income in the same period. The income sensitivity
estimates are of great use in business forecasting. It has been found that telephone
service, automobiles, air-transportation, television repair and foreign travel have

66
 high income sensitivities (co-efficients equal to 1.5 or more) while shoes, clothing,
local bus-transportation and dental care have a low income sensitivity (co-efficient
less than 0.5).

2) Importance in planned developing economies. In less developed countries

like India as level of living rises, demand for some commodities is expected to go
up much faster than the demand for others. In the earlier stages income elasticity
of demand for food tends to be high. Generally as income rises there is a shortage
of food, which when not satisfied leads to inflation. Similarly, in urban areas the
demand for comforts like superior foot-wears, auto-cycles and scooters, movies,
readymade garments and medical care have high income elasticities of demand
which work to create an acute shortage of these goods and services. Rural areas
tend to reduce the marketable surplus of food articles while putting a pressure on
the demand for manufactures. The differing income elasticities and supply elasticities
create problems of inter-sectoral balance. If the planners know the income
elasticities of demand of at least the goods and services of general use, steps can
be taken to balance demand and supplies by introducing special controls. Thereby,
the tendency of prices to rise can be contained.

4.5 CROSS ELASTICITY OF DEMAND

When the demand for a commodity changes with a change in the price
of another related commodity, the case is of Cross Demand. Cross Elasticity
of demand measures the responsiveness of demand for a commodity, say tea,
when the price of another related commodity, say coffee, changes by a small
amount.

In the words of Liebhafsky, “The cross elasticity of demand is a measure of the

responsiveness of purchases of Y to change in the price of X.” Speaking out more exactly,
Prof. Ferguson observes, “The cross elasticity of demand is the proportional change in the
quantity of X demanded resulting from a given relative change in the price of the relative
good Y.”

Measurement of Cross Elasticity of Demand

67
 Proportionate change in demand of X
Exy=
Proportionate change in the price of Y

Writing in symbols:

E xy =

Where p and q have their usual meanings of price and quantity and is the small change
in it.

A numerical example will explain the concept further. Suppose the price of coffee
rises from Rs.10 per tin of 250 gms to Rs.12 per tin. As a result, consumers’ demand for
tea, an immediate substitute, rises from 70 kilos to 100 kilos. Then, the cross elasticity of
demand of tea for coffee can be calculated as follows:
qx= 100 - 70 = 30 kilos.
qy = 70 kilos.
yx = Rs. 12 - Rs. 10 = Rs. 2
py = Rs. 10
Therefore, the Cross elasticity of demand in this case = 2.14

4.6.1 Classification of Commodities through Cross Elasticity

Cross elasticity of demand can be used to classify goods into three types:

1. Substitute goods. Examples of substitute goods are tea and coffee. The cross
elasticity of demand for these goods is positive, because a rise in the price of tea
will raise the demand for coffee. The rise in demand for coffee as a result of the
rise in the price of tea will give a positive coefficient of cross elasticity.

68
 2. Independent goods. Such goods as eggs and diesel engines have no price
relationship with one another. If eggs go cheaper; the demand for diesel engines
remains unaffected. The value of cross elasticity in such cases is zero; these are,
therefore, called ‘independent goods.

3. Complementary goods. Milk and sugar are examples of complementary goods.

When the price of milk rises, its demand falls. Since sugar is used along with milk,
demand for sugar will also fall. The value of cross elasticity in this case will be
negative because the price of milk and the demand for sugar move in opposite
directions.

4.7 METHODS OF MEASURING ELASTICITY OF DEMAND

Elasticity of demand can be measured through three popular methods. These are:

• Total Expenditure Method

• Graphical Method
• Mathematical Method
4.7.1 Total Expenditure Method

Elasticity of demand can be measured from the changes in the expenditure of the
consumers on the commodity as its price changes also known as the outlay method, given
by Marshall. He distinguished between three separate cases of changes in total outlay
resulting from a change in the price of the commodity. These three cases can be shown
with the help of a table 4.1.

In Table 4.1, the price of the commodity goes down from rupees ten to rupee one.
Suppose the amount demanded increases from one kilogram to ten kilograms. We can
easily calculate the resulting changes in total outlay. These changes can be easily classified
into three parts as shown in the table given below:

In table 4.1, three separate cases of price elasticity of demand are easily traced out.

(i) If with a (small) change in price of the commodity total expenditure by consumers on
its purchase remains the same, then the elasticity of demand within that range of price
change is equal to one.
69
(ii) If with a ‘small’ fall in the price of the commodity total expenditure on it also falls, the
elasticity of demand in that range of price change is said to be less than one. That is,
if total outlay and price move in the same direction elasticity of demand is taken to be
less than one. For example, in the lowest part of the given table, this is the case.

Table 4.1

Price Amount Total Elasticity Direction Direction

demanded expenditure of demand of Price of total expenditure

Rs. Kilos Rs.

10 1 10
9 2 18 Greater Down Increasing
8 3 24 than Unity
7 4 28
6 5 30 Equal to Down Constant
5 6 30 Unity
4 7 28
3 8 24 Less than Down Decreasing
2 9 18 Unity
1 10 10

(iii) If a ‘small’ fall in the price results in an increase of total outlay on the commodity, the
elasticity of demand in this range of price variation is said to be greater than one. In
such cases total outlay and price move in opposite directions. This is the case in our
table in the first part.

4.7.2 Graphic Method

The second popular method for measuring elasticity of demand was also given by
Marshall. In this method we make use of a demand curve drawn on a graph. Therefore, it
is called the graphic method or the Geometrical method. The method can be illustrated
with the help of a Figure 4.3.

70
 In the figure 4.3, we have a straight line demand curve in the (a) portion of the
diagram and a curve convex to the origin in part (b). We can illustrate the method of
finding out the price elasticity at any point of the demand curve.

Figure 4.3: Measuring Price Elasticity of Demand Geometrically.

Let us take the straight line demand curve DD in part (a). We join both sides of
the straight line demand curve with the two axes at points L and M. Elasticity at any point
P is equal to the ratio of the distance from the point P to the X-axis and the distance to the
Y-axis. In the diagram the point P is half way between M and L.
PM
Elasticity of Demand = Ep = (because PM is equal to PL) = 1.
PL
Similarly, at the point P1, elasticity of demand is equal to P1M/P1L. Here elasticity
is greater than one because the point P1 is higher than the mid-point P. Elasticity at the
point P2 is given as P2 M1 P2L, which is less than one.

In the part (b) of the figure we have the convex demand curve DD. Suppose we

71
want to find out price elasticity at the point P1. For this we draw a tangent LM at the point
P1 . The elasticity is found easily as P1 M/P1 L. Similarly, for finding out elasticity at the
point P2 we draw a tangent at this point to the demand curve. The elasticity at this point is
given by the ratio of the distance along the tangent to the X-axis divided by the distance to
the Y-axis.

It should be remembered that the method of measuring price elasticity given above
is designed to measure it around a point for small changes in price. Therefore, this measure
is also called the point elasticity measure.

4.7.3 Mathematical Method

In this method, price elasticity is estimated by dividing the percentage change in

amount demanded by the percentage change in price of the commodity. If the proportionate
(percentage) change in amount demanded is higher than the percentage change in price,
elasticity will be greater than one. In a mathematical form we can write:

E p = Price elasticity of Demand

= Proportionate change in Demand /Proportionate change in Price

= Change in Demand/Change in Price B Original Demand /Original Price

The formula for price elasticity of demand given above suggests three different
ways of finding out the proportionate change in demand and the proportionate change in
price.

The first commonly adopted procedure is what Marshall called the point elasticity
measure. If the difference between the original price and the new price is very small, then
we get point elasticity measure through the above formula.

As Leftwitch has also remarked, “Elasticity computed at a single point on the

curve for an infinitely small change in price is point elasticity.”

The formula given above tells us that price elasticity of demand is not simply a co-
efficient or the slope of a curve of demand for the commodity. It is a ratio of the proportionate
change in demand divided by the proportionate change in price. If we write q for the

72
original demand and p for the original price, then p and q denote the absolute changes
in demand and price respectively.

q p
E p 
q p

q p
 
q p


Original Price Change in Demand
Original Demand Change in Price

@q
This shows that @ q represents the slope of the demand curve which has to be
multiplied with the ratio of price to quantity so as to get the estimate of price elasticity. Thus, it
should be clear that we cannot judge elasticity from the slope of a demand curve alone.

Some writers such as Schnider and Bilas have suggested that we must not just
take the original price or original demand in finding out price elasticity. It will be better if
we take the lower value of the price elasticity of the original price and the lower value of
demand instead of the original demand. Taking lower values of Q and P will ensure a
lower value of the price elasticity. It will avoid unnecessary, over-estimation of price elasticity.

4.8 SUMMARY

Elasticity of demand is the measure of the degree of change in the amount

demanded of the commodity in response to a given change in price of the commodity,
prices of some related goods or changes in consumers’ income.

Elasticity of demand can be mainly of three types viz., price, income and cross
elasticity of demand.

Price elasticity of demand is commonly called the elasticity of demand. This is because
73
price is the most changeable factor influencing demand. Elasticity of Demand for different
commodities is different. Some commodities have more elastic demand while others have
relatively inelastic demand. Elasticity of demand may have a value from zero to infinity.

Price elasticity of demand depends upon a number of factors such as availability of

substitutes, nature of the commodity, number of uses of the commodity, level of income of
the consumers of the commodity, time period, Joint demand etc.

Price elasticity of demand is a very useful concept for producers, farmers, workers
and the Government.

The percentage change in amount demanded as a result of a given percentage

change in income of a consumer is called Income Elasticity of demand.

The response of demand to income changes is classified into three categories, as

positive income elasticity of demand, zero income elasticity of demand, and negative income
elasticity of demand.

When the demand for a commodity changes with a change in the price
of another related commodity, the case is of Cross Demand. Cross Elasticity
of demand measures the responsiveness of demand for a commodity, say tea,
when the price of another related commodity, say coffee, changes by a small
amount.

Elasticity of demand can be measured through three popular methods like Total
Expenditure Method, Graphical Method, and Mathematical Method. Elasticity of demand
can be measured from the changes in the expenditure of the consumers on the commodity
as its price changes also known as the outlay method, given by Marshall.

The second popular method for measuring elasticity of demand was also given by
Marshall. In this method we make use of a demand curve drawn on a graph. Therefore, it
is called the graphic method or the Geometrical method.

In mathematical method, price elasticity is estimated by dividing the percentage

change in amount demanded by the percentage change in price of the commodity. If the

74
proportionate (percentage) change in amount demanded is higher than the percentage
change in price, elasticity will be greater than one.

4.9 SELF ASSESSMENT QUESTIONS

1. Explain any five factors determining price elasticity of demand?

__________________________________________________________

__________________________________________________________

__________________________________________________________
2. What do you understand by price elasticity of demand? How is it measured?

__________________________________________________________

__________________________________________________________

__________________________________________________________
3. Show the different degrees of elasticity of demand with th e help of a
Diagram?

___________________________________________________________

___________________________________________________________

___________________________________________________________

4.10 SUGGESTED READINGS

• Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S.

Chand and Company Ltd, New Delhi.

• Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,

New Delhi.

• Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

****

75
B.Com. Semester-I Unit-I
C. No. BCG-103 LESSON No. 5

SUPPLY FUNCTION

STRUCTURE

5.1 INTRODUCTION

5.2 OBJECTIVES

5.3 SUPPLY

5.3.1 Concept of Supply

5.4 LAW OF SUPPLY

5.4.1 Changes in Supply

5.4.2 Elasticity of Supply

5.4.3 Degrees of Elasticity

5.5 DETERMINANTS OF SUPPLY

5.6 SUMMARY

5.7 SELF ASSESSMENT QUESTIONS

5.8 SUGGESTED READING

76
5.1 INTRODUCTION

As demand is defined as a schedule of the quantities of good that will be purchased

at various prices, similarly the supply refers to the schedule of the quantities of a good that
the firms are able and willing to offer for sale at various prices. How much of a commodity
the firms are able to produce depends on the resources available to them and the technology
they employ for producing a commodity. How much of a commodity the firms will be
willing to offer for sale depends on the profits they expect to make on producing and
selling the commodity. Thus, the supply refers to the entire relationship between the price
of a commodity and the quantity supplied at various possible prices.

5.2 OBJECTIVE

The specific objectives of this chapter are:

• To define the concept of supply.

• To explain law of supply and elasticity of supply.

• To express factors affecting supply.

5.3 SUPPLY

The concept of supply occupies an important place in economic theory. Supply of a

commodity influences price as does the demand. Economists use the word ‘supply’ with
different connotations. It may mean ‘total supply’ in the market, i.e., the sum total of
supply available with the retailers and wholesalers or it may mean supply held by the
wholesalers or may refer to the total amount of the commodity produced during a season.
It is necessary to clarify the meaning of the word ‘supply as it is used in economics.

Supply should be carefully distinguished from stock. The amount of a commodity

that a seller is willing to supply at a given price is known as supply. As against this, a
quantity which a seller can place on the market for sale when demanded is termed as
stock. Thus, supply constitutes a part of the stock of the commodity which is offered for
sale in the market. Supply need not be equal to stock. A producer may keep back a part
of total output produced by him during a given period of time. Besides, the supply in the

77
market may exceed current production if past stocks are unloaded along with the present
production. On the other hand, supply may fall short of current production to the extent to
which a part of the current production is held back for building up stock.

5.3.1 Concept of Supply

Supply means the various amounts of the commodity, other things remaining constant,
the sellers are willing and able to sell at different prices at any moment of time or during any
one period of time. In the words of Prof. Bach, “Supply is a schedule of amounts that will
be offered for sale at different prices during any given time period, other factors remaining
unchanged.” The phrase “other factors remaining unchanged” is a very important qualification
to be taken note of. In fact the amount of a commodity which sellers are willing to sell
depends upon a number of factors like price of that commodity, prices of factors of
production, state of technology, supply of co-operant factors etc. But for our purpose,
supply is taken as function of price alone, all other factors remaining the same.

5.4 LAW OF SUPPLY

Supply is said to be functionally related to price. According to the law of supply,

other things remaining the same, as the price of a commodity rises, its supply is extended
and as the price falls its supply is contracted. In the words of Prof. Lipsey, “Ceteris
paribus, the quantity of a commodity produced and offered for sale will increase as the
price of the commodity rises and decreases as the price falls”.

The law of supply establishes a direct relationship between price and quantity
supplied, i.e., the higher the price, the larger is the supply; the lower the price, the smaller
is the supply.

The following is the market supply schedule (Fig, 5.1) of commodity X. It is the
sum total of individual supply schedules. It shows the various quantities of the commodity
X that are offered for sale in the market at alternative prices.

It is evident from the study of market supply schedule and the supply curve that
higher the price more quantity will be supplied and vice versa. The supply curve slopes
upwards from left to right showing that price and quantity supplied move in the same direction.

78
A supply curve can be a straight line or a curve. For simplicity in the figure given below we
have dealt with a straight line curve. The things that are kept constant in defining supply
schedule and in drawing a supply curve are: the technology in the production of the commodity,
the supplies of inputs, climate and weather conditions, wages, interest, prices, of machinery,
prices of raw materials etc.

Table 5.1: MARKET SUPPLY SCHEDULE FOR COMMODITY X

Price per Quintal Rs. Number of Quintals Supplies

40 5

50 10

60 15

70 20

80 25

Figure 5.1 The Market Supply Curve

79
 There are of course, exceptions to the law of supply. It is just possible that in the
case of some commodities supply may not change in response to a change in price. For
example, the supply of paintings by Raphael is fixed for all times. The law of supply does
not apply here. It may also happen that in some cases, as the price rises, sellers may
choose to sell smaller quantity than before. The backward sloping supply curve of labour
illustrates the above mentioned case. The workers have a low standard of living and have
fixed needs. When wages rise, they are able to satisfy their meagre wants by working less
hours or days in a month. So higher wages induce increased absenteeism on the part of
workers. This means that as wages rise, supply of labour falls off.

5.4.1 Changes in Supply

While defining the law of supply, we assume “other things remain unchanged”. This
phrase implies that there is no change in the methods of production, availability of other
inputs, climate and weather conditions, cost of production and all other variables which
exert their influence on supply. Thus, we normally maintain that other things remaining the
same, the law of supply holds good. But other things seldom remain the same. A change in
‘other things’ will be attended by either an increase in supply or decrease in supply.

I. Increase in Supply

Increase in supply is there when (a) at the same price more is offered for sale; and
(b) the same quantity is offered at a lower price. We will illustrate increase in supply in the
following figures. In both these figures, SS is the original supply curve andS1S1 is the new
supply curve. In Figure 5.2 (a), at price OP supply equals OR. It is just possible that with
a change in real conditions supply increases to OT. This increase in supply from OR to OT
at the same price is not due to a rise in price but due to change in other variables, such as
reduction in the cost of production, adoption of better techniques etc. In Fig. 5.2 (b)
where the producer supplies the same amount at lower price, supply, curve shifts from SS
to S1S1. In both these figures supply curve shifts to the right showing that more is supplied
at the same price or same is supplied at a reduced price.

80
 Fig. 2. Increase in Supply

II. Decrease in Supply

In the case of decrease in supply, either less is supplied at the same price or same
amount is supplied at a higher price. In both these cases, supply curve shifts to the left as
is shown in Figures 5.3.

In both of these figures, SS is the original supply curve whereas S2S2 is the supply
curve after the change in supply. In Fig. 5.3 (a) initially the producers supplied ON amount
at OP price. But now they supply less i.e., OM at the same price, because supply curve
shifts from SS to S2S2. In Fig. 5.3(b), the producers supply the same amount i.e., OM
despite a rise in price from OP1 to OP. It is decrease in supply because supply curve also
shifts upwards and to the left.

Figure 5.3. Decrease in Supply

81
 We must carefully understand the distinction between an increase in supply and
extension of supply and also between decrease in supply and contraction of supply.
Extension of supply means that more is being offered for sale at a high price and contraction
of supply means that less is supplied at reduced price. These are shown on the same
supply curve whereas increase or decrease in supply is shown by shifts in the supply curve
either downwards or upwards.

5.4.2 Elasticity of Supply

Elasticity of supply of a commodity measures the responsiveness of the quantity supplied

to changes in price. It measures the degree to which price is effective in calling forth or
holding back the quantity. In the words of Boulding. “The relationship between price and
quantity supplied is rather like the relation between a whistle and a dog, the louder the
whistle, the faster comes the dog; raise the price and the quantity supplied increases. If the
dog is responsive, in economic terminology elastic, quite a small upsurge in the whistle will
send him bounding along. If the dog is unresponsive or inelastic, we may have to whistle very
loudly before he comes along at all. We need, therefore, a quantitative measure of this
responsiveness of quantity to changes in price. One such measure is elasticity”. In technical
terms, the coefficient of price elasticity of supply measures the percentage change in the
quantity supplied of a commodity per unit of time resulting from a given percentage change in
the price of the commoditv.

Elasticity of supply =

5.4.3 Degrees of Elasticity

There are five types of elasticity of supply. They are as follows:

1. Perfectly Elastic Supply. Perfectly elastic supply is one in the case of which a slight
change in price is attended by an infinite change in supply. Such a supply curve runs
parallel to the X-axis as is shown in figure given below Fig. 5.4 (a) the supply curve SS
runs parallel to X-axis showing that an infinite small change in price causes an infinitely
large change in the quantity supplied.

82
2. Perfectly Inelastic Supply. A perfectly inelastic supply is one in the case of which
supply is completely non responsive to changes in price. Such a supply curve runs parallel
to y-axis. For example refer to Fig. 5.4(b). In this figure, supply curve SS runs parallel to
Y-axis showing that quantity-supplied does not change at all in response to a change in
price.

Figure 5.4 (a) Perfectly elastic supply, (b) Perfectly Inelastic Supply

3. Relatively Elastic Supply. A relatively elastic supply is one in the case of which a
given change in price produces more than proportionate change in quantity supplied. For
example, a supply is relatively elastic if a doubling of price will result in more than double
the quantity supplied. In Fig. 5.5(a), a given change in price from OP to OP is attended by
a much more change in supply, that is from 0S to OS1. Hence supply curve SS is relatively
elastic.

4. Relatively Inelastic Supply. A relatively inelastic supply curve is one in which a

given change in price is attended by a less than proportionate change in quantity supplied.
In this case, two per cent rise in price will produce less than two per cent rise in quantity
supplied. Refer to Figure 5.5(b). According to this figure, a rise in price from OP1 to OP
brings about less than proportionate change in supply from OS1 to OS. Hence supply
curve SS is relatively inelastic.

83
 Figure 5.5 (a) Relatively elastic Supply; 5.5 (b) Relatively Inelastic Supply

5. Unitary Elastic Supply. If a proportionate change in supply equals the proportionate

change in price, then, elasticity of supply equals unity. In Fig. 5.6, SS is the unitary elastic
supply curve. Increase in price from OP to OP1 is attended by a proportionate change in
supply from OS to OS1.

Figure 5.6: Unitary Elastic Supply

Figure 5.6. Unitary Elastic Supply

84
5.5 DETERMINANTS OF SUPPLY

Increase or decrease in supply may be brought about by a number of factors.

1) Change in the Cost of Production : A in the cost of production may affect the
position of supply curve. A rise in costs will shift the supply curve upwards indicating
a decrease in supply. Conversely, a fall in the cost of production may enable the
producer to supply more at the same price. In that case supply curve shifts
downwards.

2) Technological Progress. Technological progress by lowering the cost of

production may enable the producer to supply more at the same price. In this case
the supply curve will shift downwards and to the right.

3) Discovery of new sources of raw material. Discovery of new sources of raw

material and exploitation of new mines may enable the producers to supply more
at the same price. As against this, with the progressive depletion of existing sources
of basic materials, supply of the commodity may decrease.

4) Complementary Relationship. It is just possible that production of one

commodity may result in the production of another commodity as in the case of
wool and beef. This happens in the case of joint goods. If the production of one is
increased, the supply curve of other commodity will shift downwards and to the
right.

5) Natural Factors. The supply of agricultural commodities depends upon a number

of natural factors. The supply of agricultural products may change because of a
change in rainfall, weather conditions, Supply of other inputs etc. Adequate and
timely rainfall, improvement in irrigation facilities, adequate supply of manures,
better seeds and fertilisers may enable the agriculturists to increase the supply. On
the contrary, failure of rains, floods, pests and deterioration in the technology will
decrease the supply.

6) Intensity of desire for self - Consumption. A change in the intensity of desire

of producers for their own product will bring about a change in the supply. For

85
 example, if milk producers decide to drink less milk themselves the. supply of milk
will increase.

7) Change in the price of Substitutes. A fall in the price of a substitute commodity

and its fall in production may also cause the supply of the commodity to increase,
for the production of the substitute will be less profitable and resources previously
used in making the substitute will turn to the now relatively higher priced commodity.

8) Means of Transport. Changes in the costs of transport and communications also

bring about changes in the supply. Improvement in means of transport results in
the extension of market for the commodity. This affects the supply of the commodity
under consideration.

9) Political and Social Factors. Changes in political and social factors also bring
about changes in the supply of the commodities. Deterioration in law and order
situation and political uncertainty adversely affect the supply.

5.6 SUMMARY

The concept of supply occupies an important place in economic theory. Supply of a

commodity influences price as does the demand. Economists use the word ‘supply’ with
different connotations. . It is necessary to clarify the meaning of the word ‘supply’ as it is
used in economics.

Supply means the various amounts of the commodity, other things remaining
constant, the sellers are willing and able to sell at different prices at any moment of time or
during any one period of time.

According to the law of supply, other things remaining the same, as the price of a
commodity rises, its supply is extended and as the price falls its supply is contracted. In the
words of Prof. Lipsey, “Ceteris paribus, the quantity of a commodity produced and
offered for sale will increase as the price of the commodity rises and decreases as the
price falls”.

The supply curve slopes upwards from left to right showing that price and quantity
supplied move in the same direction.

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 While defining the law of supply, we assume “other things remain unchanged”. We
normally maintain that other things remaining the same, the law of supply holds good. But
other things seldom remain the same. A change in ‘other things’ will be attended by either
an increase in supply or decrease in supply.

Elasticity of supply of a commodity measures the responsiveness of the quantity

supplied to changes in price. It measures the degree to which price is effective in calling
forth or holding back the quantity. In technical terms, the coefficient of price elasticity of
supply measures the percentage change in the quantity supplied of a commodity per unit of
time resulting from a given percentage change in the price of the commodity.

Further, increase or decrease in supply may be brought about by a number of factors,

and these are; Change in the Cost of Production, Technological Progress, Discovery of
new sources of raw material, Complementary Relationship, Natural Factors, Change in
the price of Substitutes etc.

5.7 SELF ASSESSMENT QUESTIONS

1. Explain the law of supply with the help of a supply schedule and supply
curve?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. Explain determinants of the market supply of a commodity?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

87
3. What are the exceptions to the law of supply?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

5.8 SUGGESTED READINGS

• Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S. Chand
and Company Ltd, New Delhi.

• Business Economics, Chopra P.N., Kalyani Publishers, New Delhi.

• Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

---------

88
 CONSUMER BEHAVIOUR

B.Com. Semester-I Unit-II

C. No. BCG-103 LESSON No. 6

UTILITY ANALYSIS

STRUCTURE

6.1 INTRODUCTION

6.2 OBJECTIVES

6.3 CARDINAL UTILITY ANALYSIS

6.3.1 Assumptions

6.4 LAW OF DIMINISHING MARGINAL UTILITY

6.4.1 Explanation

6.4.2 Assumptions

6.4.3 Importance

6.4.4 Limitations

6.5 SUMMARY

6.6 SELF ASSESSMENT QUESTIONS

6.7 SUGGESTED READING

89
6.1 INTRODUCTION

We have already studied the concepts of individual and market demand. But why
does the consumer behave as he does? What is it that governs his decisions to increase or
decrease the demand for various goods and services? Why is it that a consumer would
like ordinarily to purchase more of a commodity when its price falls and less when its price
rises? The answers to these questions are not easy to formulate scientifically; these comprise
what is popularly called the Theory of demand, or the Theory of Consumer’s Demand or
also the Theory of Consumer Choice. The main aim, therefore, of the theory of demand is
to explain consumer’s demand to establish the Law of Demand. Since the law of demand
is nothing but a statement of the tendency on the part of an individual consumer to adjust
his purchases when price changes (or income changes). From time to time, different theories
have been advanced to explain consumers’ demand for a product and derive the law of
demand which establishes an inverse relationship between price and quantity demanded
for product and derive a valid demand theorem. Cardinal utility analysis is the oldest
theory of demand which provides an explanation of consumers’ demand for a product.
Though cardinal utility analysis approach is very old, its final shape emerge in the hands of
Alfred Marshall.

6.2 OBJECTIVES

After reading this chapter, you will be able:

• To define utility analysis and cardinal utility analysis.

• To explain the concept of diminishing marginal utility.

6.3 CARDINAL UTILITY ANALYSIS

This approach to the theory of demand was started by the classical economists of
the late eighteenth and nineteenth centuries but matured at the hands of the twentieth
century economists, the neo-classical like Marshall and Pigou. The basic idea of this
approach is that a consumer buys a certain commodity or service because of its utility i.e.
the power that it possesses to satisfy his want. Every economic good is supposed to have
the property of satisfying a particular want of a consumer, whatever the nature of want.

90
Liquor and cigarettes satisfy drunkards and smokers and, thus, possess utility although
they may be harmful for them.

Utility is an economic concept that differs from the pleasure and usefulness a
commodity may give to an individual. It was assumed by the neo-classical that utility which
a consumer derives out from a commodity is identical with the satisfaction he expects to
get out of its consumption. It can be measured cardinally; it is possible to know exactly the
number of units of utility that a commodity or service contains for the consumer.

The cardinal utility analysis of demand made many bold assumptions besides the
one that utility is cardinally measurable. (1) The consumer is thought to be rational in that
he is deemed to make deliberate calculations and consistent choices: that if he prefers A
to B, and B to C, then he does not prefer C to A. (2) He is also assumed to maximise
utility under given circumstances. Further, it is assumed that his wants and subjective utilities
of commodities are not influenced by prices. The consumer does not buy a commodity
simply because its price is very high or very low. (3) The biggest assumption of the cardinal
utility approach is the ‘law of diminishing marginal utility’, which is the generally felt and
observed fact that the marginal utility of a commodity falls, other things remaining the same
as consumer buys more and more of it. (4) This law itself is further based on many
assumptions; the units of commodity must be appropriate, that the tastes of the consumer
do not change, that it is possible to know somehow the marginal utility of a commodity and
that utilities of different commodities are independent of each other, i.e., the commodities
are neither substitutes nor complements.

6.3.1 Basic Assumptions of Cardinal Utility Analysis

The cardinal ut ilit y analysis o f demand was based on so me explicit

assumptions.

1. The Cardinal Measurability of Utility- The exponents of the analysis believed

that every economic good gives utility to the consumer when he consumes it. And
this utility is cardinally measurable; that is utility derived by the consumer can be
stated in quantitatively terms. It was also held that the consumer can tell how much
more or less utility he gets from one amount of one commodity over some amount

91
 of another commodity. The assumption was that utility is quantitatively measurable
and comparable.

2. Independence of Utilities of Different Goods- Another assumption of marginal

utility analysis is that the utilities of different commodities are independent. The
utility obtained from the consumption of a good is a function of the quantity of that
good alone. This assumption amounts to taking absence of any ‘external effects’ of
consumption that goods entering the budget of the consumer are neither substitutes
nor complements. It is on the basis of this assumption that the utility functions were
considered to be additive. Marginal utility is the addition made of the total utility
derived from the consumption of a commodity by the purchase of an additional unit
of it.

3. Constancy of the Marginal Utility of Money- The Marshallian marginal utility

analysis of demand assumes that the marginal utility of money to the consumer
remains constant to him as he spends more’ and more on a commodity. So the
consumer’s diminishing marginal utility from the successive units is measured by the
lower and lower price the consumer is willing to pay for them. However, the validity
of this assumption of constancy of the marginal utility of money has been contested.

4. The Law of Diminishing Marginal Utility- The marginal utility analysis of

demand was built on a fundamental premise about marginal utility behaviour
called the Law of Diminishing Marginal Utility. Dr. Marshall stated the law as:
“The additional benefit which a person derives from a given increase of his
stock of a thing diminishes with every increase in the stock that he already
has.” In other words, the law states that the marginal utility derived by a
consumer from the consumption of a commodity goes on diminishing as he
consumes more and more of it, other things remaining the same.

6.4 LAW OF DIMINISHING MARGINAL UTILITY

One of the most important propositions of the marginal utility approach to demand
was the Law of Diminishing Marginal Utility. German economist Gossen, was the first to
explain it. Therefore, it is also called Gossen’s First Law.

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Definition

This law has been stated differently by different economists, According to Marshall,
“The additional benefit which a person derives from a given increase of a stock of a thing
diminishes, other things being equal, with every increase in the stock that he already has.”

Chapman stated the law as, “The more we have of a thing the less we want
additional increments of it or the more we want not to have additional increments of it.”

This law simply tells us that we obtain less and less utility from the successive units
of a commodity as we consume more and more of it.

6.4.1 Explanation

The basis of this law is a fundamental feature of wants which is that every want
needs to be satisfied only upto a limit. After this, limit is reached the intensity of our want
becomes zero. It is called complete satisfaction of the want. Therefore, as we consume
more and more units of a commodity to satisfy our needs, the intensity of our want for it
becomes less and less. Therefore, the utility obtained from the consumption of every unit
of the commodity is less than that of the units consumed earlier. We can better explain this
law with the help of a table and a diagram.

Suppose a man wants to consume apples and is hungry. In this condition, if he gets
one apple, he has very high utility for it. Let us say that the measure of this utility is equal to
30 units (also called utils). Having eaten the first apple he will not remain so hungry as
before. Therefore, if he consumes the second apple he will have a lesser amount of utility
from the second apple even if it was exactly like the first one. Suppose the utility he got
from the second apple equals 20 units. The third, fourth, fifth and sixth apples give him
utility equal to 15,10,5 and 2 units respectively. If, now, he is given the seventh apple, he
has no use for it. In other words, the utility of the seventh apple to the consumer is zero. It
is just possible that if he is given the eighth apple for consumption, it may harm him. In this
case, the utility obtained will be negative. We are, therefore, clearly led to believe that the
additional utility of the successive apples to the consumer goes on diminishing as he consumes
more and more of it.

93
 The Law of Diminishing Marginal Utility is clear from the following table showing
the total and marginal utilities in the example given above. The law can be explained with
the help of a diagram given in figure 6.1 where the horizontal axis shows the units of apples
and the vertical axis measures the marginal utility obtained from the apple units. The utility
curve shows the utility obtained from the successive apples. The curve shown thickly and
falling from left down to the right clearly enlighten us that the marginal utility of the successive
apples is falling.

Table: 6.1

Units of Apples Total Utility Marginal Utility

1 30 30

2 50 20

3 65 15

4 75 10

5 80 5

6 82 2

7 82 0

8 80 -2

The marginal utility of the first apple is known as initial utility. It is 30 units. The
marginal utility of the seventh apple is zero. Therefore, this point is called the satiety point.
The marginal utility of the eighth apple is -2. Therefore, the MU curve lies below the x –
axis (Figure 6.1).

94
 Fig. 6.1: The Law of Diminishing Marginal Utility

6.4.2 Assumptions

The law is based on some assumptions and applies only when these assumptions
are satisfied.

1. Uniform quality and size of the commodity- The successive units of the
commodity should not differ in any way either in quality or size.

2. Consumption within the same time- Consumption may be in one

continuous shying. There should not be so much difference in time between the
consumption of successive units.

3. No change in the mental condition of the consumer during consumption- The

consumer should not feel any change in hi£ mental condition due to the consumption
of the commodity. This condition is not satisfied in the case of liquor.

95
 4. No change in fashion or taste- The law applies only when consumer’s taste for
it remains the same.

5. No change in the price of the commodity or its substitutes- The law is based
on the assumption that the commodity’s price is not changed with; successive
units. The price of the substitutes is also kept at the same level.

6. Applicable to a pleasure economy- According to Patten, consumer’s economy

may be that of pleasure or pain. When the commodity is directly needed by the
consumer, then a less unit of the commodity is likely-to pain him. In such commodities
as food grains during famine conditions -the law does not apply. It is only when
the consumer has the pleasure of obtaining or forgoing a unit of the commodities.
That this law is applicable.

6.4.3 Importance

The law has theoretical and practical advantages. This is why it is one of the most
important laws of economics. The theoretical and practical advantages are:

1) Basis of the Law of Demand. The Law of Demand is based on this law. The
Law of Demand tells us that as the price of a commodity falls, its demand goes up.
This is due to diminishing utility of the commodity to the consumer as he purchases
more of it. If we want a consumer to purchase more units of a commodity; we
have to reduce its price so that a consumer is able to equate the reduced price
with reduced marginal utility.

2) Theory of Value. The law tells us the difference between value-in-use and value-
in-exchange. The Law also helps in knowing the difference between value-in-use
and value-in-exchange. Water has no value in exchange because the marginal
utility of another litre of water is zero. On the other hand, the marginal utility of a
commodity like gold is very high because its marginal utility is quite high. In the
former case, the marginal utility is already zero. In the latter case, it is still very
high.

3) Consumer’s Surplus Concept. The idea of consumer’s surplus is also based

on this law. A consumer purchases as many units of a commodity the marginal

96
 utility of which equals the average unit price. In this Way, the consumer obtains
some surplus utility from the earlier units. This is called Consumer’s Surplus.

4) Importance to Finance Minister. A AFinance Minister keeps this law in mind

when he taxes the commodities purchased by the rich at a high rate and those
purchased by the poor people at a lower rate. Sometimes, the rate of taxation of
income also goes on rising. This is called progressive taxation. The main reason
behind this is the belief that the marginal utility of money to the poor is much higher
than the marginal utility of the money to the rich.

5) Socialism. Socialists want equitable distribution of wealth. They would like to

transfer some part of wealth with the rich to the poor people through taxation and
grants. They argue that the measure of sacrifice by the rich in terms of utility is
much less as compared to the utility obtained by the poor people. There is a net
gain to society through this income transfer.

6) Variety in Consumption and Production. This Law strongly supports the

provision of variety for consumers. A consumer purchasing the same variety of a
product may find his marginal utility going down very fast. But if he is given another
variety of the commodity, his marginal utility may fall but at a lesser speed. Variety
adds to the consumer’s satisfaction.

7) Importance to the Consumer. A consumer also benefits from this law. He is

advised to spend his income over the purchase of a number of commodities rather
than on one commodity. It is in this way that he can get the maximum utility out of
his expenditure. This law, therefore, induces the consumer to maximise his utility.

6.4.4 Limitations

There are some instances when this law does not apply. These are some common
examples of the exceptions to this law.

i. Rare and curious things. This law does not apply to rare and curious things-like
old coins, rare paintings, etc.

ii. Goods of display. Things which satisfy consumer’s taste for display of wealth or
fashion, as is the case with jewellery.
97
 iii. Consumption of public goods. The law does not apply to such public goods as
telephones because the greater the number of telephones in a town, the greater is
utility obtained from the use of a telephone.

iv. Intoxicants. There are many commodities which change the mental
condition of the consumer as they are consumed more and more. This is the case
with drinking.

v. Good books or poetry. According to Taussig, good books, music, or poetry may
give the interested persons more and more utility.

vi. First time consumption of a commodity. When a consumer consumes a

commodity for the first time, then he may get increasing marginal utility for some
time. This may be the case with a man who has seen the television for the first time
in his life.

6.5 SUMMARY

Utility is an economic concept that differs from the pleasure and usefulness a
commodity may give to an individual. It was assumed by the economists that utility which
a consumer derives out from a commodity is identical with the satisfaction he expects to
get out of its consumption. It can be measured cardinally; it is possible to know exactly the
number of units of utility that a commodity or service contains for the consumer.

The cardinal utility analysis of demand was based on some conditions that utility is cardinally
measurable, utilities of different commodities are independent, the marginal utility of money
to the consumer remains constant, and finally the law of diminishing
marginal utility.

The basis of this law is a fundamental feature that every want needs to be satisfied
only upto a limit. After this, limit is reached the intensity of our want becomes zero. It is
called complete satisfaction of the want. Therefore, as we consume more and more
units of a commodity to satisfy our needs, the intensity of our want for it becomes less
and less. Therefore, the utility obtained from the consumption of every unit of the
commodity is less than that of the units consumed earlier.

98
 This law of diminishing marginal utility is based on certain assumptions, such as
Uniform quality and size of the commodity, Consumption within the same time, No change
in the mental condition of the consumer during consumption, No change in fashion or
taste, No change in the price of the commodity or its substitutes, and Applicable to a
pleasure economy. This is one of the most important laws of the economy.

6.6 SELF ASSESSMENT QUESTIONS

1. Explain the law of diminishing marginal utility with an illustration?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

2. What is utility? How is total utility derived from marginal utility?

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

3. Make a critical evaluation of the Marshallian cardinal Utility analysis.

_____________________________________________________________

_____________________________________________________________

_____________________________________________________________

6.7 SUGGESTED READINGS

• Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.

• Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

----------

99
B.Com. Semester-I Unit-II
C. No. BCG-103 LESSON No. 7

INDIFFERANCE CURVE ANALYSIS

STRUCTURE

7.1 INTRODUCTION

7.2 OBJECTIVE

7.3 IMPORTANT CONCEPTS

7.3.1 Definition

7.3.2 Indifference Schedule

7.3.3 Indifference curve

7.3.4 Indifference Map

7.3.5 Marginal Rate of Substitution (MRS)

7.4 ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS

7.5 PROPERTIES OF INDIFFERENCE CURVES

7.6 SUMMARY

7.7 SELF ASSESSMENT QUESTIONS

7.8 SUGGESTED READING

100
7.1 INTRODUCTION

The classical economists including Marshall had adopted the cardinal utility approach to
the theory of demand. Its main merit was its simplicity but it was widely criticised because
of the defective assumptions on which it was based. Taking these criticisms seriously some
economists wanted to search for an alternative approach which could be free from
criticisms. The most defective assumption and the most unrealistic assumption was that
utility can be cardinally measured. Edgeworth, Fisher and Pareto had given some ideas
about the possibility of building demand analysis on what was ordinal utility, that is, a
measure of utility in which commodities or their combinations arc ordered according to the
preference of the consumer. In cardinal utility, the amount of utility in a commodity is
measured absolutely and is given as so many units. In ordinal utility, commodities are
ranked as first, second, third and so on according to the preference of the consumer.
Russian economist Slutsky is credited with the first statement of the law of demand with
the help of ordinal utility in the year 1915. But a detailed study of the indifference curve
analysis was given by Prof. Hicks and Allen in the year 1928 in a paper: “A Reconsideration
of the Theory of Value”. In this paper they strongly criticised cardinal utility theory and
gave their own approach to consumer’s demand, which they called ‘Indifference Curve
Approach’. J.R. Hicks wrote down the indifference curve theory in a much more detailed
form in his book ‘Value and Capital’ published in 1939.
This analysis starts by rejecting the idea that utility can be cardinally measured. This is
because utility is something subjective. According to Hicks and Allen cardinal utility
measurement is not necessary for building a theory of demand. According to them, a
consumer makes comparisons of the satisfaction obtainable from combinations of different
commodities. Given two combinations of commodities, a consumer can easily tell us which
of the two he prefers. But he cannot tell us how much he prefers one over the other. The
consumer is able to put the various combinations in order as first, second, third, as he
views these combinations from the point of view of his satisfaction. Thus, Hicks and Allen
claimed that their indifference curve analysis was merited on two grounds: (1) It had fewer
assumptions and yet could establish the law of demand. (2) It was more realistic because
it could take into consideration combinations of commodities which were related with one
101
another. The cardinal utility analysis was unrealistic because it assumed the commodities
to be independent and being bought one at a time.

7.2 OBJECTIVES

The objectives of this chapter are:

 To explain indifference curve and its related concepts.

To provide assumptions about indifference curve.

7.3 BASIC CONCEPTS OF THE INDIFFERENCE CURVE ANALYSIS

The indifference curve analysis is in many ways similar to the cardinal utility analysis but it
has important differences with that analysis also. It has its own concepts. Before we take
up the analysis of indifference curves, these concepts must be made very clear.

7.3.1 Definition
According to Hicks, a consumer can tell whether the various combination of any two
commodities which he wants to purchase give him equal satisfaction so that he is indifferent
between them. If we show these combinations on a graph showing one commodity on the
horizontal axis and the other on the vertical axis, then the combinations bearing consumer’s
indifference can be shown as points on the graph. If we join these points to form a curve,
it will be known as an indifference curve. An indifference curve is the locus of all those
points representing various combinations of two commodities giving the same satisfaction
to the consumer. In the words of A. L. Meyers, “An indifference schedule (curve) may be
defined as a schedule of various combinations of goods which will be equally satisfactory
to the consumer concerned. According to Prof. Leftwitch, “A single indifference curve
shows the different combinations of X and Y that yield equal satisfaction to the consumer.”

7.3.2 Indifference Schedule

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An indifference schedule is a table representing the various combinations of goods which
give equal satisfaction to the consumer. According to A.L Meyers, “An indifference schedule
may be defined as a schedule of various combinations of goods that will be equally
satisfactory to the individual concerned.” The following table shows the indifference schedule
of combinations of biscuits and cups of tea for a consumer.

Table 7.1
Indifference Schedule

In Table 7.1 the consumer is assumed to be purchasing combinations of cups of tea and
biscuits. He tells us that he is indifferent between the six combinations given above.
Combination A shows that the consumer has one cup of tea and 50 biscuits. While
combination B shows that the consumer gets two cups of tea and 38 biscuits. The consumer
is indifferent between these combinations since they give him the same level of satisfaction.
Similar is the case with the other combinations i.e. C, D, E and F. The consumer is indifferent
among these combinations. In other words, he prefers none of these combinations.

7.3.3 lndifference curve

When we show these combinations on a graph showing cups of tea on the X-axis and

biscuits on Y-axis we obtain a curve as is shown in the figure 7.1. It is called an Indifference
Curve because it joins the points of indifference on the graph.

103
 5 6
Fig. 7.1 An Indifference Curve and the falling marginal rate CUPSofOF
substitution
TEA

In figure 7.1, IC is an indifference curve. The different points on it shows the various
combinations of Tea and Biscuits. The consumer likes all of them equally. Therefore, he is
indifferent among them. By joining these points we obtain the Indifference curve IC. Al
though in the successive combinations the amount of biscuits goes on diminishing as we
move from the left side of the indifference curve to the right side, the increase in the
quantity of cups of tea is sufficient to compensate him for the loss of biscuits so that the
consumer is indifferent among them.

7.3.4 Indifference Map

It is possible for us to build up higher and higher schedules of the two commodities which
contain greater quantities of both the commodities. However, the combinations in each of
them are such that the consumer is indifferent between them. The schedule given above
(fig. 7.1) gave us only one Indifference curve. We can build higher schedules, say double
the cups and biscuits, three times the cups and biscuits. These will give us higher and

104
higher Indifference curves. The set of indifference curves representing the different levels
of satisfaction obtainable from different schedules of indifference is called an Indifference
Map. This is shown for commodities A and B in Fig. 7.2. The Indifference Map is a
geometrical expression of a number of indifference schedules on the assumption that the
commodities constituting the combinations of each schedule are finitely divisible.
In Fig. 7.2 there are three combinations of commodity A and commodity B. These are R1,
R2, R3 among which the consumer is indifferent. Therefore, these may be taken to give an
equal level of satisfaction to the consumer. Hence, these combinations lie on the same
indifference curve IC1. However, combinations P and Q are in the north-east of these
combinations. They show greater amounts of both the commodities. Combinations P and
Q are lying on higher indifference curves and show greater amounts of both the commodities.

Therefore, combinations P and Q are preferred to those on the IC1. We may, therefore,
say that the higher an indifference curve is, the greater the level of satisfaction it represents.

COMMODITY A

7.3.5 Marginal Rate of Substitution (MRS)

Fig. 7.2 An Indifference Map

105
A study of the Indifference curve shows that as the consumer gets one more unit of the
commodity on the horizontal axis, his total satisfaction is increased. If he wants to maintain
his satisfaction at the same level, he has to sacrifice some units of the commodity on the
vertical axis. If by obtaining one unit of a commodity A, he is prepared to give up five units
of the commodity B and maintain his satisfaction at the same level, then five units of
commodity B is the marginal rate of substitution for one unit of the commodity A.
According to Prof. Bilas, “The marginal rate of substitution of X for Y is defined as the
amount of Y the consumer is just willing to give up to get one more unit of X and maintain
the same level of satisfaction.”
The marginal rate of substitution between two commodities is shown by the slope of the
indifference curve showing their combinations. If the two commodities are X and Y, the
marginal rate of substitution between them is written as MRSyx = . It is the rate at
which the consumer is willing to substitute Y for X. The main characteristic of the MRS is
that it diminishes as one commodity is increased and the other commodity is decreased in
the consumer’s indifference schedule. As a result the indifference curve slopes from left
down to the right. It means a negative and diminishing rate of substitution of one commodity
for the other.
Prof. J.R. Hicks has built up the Principle of Diminishing Marginal Rate of Substitution.
This principle is similar to the law of diminishing marginal utility and is yet different. According
to Hibdon, “The law of Diminishing Marginal Rate of Substitution states that the consumer
will be willing to forgo smaller and smaller units of Y in order to have successive additional
units of A”. We can explain the law much better with the help of the indifference schedule
which we have given earlier. We reproduce the same schedule here and calculate the MRS
of cups of tea for biscuits.
In table 7.2, all the combinations give the same satisfaction to the consumer. If he chooses
combination A he gets one cup of tea and fifty biscuits. In the combination B, he gets one
more cup of tea and is prepared to give twelve biscuits for it. The MRS here is therefore 1:
12. In the combination C, he is willing to sacrifice only ten biscuits for another cup of tea.

106
The MRS falls to become 1: 10. In the successive combinations D, E and F, the MRS
continues to fall. This illustrates the diminishing marginal rate of substitution.
Table 7.2
Marginal rate of substitution

MRS of X for Y is the ratio of the change in the quantity of Y which would keep the
consumer on the same indifference curve for a change in the marginal quantity of X.
MRSxy =
Since MRS is denoted as the slope of an indifference curve, it is commonly negative and
falling. The convex indifference curve falling from left down to the right shows the Law of
Diminishing Marginal Rate of Substitution.
Prof. Hicks has given his justification for assuming a diminishing MRS. There are two reasons
for this. In the first place, each particular want is satiable. Therefore, as a consumer obtains
more and more of one commodity, his intensity of the need for it goes on diminishing. As a
result, the consumer will be prepared to sacrifice less amount of the other commodity in
order to obtain more and more of this commodity.
Secondly, goods are imperfect substitutes for one another. Normally, a commodity is not
completely substitutable for another. If it were, then the two commodities are the same.
There is no need to distinguish between the two. But goods are imperfect substitutes just
as tea and coffee are. Commodities are to some extent complementary also. Therefore,
the MRS of one for the other must diminish. In his opinion if it does not diminish then
consumer’s equilibrium is rendered unstable. Since in practice we see consumer’s passing
from one point of equilibrium to another with change in prices without any instability of
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behaviour, we can safely assume that the MRS is always diminishing around the point of
consumer’s equilibrium.
There are limitations to this law also. But these are in the nature of rare exceptions. The
first is the case of perfect complementarily. For example, the left foot and right foot shoes
have no rate of substitution. Secondly, there is the case of perfect substitutes wherein
MRS becomes infinite. An example is the products of two firms in perfect competition.
Consumer’s indifference curves in this situation would be straight lines.
These are, however, extreme cases not commonly found in consumer’s choice, the
diminishing MRS must not be confused with the diminishing marginal utility of the cardinal
utility analysis.
The two concepts are entirely different. The main differences are as follows:
a) MRS denotes the rate of commodity substitution. It has no subjective
element in it. It just tells us as to how much amount of one commodity the
consumer is willing to forgo to get a small amount of another and yet remain
on the same indifference curve. It is an objective thing.
b) It does not need the assumption of independent commodities in the
combinations. It allows complementarily and substitution. As such MRS is a
wider concept than diminishing marginal utility.
c) The law of diminishing MRS does not need the assumption of constant
marginal utility of money because it deals with physical amounts of the
commodity. Money does not come anywhere in its justification. The law
of diminishing marginal utility cannot do without these assumptions.

7.4 ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS

The indifference curve analysis given by Hicks and Allen is built on the following assumptions:
1. Rational behaviour of the consumer
It is assumed that the consumer behaves rationally which means that he tries to
obtain the maximum satisfaction from his expenditure on consumer goods. As
such the consumer is supposed to choose such a combination of his needed
consumer goods as provides him with the maximum possible satisfaction.

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2. Scale of Preference
Another assumption of the analysis is that the consumer is able to arrange the
available combinations of goods according to preference or indifference for them.
Between two combinations he is assumed to be either indifferent or prefer one to
the other. In technical language, it is called ‘Scale of Preference’. Stated simply it
means that if there are a number of combinations, the consumer is able to arrange
them in an ascending or descending order of his preference and is able to indicate
the combinations among which he is indifferent. This assumption may be called the
assumption of ordering ability.
3. Concept of ordinal utility
The indifference curve analysis is based on the concept of ordinal utility. Ordinal
Utility implies that the consumer is in a position to rank the alternative combinations,
available to him by a simple comparison of the satisfaction obtainable from the
given combinations. Ordinal utility does not require quantitative measurement of
utilities of different combinations.
4. Diminishing marginal rate of substitution
Another assumption behind the indifference curve analysis is that of ‘diminishing
marginal rate of substitution’. This means that as the amount of a commodity with
the consumer goes on increasing he is prepared to exchange lesser and lesser
amounts of the other commodity for equal units of the commodity whose amount
is increasing.
5. Assumption of consistency
It is assumed that the consumer is consistent in his behaviour. If he is indifferent
between combination A and combination B, and is also indifferent between
combinations B and C, then he must be indifferent between combinations A and C.
Stated negatively, this assumption requires that if the consumer prefers A to B and
B to C, then he does not prefer C to A in any circumstances.

6. Scale of preferences is independent of the market prices

It is further assumed that the consumer is not influenced in his preference or
indifference between combinations by the market prices of different goods. In

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 other words, he is supposed not to regard a higher-priced commodity as superior
and lower priced commodity as inferior.
7. Weak ordering
Indifference curve analysis is based on the weak ordering form of preference
hypothesis. According to J.R. Hicks, weak ordering implies that there is a possibility
of the consumer being indifferent between any two combinations along with the
possibility of preferring one combination to the other. The consumer may prefer A
to B or B to A, or he may be indifferent between two combinations. As against weak
ordering, strong ordering means that the consumer is allowed to indicate his
preference only. The possibility of indifference between two combinations is ruled
out in strong ordering.
8. Assumption of transitivity
Another assumption underlying indifference curve analysis is that consumer’s
preference or indifference relations do not contradict the consumer’s position of
indifference between combinations taken as whole and taken separately. It means
that if the consumer prefers A to B, B to C and C to D, then, he also prefers A to D.
Likewise, if he declares his indifference between pairs of combinations separately,
then he is indifferent between all of them. His indifference lies all over his choice
field.
9. Assumption of continuity
The indifference curve analysis given by Hicks and Allen was based on the
assumption of continuity. Continuity means that the consumer is in a position to
rank all conceivable combinations of the needed goods according to his preference
or indifference. This means further that the consumer is never tired of ordering the
combinations available to him, howsoever small the difference in satisfactions may
be between the combinations. The consumer is assumed to make minute
comparisons so that different sets of indifference curves are available from him.
Prof. Hicks gave up this assumption in his ‘Revision of Demand Theory’.

7.5 PROPERTIES OF INDIFFERENCE CURVES

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The indifference curves, as prepared from consumer’s indifference schedules, possess
some properties that we must note before we make use of them as tools of the analysis of
demand. These properties are of rationality, transitivity and the diminishing marginal rate of
substitution, when these are interpreted in their geometrical form.
(1) Higher Indifference curves represent higher levels of satisfaction: An
indifference curve that lies above and to the right of another indifference curve
represents preferred combinations of commodities, and therefore, higher levels
of satisfaction. In Fig. 7.3, the indifference curve IC2 lies above and to the
right of the indifference curve IC1. Since IC2 is the higher indifference curve, it
shows A1A2 more of commodity A with the same amount of the commodity B
given by OB. If this were not the case, there would be no difference between
the points A1 and A2.
COMMODITY B

COMMODITYA
2) Indifference Curves must slope from left downward to the right:

Fig. 7.3 Higher indifference curves represent higher

levels of satisfaction

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 Indifference curves must slope down from left to the right, that is, they
must have a negative slope. Our assumption that the consumer would like
to have more of both commodities helps in proving this. As we move
from left to the right on an indifference curve, it means more of the
commodity represented on the X-axis. With every increase in the amount
of one commodity, the consumer becomes better off. If the consumer is to
be on the same indifference curve he should possess such combinations of
the commodities as neither make him better off nor worse off. Therefore,
he must be made to give up some amount of the commodity on the Y-axis,
as he gains some of the commodity on the X’-axis.
Fig. 7.4 Indifference curves cannot be horizontal or vertical straight

lines, nor can they be upward rising straight lines.

The diagram (Fig. 7.4) shows the three impossible shapes of indifference curves. In all the
three cases the consumer has the points P1 P2 on the same indifference curve. These points
show two combinations of commodity d and commodity B. In all the three diagrams the
combinations shown by P1 and P2 do not contain any less of one of the commodities in
order to obtain more of the other commodity. The consumer is able to obtain more of both
commodities in the extreme left diagram and is yet having the same satisfaction. In the
central figure the consumer has more of commodity B. In the extreme right figure, he has
more of A with the same satisfaction. This is against our assumption of diminishing MRS.
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3).Indifference curves do not intersect: Third, Indifference curves can never meet or
intersect so that only one indifference curve can pass through any one point in the indifference
map. In other words, one combination of commodities can lie only on one indifference
curve. We can easily prove this property by showing that if two indifference curves intersect,
it leads to absurd results. In figure 7.5, two indifference curves IC1 and IC2 cut each other
at C. Since points (combinations) C and C1 lie on the same indifference curve IC2, the
consumer is indifferent between them. So they may be supposed to give equal satisfaction
to him. Thus we have:

Fig. 7.5 Indifference Curves Cannot Intersect

OA of apples+ OF of bananas = OB of apples + OG of bananas

……. (1)

Similarly, combinations C and C2 lie on the same indifference curve IC1 and the consumer is
indifferent between them. Therefore,
OA of apples + OF of bananas = OB of apples + OH of bananas

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 ... (2)
The left hand sides of (1) and (2) are equal, therefore
OB of apples +OG of bananas = OB of apples + OH of bananas
The amount OB of apples is common to both sides. We, therefore, arrive at the
result that OG of bananas is equal to OH of bananas, which is obviously absurd. We
conclude that indifference curves cannot intersect.
4) IndifferenceCurves are Convex to the Origin : Indifference curves
are convex to the origin. This is equivalent to saying that the marginal rate of substitution
between the commodities diminishes as we move from left down to the right along the
indifference curve as shown in figure 7.6.

Figure 7.6 Diminishing Marginal Rate of Substitution and the negative

diminishing slope of an indifference curve.

Points (combinations) P and Q lie on indifference curve IC but as we move from P to Q,

it means a small (M1 M2 = A) increase of commodity A but a corresponding loss
(K3K4 = B) of commodity B. The marginal rate of substitution of B for A is A/ B.

114
Next, if the consumer is given the same increment (M lM 2= M2 M3) in commodity A, he
is prepared to part with less (K3 K2 ) of B than before. In other words, the MRSAB goes
on diminishing along the indifference curve IC.
The justification for assuming a diminishing marginal rate of substitution has already been
given. Besides that, we can think of two other theoretical possibilities of the trend of
change in the marginal rate of substitution. It may remain the same or it may increase as we
move along the indifference curve. In the former case shown in the central part of the
figure 7.7 below, the indifference curve is a straight line and in the latter case shown on the
extreme right; it is concave to the origin. However, these are remote possibilities. A straight
line indifference curve shows perfect substitutes on the X and Y axis; therefore, the marginal
rate of substitution remains the same in spite of the fact that the stock, of one commodity
continues to increase, and that of the other diminish, with the consumer. Inthe case where
indifference curve is concave to the origin, it wilj induce the consumer to substitute one
commodity entirely for the other. It means that the consumer will like to have only one
commodity by spending all on it. This is called monomania and it shows practically that the
consumer would not like to have a variety of goods. This conclusion is contrary to general
experience. Therefore, generally, indifference curves are expected to be convex to the
origin.

IS DIMINISHING IS CONSTANT IS INCREASING

COMMODITY A COMMODITY A

Fig. 7.7 Falling Indifference Curves and the Marginal Rate of Substitution

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5) Indifference Curves May not be Parallel to each other. They can be
parallel to each other only if the two commodities being shown on the
horizontal axis and the vertical axis arc independent of each other in the
sense that they are neither substitute nor complementary goods, and further
that none of them is ‘inferior’ or ‘superior’ in relation to each other whatever
the amounts of each with the consumer. The assumption of independence and
absence of any income effects by Dr. Marshall, if introduced in the indifference
curves, would give us a set of indifference curves parallel to each other and
always equidistant from one another. It is obvious that this is an extreme case.
Normally, a consumer demands goods which are related goods for which the
income effect is positive. Therefore, the normal position of indifference curves
is that they converge on both sides to one another as we go left upwards or
right downwards but do not meet.
6) Indifference curves for perfect substitutes and perfect complements-
Straight-line indifference curves show that the two goods being shown on
the two axes are perfect substitutes. It means that the consumer does not
distinguish at all between the satisfaction yielding quality of the two goods
in question. The ‘indifference curves’ here must be straight lines connecting
the axes because the marginal rate of substitution stays unchanged regardless
of how much of each commodity the consumer possesses. In the event of
perfect complementarity between the two commodities, on the other extreme,
goods can be used only in definite, fixed proportions. In this case the
indifference curves must be rightangular, showing that more of commodity A
without any addition of commodity B, or more of commodity B without any
addition of commodity A, leaves the consumer on an unchanging indifference
level. The figures 7.8 (a) and (b) show perfect substitutes and perfect
complements on their axes, and the associated indifference curves in the two
cases.

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 COMMODITY A COMMODITY A

7.8 (a) Straight line Indifference Curves: 7.8 (b) Right Angled Indifference
Goods perfect substitutes Curves: goods perfect complements
7) Complementarity of commodities and curvature of Indifference
curves : One of the merits of indifference-preference analysis is its recognition
of interdependence between different commodities. It analyses the
substitutability and complementarity between the goods demanded by the
consumer. We can take a brief and rough view of this here.
There is an important relationship between the curvature (slope) of an
indifference curve and the degree of complementarity or substitutability of the
two commodities shown on the two axis. The extent to which commodities
are substitutes for each other is reflected in the straightness or flatness of
indifference curves. When the two commodities shown on the two axes are
perfect substitutes for each other, their indifference curves are straight lines
showing that the marginal rate of substitution of one for the other remains the
same whatever the amount the consumer may have of one commodity. The
consumer is indifferent, in such a case, as to which commodity he has. There
is little theoretical point in differentiating between perfect substitutes, for they
are the same commodity. This is an extreme case. The lesser the substitutability
of the two commodities, the greater is the convexity of indifference curves to
the origin and vice versa. The greater the complementarity between the two,
the greater the convexity of the indifference curves.
The relationship between the convexity of indifference curves and the nature
of the two commodities may differ in different parts of the indifference curves.

117
Commodities may be good substitutes when combined in certain proportions
but not so good in others. Similarly, about complementarity also we just cannot
say that the two commodities are equally good complements along the whole
of the indifference curve. There are some commodities that are good substitutes
or complements within a particular range but not out of it. For example, consider
indifference curve IC1 in figure 7.9 (a) within the range PQ, cycle tyres and tubes
can be substituted for each other. Old tyres can be used with new tubes and
new tyres can be run with old tubes. Thus, if we assume a constant level of
satisfaction, it is possible to increase the consumption of tyres, to some extent,
at the expense of consumption of tubes. But this kind of substitution is possible
within certain limits only, such as, between points P and Q in the figure. Within
this range the two commodities are substitutes but out of these limits, the
complementary relationship between them is more important. Thus, it is not
appropriate always to say that commodities are either substitutes or
complements. They may be to some extent complements, but are substitutes
beyond a point. Indifference curves take an interesting shape when the two
commodities shown on the two axes are complementary in nature and arc
used only in fixed proportions, for example, the two feet of shoes. In such
cases the indifference curves are parallel to the two axes having a sudden right
angle kink, as shown in figure 7.9(b).

Figure 7.9 Indifference Curves and Complementary Goods

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 8) Indifference curves do not touch the horizontal or the vertical axis:
Indifference curves have the basic assumption that the consumer purchases
combinations of different commodities. Therefore, he is not supposed to
purchase only one commodity because in that case the indifference curve will
touch one axis. Purchasing only one commodity means monomania, that is
consumer’s lack of interest in the other commodity or his insistence on
purchasing only one commodity. Figure 7.10 shows an indifference curve,
meeting the horizontal axis at C and a vertical axis at D. This violates the basic
assumption of indifference curves because at point C the consumer is purchasing
only the commodity d. Similarly, at the point D the consumer is purchasing
only commodity B, nothing of commodity A. This is against our basic
assumption that the consumer purchases the two commodities in a combination.
Fig. 7.10 Indifference Curves do not touch either axis

COMMODITY A
7.6 SUMMARY

The indifference curve analysis is in many ways similar to the cardinal utility analysis but it
has important differences with that analysis also. An indifference curve is the locus of all
those points representing various combinations of two commodities giving the same
satisfaction to the consumer. Whereas indifference schedule is a table representing the

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various combinations of goods which give equal satisfaction to the consumer.

The set of indifference curves representing the different levels of satisfaction obtainable
from different schedules of indifference is called an Indifference Map. According to Prof.
Bilas, “The marginal rate of substitution of X for Y is defined as the amount of Y the
consumer is just willing to give up to get one more unit of X and maintain the same level of
satisfaction.” The marginal rate of substitution between two commodities is shown by the
slope of the indifference curve showing their combinations. The main characteristic of the
MRS is that it diminishes as one commodity is increased and the other commodity is
decreased in the consumer’s indifference schedule.

The indifference curve analysis given by Hicks and Allen is built on the following assumptions;
such as the consumer behaves rationally, consumer is able to arrange the available
combinations of goods according to preference, the consumer is in a position to rank the
alternative combinations, Diminishing marginal rate of substitution, the consumer is consistent
in his behaviour, the consumer is not influenced in his preference or indifference between
combinations by the market prices of different goods, Indifference curve analysis is based
on the weak ordering form of preference, consumer’s preference or indifference relations
do not contradict the consumer’s position of indifference between combinations taken as
whole and taken separately, and finally the consumer is never tired of ordering the
combinations available to him.
The indifference curves, as prepared from consumer’s indifference schedules, possess
some properties that we must note before we make use of them as tools of the analysis of
demand. These properties are; Higher Indifference curves represent higher levels of
satisfaction, Indifference Curves must slope from left downward to the right, Indifference
curves do not intersect, Indifference Curves are Convex to the Origin, Indifference Curves
May not be Parallel to each other, Indifference curves for perfect substitutes and perfect
complements, Complementarity of commodities and curvature of Indifference curves, and
Indifference curves do not touch the horizontal or the vertical axis.

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7.7 SELF ASSESSMENT QUESTIONS

1. Give basic assumptions on which the indifference curve is built?

__________________________________________________________

__________________________________________________________
2. Compare Indifference Curve Analysis with Marginal Utility Analysis of
Demand.

___________________________________________________________

__________________________________________________________

__________________________________________________________

3. What is Marginal Rate of Substitution (MRS)?

__________________________________________________________

__________________________________________________________

__________________________________________________________

7.8 SUGGESTED READING

 Advanced Economic Theory. Micro Economic Analysis, 2012, Ahuja, H.L., S.

Chand and Company Ltd, New Delhi.

 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,

New Delhi.

 Economic Theory, Chopra, P.N., Kalyani Publishers, New Delhi

****

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B.Com. Semester-I Unit-II
C. No. BCG-103 LESSON No. 8

CONSUMER EQUILIBRIUM UNDER UTILITY APPROACH

STRUCTURE
8.1 INTRODUCTION
8.2 OBJECTIVE
8.3 EQUILIBRIUM OF THE CONSUMER THROUGH UTILITY ANALYSIS
8.3.1 Consumer's Equilibrium with One Commodity
8.3.2 Consumer's Equilibrium with Two Commodities
8.4 LIMITATIONS OF CARDINAL UTILITY ANALYSIS OF DEMAND
8.5 SUMMARY
8.6 SELF ASSESSMENT QUESTIONS
8.7 SUGGESTED READINGS
8.1 INTRODUCTION
A consumer is an economic agent who uses goods and services for the direct satisfaction
of his/her wants. Generally, the consumer is thought of as an individual but in practice
consumers consist of institutions, individuals, and groups of individuals or households. The
consumer behaviour refers to the way in which consumers spend their income. The consumer
derives utility from his expenditures. The consumer chooses his expenditures and maximises
his utility given his income and the prices of goods and services.
Consumer’s equilibrium refers to a situation where in a consumer gets maximum satisfaction
out of his given income and he has no tendency to make any change in his existing

122
expenditure. “A consumer is in equilibrium when he regards his actual behaviour as the
best possible under the circumstances and feels no necessity to change his behaviour as
long as circumstances remain unchanged,”
In the words of Samuelson, “The consumer is in equilibrium when he maximises his
satisfaction given his income and the market prices.”
Consumer’s equilibrium through utility analysis is based on the assumptions such as rational
consumer, Cardinal utility, independent utility, and marginal utility of money is constant.
Consumer’s equilibrium through utility analysis is discussed with reference to; single
commodity and two or more commodities.
8.2 OBJECTIVES
The main objective of this chapter is to explain consumers' equilibrium with the help of
cardinal utility approach. Besides this an attempt shall be made:

 To explain equilibrium with one commodity and also with two commodities.

8.3 EQUILIBRIUM OF THE CONSUMER THROUGH UTILITY ANALYSIS

The aim of the consumer in the expenditure of his income is to obtain the maximum utility
from the goods purchased. The law of diminishing marginal utility tells us that as consumer
purchases more and more units of a commodity, he gets less and less additions of utility
from the successive units of expenditure. At the same time as he purchases more and more
of one commodity a lesser amount of income is left with him to be spent on other goods.
Therefore, in the choice of his expenditure on different goods and services, the consumer
is guided by the Law of Diminishing Marginal Utility of a commodity on the one side and
the reduced income left with him on the other. A sensible consumer will balance his
expenditure over different commodities so that he gets the maximum satisfaction. When he
does so, he is said to be in equilibrium. A consumer is in equilibrium when he has no
intention to change the pattern of consumption of different goods.
8.3.1 Consumer’s Equilibrium with One Commodity
Suppose a consumer has to decide the amount of expenditure on a single commodity.

123
How many units of that commodity will he buy? The process of determination of consumer
equilibrium in this case can be illustrated with the help of Fig. 8.1.

MARKET PRICE

APPLES
Fig. 8.1 Consumer's Equilibrium with one
commodity

In Fig. 8.1 the marginal utility of apples is shown to be falling in the marginal utility curve
starting from point A. The market price of apples is given at the level OP. The consumer
gets a surplus utility from the first unit of apples equal to AP. The consumer's surplus on
successive units of apples goes on diminishing. The surplus utility in zero at the point B.
Therefore, the consumer's surplus satisfaction is the maximum with the purchase of OM
apples. Or we can say since the falling MU curve of apples intersects the market-price
horizontal line at the point B, the consumer decides to purchase OM of apples. He does
not buy less or more of apples because in these cases the utility obtained from the purchase
of apples shall be less than that obtained in the present case. Suppose he purchases only
OM apples. This will save him money income equal to area EBMM1. But the loss in the
utility shall be EBMM1. He shall have a net loss in utility equal to the shaded area EFB. It
diminishes his total utility. Similarly, we can show that by spending MM2 more on apples
the consumer suffers a loss of utility equal to the shaded area BCD. Hence it is in the best
interest of the consumer to purchase OM apples.

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8.3.2 Consumer's Equilibrium with Two Commodities
In finding out the equilibrium of the consumer with two commodities, we are guided by the
principle of equi-marginal utility applicable to the consumer. Suppose the consumer has to
distribute his money income of 100 between apples and bananas. Let us call these
commodities A and B. The consumer shall be in equilibrium with regard to the purchase of
two commodities when the following condition is satisfied.
Marginal Utility of A = Marginal Utility of B
Price of A Price of 5
The condition given above states that in the consumer's equilibrium condition, the ratio of
the marginal utility of apples to their price must be the same as the ratio of marginal utility
to price for bananas. The condition given above can be reduced to a simpler equation if
we consider the marginal utilities of the money spent on the two commodities rather than
the marginal utility of their physical units. If we assume that the marginal utility of money is
a given constant, then consumer's equilibrium requires that the marginal utilities of the last
units of money spent on the two goods give equi-marginal utility to the consumer. This is
easily illustrated with the help of the Fig. 8.2.

Fig. 8.2 Consumer’s Equilibrium with two Commodities

In Fig. 8.2, we show money spent on apples and bananas on the horizontal axis and the
marginal utilities of the two commodities along the respective vertical axes. The total money
with the consumer is 00' which he has to allocate between apples and bananas. The curve
AE shows the falling marginal utility of expenditure on bananas. The curve BD shows the

125
diminishing marginal utility of expenditure on apples.
Since the two marginal utility curves intersect at the point E, the marginal utilities of
expenditure on apples and bananas are equal at this point. It is EN. The consumer spends
ON on bananas and the remaining amount O'N is spent on apples. This pattern of spending
the limited income gives the maximum total utility to the consumer. Any change in this
pattern of expenditure shall reduce the total utility of the consumer. This can be easily seen
in the diagram. Suppose, the consumer reduces his expenditure of bananas to OM and
increases his expenditure on apples by MN. This change in spending increases consumer's
total utility by the area MNED and reduces his total utility by the area MNEC. There is a
net loss in the total utility equal to the shaded area CDE. Thus, it is clear that the consumer
will be in equilibrium with a pattern of expenditure which gives him equal marginal utility in
case of the two goods.
8.4 LIMITATIONS OF CARDINAL UTILITY ANALYSIS OF DEMAND
Utility analysis was the first attempt at building up a systematic theory of demand. Its
development was spanned over a century and a half and was perfected to its present form
by Prof. Marshall. Although A.C. Pigou and many other successors of Marshall tried to
clear up ambiguities in the analysis, yet the form in which Marshall had put it could not be
defended. The main points of criticism of this theory are as:
1. Subjective nature of Utility- The use of the word 'utility' to explain the origin of
demand has been criticised. While market demand is an objective phenomenon, the utility
theorists tried to give a subjective explanation of the same. Therein they involved themselves
in difficult psychological and philosophical questions. The critics point out that human
beings do not engage in deliberative and careful comparisons or calculations of marginal
utility derived from the consumption of a commodity.
2. Difficulty in measuring utility- Utility analysis is based on the assumption of
cardinal measurement of utility. At a very early stage of development of the theory, doubt
was expressed about the quantitative measurability of utility. Marshall tried to measure it
through the assumption of constant marginal utility of money but could not free it from its
subjective colour. Subsequently, an objective unit of measurement called 'util' was
introduced. But all this did not stop the tide of criticism on the measurability of utility.

126
3. Too many assumptions- Critics of the utility analysis point out that while it assumes
‘too much’, it proves ‘too little’. Marshall, who perfected the theory to its final form,
assumed too much under ‘other things remaining the same’'. If the theory is to have any
realism and relevance, some of the assumptions ought to be let out of Marshall's list. The
indifference preference analysis built up by Hicks and Allen achieves the same results as
the marginal utility theory. It is better because it is based on fewer assumptions.
4. Unrealistic assumption of constant marginal utility of Money- Marshall’s
statement of the Law of Demand is based on the assumption that marginal utility of money
to the consumer does not change even as he purchases more or less of the commodity he
wants. This assumption is not justified for those commodities which claim a major part of
consumer's budget such as wheat, atta, ghee clothing and fuel. The assumption is practically
invalid.
5. Ignores Income Effect- Marshallian analysis of demand applies to the one
commodity case only and therefore the income effect is ignored. As Professor Hicks has
remarked, "Theory of demand for a single commodity is only the beginning of demand
theory. The general theory of demand is a theory of the relation between the set of prices
at which purchases are made, and the set of quantities which are purchased." To be really
useful, Marshall's theory needed to be generalised by taking into consideration the income
effect of price change of a commodity.
6. Fails to explain Giffen Paradox- The marginal utility analysis does not divide
‘price effect’ into ‘income effect’ and the ‘substitution effect’. The demand theorem (curve)
derived from it simply tells us that the amount demanded of a commodity extends with a
fall in its price and vice versa. Marshall could not explain as to why the demand for some
(Giffen) goods such as bread rose up as their prices also went up. The Marshallian demand
curve is the usual price-quantity demand curve along which real income changes although
money income remains constant. This demand curve, therefore, puts together the change
in amount demanded as a result of the income and the substitution effects. This is why the
analysis failed to explain Giffen Paradox.
8.5 SUMMARY
Consumer's equilibrium refers to a situation where in a consumer gets maximum satisfaction
out of his given income and he has no tendency to make any change in his existing
127
expenditure. “A consumer is in equilibrium when he regards his actual behaviour as the
best possible under the circumstances and feels no necessity to change his behaviour as
long as circumstances remain unchanged,”
Consumer’s equilibrium through utility analysis is based on the assumptions such as rational
consumer, Cardinal utility, independent utility, and marginal utility of money is constant.
The aim of the consumer in the expenditure of his income is to obtain the maximum utility
from the goods purchased. Therefore, in the choice of his expenditure on different goods
and services, the consumer is guided by the Law of Diminishing Marginal Utility of a
commodity on the one side and the reduced income left with him on the other. A consumer
is in equilibrium when he has no intention to change the pattern of consumption of different
goods.
Consumers’ equilibrium through utility analysis is explained under two different situations
i.e. with respect to single commodity; and with two commodities. In finding out the
equilibrium of the consumer with two commodities, we are guided by the principle of equi-
marginal utility applicable to the consumer.
Utility analysis was the first attempt at building up a systematic theory of demand. Its
development was spanned over a century and a half and was perfected to its present form
by Prof. Marshall. Further, this analysis is criticised on the basis of certain points, i.e.,
Subjective nature of Utility, Difficulty in measuring utility, too many assumptions, Unrealistic
assumption of constant marginal utility of Money, ignores Income Effect, and fails to explain
Giffen Paradox.
8.6 SELF ASSESSMENT QUESTIONS
1. What is consumer’s equilibrium? Give its assumptions.
__________________________________________________________
__________________________________________________________
2. Explain the conditions of consumer’s equilibrium when the consumer Consumes
a single commodity and several commodities?
__________________________________________________________
__________________________________________________________
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3. Total utility is maximum, when marginal utility (MU) is zero. Explain with an
illustration?
__________________________________________________________
__________________________________________________________

8.7 SUGGESTED READINGS

 Economic Theory, Chopra, P.N., Kalyani Publishers, New Delhi.

 Advance Economic Theory (Micro Economic Analysis), Ahuja, H.L., S. Chand,

New Delhi.

 Managerial Economics, Mehta P.L., Sultan Chand & Sons, Delhi.

 Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.

-----

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B.Com. Semester-I Unit-II
C. No. BCG-103 LESSON No. 9

CONSUMER EQUILIBRIUM UNDER INDIFFERENCE

CURVE APPROACH
STRUCTURE
9.1 INTRODUCTION
9.2 OBJECTIVES
9.3 ASSUMPTIONS
9.4 PRICE LINE
9.4.1 Shifting Price Line with Change in Consumer's Income
9.4.2 Shifting Price Line with Change in Price of the Commodity
9.4.3 Consumer Indifference Map
9.5 EQUILIBRIUM OF THE CONSUMER
9.5.1 Unstability of Consumer Equilibrium
9.6 SUMMARY
9.7 SELF ASSESSMENT QUESTIONS
9.8 SUGGESTED READINGS

9.1 INTRODUCTION
Every consumer aims at spending his income in a way that gives him maximum satisfaction.
When a consumer gets maximum satisfaction from his expenditure, he is said to be in

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equilibrium. Therefore, a consumer is in equilibrium when he obtains the maximum
satisfaction from his expenditure on the commodities he wants to purchase. Consumer's
equilibrium shows a situation in which the consumer purchases such a combination of the
commodities that he gets the maximum satisfaction from his given income and with given
prices of the commodities. The point of equilibrium is such that he does not want a change
from it. The pattern of the consumption of the commodities as well as the rate of consumption
per unit of time is the best possible from the point of view of the consumer. Consumer's
equilibrium can also be defined as a point of rest for the consumer. In other words,
consumer's equilibrium is a situation where the consumer does not want to move either
forward or backward. The reason is that the point of equilibrium is regarded by the consumer
as the ideal point. In the words of Tiber Scitovasky, “A consumer is in equilibrium when he
regards his actual behaviour as the best possible under the circumstances and he feels no
urge to change his behaviour as long as circumstances remain unchanged”.
9.2 OBJECTIVES
After reading this chapter, you will be able:
 To define budget line
 To explain how this budget line shifts
 To explain consumer's equilibrium through indifference curve analysis.
9.3 ASSUMPTIONS
The indifference curve analysis of consumer's equilibrium is based on the following
assumptions:
1) Prices of the commodities are given to the consumer.
2) Consumer's income is also given.
3) The consumer knows the prices of the commodities and the possible
combinations of the two commodities which he can choose.
4) The consumer can spend his income in small amounts also.
5) The consumer is rational and wants to obtain the maximum satisfaction.
6) The consumer knows the combinations among which he is indifferent. He knows
his indifference map fully.
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 7) There is perfect competition in the market from where he is purchasing the
commodities.
8) The commodities he is purchasing are divisible enough to form different
combinations acceptable to the consumer
9.4 BUDGET LINE
In order to study consumer's equilibrium, we assume that the consumer has the given
income with which he wants to purchase at the given prices of the commodities. The
consumer wants to go higher and higher up on his indifference curves in his indifference
map. But choice is limited to the combinations of the commodities he can purchase with
his given income at the given prices. Suppose the consumer has an income of Rs. 5 to
spend on biscuits and cups of coffee. He wants to purchase a combination of the
commodities which gives him the highest possible satisfaction. Suppose further that the
cup offered is a special big cup of coffee priced at Re. 1. The biscuit is priced at 5 paise.
Now, if the consumer spends his total income of Rs. 5 on cups of coffee alone, he can
purchase five cups. On the other hand, if he purchases biscuits alone, he can get hundred
biscuits by spending his total income. These are extreme points of his choice. Generally
the consumer will purchase combinations of coffee and biscuits. The following table gives
the obtainable combinations of coffee and biscuits with the income of Rs. 5 at the given
prices.
Table 9.1
The Attainable Combinations of Coffee and Biscuits

The schedule given above shows the various combinations available to the consumer at
given prices with his given income. He has to choose a combination out of this set which
gives him the maximum satisfaction. We can show all the combinations available to him on

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a graph. These points showing these combinations shall lie on a straight line shown as LM
in the figure 9.1. This line joining the points of five cups on the X-axis and hundred biscuits
on the Y-axis is called the price line. The price line shows all those combinations which can
be bought by the consumer at the given prices. Therefore, it is also called the price-
opportunity line or budget line. It shows the possible combinations of consumer's
consumption. Therefore, it is also known as the consumption possibility line.
The price line is a straight line sloping from left down to the right. It has only one slope
throughout which shows the constant price ratio for the two commodities. It has a negative
slope which shows that the consumer can have more of one commodity only by sacrificing
some of the other. The point of consumer's equilibrium must be a point on this line.
BISCUITS

0
Figure 9.1: Price Line or Budget Line
If consumer's income changes or there is a change in the price of the two commodities, the
price line also changes its position. The change in the position of the price line can be
shown through figures as under.
9.4.1 Shifting Price Line with Change in Consumer’s Income
The position of the price line depends upon consumer's income and the product prices. If
prices remain at the same level, a rise in income leads to a shift of the price line to the right

133
hand side in a parallel position. A fall in the income level results in a parallel shift to the left
hand side depending upon the amount of income fall.
In figure 9.2 L1 M1 was the position of the price line when the consumer had a lower level
of income. The income level was just enough to purchase OM1 of commodity A or OL1
of commodity B at the given prices of the two commodities.
As consumer's income increases, he is enabled to purchase OM2 of commodity A or OL2
of commodity B. The new price line after the increase in income is L2M2. It is parallel to
the earlier price line L1M1 because the prices of the two commodities are maintained
constant.

O M1 M2 O M1 M2
COMMODITY A COMMODITY A
Fig. 9.2 Increase in consumer's income price Fig. 9.3 Fall in the price of
remaining the same commodity A only.

9.4.2 Shifting Price Line with Change in Price of the Commodity

Change in price of any one of the two commodities results in a change in the slope of the
price line. The diagram given above on the right-hand side (Fig. 9.3) shows the change in
the slope of the price line when commodity A becomes cheaper and the price of commodity
B remains the same. In the diagram the consumer had a level of income enough to purchase
OL of commodity B or OM of commodity A. As the price of commodity A falls, the
consumer is able to purchase OM2 of the commodity A, thereby giving the consumer a
new price line OM2. The price line is branching from the same point L because the price
of commodity B is maintained constant.
The description of the changes in the position of the price line given above shows that a

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knowledge of the price line is necessary to find out the attainable combinations with given
income and prices. It provides a full view of the income side of the consumer.
9.4.3 Consumer Indifference Map
The price line shows the combinations of commodities which the market offers at the given
prices to the consumer with a given level of income. For equilibrium of the consumer we
must also know his scale of preferences. Consumer's preferences take the form of the
indifference schedule which when presented graphically gives us the consumer’s indifference
map. A set of indifference curves is drawn to represent the consumer’s tastes or preferences.
The map shows the combinations of the commodities on different indifference which he
considers to be giving him equal satisfaction. The indifference map of a consumer shows
all the properties of normal indifference curves. All indifference curves slope from left
down to the right. Further, all indifference curves are convex to the origin. They do not
touch any one of the two axes. Higher indifference curves represent higher levels of
satisfaction.
9.5 EQUILIBRIUM OF THE CONSUMER
Given the indifference map of the consumer and his price line, we can find out the
combination which gives him the maximum satisfaction. For this we superimpose the price
line on consumer’s indifference map. The Fig. 9.4 shows the indifference map and the
price line together.

COMMODITY A
Figure 9.4: Consumer’s Equilibrium Through
Indifference Curves
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The aim of the consumer is to obtain the highest combination he can on his indifference
map. In other words, he tries to go to the highest indifference curve attainable with his
given price line. He would be in equilibrium only at such a point which lies on his price line
as well as on the highest attainable indifference curve. Let us look for this point in the figure
9.4 given above.
Consumer’s equilibrium point is a common point between the price line and one of the
indifference curves in the indifference map. There are many points on the price line which
are also on some indifference curve in the map. We are interested in the common point
which is on the highest indifference curve. This is the point where the price line LM is
touching the highest possible indifference curve IC3 from below. The consumer is in
equilibrium at the point P. This point shows a combination of the two commodities which
the consumer can buy with his income at given prices and which is also on the highest
possible indifference curve the consumer can reach.
Equilibrium P lies at the point of touch of the price line LM and the indifference curve IC3.
It gives us the condition of consumer's equilibrium. At this point the slope of the price line
must be equal to the slope of the indifference curve. The slope of the indifference curve
shows the marginal rate of substitution (MRS) at the point P. Slope of the price line is the
(inverse) ratio of the prices of the two commodities. Both the slopes have a negative sign
with them because the price line and the indifference curves both slope from left down to
the right. Thus, the equilibrium condition being satisfied at the point P is,
(Price of A)/(Price of B)=MRS AB = Marginal rate of Substitution of A for B
The equilibrium condition given above states that the rate at which the individual is willing
to substitute commodity A for commodity B must equal to the rate at which he can substitute
A and B in the market at given prices. Consumer's equilibrium also requires another
condition. It is that the marginal rate of substitution (MRS) should be diminishing at the
point of equilibrium. In other words, indifference curve should be convex to the origin at
the point of touch with the price line. If this condition is not satisfied, the equilibrium of the
consumer cannot be stable.
9.5.1 Unstability of Consumer Equilibrium
Suppose that the marginal rate of substitution is not falling then it can either be constant or

136
increasing. The constant marginal rate of substitution is not possible since it shows that the
utility derived from the consumption of goods remains the same. The second possibility of
increasing marginal rate of substitution is also ruled out because it shows that the utility
derived from another unit is more than the utility got from its previous unit. So this is also
absurd. Thus MRS can be only diminishing i.e. IC should be convex to the origin. This can
be shown with the help of figure 9.5.

Fig. 9.5 Consumer’s equilibrium will be unstable if the IC curve is

convex to the origin
Figure 9.5 measures commodity A on X-axis and commodity B on Y-axis. LM is the price
line. E is a point where indifference curve (IC) is tangent to the price line. So, on point E
the ratio of the prices of two goods and MRS is the same. But point E is not a stable
equilibrium point because here MRS is increasing. IC is concave to the origin. It means
that any movement to the right or left of point E will give more utility to the consumer as it
will take him to a higher indifference curve. So E is not a point of stable equilibrium. Hicks
called point E as the 'minimum utility point’. In this case, the consumer will be in equilibrium
at point R where indifference curve touches the price line on its lower point M.
Overall, the conditions for consumer’s equilibrium are:
(i) The indifference curve should be tangent to the price line at the point of equilibrium.
(ii) The slope of the price line should be equal to the slope of the indifference curve.
(iii) The indifference curve should be convex to the origin at the point of equilibrium.

137
One thing should be clear that consumer’s equilibrium is not a stable or permanent thing. It
undergoes a change with changes in the consumer's income and the prices of the goods he
purchases.
9.6 SUMMARY
Every consumer aims at spending his income in a way that gives him maximum satisfaction.
When a consumer gets maximum satisfaction from his expenditure, he is said to be in
equilibrium. Thus, Consumer's equilibrium shows a situation in which the consumer
purchases such a combination of the commodities that he gets the maximum satisfaction.
Consumer's equilibrium can also be defined as a point of rest for the consumer.
In earlier chapter, the concept of utility analysis is used to explain consumer’s equilibrium.
Further, in this chapter, the consumer's equilibrium is explained with the help of indifference
curve analysis, which is based upon certain assumptions, viz., Prices and income are given
to the consumer, consumer can spend his income in small amounts, rational consumer,
consumers' knows his indifference map, perfect competition prevails, and the commodities
are divisible.
For studying consumer’s equilibrium, we assume that the consumer has the given income
with which he wants to purchase at the given prices of the commodities. The consumer
wants to go higher and higher up on his indifference curves in his indifference map. But
choice is limited to the combinations of the commodities he can purchase with his given
income at the given prices. The price line shows all those combinations which can be
bought by the consumer at the given prices. Therefore, it is also called the price-opportunity
line or budget line. The price line is a straight line sloping from left down to the right. It has
only one slope throughout which shows the constant price ratio for the two commodities.
The point of consumer’s equilibrium must be a point on this line.
If consumer's income changes or there is a change in the price of the two commodities, the
price line also changes its position, which further leads to shifting of price/budget line due
to change in income of the consumer or prices of the commodities. Consumer's preferences
take the form of the indifference schedule which when presented graphically gives us the
consumer’s indifference map. A set of indifference curves is drawn to represent the
consumer’s tastes or preferences. Given the indifference map of the consumer and his

138
price line, we can find out the combination which gives him the maximum satisfaction. The
aim of the consumer is to obtain the highest combination he can on his indifference map. In
other words, he tries to go to the highest indifference curve attainable with his given price
line. He would be in equilibrium only at such a point which lies on his price line as well as
on the highest attainable indifference curve.
Consumer’s equilibrium point is a common point between the price line and one of the
indifference curves in the indifference map. We are interested in the common point which
is on the highest indifference curve.
9.7 SELF ASSESSMENT QUESTIONS

1. Show how a consumer attains equilibrium with the help of indifference curves?
___________________________________________________________
___________________________________________________________
2. Explain the uses of indifference curves.
___________________________________________________________
___________________________________________________________
3. Explain the proposition that it is good to allow people exchange the goods
under rationing?
___________________________________________________________
__________________________________________________________
9.8 SUGGESTED READINGS
 Advance Economic Theory, Ahuja, H.L., S. Chand & Sons, New Delhi.
 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.

139
B.Com. Semester-I Unit-II
C. No. BCG-103 LESSON No. 10

DEMAND FORECASTING
STRUCTURE
10.1 INTRODUCTION
10.2 MEANING
10.3 OBJECTIVES
10.3.1 Definition
10.3.2 Procedure to Prepare Sales Forecast
10.4 TYPES OF FORECASTING
10.5 FORECASTING TECHNIQUES
10.6 CRITERIA OF A GOOD FORECASTING METHOD
10.7 SIGNIFICANCE OF FORECASTING
10.8 SUMMARY
10.9 SELF ASSESSMENT QUESTIONS
10.10 SUGGESTED READING

10.1 INTRODUCTION
Forecasts are becoming the lifetime of business in a world, where the tidal waves of
change are sweeping the most established of structures, inherited by human society.
Commerce just happens to the one of the first casualties. Survival in this age of economic

140
predators requires the tact, talent and technique of predicting the future. Forecast is
becoming the sign of survival and the language of business. All requirements of the business
sector need the technique of accurate and practical reading into the future. Forecasts are,
therefore, very essential requirement for the survival of business. Management requires
forecasting information when making a wide range of decisions. The sales/demand forecast
is particularly important as it is the foundation upon which all company plans are built in
terms of markets and revenue. Management would be a simple matter if business was not
in a continual state of change, the pace of which has quickened in recent years. It is
becoming increasingly important and necessary for business to predict their future prospects
in terms of sales, cost and profits. The value of future sales is crucial as it affects costs
profits, so the prediction of future sales is the logical starting point of all business planning.
10.2 OBJECTIVES
The specific objectives of this chapter are:
 To Define sales/demand forecasting.
 To Explain types and techniques of forecasting.
 To portray the significance of demand forecasting.
10.3 MEANING
A forecast is a prediction or estimation of future situation. It is an objective assessment of
future course of action. Since future is uncertain, no forecast can be percent correct.
Forecasts can be both physical as well as financial in nature. The more realistic the forecasts,
the more effective decisions can be taken for tomorrow.
10.3.1 Definition
In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period which is tied to a proposed marketing plan and which assumes a
particular set of uncontrollable and competitive forces”. Therefore, demand forecasting is
a projection of firm’s expected level of sales based on a chosen marketing plan and
environment.

141
10.3.2 Procedure to Prepare Sales Forecast
Companies commonly use a three-stage procedure to prepare a sales forecast. They
make an environmental forecast, followed by an industry forecast, and followed by a
company's sales forecast, the environmental forecast calls for projecting inflation,
unemployment, interest rate, consumer spending, and saving, business investment,
government expenditure, net exports and other environmental magnitudes and events of
importance to the company.
The industry forecast is based on surveys of consumers' intention and analysis of statistical
trends is made available by trade associations or chamber of commerce. It can give
indication to a firm regarding tine direction in which the whole industry will be moving. The
company derives its sales forecast by assuming that it will win a certain market share.
10.4 TYPES OF FORECASTING
Forecasting can be broadly classified into; Passive Forecast and Active Forecast. Under
passive forecast prediction about future is based on the assumption that the firm does not
change the course of its action. Under active forecast, prediction is done under the condition
of likely future changes in the actions by the firms.
I. Short term demand forecasting and long term demand forecasting: In a
short run forecast, seasonal patterns are of much importance. It may cover a
period of three months, six months or one year. It is one which provides information
for tactical decisions. Which period is chosen depends upon the nature of business.
Such a forecast helps in preparing suitable sales policy. Long term forecasts are
helpful in suitable capital planning. It is one which provides information for major
strategic decisions. It helps in saving the wastages in material, man hours, machine
time and capacity. Planning of a new unit must start with an analysis of the long
term demand potential of the products of the firm.
II. External and Internal forecast: External forecast deals with trends in general
business. It is usually prepared by a company's research wing or by outside
consultants. Internal forecast includes all those that are related to the operation of
a particular enterprise such as sales group, production group, and financial group.
The structure of internal forecast includes forecast of annual sales, forecast of

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 products cost, forecast of operating profit, forecast of taxable income, forecast of
cash resources, forecast of the number of employees, etc.
10.5 FORECASTING TECHNIQUES
Demand forecasting is a difficult exercise. Making estimates for future under the changing
conditions is a Herculean task. Consumers' behaviour is the most unpredictable one because
it is motivated and influenced by a multiplicity of forces. There is no easy method or a
simple formula which enables the manager to predict the future. Economists and statisticians
have developed several methods of demand forecasting. Each of these methods has its
relative advantages and disadvantages. Selection of the right method is essential to make
demand forecasting accurate. In demand forecasting, a judicious combination of statistical
skill and rational judgement is needed. Mathematical and statistical techniques are essential
in classifying relationships and providing techniques of analysis, but they are in no way an
alternative for sound judgement. Sound judgement is a prime requisite for good forecast.
The judgment should be based upon facts and the personal bias of the forecaster should
not prevail upon the facts. Therefore, a mid way should be followed between mathematical
techniques and sound judgment or pure guess work
The various methods of demand forecasting can be summarised in the form of a chart:

143
The more commonly used methods of demand forecasting are discussed below:
I. Opinion Polling Method
In this method, the opinion of the buyers, sales force and experts could be gathered to
determine the emerging trend in the market.
The opinion polling methods of demand forecasting are of three kinds:
(1) Consumer's Survey Method or Survey of Buyer's Intentions: In this method,
the consumers are directly approached to disclose their future purchase plans. This is
done by interviewing all consumers or a selected group of consumers out of the relevant
popu-lation. This is the direct method of estimating demand in the short run. Here the
burden of forecasting is shifted to the buyer. The firm may go in for complete enumeration
or for sample surveys. If the commodity under consideration is an intermediate product
then the industries using it as an end product are surveyed.
(a) Complete Enumeration Survey: Under the Complete Enumeration Survey, the firm
has to go for a door to door survey for the forecast period by contacting all the households
in the area. This method has an advantage of first hand, unbiased information, yet it has its
share of disadvantages also. The major limitation of this method is that it requires lot of
resources, manpower and time. In this method, consumers may be reluctant to reveal their
purchase plans due to personal privacy or commercial secrecy. Moreover, at times the
consumers may not express their opinion properly or may deliberately misguide the
investigators.
(b) Sample Survey and Test Marketing: Under this method some representative
households are selected on random basis as samples and their opinion is taken as the
generalised opinion. This method is based on the basic assumption that the sample truly
represents the population. If the sample is the true representative, there is likely to be no
significant difference in the results obtained by the survey. Apart from that, this method is
less tedious and less costly. A variant of sample survey technique is test marketing. Product
testing essentially involves placing the product with a number of users for a set period.
Their reactions to the product are noted after a period of time and an estimate of likely
demand is made from the result. These are suitable for new products or for radically
modified old products for which no prior data exists. It is a more scientific method of

144
estimating likely demand because it stimulates a national launch in a closely defined
geographical area.
(c) End Use Method or Input-Output Method: This method is quite useful for industries
which are mainly producer's goods. In this method, the sale of the product under
consideration is projected as the basis of demand survey of the industries using this product
as an intermediate product, that is, the demand for the final product is the end user demand
of the intermediate product used in the production of this final product. The end user
demand estimation of an intermediate product may involve many final good industries
using this product at home and abroad. It helps us to understand inter-industry relations.
In input-output accounting two matrices used are the transaction matrix and the input co-
efficient matrix. The major efforts required by this type are not in its operation but in the
collection and presentation of data.
(2) Sales Force Opinion Method
This is also known as collective opinion method. In this method, instead of consumers, the
opinion of the salesmen is sought. It is sometimes referred as the “grass roots approach”
as it is a bottom-up method that requires each sales person in the company to make an
individual forecast for his or her particular sales territory. These individual forecasts are
discussed and agreed with the sales manager. The composite of all forecasts then constitutes
the sales forecast for the organisation. The advantages of this method are that it is easy and
cheap. It does not involve any elaborate statistical treatment. The main merit of this method
lies in the collective wisdom of salesmen. This method is more useful in forecasting sales of
new products.
(3) Experts Opinion Method
This method is also known as “Delphi Technique” of investigation. The Delphi method
requires a panel of experts, who are interrogated through a sequence of questionnaires in
which the responses to one questionnaire are used to produce the next questionnaire.
Thus any information available to some experts and not to others is passed on, enabling all
the experts to have access to all the information for forecasting.The method is used for
long term forecasting to estimate potential sales for new products. This method presumes
two conditions: Firstly, the panellists must be rich in their expertise, possess wide range of

145
knowledge and experience. Secondly, its conductors are objective in their job. This method
has some exclusive advantages of saving time and other resources.
II. Statistical Method
Statistical methods have proved to be immensely useful in demand forecasting. In order to
maintain objectivity, that is, by consideration of all implications and viewing the problem
from an external point of view, the statistical methods are used.The important statistical
methods are:
(1) Trend Projection Method
A firm existing for a long time will have its own data regarding sales for past years. Such
data when arranged chronologically yield what is referred to as 'time series'. Time series
shows the past sales with effective demand for a particular product under normal conditions.
Such data can be given in a tabular or graphic form for further analysis. This is the most
popular method among business firms, partly because it is simple and inexpensive and
partly because time series data often exhibit a persistent growth trend.Time series has got
four types of components namely, Secular Trend (T), Secular Variation (S), Cyclical Element
(C), and an Irregular or Random Variation (I). These elements are expressed by the equation
O = TSCI. Secular trend refers to the long run changes that occur as a result of general
tendency.
Seasonal variations refer to changes in the short run weather pattern or social habits.
Cyclical variations refer to the changes that occur in industry during depression and boom.
Random variation refers to the factors which are generally able such as wars, strikes,
flood, famine and so on. When a forecast is made the seasonal, cyclical and random
variations are removed from the observed data. Thus, only the secular trend is left. This
trend is then projected. Trend projection fits a trend line to a mathematical equation. The
trend can be estimated by using Graphical and Least Square Method.
(2) Barometric Technique
A barometer is an instrument of measuring change. This method is based on the notion that
“the future can be predicted from certain happenings in the present.” In other words,
barometric techniques are based on the idea that certain events of the present can be used
to predict the directions of change in the future. This is accomplished by the use of economic

146
and statistical indicators which serve as barometers of economic change.
(3) Regression Analysis
It attempts to assess the relationship between at least two variables (one or more
independent and one dependent), the purpose being to predict the value of the dependent
variable from the specific value of the independent variable. The basis of this prediction
generally is historical data. This method starts from the assumption that a basic relationship
exists between two variables. An interactive statistical analysis computer package is used
to formulate the mathematical relationship which exists.
(4) Econometric Models
Econometric models are an extension of the regression technique whereby a system of
independent regression equation is solved. The requirement for satisfactory use of the
econometric model in forecasting is under three heads: variables, equations and data. The
appropriate procedure in forecasting by econometric methods is model building.
Econometrics attempts to express economic theories in mathematical terms in such a way
that they can be verified by statistical methods and to measure the impact of one economic
variable upon another so as to be able to predict future events.
10.6 CRITERIA OF A GOOD FORECASTING METHOD
There are thus, a good many ways to make a guess about future sales. They show contrast
in cost, flexibility and the adequate skills and sophistication. Therefore, there is a problem
of choosing the best method for a particular demand situation. There are certain economic
criteria of broader applicability. They are:
(i) Accuracy: The forecast obtained must be accurate. How is an accurate forecast
possible? To obtain an accurate forecast, it is essential to check the accuracy of past
forecasts against present performance and of present forecasts against future performance.
Accuracy cannot be tested by precise measurement but buy judgment.
(ii) Plausibility: The executive should have good understanding of the technique chosen
and they should have confidence in the techniques used. Understanding is also needed for
a proper interpretation of results. Plausibility requirements can often improve the accuracy
of results.

147
(iii) Durability: Unfortunately, a demand function fitted to past experience may back
cost vary greatly and still fall apart in a short time as a forecaster. The durability of the
forecasting power of a demand function depends partly on the reasonableness and simplicity
of functions fitted, but primarily on the stability of the understanding relationships measured
in the past. Of course, the importance of durability determines the allowable cost of the
forecast.
(iv) Flexibility: Flexibility can be viewed as an alternative to generality. A long lasting
function could be set up in terms of basic natural forces and human motives. Even though
fundamental, it would nevertheless be hard to measure and thus not very useful. A set of
variables whose co-efficient could be adjusted from time to time to meet changing conditions
in more practical way to maintain intact the routine procedure of forecasting.
(v) Availability: Immediate availability of data is a vital requirement and the search for
reasonable approximations to relevance in late data is a constant strain on the forecasters
patience. The techniques employed should be able to produce meaningful results quickly.
Delay in result will adversely affect the managerial decisions.
(vi) Economy: Cost is a primary consideration which should be weighted against the
importance of the forecasts to the business operations. A question may arise: How much
money and managerial effort should be allocated to obtain a high level of forecasting
accuracy? The criterion here is the economic consideration.
(vii) Simplicity: Statistical and econometric models are certainly useful but they are
intolerably complex. To those executives who have a fear of mathematics, these methods
would appear to be Latin or Greek. The procedure should, therefore, be simple and easy
so that the management may appreciate and understand why it has been adopted by the
forecaster.
(viii) Consistency: The forecaster has to deal with various components which are
independent. If he does not make an adjustment in one component to bring it in line with a
forecast of another, he would achieve a whole which would appear consistent.
10.7 Significance of Forecasting
Forecasting reduces the risk associated with business fluctuations which generally produce

148
harmful effects in business, create unemployment, induce speculation, discourage capital
formation and reduce the profit margin. Forecasting is indispensable and it plays a very
important part in the determination of various policies. In modem times forecasting has
been put on scientific footing so that the risks associated with it have been considerably
minimised and the chances of precision increased. In most of the advanced countries there
are specialised agencies. In India businessmen are not at all interested in making scientific
forecasts. They depend more on chance, luck and astrology. They are highly superstitious
and hence their forecasts are not correct. Sufficient data are not available to make reliable
forecasts. However, statistics alone do not forecast future conditions. Judgment, experience
and knowledge of the particular trade are also necessary to make proper analysis and
interpretation and to arrive at sound conclusions. Decision support systems consist of
three elements: decision, prediction and control. It is, of course, with prediction that
marketing forecasting is concerned. The forecasting of sales can be regarded as a system,
having inputs apprises and an output. This simplistic view serves as a useful measure for
the analysis of the true worth of sales forecasting as an aid to management. In spite of all
these no one can predict future economic activity with certainty. Forecasts are estimates
about which no one can be sure.
10.8 SUMMARY
Forecasts are becoming the lifetime of business in a world, where the tidal waves of
change are sweeping the most established of structures, inherited by human society. Forecast
is becoming the sign of survival and the language of business. Management requires
forecasting information when making a wide range of decisions. The sales/demand forecast
is particularly important as it is the foundation upon which all company plans are built in
terms of markets and revenue. Forecast is a prediction or estimation of future situation. It
is an objective assessment of future course of action. The more realistic the forecasts, the
more effective decisions can be taken for tomorrow. Therefore, demand forecasting is a
projection of firm's expected level of sales based on a chosen marketing plan and
environment. Companies commonly uses a three-stage procedure to prepare a sales
forecast.
Forecasting can be broadly classified into; Passive Forecast and Active Forecast. Under
passive forecast prediction about future is based on the assumption that the firm does not

149
change the course of its action. Under active forecast, prediction is done under the condition
of likely future changes in the actions by the firms. Demand forecasting is a difficult exercise.
Making estimates for future under the changing conditions is a Herculean task. Consumers'
behaviour is the most unpredictable one because it is motivated and influenced by a
multiplicity of forces. There is no easy method or a simple formula which enables the
manager to predict the future. Economists and statisticians have developed several methods
of demand forecasting. Each of these methods has its relative advantages and
disadvantages.
The more commonly used methods of demand forecasting are broadly classified into two
categories, i.e., Opinion Polling Methods and Statistical Methods.
Forecasting reduces the risk associated with business fluctuations which generally produce
harmful effects in business, create unemployment, induce speculation, discourage capital
formation and reduce the profit margin. Forecasting is indispensable and it plays a very
important part in the determination of various policies. Decision support systems consist
of three elements: decision, prediction and control. It is, of course, with prediction that
marketing forecasting is concerned. This simplistic view serves as a useful measure for the
analysis of the true worth of sales forecasting as an aid to management. In spite of all these
no one can predict future economic activity with certainty. Forecasts are estimates about
which no one can be sure. Therefore, the ideal forecasting method is one that yields returns
over cost with accuracy, seems reasonable, can be formalised for reasonably long periods,
can meet new circumstances adeptly and can give up-to-date results. The method of
forecasting is not the same for all products. There is no unique method for forecasting the
sale of any commodity. The forecaster may try one or the other method depending upon
his objective, data availability, the urgency with which forecasts are needed, resources he
intends to devote to this work and type of commodity whose demand he wants to forecast.
10.9 SELF ASSESSMENT QUESTIONS
1. What is Delphi method? Describe its main advantages and limitations.
___________________________________________________________
___________________________________________________________
___________________________________________________________

150
2. What is trend projection? Why this method is often employed in economic
forecasting?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. What are the main characteristics of accurate forecasts?
___________________________________________________________
___________________________________________________________
___________________________________________________________
4. What is the basic shortcoming of trend-projection that baromertric approaches
improve on?
___________________________________________________________
___________________________________________________________
___________________________________________________________
10.10 SUGGESTED READING
 Advance Economic Theory, Ahuja, H.L., S. Chand & Sons, New Delhi.
 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.

****

151
B.Com. Semester-I Unit-III
C. No. BCG-103 LESSON No. 11

FACTORS OF PRODUCTION

STRUCTURE
11.1 INTRODUCTION
11.2 OBJECTIVES
11.3 FACTORS OF PRODUCTION
11.3.1 Fixed Factors
11.3.2 Variable Factors
11.4 PRODUCTION FUNCTION
11.5 SUMMARY
11.6 SELF ASSESSMENT QUESTIONS
11.7 SUGGESTED READING

11.1 INTRODUCTION
Supply of goods and services comes out of production. And supply analysis, therefore,
must be based on the theory of production. As we have equilibrium of the consumer in the
theory of demand, here we have equilibrium of the producer. With changes in conditions
of production, the equilibrium of the producer continues to change his production and
induce thereby changes in supply. As we shall see later, theory of demand and theory of
production are essentially similar. But in so far as production is a process distinctly different

152
from demand, there are some differences. For a clear understanding of the theory of
production and its differences with the theory of demand, some points about the process
of production need to be borne in mind.
The process of production can be looked at from two different angles. From the
technologist's point of view, it is a purely physical process in which quantities of raw
materials and labour are transformed into quantities of output, the quantities being rigidly
determined by the laws of physical science. The technologist is mainly interested in these
physical laws which describe the behaviour of the amounts of product that may be expected
through different methods of production. The other viewpoint takes production not as a
process of physical nature but of human action. This is an economist's perspective on
production.
11.2 OBJECTIVES
After reading this chapter, you will be able:
 To define production function.
 To explain fixed and variable factors of production.
11.3 FACTORS OF PRODUCTION
For improving their economic positions men undertake production. They secure the
necessary resources; supervise the work of transformation of these inputs into output.
Inputs are those things that a firm buys for use in production and prepare the output. An
input may be a commodity, such as a raw material, or a service, or a piece of information
about the technology of production. Traditionally, the inputs sufficient for the production of
a given product have been classified by economists into four factors of production-land,
labour, capital and organisation. Capital was the produced ‘factor’ , i.e., a class of means
of production that had been produced, in turn, through the combination of other resources.
Land, labour were thought to be the ‘original’ factors, ‘abour’ including all services provided
directly by human beings and ‘land’ representing all other nature-given things and services
that could be used for production. The fourth factor of production was the organising and
entrepreneurial ability, the act of risk-taking and uncertainty-bearing.
This classification was adopted by economists on the belief that the remuneration earned
by each class was governed by different laws. This classification, though it provided a
153
grouping useful for a number of purposes, is no longer held by modern economists. They
believe that this distinction between different factors is not of much economic significance
because the laws governing price determination of all productive services are the same.
Actually, the one classification we require in the theory of production and price is between
fixed and variable factors.
11.3.1 Fixed Factors
Fixed factors are those factors whose total cost is constant over some range of output.
For example, the total cost of using machinery remains constant whether output is at zero
or rises to 10,000 units. Output greater than 10,000 units might be possible only with the
introduction of, and expenditure upon, additional machinery. It is very much possible that
the services of some factors will be fixed for greater ranges of output than for others. A
further distinction among fixed factors is between 'divisible' and 'indivisible' fixed factors.
Divisible fixed factors are those whose total cost is constant, although technically the factors
consist of separable units which may be independently utilised. Fundamentally they are
variable factors, though the exigencies of construction or mode of hire may compel that
they be purchased as a unit. Indivisible factors, on the other hand, are constructed as a
single mass: the irreducible unit must serve over a wide range of outputs. Divisibility or
indivisibility thus refers to the mode of use, not to the terms of payment of the fixed factors.
11.3.2 Variable Factors
Variable factors are those whose cost changes with movements in output. The precise line
distinguishing them from fixed factors is in the increased total cost of using them with
continuously increased output.
11.4 PRODUCTION FUNCTION
The relationship between inputs and the resulting outputs is generally summed up in a
mathematical form which is called production function. The word 'function' in mathematics
means the precise relationship that exists between one dependent variable and many (or
one) independent variables. The production function formalises the relationship between
the maximum quantity of output (dependent variable) yielded by a productive process and
the quantities of the various inputs used in that process. Algebraically, a production function
is written as x = f (a1, a2,……. an). This equation tells us the quantity of the product x,
which is produced on the given quantities of a1, a2, a3, an (of the inputs a1, a2, a3…….an
154
respectively) employed in the production process.
1. It is a technical relation- Concerned with the physical aspects of production
inside a firm and representing a state of technology or method of organisation employed,
the production function concept is external to economics; it is given to the economist by
the production engineer. The engineer or technician can tell the economists the various
combinations of inputs that are possible and the outputs resulting from them by using a
particular process of production. The engineer presents the production function in the
form of a table showing the various production processes, the various combinations of
inputs and the obtainable outputs from these processes. The technician is interested in
physical combinations, the producer is interested in the cost of these combinations and the
revenues they can fetch in the market.
2. It has economic importance- Although the Production Function is given to the
firm by the technician, it has important economic implications for the firm. Production
function expresses the relationship between a quantity of output and the requirements of
inputs for production of the quantity. Stated in alternative terms, production function relates
the various amounts of inputs with the maximum possible outputs which can be obtained
out of the inputs. Every producer is interested in minimising the output from a given
combination of inputs. The form of production function of a firm is determined by the state
of technology. A short-period production function is different from a long-period production
function.
3. Production functions differ from firm to firm and industry to industry. The
economic theorist is interested in the properties or features shared by all production functions.
Economic theorist analyses two kinds of input-output relations in production function:
first, the relation where quantities of some inputs are fixed while quantities of other inputs
vary; second, where all the inputs are variable and the relationship is between changes in
the amounts of all inputs and the resulting outputs.
11.5 SUMMARY
For improving their economic positions men undertake production. They secure the
necessary resources; supervise the work of transformation of these inputs into output.
Therefore, inputs are those things that a firm buys for use in production and prepare the
output.
155
The inputs sufficient for the production of a given product have been classified by economists
into four factors of production-land, labour, capital and organisation.
The other classification we require in the theory of production and price is between fixed
and variable factors. Fixed factors are those factors whose total cost is constant over
some range of output. Whereas, variable factors are those whose cost changes with
movements in output. Further, the relationship between inputs and the resulting outputs is
generally summed up in a mathematical form which is called production function.
To sum up, production function is a technical relationship which is concerned with the
physical aspects of production inside a firm and representing a state of technology or
method of organisation employed. Also, the concept of production function is external to
the economics; it is given to the economist by the production engineer. Although, the
Production Function is given to the firm by the technician, it has important economic
implications for the firm. Production functions differ from firm to firm and industry to industry
and the economic theorist is interested in the properties or features shared by all production
functions.
11.6 SELF ASSESSMENT QUESTIONS
1. What are the fixed factors of production?
___________________________________________________________
___________________________________________________________
___________________________________________________________
2. Write a note on the managerial use of the production function?
___________________________________________________________
___________________________________________________________
___________________________________________________________

11.7 SUGGESTED READINGS

 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

156
B.Com. Semester-I Unit-III
C. No. BCG-105 LESSON No. 12

LAW OF VARIABLE PROPORTION

STRUCTURE
12.1 INTRODUCTION
12.2 OBJECTIVE
12.3 LAW OF VARIABLE PROPORTION
12.3.1 Assumptions
12.3.2 Explanation
12.3.3 Diagram
12.3.4 Phases of the Law
12.4 SUMMARY
12.5 SELF ASSESSMENT QUESTIONS
12.6 SUGGESTED READING

12.1 INTRODUCTION
The law of variable proportions in production is one of the fundamental laws of economics.
A French economist was the first to discuss this law. The law deals with behaviour of
production in the short run. In the short run, factors of production are of two types: (i)
fixed factors of production, (ii) variable factors of production. In the short run, the volume
of production can be changed only by altering the variable factors of production. This is
because the quantity of fixed factors like the plant size cannot be changed is desired due to

157
the short span of time at the disposal of the producer.
12.2 OBJECTIVES
The objectives of this chapter are:
 To describe the meaning of law of variable proportion.
 To explain the conditions necessary for Law.
 To define different stages of the Law.
12.3 LAW OF VARIABLE PROPORTION
Law of variable proportions shows the production function with one factor variable while
other factors of production are kept constant/fixed. The ratio of variable factor to fixed
factors in the production process increases when the proportion of variable factor to fixed
factors is increased. We can explain this law with the help of an example. Suppose, there
are two factors of production, land and labour. Land is a fixed factor while labour is a
variable factor. Further, we assume that cultivate a piece of land of one acre with 10
labourers. And the ratio of land to labour is 1:10. Now to increase the size of production,
15 labourers are put to work on the same piece of land. It will change the ratio of land to
labour to 1:15. This variation in the ratio of the factor inputs causes a change in the size of
production not at constant rate but at various rates. This tendency of change in the production
in response to changes in factor proportions is termed 'the law of variable proportions'.
This law shows that continuous change in proportion of the factors of production changes
the product first at increasing rates, then at constant rates and finally the output change
takes place at diminishing rates.
The law of variable proportions exhibits the direction and the rate of change in the firm's
output when the amount of only one factor of production is varied. The law is known as
the law of variable proportions because in this law we study the effects of variations in
factor proportions on the firm's production.
According to Leftwitch, “The law of variable proportions states that if the input of one
resource is increased by equal increments per unit of time while the inputs of other resources
are held constant, total product (output) will increase, but beyond some point the resulting
output increases will become smaller and smaller.”

158
12.3.1 Assumption
The law of variable proportions holds good only if the following conditions prevail:
1. Constant technology. The law of variable proportions assumes the techniques
of production as constant. The reason is that if the state of technology changes then marginal
and average product may rise instead of diminishing.
2. Short run. The law specially operates in the short run because here some factors
are fixed and the proportion of others has to be varied. It assumes that one factor is
variable while the others are fixed.
3. Homogeneous factors. This law is based on the assumption that the variable
resource is applied unit by unit. And each factor unit is homogeneous or identical in amount
and quality.
4. Changeable input ratio. Lastly, the law supposes the possibility of the ratio of
fixed factors to variable factors being changed. In other words, it is possible to use various
amounts of a variable factor with fixed factors of production.
12.3.3 Explanation of Law
The law can be explained with the help of a table showing the production function of a
farmer. Suppose a farmer has 10 acres of land to cultivate. The land has some fixed
investments on it: a tube well, a farm house and farm equipment. In order to increase his
farm output, the amount of land and capital is called fixed factors of production. The
farmer can vary the number of men to be employed on its cultivation. Any change in the
number of men employed will change total output also. The response of output (product)
to the increases in the variable factor labour is shown in the table given below. We define
the average product and marginal product as follows:

159
 Table 12.1

The table 12.1 shows changes in from output when one variable factor, namely labour, is
varied. At first, as the number of men is increased from 1 to 2, marginal product as well as
the average & product increase. But as more men are employed, the average product falls
and the marginal product falls faster. Fall of the average and marginal product continues as
more men are put on the farm. Hiring of the seventh man is fruitless, since he adds nothing
to production on the farm (Because his marginal product is zero). Henceforth if more men
are added they will prove a nuisance to the already working men and will decrease
production rather than increase it; in other words, the marginal product of labour would
become negative. We state the law of variable proportions with reference to the behaviour
of the marginal product. In the given production function shown in the table behaviour of
the marginal product clearly shows three stages: in the first MP increases; in the second it
continues to fall; and in the third, it becomes negative.
12.3.3 Diagrammatic explanation
The law of variable proportions is shown through the figure given below. The horizontal
axis shows the units employed of labour, the variable factor. The vertical axis shows the
total, the average and the marginal products of the variable factor labour as it is increasingly

160
employed along with the given fixed resources. In figure 12.1, we find that as the quantity
of variable factor is increased relative to the fixed factors, total product TP rises at first,
remains constant at point and then starts falling. We can derive the shapes of the average
product and marginal product curves from the total product curve. This is helpful in
pinpointing the three stages of the law. As shown in the figure, average product of the
variable factor with OA units employed equals total product (AM) divided by the total
units of the factor being used (OA). At point P the average product is the maximum and is
also equal to the marginal product. In the initial stage, the marginal product continues to
increase and then falls to equal the average product. Point N marks the end of the 1st
stage of the Law of Variable Proportions because MP declines from point P.
Now let us come to the total product (TP) curve. After point M, total product increases
but at a lesser rate. As a result, marginal product becomes less than average product.
Average product, after attaining a maximum at point P, starts declining and the marginal
product curve falls faster than the average product curve. Total product is the maximum
(BK) when OB units of the variable factors are employed. The MP at point B is zero.
From point A to B is the second stage of the law. In this stage the average product as well
as the marginal product curves are falling but are positive.
If more than OB units of the variable factor are employed, total product starts declining.
And marginal product becomes negative. It is also called the stage of negative returns. In
this stage, when a variable factor is used in a greater quantity, it adds nothing to the total
product. Rather it reduces the total product. Here applies the proverb ‘Too many cooks
spoil the broth’. Thus, when the variable factor is used in a larger quantity than what is
fruitful, it reduces the total product. The third stage of the law is where the marginal product
of the variable factor is negative.

161
 Figure 12.1 Law of variable Proportion

12.3.4 Different Phases of the Law

The three stages of the law of variable proportion are easily identified in figure 12.1.
Marginal product increases as we employ more units of the variable factor till ON units
are employed. This is the first phase of the law popularly called the stage of increasing
returns. If we add more variable factor units, marginal product starts falling but average
product rises so long as marginal product is above it. Both are equal to AP when OA
variable factor units are employed. Here the first phase of the law of variable proportions,
the stage of increasing returns, is over. Point A corresponds to the maximum average
product of the variable factor with given fixed resources. The second phase of the law
starts with the employment of more units of the variable factor after OA. Average product
and also marginal product of the factor start falling. The OBth unit of the variable factor
has a marginal product which is zero. The second stage, therefore, ends here. The second
stage of the law is called the Law of Diminishing Returns.
The third stage starts after the employment of more than OB units. If more units of labour

162
are added, they have a marginal productivity less than zero. The additional units of the
variable factor employed in the third stage are not only redundant but harmful also, since
they hinder rather than help production. This is clear from the fact that the total product
(TP) curve continues to fall in the third stage of the Law. In older terminology, point B
corresponds to the intensive margin beyond which profitable production will not take
place.
In the third stage, fruitlessness of further application of the units of the variable factor is
depicted by the falling of the total product. This stage is also termed as the stage of negative
returns.
12.4 SUMMARY
The law of variable proportion in production is one of the fundamental laws of economics.
A French economist was the first to discuss this law. The law deals with behaviour of
production in the short run. Thus, Law of variable proportions shows the production
function with one factor variable while other factors of production are kept constant/fixed.
According to Leftwitch, “The law of variable proportions states that if the input of one
resource is increased by equal increments per unit of time while the inputs of other resources
are held constant, total product (output) will increase, but beyond some point the resulting
output increases will become smaller and smaller.”

The law of variable proportions assumes Constant technology the techniques of production
as constant (constant technology), the law specially operates in the short run because here
some factors are fixed and the proportion of others has to be varied, and each factor unit
is homogeneous or identical in amount and quality, and finally, the law supposes the
possibility of the ratio of fixed factors to variable factors being changed.

Diagrammatically, the law of variable proportion explain with the help of three stages; In
the initial stage, the marginal product continues to increase and then falls to equal the
average product, the second stage of the law shows that the average product as well as
the marginal product curves are falling but are positive, finally, the third stage of the law is
where the marginal product of the variable factor is negative.
163
12.5 SELF ASSESSMENT QUESTIONS
1. Explain the law of variable proportion in terms of the behaviour of Total physical
product, with the help of a diagram?
___________________________________________________________
___________________________________________________________
___________________________________________________________
2. State and explain the law of diminishing return to a factor?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. Explain the relationship between AP and MP using a suitable diagram?
___________________________________________________________
___________________________________________________________
___________________________________________________________

12.6 SUGGESTED READING

 Economic Theory. Micro Economic Analysis, Ahuja, H.L., S. Chand and Company
Ltd, New Delhi.
 Principles of Economics, Mishra and Puri, Himalaya Publishing House, New Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.
-----

164
B.Com. Semester-I Unit-III
C. No. BCG-103 LESSON No. 13

LAW OF RETURN TO SCALE

STRUCTURE
13.1 INTRODUCTION
13.2 OBJECTIVE
13.3 LAWS OF RETURN TO SCALE
13.3.1 Meaning
13.4 CONSTANT RETURNS TO SCALE
13.5 INCREASING RETURNS TO SCAE
13.5.1 Causes
13.6 DECREASING RETURNS TO SCALE
13.6.1 Causes
13.7 SUMMARY
13.8 SELF ASSESSMENT QUESTIONS
13.9 SUGGESTED READINGS

13.1 INTRODUCTION
In the previous chapter, we explained the behaviour of output when alteration in factor
proportions is made. Factor proportions are altered by keeping the quantity of one or

165
some factors fixed and varying the quantity of other. The changes in output as a result of
the variation in factor proportion, as seen before, forms the subject matter of the “law of
variable proportions”. Now in this chapter we shall take the study of changes in output
when all factors or inputs in a particular production function are increased together
proportionately. In other words, we shall study the behaviour of output in response to the
changes in the scale. The scale of production in the context of two factor production
function means a given amount of labour and capital used in the production process. The
proportionate changes in both the factors bring about change in the scale. Thus, an increase
in the scale means that all inputs or factors used in a production process are increased in
the same proportion. Increase in the scale thus occurs when all factors or inputs are increased
keeping factor proportion unaltered. The term returns to scale refers to the degree by
which output changes as a result of a given proportionate change in the amounts of all
factors (inputs) used in production.
13.2 OBJECTIVES
Broadly, the objective of this chapter is to explain the concept of law of return to scale.
Besides this, an attempt shall be made;
 To describe the three stages of law of returns to scale.
 To explain the causes of diminishing and increasing returns to scale.
13.3 LAWS OF RETURN TO SCALE
In the long run, expansion of output can be achieved by variation in the use of all factors as
all factors are variable. The laws of returns to scale can be increased by effecting a change
in the use of all factors keeping the same proportion or by changes in different proportions.
But the concept of returns to scale is concerned with the first case, i.e., the behaviour of
output as all inputs are varied by the same proportion.
13.3.1 Meaning
The responsiveness of output to a given proportionate change in the quantities of all inputs
is called returns to scale. Here, we try to find out that in what proportion output changes
when there is some proportionate change in the amount of all inputs. There are three

166
possibilities: viz; (a) constant returns to scale, (b) increasing returns to scale and (c)
decreasing return to scale. All these possibilities are shown in table 13.1.

Table 13.1
Varying Returns to Scale

13.4 CONSTANT RETURNS TO SCALE

In case of constant returns to scale, when all factors of production are increased in a given
proportion, the output would also increase in the same proportion. For example, if the
quantity of labour and capital is increased by 10%, output also increases by 10%. If
labour and capital are doubled, output also doubles, similarly, if all inputs are reduced by
a given proportion, output is reduced by the same proportion.

167
 Figure 13.1: Constant Returns to Scale
Figure 13.1 (A), shows that equal increase in inputs is attended by equal increase in
output. When the amount of capital (k) and labour (L) is increased two times, output
increases from 10 units to 20 units. Similarly, when the quantity of capital and labour is
increased by three times, output also goes up by three times. The OR ray is known as
scale line. It shows the proportion in which the two inputs are being used. In case of
constant returns to scale, the successive intercepts produced along the scale line by different
isoquants of the same length. The intercept CD equals DE. Part B of the figure 13.1
shows the output-input relation. Output has been taken along Y-axis and ratio of capital
and labour along X-axis. The figure shows that the output line is linear.

168
13.5 INCREASING RETURNS TO SCAE
In case of increasing return to scale, when all factors are increased in a given proportion,
output increases by a greater proportion. For example, if the amount of labour and capital
is increased by 10%. If the quantity of labour and capital doubles, output more than
variables doubles. This increasing returns to scale is shown in figure 13.2.

Figure 13.2: Increasing Returns to Scale

Panel A of figure 13.2 shows that a given proportionate increase in the use of labour and
capital is attended by more than the proportionate increase in output. When labour and
capital are doubled, output increase from 10 units to 40 units, i.e., output more than
doubles. Whereas part B of figure 13.2, shows that the output line is concave from above.

169
It is showing increasing returns to scale. It is evident from the output line that a proportionate
increase in the use of labour and capital results in more than a proportionate increase in
output.
13.5.1 Causes
The causes of increasing returns to scale are:
1. Specialisation: Each worker can acquire specialisation in the performance of
simple repetitive task rather than many different tasks. As a result, labour
productivity registers a rise.
2. Use of specialised machinery: A large scale of operation permits the use of
more productive specialised machinery which was not feasible at a smaller scale
of operation.
3. Economies of large scale: Moreover, as a firm expands its scale of production,
it comes to enjoy certain economies- financial, technical, marketing, managerial
and so forth.
4. Indivisibility: Indivisibility is another source of increasing returns to scale. An
inidivisible factor cannot be sub-divided into parts. The whole of it has to be
employed to carry on production. for example, capital and entrepreneur.
13.6 DECREASING RETURNS TO SCALE
In decreasing returns to scale, output increases in a smaller proportion than the increase in
all inputs, i.e., in this case as inputs are increased by a particular proportion, output increases
less than proportionately. For example, if inputs are increased by 10% output increases by
less than 10%. If inputs double, output will less than double (figure 13.3).
Part A of the figure shows that a proportionate increase in the use of labour and capital
leads to less than proportionate increase in output. When use of labour and capital doubles,
output increases from 10 units to 14 units. Similarly where use of labour and capital is
increased three times, output goes up from 14 units to 17 units. It means that as inputs
increased by equal increments, output increases less than proportionately.

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 Figure 13.3: Decreasing Returns to Scale
13.6.1 Causes of Decreasing Returns to Scale
Decreasing returns to scale caused due to:
1. Diseconomies of large scale production- As a firm expands, it experiences
growing diseconomies of large scale production. These diseconomies are mainly
the result of increasing managerial difficulties. Co-ordination of the work becomes
more and more difficult. In large scale businesses, the entrepreneur has to depend
upon a team of managers. Lines of communication increases. Decision making
becomes difficult. Thus, as the output grows, management becomes overburdened
and less efficient in the discharge of its functions as co-ordinator and ultimate
decision maker.

171
2. Exhausitble National resources- Another cause for decreasing returns to scale
may be found in the exhaustible natural resources. For example, if more and more
fishermen are employed to fish in a certain area, the catch of the fish will not
increase in the same proportion. Similarly, if we keep the area of mining operation
fixed and increase labour and capital equipment, output will not increase in the
same proportion as the number of workers or the quantity of capital increased.
13.7 SUMMARY
In the long run, expansion of output can be achieved by variation in the use of all factors as
all factors are variable. The laws of returns to scale can be increased by effecting a change
in the use of all factors keeping the same proportion or by changes in different proportions.
The responsiveness of output to a given proportionate change in the quantities of all inputs
is called returns to scale. Here, we try to find out that in what proportion output changes
when there is some proportionate change in the amount of all inputs.
There are three possibilities of returns to scale, viz; (a) constant returns to scale, (b) increasing
returns to scale and (c) decreasing return to scale. In case of constant returns to scale,
when all factors of production are increased in a given proportion, the output would also
increase in the same proportion. In case of increasing return to scale, when all factors are
increased in a given proportion, output increases by a greater proportion. For example, if
the amount of labour and capital is increased by 10%.
The causes of increasing returns to scale are; Specialisation means each worker can acquire
specialisation in the performance of simple repetitive task rather than many different tasks,
use of specialised machinery, economies of large scale, indivisibility.
In decreasing returns to scale, output increases in a smaller proportion than the increase in
all inputs, i.e., in this case as inputs are increased by a particular proportion, output increases
less than proportionately. Decreasing returns to scale is caused due to; Diseconomies of
large scale production which shows that as a firm expands, it experiences growing
diseconomies of large scale production. These diseconomies are mainly the result of
increasing managerial difficulties. Co-ordination of the work becomes more and more
difficult. Another cause for decreasing returns to scale may be found in the exhaustible
natural resources. For example, if more and more fishermen are employed to fish in a

172
certain area, the catch of the fish will not increase in the same proportion.
To sum up, law of return to scale are a matter of interaction between economies and
diseconomies of large scale production. Initially, when a firm expands, it faces increasing
returns to scale because of the scale economics. As the scale of operation rises, increasing
returns to scale give way to constant returns to scale, because here economies and
diseconomies of large scale production balance each other. But if the firm continues to
expand its scale of production beyond a point, it experiences diminishing returns to scale.
This is due to the fact that eventually the economies of large scale production are swamped
by the diseconomies of large scale production and this results in decreasing returns to
scale.
13.8 SELF ASSESSMENT QUESTIONS
1. Explain the concepts of returns to scale. State the reasons for constant return to
scale?
___________________________________________________________
___________________________________________________________
2. Distinguish between returns to scale and returns to a variable factor. Explain the
reasons for increasing returns to scale?
___________________________________________________________
___________________________________________________________
3. What causes diminishing returns?
___________________________________________________________
___________________________________________________________
13.9 SUGGESTED READINGS
 Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.
 Advance Economic Theory, Ahuja, H.L., Sultan Chand & Sons, New Delhi.

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B.Com. Semester-I Unit-III
C. No. BCG-103 LESSON No. 14

ECONOMIES AND DISECONOMIES OF SCALE

STRUCTURE
14.1 INTRODUCTION
14.2 OBJECTIVES
1 4.3 INTERNAL ECONOMIES OF SCALE
1 4.4 EXTERNAL ECONOMIES
14.4.1 Sources
14.4.2 Criticism
14.4.3 Importance
14.5 DISECONOMIES OF SCALE
14.5.1 Internal diseconomies
14.5.2 External Diseconomies
14.6 USE OF EXTERNAL ECONOMIES AND DISECONOMIES
14.7 SUMMARY
14.8 SELF ASSESSMENT QUESTIONS
14.9 SUGGESTED READINGS
14.1 INTRODUCTION
Occurrence of increasing returns is explained in terms of the economies of scale. Economies
of scale refer to the situation in which increasing the scale of production reduces the unit

174
cost of production or raises output per unit of the factor inputs. Broadly, economies of
scale are classified as; (a) internal economies of scale and (b) external economies of scale.
14.2 OBJECTIVES
After reading this chapter, you will be able:
 To define economies and diseconomies of scale.
 To explain the sources of economies and diseconomies of scale.
 To describe the importance of economies and diseconomies of scale.
14.3 INTERNAL ECONOMIES OF SCALE
When a firm increases its scale of production, the reduced costs or economies which this
firm gets as a result are called internal economies. The word ‘internal’ is used here to
denote the limitation of these economies to the firm itself. According to Cairncross, "Internal
economies are those which are open to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and
cannot be achieved unless output increases." Internal economies mean increasing return to
scale. These are the result of increased division of labour or the improved production
methods. The benefit of these economies is received by a firm according to its organisational
efficiency.
The main factors responsible for internal economies are as under:
1. Technical Economies- Technical factors also affect the returns to scale. Bigger firms
are having more of resources at their disposal. They are able to install the most suitable
machinery. Some machines are having a technically minimum size. The smaller sized firm
may not be able to use such machines to full capacity. As a result, larger firms have lower
costs of production because of the full capacity use. Technical economies may arise out of
any one of the three reasons.
(a) Economies of increase of dimension. When a firm increases its scale of
production, its average cost of production falls simply because of the larger volume of
production. For example, if a firm doubles the length and breadth of a godown, the godown
capacity is more than doubled. This is simple arithmetical example.

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(b) Economies of linking of processes. As a firm increases its scale of production,
it is enabled to link its production processes much better. A large firm is enabled to use all
the production processes from the use of a raw material to the marketing of its finished
products. Linking of the production processes saves time, material and labour costs.
(c) Economies of the use of by-products. A large sized firm is in a position to use
its by-products and waste material to produce another product. This lowers the cost of
production of the main product. For example, a big sugar factory can have a small plant to
produce power alcohol from the residual liquid left after sugar extraction. This lowers the
cost of sugar-production.
2. Managerial Economies- With the increase in the scale of production a firm can
benefit by specialising its managerial departments. Each department is under the charge of
an expert. A small firm cannot afford this specialisation. Experts are able to reduce the
costs of production under their supervision.
3. Labour Economies- Increase in the scale of a firm also enables it to take the
advantage of labour economies. A larger firm employs a large number of workers. Each
worker is given the kind of job he is fit for. The personnel officer evaluates the working
efficiency of the labour if possible. Workers get skilled in then-operations which saves
production time on the one hand and encourages new ideas on the other. All this leads to
falling cost with increased scale.
4. Marketing Economies- As the scale of a firm is increased, it obtains economies
of purchase and sale. Since the firm purchases on large scale, it gets all the inputs at a
cheaper rate compared to the small firms. Similarly, wholesalers charge less' for the sale of
the products of a large-sized firm.
5. Financial Economies- A larger firm is able to reduce its costs of borrowing from
the market. A bigger firm is better known to the financial institutions and the stock market.
The charges of selling bonds and shares or of borrowing direct from the market are much
less than those demanded from smaller firms.
6. Risk-bearing Economies- The ability of a larger firm to bear risks of business is
much better. Every firm has to face some particular and some general risks in order to

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continue production. For example, during depression market prices fall for every firm.
There is some particular risk to be borne by a particular firm when the price of a particular
product falls in the market. Whether risks are general or of the particular type, a small firm
has less ability to face them because of less financial resources and a smaller area of the
market for sale. But bigger firms are able to face risks due to the stronger financial position.
These risk-bearing economies are also called 'survival economies' because these help the
bigger firm to survive the business crisis while the smaller firm fails.
The examples of internal economies given above are also particular to a firm. Hence they
are called 'Internal'. These partly help us to explain the increasing returns to scale and
partly serve to account for the fall in average cost as the size of the firm increases. Internal
economies are connected with a particular firm. Therefore, they are relevant to particular-
equilibrium analysis.
14.4 EXTERNAL ECONOMIES OF SCALE
External economies include all those cost reducing benefits or facilities which accrue to a
firm when the size of the industry in which the firm is working increases. According to
Cairncross, “External economies are those benefits which are shared in by a number of
firms or industries when the scale of production in any industry or groups of industries
increases.” As the name also tells us these economies are of the common benefit for all the
firms working in the expanding industry. Therefore, about external economies Cairncross
has observed, “They are not monopolised by a single firm when it grows in size, but are
conferred on it when some other firms grow larger.” External economies result from the
progress an industry makes in providing the social overhead capital needed by the constituent
firms. Use of cost saving machines by research and development, development of the
means of communication and transport, advantages of localization, facilities for advertising,
insurance, banking, credit, opening of a common training school for labour, publication of
industrial journal, opening of information centres etc. are the factors which benefit all the
firms and reduce their costs of production. These are, therefore, called external economies.
Let us explain the idea of external economies through an example. Suppose there are
seven textile mills in a city which produce cloth not enough to run a printing plant full time.
As a result, these firms are compelled to send cloth to another centre for fashion printing.
Now, suppose that the size of textile industry in the city increases and the number of firms

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rises to twelve. They produce cloth enough for printing to enable a minimum sized printing
firm to work in the city itself. This saves costs of transport of cloth to and from the printing
plant. It is a common facility made open to all the firms with the increase in the size of the
industry itself. We may classify the main sources of external economies in any industry as
follows.
14.4.1 Sources of External Economies
1. Physical Factors. As the size of an industry expands, some physical factors may
work to reduce the costs of all the firms working in the industry. An example shall make
this point clear. Suppose a few firms are working in an area for coal mining. As they mine
coal from underneath the surface earth, they have to pump water out of the coal mines
which seeps from the side of the mines. Now if the number of firms, mining coal in the area
increases, the costs of pumping out water of each firm shall go down because the share of
seeping water needing pumping out for each firm shall be less than before. Similarly, in
many other industries such physical factors work to reduce costs as industry’s size expands.
2. Economies of Concentration. When the firms in an industry are established at
the same place, then all these firms get some common benefit like development of means
of transport and communication, availability of specialized trained labour, opening of
specialized auxiliary industries to serve this industry etc. Besides this, opening of business
and financial institutions to serve this industry is also of common benefit to the individual
firms due to their concentration in an area.
3. Economies of Information. As the number of firms in an industry expands,
possibilities of many collective and co-operative ventures can be realised. For example,
the publication of newspapers and journals giving scientific and commercial information
about the industry becomes possible. Similarly, information collection from the firms in the
industry is also made easier. Intending purchasers of the industry’s products can at once
obtain all the information and this helps all the firms.
4. Economies of disintegration. As an industry develops, the firms working in it
are more agreeable to the splitting of processes of manufacture and handing over each
process to different firms. This makes specialisation possible. The separation of the different
stages of production of a commodity with a view to reducing costs is of two types: (1)

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horizontal disintegration, and (2) vertical disintegration. Vertical disintegration is illustrated
by the separation of the process of cotton refining, spinning and weaving of cloth. Horizontal
disintegration takes place when eyery firm tries to specialize in one particular item in a line
of production rather than producing a variety of items. If a firm produces only woollen
suiting instead of shirting, suiting and sarees, it is having horizontal disintegration. Both
vertical and horizontal disintegration reduce costs for the member firms in an industry by
reducing duplication, saving time and materials.
14.4.2 Limitations of External Economies
Many economists have criticised the concepts of external economies developed by Marshall
and Viner. There are two major criticisms made by modern economists.
First, Prof. Tibor Scitovsky has expressed the view that technological external economies
are non-existent. Such examples, as have been given, must be dismissed as bucolic or
rustic in nature. He takes the classic example of the bee-keeper and the fruit-grower
where the two industries provide external economies to each other. Such economies, in
his view, are of little importance under modern conditions. He has doubted whether the
pollination of fruit by the bees and the gathering of honey from the fruit trees should be
regarded as true externalities so much as inappropriabilities. It is a case of the inability of
the bee-keeper to charge the fruits grower for the services of his bees because of
imperfections of the market mechanism, and the inability of the fruit-grower to charge the
bee-keeper.
Second, another criticism has been made against pecuniary external economies. It has
been suggested that external pecuniary economies are typically the result of internal
economies in another industry where the increased efficiency is passed along in the form of
lower prices for intermediate goods. If this is really so, then external economies are more
a myth than a reality.
14.4.3 Importance of External Economies
The concept of external economies has proved very useful both in theoretical and applied
economies. The main applications of the concept are as under:
1. External Effects and Welfare Economics. External economies belong to the
field of general equilibrium analysis in so far as they reflect interdependence between firms

179
and industries. The concept of external economies has been generalised. It has been pointed
out that there are external economies of consumption also. One man's consumption
influences the utility of consumption of another person. Examples are, of smoking in a
cinema hall, drinking at public places. Another example is the enjoyment a person obtains
from a well laid-out flower-garden in the neighbourhood. Thus, it is now realized that
external economies are examples of the general external effects we find in common life.
Recently a full-fledged analysis of externalities has been introduced in welfare economies,
thereby changing the policies based on it substantially.
2. Importance in Economic Development. External economies have played a
major role in development economics. These are also called ‘spill over’ or ‘linkage’ effects.
In an article published in the Economic Journal (December, 1928), Allyn Young argued
that economic progress generates some external economies which make the hitherto
unprofitable projects profitable. Prof. Tibor Seitovsky extended the concept of external
economies to advocate 'balanced growth' for a developing economy. His use of the concept
of external economics was entirely different from the concept used in equilibrium theory,
both partial and general. Scitovsky pointed out that it is the internal technical technological
and internal pecuniary economies which are of real importance in economic development.
The central idea in balanced growth theory is that in the initial stages the development of an
economy must be inter-related horizontally and vertically. Prof. Resenstein-Roden has
used the external economies argument to give his 'Theory of the Big Push'. The underlying
idea of his thesis is that the development process consists of the propagation of external
economies. This process will work better and faster if the development of industries is in
the same line of production, especially factor producing industries where there is scope for
reaping economies of scale.
3. A Concept in Macro Dynamics. The external economies concept as used by
modern economists is really dynamic in nature. Marshall evolved the concept at the micro
level with reference to only one industry. Development economists have broadened the
concept and used it in the general equilibrium analysis of economic growth. Economic
development or economic growth is a dynamic phenomenon. Only dynamic concepts can
explain it.

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4. Basis of the Theory of Unbalanced Growth. Albert O. Hirschman has
advocated his theory of unbalanced growth with reference to the vertical propagation of
external economies. He calls external economies as forward and backward linkages. He
has argued that there is a basic core of industries of economic activities which have the
maximum vertical propagation of external economies. These industries must be developed
first. This policy is of unbalanced growth.
In short, the concept of external economies is the basis of much of theorising in development
economics.
14.5 DISECONOMIES OF SCALE
The economies obtained by a firm or an industry are ultimately limited. A point comes
where some factors start operation in the opposite direction and the costs of production
start rising. These factors are sometimes called internal and external diseconomies.
14.5.1 Internal diseconomies
Internal diseconomies are those factors which raise the cost of production of a firm as its
scale of production is increased beyond a point. These factors may be the following two:
1. Unwieldy management. A main reason for decreasing return to scale is the
difficulties of managing a large-sized firm. It becomes difficult to co-ordinate and supervise
the work of different departments as specialisation increases. There is a limit to the
decentralization of decisions. Beyond a limit the operational efficiency of top management
falls. These are the major factors behind internal diseconomies.
2. Technical difficulties. The second major reason for the onset of internal
diseconomies is technical difficulties of operating a large sized firm. There is a limit to the
division of labour and splitting down of production processes. As division of labour is
pressed beyond a point, indivisibility of factors comes in. Every machine has an optimum
capacity for work and an optimum proportion with other factors. If this proportion is
exceeded, internal diseconomies follow.
14.5.2 External Diseconomies
While internal diseconomies are practically known to exist, external diseconomies are so
far a part of economic theory only. Some writers argue that there must be a limit to the

181
expansion process between industries. The forces which ultimately limit the expansion of
an industry may be, called external diseconomies. In support of the contention they give
three reasons: (1) When an industry gets localised or concentrated at one place, the cost
of transportation increases due to congestion. (2) Similarly, as an industry expands there is
scarcity of some raw material or the other which cannot be totally substituted. As a result
costs start rising. As an industry expands there are difficulties of obtaining skilled workers,
finance and credit because other industries also compete for them. As a result of all the e
factors, external diseconomies become more forceful as an industry matures.
14.6 USES OF EXTERNAL ECONOMIES AND DISECONOMIES
The concepts of external economies and diseconomies have been used to classify industries
into three types in order to determine their equilibrium. Marshall was the first to do this
because he discussed the equilibrium of a perfectly competitive industry in the long period.
This classification of industries was used to show the determination of normal price in the
three cases of diminishing returns, constant returns and increasing returns.
1. A Decreasing Cost Industry (Increasing returns) - External economies are a
definite possibility when a young industry expands. The fall in costs of firms in rail-roads,
electric supply and communication as the industries expand is a known feature. This is
because in these industries a good deal of capacity is created by huge fixed investment. As
this capacity is used more and more, average cost of production continues to fall. External
economies are much stronger as compared to the external diseconomies. The result is that
many public utilities may experience increasing returns as the size of the industry expands.
They are examples of decreasing cost industries.
2. A Constant Cost Industry (constant returns)- In some industries, the external
economies may be just matched by external diseconomies. In such a case as the industry
expands, there is no change in their average cost. An industry may be in this category
when it has come fairly of age so that its impact on the market for productive services
gives rise to external economies and diseconomies in balance with one another.
3. An Increasing Cost Industry (Diminishing Returns)- External economies
cannot continue indefinitely. We can easily assume that the fountains of external economies
dry up as an industry expands. Rather as the number of firms in an industry increases

182
further the pressure of demand for specific specialised resources like highly skilled labour
or highly specialised machinery or a mineral resource may become so much as to raise
costs to the firms in the industry.
We make use of this classification of industries in the long-period price determination of
the industries under perfect competition.
14.7 SUMMARY
When a firm increases its scale of production, the reduced costs or economies which this
firm gets as a result are called internal economies. According to Cairncross, "Internal
economies are those which are open to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and
cannot be achieved unless output increases". The main factors responsible for internal
economies are; Technical factors, Managerial Economies, Labour Economies (Increase
in the scale of a firm also enables it to take the advantage of labour economies), Marketing
Economies (As the scale of a firm is increased, it obtains economies of purchase and sale),
Financial Economies (A larger firm is able to reduce its costs of borrowing from the market).
A bigger firm is better known to the financial institutions and the stock market, Risk-
bearing Economies (The ability of a larger firm to bear risks of business is much better).
Every firm has to face some particular and some general risks in order to continue
production. Internal economies are connected with a particular firm. Therefore, they are
relevant to equilibrium analysis.
On the other hand, External economies include all those cost reducing benefits or facilities
which accrue to a firm when the size of the industry in which the firm is working increases.
These economies are of the common benefit for all the firms working in the expanding
industry. External economies result from the progress an industry makes in providing the
social overhead capital needed by the constituent firms. Sources of External Economies
includes, Physical Factors, Economies of Concentration, Economies of Information and
Economies of disintegration. Many economists have criticised the concepts of external
economies developed by Marshall and Viner. There are two major criticisms made by
modern economists. First, the view that technological external economies are non-existent
and another criticism has been made against pecuniary external economies. It has been
suggested that external pecuniary economies are typically the result of internal economies

183
in another industry where the increased efficiency is passed along in the form of lower
prices for intermediate goods. The concept of external economies has proved very useful
both in theoretical and applied economies.
The economies obtained by a firm or an industry are ultimately limited. A point comes
where some factors start operation in the opposite direction and the costs of production
start rising. These factors are sometimes called internal and external diseconomies. Internal
diseconomies are those factors which raise the cost of production of a firm as its scale of
production is increased beyond a point. The factors which are responsible for these types
of economies are: Unwidely management and Technical difficulties.
While internal diseconomies are practically known to exist, external diseconomies are so
far a part of economic theory only. The forces which ultimately limit the expansion of an
industry may be, called external diseconomies. The concepts of external economies and
diseconomies have been used to classify industries into three types in order to determine
their equilibrium. This classification of industries was used to show the determination of
normal price in three cases, i.e. diminishing returns, constant returns and increasing returns.
14.8 SELF ASSESSMENT QUESTIONS
1. Explain the various economies of scale and diseconomies of scale that accrue
to the firm when it expands its scale of production?
___________________________________________________________
___________________________________________________________
2. Explain external economies. How are these economies achieved?
___________________________________________________________
___________________________________________________________
3. Write notes on: (1) Internal diseconomies and (2) External diseconomies.
___________________________________________________________
___________________________________________________________
___________________________________________________________

184
14.9 SUGGESTED READINGS
 Advanced economic theory, Ahuja, H.L., S. Chand & Sons, New Delhi.
 Economic theory, Chopra, P.N., Kalyani Publishers, New Delhi.
 Micro economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

------

185
B.Com. Semester-I Unit-III
C. No. BCG-103 LESSON No. 15
COST ANALYSIS
STRUCTURE
15.1 INTRODUCTION
15.2 OBJECTIVES
15.3 KINDS OF COSTS
15.3.1 Money Cost
15.3.2 Opportunity Cost
15.3.3 Social Cost
15.3.4 Other Costs
15.4 SHORT RUN COST CURVES
15.4.1 Total costs in the short run
15.4.2 Short run average cost curve
15.4.3 Short run average variable cost
15.4.4 Short run marginal cost curve
15.4.5 Relationship between AC and MC.
15.4. 6 Relationship between different cost concepts
15.5 LONG RUN COST CURVES
15.5.1 Plant Capacity and change in scale
15.5.2 Derivation of long run average cost curve

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 15.5.3 Long run marginal cost curve
15.6 SUMMARY
15.7 SELF ASSESSMENT QUESTIONS
15.8 SUGGESTED READING
15.1 INTRODUCTION
In the previous chapters, it has been realised that the marginal cost curve slopes up from
left to the right while the marginal revenue curve slopes down from left to the right at the
point of their intersection so that a stable and determinate equilibrium of the firm is ensured.
But we did not distinguish between the short-run or long-run cost, revenue and equilibrium.
Therefore, here in this chapter we explain the concepts of all these costs both in the long
run as well as in the short run.
15.2 OBJECTIVES
The specific objectives of this chapter are:
 To define different cost concepts.
 To explain short run cost curves.
 To describe the cost curves under long run.
15.3 KINDS OF COSTS
There are different concepts of costs used in Price Theory. These concepts must be clear
before we try to know the analysis of cost for equilibrium of the firm. The different concepts
of cost are as follows:
15.3.1 Money Cost
When we talk of the cost of a firm, the immediate idea about costs that comes to our mind
is the money costs, the costs that accountants often list, the money outlays of a firm on the
processes of production of its output. These are the wages and salaries paid to labour, the
expenditure on machinery and equipment and the needed repairs, the payment for materials,
power, light, fuel and transportation; the disbursements of rents, trademarks, advertisement
and insurance and the taxes. However, the accountants may not add all such costs. For

187
example, in calculating the costs of the firms, the wages of management to the entrepreneur,
a reasonable rate of return on the land and capital owned and contributed by him must be
added in. Further, provisions for depreciation, obsolescence, and bad debts must be made
in calculating the costs of the firm.
While a producer considers only the money costs of procuring the inputs necessary for
products, another view of costs interests economists. This is the idea of real costs. They
like to look behind the money costs from the social viewpoint. The main reason for the
payments made to the factors of production is that there is disutility in rendering the services.
This was the view expressed by the neo-classical. Marshall wrote: “The exertions of the
different kinds of labour that are directly or indirectly involved in making it, together with
the absentinence or rather the waiting required for saving the capital used in making it; all
these efforts and sacrifices together will be called the real cost of production of the
commodity.
According to J.L. Hanson, “The money costs of producing a certain output of a commodity
is the sum of all the payments to the factors of production engaged in the production of that
commodity”. Thus, money cost is the cost which enters the records of the accountants of
a company.
15.3.2 Opportunity Cost
Work to an ordinary man is uncomfortable or even painful if done overtime. In the same
way, responsibility and risk-bearing in business means worry and nervous wear for the
common businessman. Similarly, accumulation of capital whose services are so important
for production is the result of a process of abstinence and waiting. It is crystallised, stored
up labour. From the social point of view no real cost may be attributed to the services of
natural resources, yet from the point of view of an individual, land (or other resource)
owner, the sacrifice of an opportunity of using it for some purpose other than the one to
which it is being put, constitutes a cost. The forgone opportunity also taken as cost and is
termed opportunity cost.
According to Leftwitch, “opportunity cost of a particular product is the value of the forgone
alternative product that resources used in its production could have produced”.
It is instructive and analytically helpful to think of production costs as opportunity costs or

188
alternative costs. The resources (or inputs) used in production generally have many alternative
uses, that is, they are non-specialised. A driver can be used to drive a taxi, a personal car,
a highway truck, a tractor or a road-building bulldozer. He cannot be put to all these
employments at the same time. His employment as a taxi driver means the loss of an
opportunity of employing him as a truck driver. The sacrifice of an alternative opportunity
from the viewpoint of the transport firm is an opportunity cost. A more interesting example
of opportunity cost is the dislocation of family life a person has to suffer in agreeing to his
wife getting employed. Similarly a businessman is generally capable of working in a few
industries. A machine can be put to a variety of uses. Its employment in one of these uses
must pay it at least that much which it can get in the next best employment; it must be
priced at least equal to its transfer earnings, which is its opportunity cost.
According to Ferguson, “The alternative or opportunity cost of producing one unit of
commodity X is the amount of commodity Y that must be sacrificed in order to use resources
to produce X rather than Y”.
15.3.3 Social Cost
The producer calculates and tries to cover his own private costs. He does not think of the
effects of his production processes on the society. In some industries, all the costs of
production are not entirely borne by the producer, some costs incidental to the production
process are borne by others.
Social cost is the total cost of production of a commodity which includes the direct and the
indirect costs which the society has to pay for the output of the commodity.
In his Economics of Welfare, A.C. Pigou drew a distinction between private and social
costs. A mill owner will count his costs of production and never those of the people living
around the factory who have to pay in the form of increased laundry bills due to the soot
and smoke coming out of the factory chimneys. In this case social cost is more than private
cost. Other examples of social cost being more than private costs can be cited: the pollution
or wastes by mining and industrial waters, the impairment of health and property values by
the air pollution from the fumes and smoke of slaughter house and factories, the crowded
parking and other inconveniences caused by cinema houses and circuses, incomplete private
compensation for injuries at work or for occupational diseases; and soil erosion,

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deforestation, and wasteful depletion of oil and coal reserves. These cases of social cost
exceeding private cost call for special attention of the State.
On the other hand, certain cases can be noticed where private cost is more than the social
cost. These are cases of firms whose operation renders some services to the other firms or
the economies which are not paid for. An engineering college or technical institute in an
area helps private industries in that area. The building of the Bhakra-Nangal system of
canals has increased land values phenomenally in their areas of Punjab, Karyana and
Rajasthan; the Bhakra Board pays for the project more than the society at large. Slum
clearance, town and country planning give a face lift to localities increasing the values of
houses in them. In many industries, cost of research is borne by one producer in bringing
out an innovation while other firms get free hints for improving their methods of production.
All these cases are those of social net product being higher than the private net product.
This difference between the two costs arises because of the inability of the private enterprise
to fully appropriate their product.
15.3.4 Other Costs
Of all cost concepts mentioned above we shall make use, in price theory, of only the
private and money costs of production. Other cost concepts shall be found to be of great
use in the discussion of welfare economics or in our discussion on socialist economics.
I. Accounting costs and economic costs. When an entrepreneur undertakes an
act of production he has to pay prices for the factors which he employs for production. He
thus pays wages to workers employed, prices for the raw materials, fuel and power used,
rent for the building he hires, and interest on the money borrowed for doing business. All
these are included in his cost of production and are termed as accounting costs. Thus
accounting costs take care, of all the payments and charges made by the entrepreneur to
the suppliers of various productive factors.
But it generally happens that an entrepreneur invests a certain amount of own capital in his
productive business. If the capital invested by the entrepreneur in his business had been
invested elsewhere it would have earned certain amount of interest or dividend. Moreover,
an entrepreneur devotes time to his own work of production and contributes his
entrepreneurial and managerial ability to do business. Had he not set up his own business

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he would have sold his services to others for some positive amount of money. Accounting
costs do not include these costs. These costs form a part of the economic cost. Thus
economic costs include : (1) the normal return on money capital invested by the entrepreneur
himself in his own business; (2) the wages or salary not paid to the entrepreneur but could
have been earned if the services had been sold somewhere else. Likewise the monetary
reward for all factors owned by the entrepreneur himself-and employed by him in his own
business are also considered a part of economic costs.
Thus accounting costs constitute those costs only which involve cash payments by the
entrepreneur of the firm. Economic costs .take into account not only these accounting
costs but in addition, they also take into account the amount of money the entrepreneur
could have earned if he had invested his money and sold his own services and other
factors in the next best alternative use. Accounting costs are also called explicit costs
whereas the cost of factors owned by the entrepreneur himself and employed in his own
business are called implicit costs. Thus economic costs include both accounting costs and
implicit costs. The concept of economic cost is important because an entrepreneur must
cover his economic cost if he wants to earn normal profits and abnormal profits are over
and above these normal profits. In other words, an entrepreneur is said to be earning
profits (abnormal) only when his revenues are able to cover not only his explicit costs but
also the implicit costs of his output.
II. Outlay costs and opportunity costs. Outlay costs involve actual outlay of funds
on, say, wages, material, rent, interest etc. Opportunity cost, on the other hand, is concerned
with the cost of foregone opportunity; it involves a comparison between the policy that
was chosen and the policy that was rejected. For example, the cost of lending or using
capital is the interest that it may earn in the next best use of equal risk.
A distinction between outlay costs and opportunity costs can be drawn on the basis of the
nature of the sacrifice. Outlay costs involve financial expenditure at some time and thus are
recorded in the books of account. Opportunity costs relate to sacrificed alternatives; they
are not recorded in the books of account in general.
The opportunity cost concept is very useful, e.g., in a cloth mill which spins its own yarn,
the opportunity cost of yarn to the weaving department is the price at which the yarn could

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be sold, for measuring profitability of the weaving operations. Similarly, during a boom
period a decision of the use of scarce capacity for a given product would involve the use
on the opportunity cost of not using it or to make some other product that can yield profit.
III. Direct or traceable costs and indirect or non-traceable costs- Direct costs
are costs that are readily identified and are traceable to a particular product, operation or
plant. Even overhead can be direct as to a department; manufacturing costs can be direct
to a product line, sales territory, customer class etc. We must know the purpose of cost
calculation before considering whether a cost is direct or indirect.
Indirect costs are neither readily identified nor easily traceable to specific goods, services,
operations, etc. but are nevertheless charged to the jobs or products in standard accounting
practice. The economic importance of these costs is that these, even though not directly
traceable to the product, may bear some functional relationship to production and may
vary with output in some definite way. Examples of such costs are electric power, the
common costs incurred for general operation of business benefiting all products jointly.
IV. Fixed and variable costs- Fixed or constant costs are not a function of output;
they do not vary with output upto a certain level of activity. These costs require a fixed
outlay of funds irrespective of the level of output, e.g., rent, property taxes, interest on
loans, depreciation when taken as a function of time and not of output. However, these
costs also vary with the size of the plant and are a function of capacity. Therefore, fixed
costs do not vary with the volume of output within a capacity level.
Fixed costs, to an economist, are overhead costs and to an accountant indirect costs.
However, a clear line of distinction is sometimes not possible; for example, depreciation,
often taken as fixed cannot be considered as fully fixed. Although depreciation is mostly
related to time, a substantial part of it depends on wear and tear (user cost) which would
be strictly variable.
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on.
They can be avoided only when operations are completely closed down. We can call
them as inescapable or uncontrollable costs. But there are some costs which will continue
even after operations are suspended, as for example, the storing of old machines which
cannot be sold in the market. Some of the fixed costs such as advertising, etc. are

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programmed fixed costs or discretionary expenses, because they depend upon the
discretion of management whether to spend on these services or not.
Variable costs are a function of output in the production period. It is like stock which is
used up with the volume of output. Variable costs vary directly and sometimes
proportionately with output. Over certain ranges of production they may vary less or more
than proportionately depending on the utilisation of fixed facilities and resources in the
process of production.
V. Shut down and abandonment costs- Shutdown costs may be those which would
be incurred in the event of a temporary cessation of business activities and which could be
saved if operations were allowed to continue. Shut-down costs, besides fixed costs, cover
the additional expenses in looking after the property not disposed of.
Abandonment costs are the costs of retiring a fixed asset from use. For example, a second
hand plant installed in war time may not be useful during peace time. Abandonment thus
involves permanent cessation of activity and raises the problem of disposal of abandoned
assets.
15.4 SHORT RUN COST CURVES
Analysis of costs of a firm depends heavily on the theory of production. The behaviour of
cost shows behaviour of the product. If the product increases, costs decrease and vice
versa, may it be total, average or marginal costs.
The costs of production of a commodity are the payments made to the factors of production.
Given a certain amount of payment to these factors, the greater is the output, the lower is
the cost, and vice versa, since the nature of production is different in the short-run (period)
from that in the long-run. In the short-run, some factors of production are fixed while
others are variable; in the long-run, all inputs are variable; in the short period only the
proportion of the inputs can be changed; in the long period, scale of production can by
varied. The fixed factors of the firm in the short-run are its plants and equipment, and in
some industries, unique kind of skilled labour. Where plant and equipment are large and
complicated, requiring heavy investments and actual construction time of many years, as in
the case of modern steel plants, the short-run can be of many years' duration. In some
other cases, it may be just a few days long, if firms can easily procure additional equipment

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and skilled labour, and if their needs for buildings are modest or minimal. In the case of tea
shops, the short-run is, for example, only a few days. Let a new public building be
constructed in an area, tea shops appear in only a few days. Therefore, the duration of the
short and the long-run differs from industry to industry according to the nature of equipment
and inputs required, the techniques employed and the stage of development of the area.
15.4.1 Total costs in the short run
Short run is a period of time in which certain inputs cannot be increased or decreased. It
means that in the short run there are certain inputs whose amount cannot be change
regardless of the amount of output produced. Similarly, there are other inputs known as
variable inputs whose amount is amenable to change. A firm's short run total costs are
splitup into groups, viz., total fixed costs and total variable costs.
TC= TFC+ TVC
Total fixed cost (TFC) is the expenditure incurred on the purchase of fixed inputs whereas
total variable cost is the sum spent for the variable inputs. Thus, total costs (TC) are equal
to total fixed cost (TFC) and total variable (TVC).
Total Fixed Costs. These are the costs incurred on factor-inputs which cannot be changed
in the short period. They remain unaffected by changes in the rate of output. Even when
the output is reduced to zero, these costs continue unchanged. Fixed costs, also known as
supplementary costs, are overhead costs and include rent, interest on long term debts
allowance for depreciation, salaries and wages of permanent staff.
Total Variable Costs. These are the costs incurred on the purchase of variable factors. The
Change when output is changed. As greater quantity of output is produced, more raw
materials are required and possibly more labour has to be used. These costs fall to zero
when output is zero. These costs are known as variable costs because they change in
response to a change in the rate of output. Variable costs are also known as prime costs
and they include payments made to the workers, suppliers of raw materials, fuel, power,
transportation and that part of depreciation of capital equipment which depends upon the
rate of output. The concepts of total fixed cost, total variable cost and total cost can be
illustrated with the help of the following table15.1.

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 Table 15.1

Diagrammatically all these costs are shown as under:

Figure 15.1: The total costs

Figure 15.1 (a) illustrates the behaviour of total fixed cost. TFC curve runs parallel to Y-
axis showing that this cost is invariant to changes in the level of output. OP is the total fixed
cost at zero output and it remains the same throughout. TFC is, therefore, graphically
denoted by a straight line parallel to the output axis.
Figure 15.1 (b) shows the behaviour of total variable cost. TVC curve starts from the
origin showing that it is zero when output is zero. The shape of TVC is the result of
operation of the law of diminishing returns. Upto point T (the point of inflection) the TVC
curve is concave downwards. It is so because the firm is using so little of the variable
inputs together with fixed inputs that the law of diminishing returns is not yet operative. It

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means that upto point T, TVC increases at a decreasing rate. After point T, TVC is concave
upwards showing that TVC increases at an increasing rate, i.e., at point T, the law of
diminishing returns begins to operate.
Figure 15.1(c) shows that at every level of output, TC equals TFC plus TVC. Thus TC
curve has the same shape as TVC but is everywhere above TVC at a height determined
by the level of TFC. Thus, by adding TFC and TVC we obtain TC of the firm.
15.4.2 Short run average fixed cost curve
The short run average cost curves that we examine are the average fixed cost, the average
variable cost, the average cost and the marginal cost curves.

As the output' of a firm increases, AFC will tend to decline continuously. This is obvious
from the very definition of fixed costs which arc costs that do not change with output.
Whether the firm produces nothing, ten or twenty units, the total fixed cost remains the
same. The following table shows the calculation of AFC.

As the output' of a firm increases, AFC will tend to decline continuously. This is obvious
from the very definition of fixed costs which arc costs that do not change with output.
Whether the firm produces nothing, ten or twenty units, the total fixed cost remains the
same. The following table shows the calculation of AFC.
Graphically AFC is shown by a failing curve in the figure 15.2. The AFC curve is negatively
sloped throughout because as output increases, it gels spread over greater number of
units. Mathematically, the AFC curve is a rectangular hyperbola showing the same level of
total fixed cost at all its points (Figure 15.2).

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 Figure 15.2: Average Fixed Cost curve
15.4.3 Short run average variable cost
The average variable cost is obtained by dividing the total variable cost (TVC) with the
corresponding level of output.

The average variable cost has usually a U-shape. Its U-shape can be explained in terms of
the law of variable proportions. Suppose for example that a factory is designed to employ
one hundred workers. The scale of plant is fixed and labour is the only variable resource.
The amount of output produced if only one man is employed will be extremely small, but
if additional man is employed, the two can split up the job to be performed and can
produce more than double the single man's output. This means that the average product of
labour increases with the employment of additional man. If doubling of labour (variable)
costs would more than double output, labour costs per unit of output (average variable
costs) will decrease." It is for this reason that initially with an increase in the average
product of the variable factor, average variable costs decrease. When enough units of a
variable factor are employed, average product decreases or average variable costs increase.

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In the figure 15.3, output has been taken along X-axis and AVC along Y-axis. We find that
the Average Variable Cost Curve (AVC) slopes downwards from left to right upto point
M and thereafter it rises upwards from left to right.

Figure 15.3: Average variable cost curve

15.4.4 Short run marginal cost curve
Marginal cost is defined as the change in total cost resulting from a unit change in output.
This can also be defined as the change in total variable cost resulting from a unit change in
output. Since fixed costs do not change with output, marginal cost depends, in no way,
upon fixed cost. In the words of Ferguson: “Marginal cost is the addition to total cost
attributable to the addition of one unit to output." It can be calculated by subtracting the
total cost of producing n -1 units from the total cost of producing n units. For example, the
marginal cost of the second unit produced is MC2 = TC2 - TC1. Similarly, the marginal
cost of third unit produced is MC3 = TC3 - TC2 and so on.
The formula for calculating marginal cost is as follows:
MCn = TCn - TCn-1 in which n stands for any number.
Therefore, it is clear that the marginal cost does not depend upon the fixed cost and it is
defined either; (a) the change in total cost resulting front a one unit change in output or (b)

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as the change in total variable cost resulting from a one unit change in output (Table 15.2
and figure 15.4 below).

It is thus clear from the above table that marginal cost decreases at first reaches a minimum
and then rises as output is increased.

Figure 15.4: Marginal Cost Curve

15.4.5 Relationship between AC and MC
In price theory, the relationship between AC and MC is of great importance. The whole
marginal analysis of product pricing depends upon it. Therefore, the relation between AC
and MC must be studied in detail. This relation is better explained with the help of a table
15.3 and a figure 15.5.

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 Table 15.3
Relation Between Average Cost and Marginal Cost

In the table given above, the following points of relationship between average cost and
marginal cost are immediately clear.
1. Both AC and MC are calculated from tolal cost of production. They are
derived from the same source.

Average cost shows the inclination of the total cost curve over the output axis. Marginal
cost is shown by the slope of the total cost curve at a particular level of output. Both
Average cost and Marginal cost can be obtained from the total cost curve.
2. When average cost is falling, the marginal cost is always lower than the
average cost. A common view is that whence falls, MC falls faster. However, this is not
the case throughout. MC reaches a minimum and may then start rising even when the
average cost is falling. The only thing to be guaranteed is that the MC lies below AC as
long as AC is failing.
3. When AC is rising, MC lies above AC and rises faster than AC- When AC
is rising, MC is not only greater than AC, but also rises faster than the AC.

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4. MC curve must cut the AC curve at AC's minimum point. This relationship
is derived from the fact that when AC is constant, MC is equal to AC. The diagram
(Fig.15.5) shows the relationship between the AC and MC in a very clear way.
In Fig 15.5, the curve AC is U-shaped mainly due to the operation of the law of variable
proportions in the short period. The related MC curve is shown as dotted. It is also U-
shaped. The MC curve intersects the AC curve at the later minimum point. The minimum
point of the AC curve is that from which the perpendicular to the X-axis is shortest. In Fig.
15.5 the output OM is produced at the lowest average cost.

Figure 15.5: Relationship between Average Cost and Marginal Cost

15.4.6 Relationship between Different Cost Concepts

In the short period we have a set of cost concepts which are interrelated with each other.
We need the following cost curves for analysis of a firm's output and pricing policies:
1. Average fixed cost
2. Average variable cost
3. Short run average cost
4. Short run marginal cost

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1. Average Fixed Cost Curve (AFC). Fixed cost is a fixed amount that does not
change with variations in output. This amount of cost will have to be borne even when the
firm is shut down. They are unavoidable contractual costs. As output increases, average
fixed cost (AFC = Cost per unit) goes on falling: Therefore, in figure 15.6 the average
fixed cost curve (AFC) approaches the X-axis as output increases. This curve traces a
rectangular hyperbola asymptotic to the output and cost axis. This means that the curve
approaches (but does not meet) the vertical and the horizontal axes at each end. To call
the AFC curve rectangular hyperbola is to say that the fixed cost is fixed as a total amount.
2. Average Variable Cost Curve (AVC): Dividing total variable costs with
corresponding output gives us average variable cost. In Fig. 15.6 the average variable
cost curve (AVC) declines at first, reaches a minimum and then rises. The average product
of variable factors increases with output, or what is the same thing, AVC falls. As output is
increased by employing more and more of variable factors, proportions continue to alter.
For some range of output, the average physical product of the variable factors may remain
constant and hence the AVC. But ultimately, as output is expanded still further, the average
physical product of the variable factors must diminish, that is to say, the AVC must start
rising. On account of the operation of the Law of Variable Proportions, the AVC curve is
U-shaped.
3. Short-run Average Cost Curve (SAC). The addition of fixed and variable
costs gives us total costs, which when divided by output, give us average cost in the short
run. Therefore, we can say that SAC curve in figure 15.6 is the sum of AFC and AVC for
each output. Since output increases, variable costs increase faster relatively to fixed costs,
the shape of SAC is governed by AVC. Being dependent on AVC mainly, the SAC curve
is also U-shaped.
4. Short-run Marginal Cost Curve (SMC). Marginal cost means the addition
made to total cost on account of the production of one more unit of output. The concept
of marginal cost curve helps us in finding out the equilibrium of a firm. In the short run the
marginal cost curve helps us in determining the supply of a product by a firm. In figure 15.6
SMC is the marginal cost curve. We must closely note down its relationship, to the average
(AVC and SAC) curves. The marginal cost curve falls faster than the average cost curve
and also rises faster than the average cost curve. The marginal cost curve always intersects

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the average cost curve from below at its minimum point. This is a purely geometric
relationship with no technological reasons behind it and of interest to us. We need to
remember only that the SMC curve intersects both AC and SAC at their minimum points.
There is a special relationship between SAC and AVC. As output is increased, fixed
costs, as they are defined, do not change; the change in total costs of the firm is brought
out only by variable costs. As one more unit of output is produced, fixed costs remain
constant; while variable costs, and by the same amount, the total costs, are increased.
Therefore, the total costs and variable costs may differ in absolute amounts but register the
same increment in them as output increases by a unit, or marginal cost is amnion to both.

Figure 15.6: Relationship between Short Run Costs Curves

15.5 LONG RUN COST CURVES
In the long-run no factor is fixed and everything including plant size is variable. The firm
can change its scale to suit its needs. In the short-run, a firm has no choice but to adjust its
production to the demand for its product by changing the proportions of variable factors
relative to the fixed factors. Firm has no choice but to adjust its production to the demand
for its product by changing the proportions of variable factors relative to the fixed factors.

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15.5.1 Plant Capacity and Change in Scale
In the long run the firm will like to change, its scale of production to suit its needs. This is
because it is always profitable for a firm to change the scale of the plant than to change the
proportions of inputs in order to adjust output to the demand for its product in the long
period. In the long run the firm will like to change, its scale of production to suit its needs.
This is because it is always profitable for a firm to change the scale of the plant than to
change the proportions of inputs in order to adjust output to the demand for its product in
the long period. This can be explained easily with the help of figure 15.7.

Figure 15.7: Relationship between short run average cost curvesand long run
average cost curve
In figure 15.7, SAC is the average cost curve of a plant of a comparatively small capacity.
SAC2 is the average cost of a plant with a higher capacity and SAC shows the average
cost of plant with a still bigger capacity (scale). The firm, in planning for its production in
the long run, will like to select one such plant with a scale that gives the required output at
the lowest average cost. In other words, we can say that in the long run a separate average
cost curve from the short-run average cost curve is relevant to the choice of a firm. Call it

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the long-run-average cost curve. In the long run too a firm has to plan to build a plant of a
capacity which gives the firm the required output at the least possible cost. In other words,
the firm has to make its choice among a set of SAC curves^ and it has to choose one of
them. If the firm plans to produce at a lower scale of the plant it will select a plant of a
smaller capacity and if the firm wants to produce a greater output, then it will select a plant
of higher capacity. The long-run ayerage cost curve, therefore, has at least one point in
common with each SAC curve. In other words, the LAC curve touches all the SAC
curves.
According to Leftwitch, “The long run average cost curve shows the least possible cost
per unit of producing various outputs when the firm has time to build any desired scale of
plant.”
Figure 15.7 shows a long period technology with constant returns to scale, that is in this
figure, an infinite divisibility of all inputs in the long run is assumed. Therefore, the minimum
points of all the short-run average cost curves lie in a straight line. Now, if the firm wants to
produce an output OM1 it will select a plant of the size shown by SAC and produce the
output with average cost ML1. Therefore, L1 lies on the long run average cost. Similarly
for producing the output OM2 the firm will make choice for the plant shown in SAC2 with
a point L2 that lies on the long-run average cost. Similarly L is also on the long-run average
cost curve. If we join the points L1, L2 and L3 we get LAC, i.e., the long run average cost
curve (or the planning curve as it is also called) which is a straight line.
15.5.2 Derivation of long run average cost curve under varying returns to scale
There are two conventional views about the behaviour of long-run average cost:
1. When the plant size is expanded, the full capacity average production cost (minimum
short-run average cost) does not either fall or rise. This is the case when there are constant
returns to scale. This is the case shown in Figure 15.7.
2. When the plant size is expanded, the full-capacity production cost falls at first,
falls to, a minimum and then starts rising as the scale of production is increased further.
This view assumes varying returns to scale. This is the case shown in Figure 15.8.
Figure 15.8 depicts the case of a firm which has varying returns to scale. Here the LAC
curve is different. It is U shaped. SAC1, SAC2 and SAC3 represent three successively

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increasing sizes of plant of the firm. Let us assume that SAC3 represents the size of a plant
where full-capacity operation produces output at the lowest possible average cost in the
long period. Therefore, point T is the minimum point of the SAC2 curve as well as that of
the long run average cost curve. As we see in figure 15.8, long-run average cost curve is
touching (tangential to) all the short-run cost curves. For example, the LAC curve is
tangential to SAC at point L1 and to SAC3 at point L3. Points L2, T and L3 he on the long-
run average cost curve. If we assume here continuities of scale, that is, if we assume here
an infinite number of choices of scale of the plant, the long-run average cost curve will be
continuous, being tangential to all the conceivable number of short-run average cost curves
representing gradually increasing scales of the plant. Thus, if we assume varying returns to
scale, as we often believe them to be in theory, and also assume perfectly divisible scale of
plant, the long run average cost curve is a U shaped, continuous curve. of course, the U
shape of the LA C is less pronounced than that of the short-run average cost curve.

Figure 15.8: Relationship between SAC curves and LAC curve Under varying
returns to scale

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15.5.3 Long run Marginal Cost Curve

Figure 15.9: Relationship between LAC curves and LMC curve:

SMC curves and LMC curve
1. Relationship between LAC and LMC. The long-run average cost curve has
also its marginal-cost curve which we call long-run marginal cost curve (LMC in figure
15.9). The long-run marginal cost curve can be derived easily from the long-run total cost
curve and LMC bears the same relationship to its average cost curve which the short-run
marginal cost curve bears to the short-run average cost curve. That is, it falls and rises
faster than the long- run average cost curve and cuts the latter at its minimum point.
2. LMC and SMC's. An interesting point that automatically comes to one's mind
is: if the LAC curve is tangential to all the SAC curves, what is the relationship between the
LMC and the SMC's? The answer is: no such easy, interesting relationship exists between
them. We can only say that when the firm has constructed proper scale of plant for producing
a given output, short run marginal cost will equal long-run marginal cost at that output.
15.6 SUMMARY
There are different concepts of costs used in Price Theory. These concepts must be clear
before we try to know the analysis of cost for equilibrium of the firm. The different concepts
of cost are:

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 Money Cost- These are the wages and salaries paid to labour, the expenditure on
machinery and equipment and the needed repairs, the payment for materials, power, light,
fuel and transportation; the disbursements of rents, trademarks, advertisement and insurance
and the taxes. According to J.L. Hanson, "The money costs of producing a certain output
of a commodity is the sum of all the payments to the factors of production engaged in the
production of that commodity". Thus, money cost is the cost which enters the records of
the accountants of a company.
 Opportunity Cost- Opportunity cost of a particular product is the value of the
forgone alternative product that resources used in its production could have produced". It
is instructive and analytically helpful to think of production costs as opportunity costs or
alternative costs. According to Ferguson, "The alternative or opportunity cost of producing
one unit of commodity X is the amount of commodity Y that must be sacrificed in order to
use resources to produce X rather than Y".
 Social Cost- Social cost is the total cost of production of a commodity which
includes the direct and the indirect costs which the society has to pay for the output of the
commodity. examples of social cost being more than private costs can be cited: the pollution
or wastes by mining and industrial waters, the impairment of health and property values by
the air pollution from the fumes and smoke of slaughter house and factories, the crowded
parking and other inconveniences caused by cinema houses and circuses, incomplete private
compensation for injuries at work or for occupational diseases; and soil erosion,
deforestation, and wasteful depletion of oil and coal reserves.
Of all cost concepts mentioned above we shall make use, in price theory, of only the
private and money costs of production. Other costs concepts include: Accounting costs
and economic costs, Outlay costs and opportunity costs, Direct or traceable costs and
indirect or non-traceable costs, Fixed and variable costs, Shut down and abandonment
costs.
Analysis of costs of a firm depends heavily on the theory of production. The behaviour of
cost shows behaviour of the product. If the product increases, costs decrease and vice
versa, may it be total, average or marginal costs.
The costs of production of a commodity are the payments made to the factors of production.

208
Given a certain amount of payment to these factors, the greater is the output, the lower is
the cost, and vice versa, since the nature of production is different in the short-run from
that in the long-run. In the short-run, some factors of production are fixed while others are
variable; in the long-run, all inputs are variable.
Also, Short run is a period of time in which certain inputs cannot be increased or decreased.
A firm's short run total costs are split up into two groups, viz., total fixed costs and total
variable costs. Total fixed cost (TFC) is the expenditure incurred on the purchase of fixed
inputs whereas total variable cost is the sum spent for the variable inputs. Thus, total costs
(TC) are equal to total fixed cost (TFC) and total variable (TVC).
The short run average cost curves are average fixed cost, average variable cost, average
cost and the marginal cost curves. The average variable cost is obtained by dividing the
total variable cost (TVC) with the corresponding level of output. The average variable
cost has usually a U-shape. Its U-shape can be explained in terms of the law of variable
proportions. Marginal cost is defined as the change in total cost resulting from a unit
change in output. This can also be defined as the change in total variable cost resulting
from a unit change in output. In the words of Ferguson: "Marginal cost is the addition to
total cost attributable to the addition of one unit to output." It is thus clear from the above
table that marginal cost decreases at first reaches a minimum and then rises as output is
increased.
In price theory, the relationship between AC and MC is of great importance. The whole
marginal analysis of product pricing depends upon it.
Whereas, in the long-run no factor is fixed and everything including plant size is variable.
The firm can change its scale to suit its needs. In the long run the firm will like to change, its
scale of production to suit its needs. This is because it is always profitable for a firm to
change the scale of the plant than to change the proportions of inputs in order to adjust
output to the demand for its product in the long period. This is because it is always profitable
for a firm to change the scale of the plant than to change the proportions of inputs in order
to adjust output to the demand for its product in the long period.
According to Leftwitch, “The long run average cost curve shows the least possible cost
per unit of producing various outputs when the firm has time to build any desired scale of
plant.”
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15.7 SELF ASSESSMENT QUESTIONS
1. What is the relationship between average cost and marginal cost? If the marginal
cost is rising, does it mean that average cost must also be rising?
___________________________________________________________
___________________________________________________________
___________________________________________________________
2. What is the difference between explicit costs and implicit costs? Should both be
considered for optimal decision making by the firm?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. Explain the concepts of total fixed cost, total variable costs and total cost. How
are they related to each other? Illustrate them through curves. Is the distinction
between the fixed costs and variable costs relevant in the long run?
___________________________________________________________
___________________________________________________________
___________________________________________________________
15.8 SUGGESTED READING
 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

210
B.Com. Semester-I Unit-IV
C. No. BCG-103 LESSON No. 16

DIFFERENT MARKET STRUCTURES

AND THEIR CHARACTERISTICS
STRUCTURE
16.1 INTRODUCTION
16.2 OBJECTIVES
16.3 PERFECT COMPETITION
16.4 PURE MONOPOLY
16.5 IMPERFECT COMPETITION
16.6 SUMMARY
16.7 SELF ASSESSMENT QUESTIONS
16.8 SUGGESTED READING

16.1 INTRODUCTION
The shape and nature of revenue functions (sales curves) is different under different market
conditions. In practice there exist innumerable varieties of marketing conditions facing
different firms for sale of their products. A market structure, or as is commonly said, a
'market' means the whole set of conditions under which a commodity is marketed: the
extent and nature of competition in selling, the number and nature of buyers; the nature of
the commodity that different sellers offer etc. taking these elements of market into
consideration, there can be as many models as the number of combinations of sellers and

211
nature of the product.
Three broad sets of market conditions are commonly recognised as; perfect competition,
monopoly and imperfect competition. This broad classification of markets is based mainly
on the number of sellers of the product in the market.
16.2 OBJECTIVES
After reading this chapter you will be able:
 To explain three types of market structure.
 To differentiate between all the three markets conditions.
16.3 PERFECT COMPETITION
The model of a market that was a pet of the classical and the neoclassical was
perfect competition. Such a market is an imaginary ideal one. A perfectly competitive
market incorporates in it certain ideal conditions all of which may not be found in any
product's market in practice.
A large number of small unrecognised sellers: The number of sellers is deemed to
be large and the amount of sales done by each so small in relation to the market that none
of the sellers, taken by himself, is able to influence the price by his own individual action of
expanding or with holding his produce. There is to be no agreement or collusion among
the sellers.
A large number of small unrecognised buyers: Again here the number of buyers is
thought to be large enough to prevent any one buyer form affecting the price in the market
by his own action of purchasing more or less, and the purchases made by any one of the
buyers are small as compared with the purchases of all the buyers in the market. Further,
buyers are also thought to be completely unrecognised.
A homogenous product: All the sellers in the market have a perfectly similar product
to offer; the product offered by each of the producers is in every way the same from the
viewpoint of the buyers: the sellers’ products are similar in colour, shape, design and
service so that no one of the buyers has reason to be attached to any one of the sellers;
there is no effect of any kind whatever to prejudice buyer’ minds in favour of their product.

212
 Free entry and Exit: Any firm from outside the industry must be able to enter the
industry without artificial hindrances being erected against it, and any firm working in the
industry must be free to go out of it as and when the firm likes.
The four conditions given above have been introduced in the market to ensure that an
individual seller is a price taker; a seller can neither raise his price above that of the market
nor can afford to lower it. If a seller raises his price above that prevailing in the market, he
losses all of his customers, for they go over to the other sellers selling at the market price.
On the other hand, he has no incentive to lower his price since he can sell the whole of his
production at the going price.
The outstanding feature of pure competition is reflected in the fact that the individual firm
has no price policy. To the individual firm the sales schedule looks like a horizontal line
parallel to its x-axis (output); the firm has perfectly elastic demand curve of its product.
The sales curve of the firm under pre-competition is shown in figure 16.1 as under.

Figure 16.1: AR and MR under perfect competition.

Average revenue is equal to marginal revenue at all outputs can be proved with the help of
following formula, where elasticity of demand (e) for the product of the firm is infinite .

213
 = AR

Sometimes, economists especially British, have used perfect competition for their analysis.
This type of market is assumed to have all the conceivable perfections. The four conditions
of pure competition given above is refer to only on perfection i.e. complete absence of
monopoly power in framing the price. Perfect completion implies pure competition and
has other perfections. It assumes perfect mobility of resources, of labour and capital in any
economic adjustment: there is no cost of mobilisation (transport) nor restraining habits,
preferences and inertia. It also pre-supposes perfect knowledge on the part of buyers and
sellers. The assumption of perfect knowledge on the part of buyers and sellers means, in
the words of Prof. Frank H. Knight, “they are performed, and to perform them in the light
of the consequences”. Even the conditions of pure competition are hard to find in the real
world. As has already been stated, perfect completion is an ideal that is assumed. This is
done to simplify analysis.
16.4 PURE MONOPOLY
Monopoly is the opposite of perfect competition. In such a market, there is only one seller
of the product, the sole controller of supply of the product in the market. The seller produces
a commodity for which it is difficult to find a substitute. The firm constitutes the industry.
The demand for output of this one firm is at once demand for the total industry; while
under pure competition, the product of one seller is thought to be a perfect substitute for
the product of another seller, the product of the monopoly firm is thought to have no close
substitute at all. Since cross elasticity of demand between the monopolised good and its
nearest substitute may be considered by buyers as highly unsatisfactory, the monopolist
has a wide latitude of choice in his price policy. He is, to a large extent, a price-maker
because he is not obliged to mind the policies and reactions of any rival.
A pure monopolist is one who can charge any price he likes by restricting his output.
Whatever the price he decides to charge, total expenditure on his product done by

214
purchasers remains the same. In other words, the elasticity of demand for the product of
the firm is unitary. The sales curve (figure 16.2) of his firm traces a rectangular hyperbola
in this case, for all outputs marginal revenue curve is the X axis itself. The formula for this
is:

MR= AR = AR

Figure 16.2: AR and MR under pure monopoly

16.5 IMPERFECT COMPETITION
Pure competition and pure monopoly are two extreme organisations of the market, the
first involving a large number of sellers and the second only one seller. But generally,
markets for products are neither purely competitive nor pure monopolies. In fact, there
are many intermediate sets of market organisations. All these sets of market structures are
labeled 'imperfect competition'. Imperfect competition consists of many market categories
ranging from two sellers to a large number of buyers and sellers. In it many sub-categories
of market situation have been identified and analysed.
16.5.1 MONOPOLISTIC COMPETITION
Monopolistic competition is the nearest to pure competition. It involves many sellers and
buyers- both of these small and unorganised. But the fundamental departure from pure
competition is that the product is differentiated. There is a difference, but not very material,
between the product of one and of another. The products are close, although not exact
substitutes; there is a high cross- elasticity of demand between the products. Differences
215
in a given family of similar products are numerous. There may be differences in quality,
style, colour, size, packing, container, trade names, brand, type of service, location of the
store, credit terms and many other considerations that may give rise to a spirit of attachment
of buyers to particular sellers. All the firms producing the closely related competing goods
compose one industry.
Under this category of market organisation, the seller has a position that can be called
monopolistic. He is a competitor in so far as he has rivals having products very much
similar to and substitutable for his own. While fixing his own price he has take into
consideration the reactions of his rivals. But he is, to some extent, a monopolist also, in so
far as some buyers have a preference for his variety of the good as against other varieties.
The seller has some discretion in setting the price of his product.
Thus, in so far as monopolistic competition involves a large number of sellers and quite
close substitutes, the outcome of the conduct of firms in the market is a price level which
the individual firm is facing, almost as in pure competition. But to the extent the differing
varieties are not perfect substitutes, individual firms constitute pockets of monopoly control,
with prices varying from one another. The difference in prices between any two firms
depends upon the proximity of their products. The average revenue curve faced by any
individual firm is quite, though not perfectly elastic; it is gently sloping. So is marginal
revenue curve. The curves AR and MR are shown in Figure 16.3 (below).

Figure 16.3 : AR and MR under Monopolistic Competition

216
16.5.2 OLIGOPOLY
Oligopoly is that market situation in which the market for a commodity is dominated by a
few firms each of which is producing and selling considerable proportion of the total output
sold in the market. When the firms are only two, the market structure is called duopoly. It
is just a special case of oligopoly. Each firm is so large relative to the size of the market
price. Changes by it in the output sold or price charged do not go unnoticed by its rivals.
Therefore, in shaping its price policy each firm must take into consideration the reactions
of the few owner producers and also his possible reactions to their reactions. No one
producer can initiate a move without provoking retaliation. There is, as a result, a unique
inter-relationship among the few sellers with respect to their price or output policies. This
inter-relationship is the outstanding characteristic of the oligopolistic market structure.
Oligopoly may be pure or differentiated according to whether sellers use labels, trademarks
etc. or not. A suggested form of sales curve of the firm in oligopoly is a 'kinked demand
curve, shown in figure 16.4. This sales curve is kinked. The average revenue curve has a
kink at the point P where the demand curve for the product of the firm suddenly becomes
quite inelastic if it lowers its price and goes elastic if it raises the price.

Figure 16.4: AR and MR when average revenue curve has a kinkunder O.

Oligopoly

217
16.6 SUMMARY
The shape and nature of revenue functions (sales curves) is different under different market
conditions. Three broad sets of market conditions are commonly recognised as; perfect
competition, monopoly and imperfect competition.
The model of a market that was a pet of the classical and the neoclassical was perfect
competition. Such a market is an imaginary ideal one. A perfectly competitive market
incorporates in it certain ideal conditions such as: large number of small unrecognised
sellers, large number of small unrecognised buyers, homogenous product, and free entry
and Exit of firms. The outstanding feature of pure competition is reflected in the fact that
the individual firm has no price policy.
Monopoly is the opposite of perfect competition. In such a market, there is only one seller
of the product, the sole controller of supply of the product in the market. The seller produces
a commodity for which it is difficult to find a substitute. A pure monopolist is one who can
charge any price he likes by restricting his output. Whatever the price he decides to charge,
total expenditure on his product done by purchasers remains the same.
Pure competition and pure monopoly are two extreme organisations of the market, the
first involving a large number of sellers and the second only one seller. But generally,
markets for products are neither purely competitive nor pure monopolies. Imperfect
competition consists of many market categories ranging from two sellers to a large number
of buyers and sellers. In it many sub-categories of market situation have been identified
and analysed. These sub- categories are:
Monopolistic Competition- Monopolistic competition is the nearest to pure
competition. It involves many sellers and buyers- both of these small and unorganised. But
the fundamental departure from pure competition is that the product is differentiated. There
is a difference, but not very material, between the product of one and of another.
Oligopoly- Oligopoly is that market situation in which the market for a commodity
is dominated by a few firms each of which is producing and selling considerable proportion
of the total output sold in the market. When the firms are only two, the market structure is
called duopoly. It is just a special case of oligopoly. Oligopoly may be pure or differentiated
according to whether sellers use labels, trademarks etc. or not. A suggested form of sales
curve of the firm in oligopoly is a 'kinked demand curve'.
218
16.7 SELF ASSESSMENT QUESTIONS
1. Define market. Explain briefly four basis on which different markets are defined?
___________________________________________________________

___________________________________________________________
___________________________________________________________
2. What are the characteristics of a perfectly competitive market? What is the relevance
of the characteristic that there are "large number of sellers" in this context?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. Distinguish between perfect competition and pure competition?
___________________________________________________________
___________________________________________________________
___________________________________________________________
16.8 SUGGESTED READINGS
 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Managerial Economics, Mehta, P.L., S. Chand, Delhi.
 Micro Economics, Mithani, D.M., Himalaya Publishing House, New Delhi.

219
B.Com. Semester-I Unit-IV
C. No. BCG-103 LESSON No. 17

PRICE-OUTPUT DECISIONS UNDER

PERFECT COMPETITION
STRUCTURE
17.1 INTRODUCTION
17.2 OBJECTIVE
17.3 PERFECT COMPETITION
17.3.1 Meaning
17.3.2 Conditions
17.3.3 Difference between Pure and Perfect competition
17.4 PRICE DETERMINATION UNDER PERFECT COMPETITION
17.4.1 Time element in the determination of price
17.5 DETERMINATION OF SHORT PERIOD PRICE
17.6 DETERMINATION OF LONG PERIOD PRICE
17.7 SUMMARY
17.8 SELF ASSESSMENT QUESTIONS
17.9 SUGGESTED READING
17.1 INTRODUCTION
Generally by the term 'market' we mean a place where goods are sold and bought. But in
economics, by market we mean a commodity whose buyers and sellers are in direct

220
competition with one another. Prof. J.C. Edwards said, "A market is that mechanism by
which buyers and sellers are bought together. It is not necessarily a fixed place." Market is
classified on the basis of competition among the buyers and sellers. Perfect competition is
a very important form of market. It is of great theoretical importance.
17.2 OBJECTIVES
The objectives of this chapter are:
 To define perfect and pure competition.
 To describe the conditions necessary for perfect competition.
 To determine price and output under perfect competition.
17.3 PERFECT COMPETITION
Perfect Competition is a form of market in which there is a large number of buyers and
sellers. They sell homogeneous goods. Firm produces only a small portion of the total
output produced by the whole industry. An industry is a group of different firms producing
the same product. A single firm cannot affect the price by its individual efforts. Price is
fixed by the industry. Firm is only a price taker and not a price-maker. It can sell the
desired output only at the price-fixed by the industry. In such a market, price of the
commodity is the same at every place. There is also free entry and exit of the firms. Both
the buyers and sellers have perfect information about the prevailing price in the market.
Thus perfect competition is the name given to a market in which buyers and sellers compete
with one 'another in the purchase and sale of a commodity'. No one of them has any
individual influence over the price of the commodity.
17.3.1 Meaning of Perfect Competition
Mrs. Joan Robinson defined perfect competition like this: "Perfect competition prevails
when the demand for the output of each producer is perfectly elastic. This entails, first that
the number of sellers is large so that the output of any one seller is a negligible small
proportion of the total output of the commodity and second, that buyers are alike in respect
of their choice in respect of rival sellers, so that the market is perfect". According to Bilas,
"The perfect competition is characterised by the presence of many firms: they all sell
identically same product. The seller is a price taker". Ferguson said, "Perfect competition

221
describes a market in which there is a complete absence of direct competition among
economic groups".
17.3.2 Necessary Conditions of perfect competition
Different definitions given by different economists point out the distinct features of perfect
competition. There are some necessary conditions which must be satisfied if the market is
to be perfectly competitive. These conditions are:
1. Large number of small, unorganised firms- The first condition which a perfectly
competitive market must satisfy is concerned with the seller's side of the market.
The market must have such a large number of sellers that no one seller is able to
dominate the market. No single firm can influence the price of the commodity.
The sellers will be the firms producing the product for sale in the market. These
firms must be all relatively small as compared to the market as a whole. Their
individual outputs should be just a fraction of the total output in the market. That
is why none of them is capable of influencing the market price by its individual
efforts. Further, firms must not have any kind of association or union to arrive at
an understanding with regard to price or sales.
2. A large number of small, unorganised buyers- On the buyers' side the perfectly
competitive market must also satisfy this condition. There must be such a large
number of buyers that no one buyer is able to influence the market price in any
way. Each buyer should purchase just a fraction of the market supplies. Further,
the buyers should not have any kind of union or organisation so that they compete
for the market demand on an individual basis.
3. Homogeneous products- Another pre-requisite of perfect competition is that all
the firms or sellers must sell completely identical or homogeneous goods. Their
products must be considered to be identical by all the buyers in the market. There
should not be any differentiation of products by sellers by way of quality, variety,
colour, design, packing or other selling conditions of the product.
4. Free entry and free exit for firms- Under perfect competition, there is absolutely
no restriction on entry of new firms in the industry or the exit of the firms from the
industry which want to leave it. This condition must be satisfied especially for long
period equilibrium of the industry.
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 If these four conditions are satisfied, the market is said to be purely competitive.
In other words, a market characterised by the presence of these four features is
called purely competitive. For a market to be perfect, some conditions of perfection
of the market must also be fulfilled. These may be added to the four conditions
given above.
5. Perfect knowledge among buyers and sellers about market conditions-
Another pre-requisite of perfect competition is that both buyers and sellers must
be having perfect knowledge about the conditions in which they are operating.
Sellers must know the prices being quoted or charged by other sellers in the
market from the buyers. Similarly buyers, must know the prices being charged by
different sellers. This condition is very necessary for a perfectly competitive market.
Single price or same price of a single product can prevail only if the buyers are
having perfect knowledge about the market price because if any seller tries to
charge a price higher than the prevailing price, buyers will reject his product. They
will purchase the product from some other seller. Thus perfect knowledge leads
to the prevalence of the same price of the commodity.
6. Perfect mobility- Another feature of perfect competition is that goods and services
as well as resources are perfectly mobile between firms. Factors of production
can freely move from one occupation to another and from one place to another.
There is no barrier on their movement. No one has monopoly or control over the
factors of production. Goods can be sold at a place where their prices are the
highest. There should not be any kind of limitation on the mobility of resources.
7. Absence of transport cost- Another feature of perfect competition is that all the
firms have equal access to the market. Price of the product is not affected by the
cost of transportation of goods. In other words, we can say that the market price
charged by different sellers does not differ due to location of different sellers in the
market. No seller is near or distant to any group of buyers. Thus, there is complete
absence of transport cost of the product from one part of the market to the other.
8. Absence of selling cost- Under conditions of perfect competition, there is no
need of selling costs. Selling costs are the expenditures done to stimulate the sale
of product or to change the shape of the demand curve. We know that under

223
 perfect competition, goods are completely homogeneous. Price of the product is
also the same for a single product. Firms have no control over the price of the
product. When they cannot change the price and when their goods are completely
similar, firms need not make any expenditure on publicity and advertisement.
Therefore, on the basis of above arguments, we can conclude that a perfectly competitive
market is a model market in which there is only one price of the product for all the buyers
and sellers. Nobody can influence the market price by his individual efforts.
17.3.3 Difference between Pure and Perfect competition
Economists often distinguish between pure and perfect competition. There is only a
difference of degree. If a market situation satisfies the four conditions of largeness of
sellers and buyers, homogeneous goods and free entry and exit of firms, it is called pure
competition. The concept of pure competition was mainly developed by Prof. Chamberlin.
According to him, the following four conditions are necessary for a purely competitive
market to exist: (1) large number of sellers and buyers, (2) identical products, (3) free
entry and exit of firms, (4) absence of selling costs. Prof. Baumol writes, "An industry is
said to be operating under conditions of pure competition when there are many firms,
homogeneity of products, freedom of entry and exit and independent decision making".
Perfect competition includes some conditions of perfection in addition to the four conditions
of purity. The perfection conditions are:
 Perfect knowledge among buyers and sellers about the market conditions,
 Perfect mobility among factors of production. It should be noted that pure
competition is a more practical concept than perfect competition.
17.4 PRICE DETERMINATION UNDER PERFECT COMPETITION
We know that there is a large number of firms under perfect competition. Firm is only a
price-taker and not a price-maker. Price is determined by the industry. Industry is a group
of firms producing identical goods. The equilibrium price is determined at a point where
the demand for and supply of the total industry are equal to each other. The process of
price determination is shown through a table given below:

224
 Table 17.1
Price Determination under Perfect Competition

The table given above shows how the price of a commodity is determined by the forces
of demand and supply. When price of the commodity is Rs. 10, its supply is 20 units but
demand is 100 units. Demand is more than the supply at this price. It will raise the price to
Rs. 20. Still demand is more than its supply. It will further raise the price of the good.
When price is increased to Rs. 30, demand for output is 60 units. Supply is also 60 units.
In this way, Rs. 30 is a price which equates the demand for and supply of output. This is
known as the equilibrium price. If price is increased further, say to Rs. 40, it extends the
supply of goods to 80 units but demand is only 40. Greater supply than its demand will
reduce the price to Rs. 30. Thus we conclude that under perfect competition, price is
determined by the interaction of the forces of demand for demand and supply of goods.
The same idea can be explained with the help of the figure 13.1.

Figure 17.1 Price Determination in a Perfectly Competitive Market

225
In Fig. 17.1, Quantity demanded and supplied are taken on X-axis. Price of the commodity
is shown on Y-axis. DD and SS are the demand and supply curves respectively. E is the
point where demand curve and supply curve intersect each other. In other words, E is the
point of equilibrium. By drawing a perpendicular from the point of intersection to X-axis
we get the equilibrium quantity demanded and supplied i.e. OM. Perpendicular drawn on
Y-axis from point E shows the equilibrium price OP
17.4.1 Time Element in the Determination of Price
Marshall propounded the theory that price of a commodity is determined by both demand
and supply. Marshall gave much importance to the time element in the determination of
price. Before Marshall, there was much controversy over whether it is demand or supply
that is more important in determining price. Marshall resolved this controversy with the
introduction of time element in the theory of value. In his view, which of the two is more
important depends upon the time period under consideration. But he pointed out that in no
case is value determined by any one of them alone. He also quoted the analogy of two
blades of a pair of scissors in this connection.
The relative importance of supply or demand in the determination of price depends upon
the time given to supply to adjust itself to demand. Marshall said, "As a general rule, the
shorter the period which one considers, the greater must be the share of our attention
which is given to the influence of demand on value; and the longer the period, the more
important will be the influence of cost of production on value". Thus time has a big hand in
determining the level of equilibrium price. Demand takes no time to increase. But supply
can be increased only after some time. The time taken by the supply to adjust itself to
demand depends upon production technology.
Marshall discussed three time periods in which price would be different. These time periods
are divided on the basis of response of supply to a given change in demand. They are as
under:
1. Market Period
Market period is also called very short period. It is a period in which only that can be
supplied which has been already produced. Supply is fixed. No adjustment can take place
in supply conditions. Market period is a time period which is too short to make an addition

226
to the existing stock of goods. In this period, goods cannot be produced more in response
to an increased demand. In this period goods are of two types: (1) Perishable goods, (2)
Non-perishable goods. The supply of perishable goods is perfectly inelastic. It means that
whatever has been produced is to be sold, whatever the price maybe. The reason is that
perishable goods perish if not sold. Second form of goods is non-perishable. These are
the goods which can be stored for some time. That is why even in the market period, a
seller can reduce the stock of goods already produced by storing them. The whole thing
depends upon the cost of storing goods and future expectations regarding the price. Bat a
seller cannot increase the supply of goods in this period. From this discussion, we come to
know that the supply curve of perishable goods is perfectly inelastic. The supply curve of
non-perishable goods has a positive slope at first but becomes perfectly inelastic after
some price level.
2. Short Period
Short period is the time span in which supply can be adjusted to a limited extent. If the
demand for a good increases, its supply can be increased through overworking of plants.
In this period, there are two types of factors of production, variable factors and the others
are fixed factors of production. In this time period, production can be increased or decreased
by changing the variable factors of production only. Fixed factors like machinery, plant,
and factory etc. cannot be altered. So supply can be changed only by the existing plants.
In this time period also, demand is more important than the supply. However, it does not
mean that supply plays no role. Supply is an important factor too.
3. Long Period- Long period is the time which is long enough to make a complete
adjustment of supply to a change in demand. It is the time period in which new plants can
be installed and new firms can enter the market. Similarly, existing firms can leave the
market. In the long run, all the factors of production can be changed. So there is no fixed
factor of production in the long run. Thus, in the long run, supply becomes all the more
elastic. Marshall attached much importance to the study of these time periods. Response
of supply to a change in demand over a period of time is different in the different time
periods. We can conclude that time element occupies an important place in Marshall's
theory of value. It is certainly a significant contribution of Marshall to the theory of value.

227
17.5 DETERMINATION OF SHORT PERIOD PRICE
Short period is a time period which is in between the market period and long period. It is
the period which is not enough to adjust to the changed demand through changes in the
supply of the commodity. In the short period, there are two types of factors of production:
(1) Fixed factors, (2) Variable factors. Fixed factors are those factors the quantity and
number of which cannot be changed due to the short span of time. Fixed factors are
machinery, building etc. The variable factors are changeable factors of production. These
factors can be altered in quantity to make changes in the supply of goods. In the short
period, supply of goods can be changed only by varying the quantity of variable factors.
That is why full adjustment between the changed demand and supply cannot take place. In
this time period, supply can be changed by changing the output possible with the existing
plant. New plants cannot be installed due to the short span of time.
In perfect competition, short-period price is determined by the short-period demand and
short-period supply of the commodity produced by the industry. Demand for the commodity
is the summation of demand schedules of all the consumers. It slopes downward from left
to right. The supply curve of an industry is the summation of the outputs produced by all
the firms of the industry. It has an upward slope. Price is determined by the interaction of
the forces of demand and supply of the industry. This equilibrium price is given to all the
firms in the industry. They can sell as much as desired on this given price. A firm is in
equilibrium where its marginal cost curve cuts marginal revenue curve from below. Average
revenue and marginal revenue are constant. They are a horizontal line. A firm can earn
supernormal profits, normal profits, and losses depending upon its cost conditions. This
idea can be explained with the help of the Figure 17.2.

Figure 17.2: Short Period Price determination under Perfect Competition

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The figure 17.2 given above shows the process of price determination in the short period.
The right hand side of the diagram shows the equilibrium of the industry while the left hand
side of the figure shows the case of a representative firm. We know that an industry is a
group of firms producing identical goods. Here the assumption of identical cost conditions
of all the firms is taken. Supply curve SRS for the industry shows levels of production
which are the result of the summation of all the firms' outputs in the industry. SRS is the
short run supply curve of the industry. DD is the initial demand curve. E is the point of
intersection between SRS and DD. OP is the equilibrium price. OM is the demand and
supply of the industry at OP price level. This price OP will be given to all the firms. The left
hand side panel of the figure shows the equilibrium of the firm at this OP price. E is the
point where short run marginal cost curve (SMC), average and marginal revenue -curves
(AR = MR) intersect each other. At OP price, the firm is earning normal profits since its
SAC is equal to its average revenue.
Now suppose that the demand curve shifts upward to take the position D1D1 .The new
point of equilibrium is E1 where OP1 price is determined. Demand and supply of the
commodity are also raised to OM1. At the OP1 price level, firm's equilibrium point is E1
which has been determined by the intersection between SMC and MR. At this price level,
the firm is earning supernormal profits equal to E1LSP1.
Next we suppose that the demand for the industry falls to D2D2.The point of intersection
of the demand and the supply curves is E2. This point of equilibrium gives OP2 as equilibrium
price. At this price, the firm is undergoing losses equal to the area E2 RTP2.
17.6 DETERMINATION OF LONG PERIOD PRICE
Long period is a time period which is long enough to adjust industry supply fully to the
changes in demand. In this time period employment of all the factors of production can be
changed. New machines can be installed. We mean to say that all necessary changes can
be made in the supply of the commodity in the long period. If the existing firms are earning
supernormal profits, new firms will be attracted to enter the industry. It will increase the
industry supply and thus price will fall. In this way, extra profits will be wiped out. Similarly,
if the firms earn losses; some firms will quit the market. It will reduce the supply of output
and price will increase. In this way, due to the free entry and exit of the firms in the long

229
run, all firms earn normal profits. Normal profits refer to the minimum profits which a
producer must earn in order to stay in production. So normal profits are added to and thus
part of the average cost of production. That is why, when price is equal lo average cost of
production, a firm is said to be earning normal profits. The price determined by the long
period forces of demand and supply in a perfectly competitive industry is called normal
price.
Normal price of a commodity is that price which has a tendency to prevail in the market
in the long period when supply can be fully adjusted according to demand. According to
Marshall, “Normal or natural value of a commodity is that which economic forces would
tend to bring about in the long run”.
Normal price is not necessarily the same as the average cost of production. Normal price
is the price which has the tendency to prevail in the market in the long period. On the
contrary, cost is the actual average of the costs of production of goods. Thus, we can say
that normal price is an expected price.
In the long period, since all factors are variable; there is no fixed cost of production.
Average cost of production plays an important role in determining the long period price.
An outstanding proposition in this regard is that the price under perfect competition in the
long run is equal to the minimum long run average cost of production. At the level of
equilibrium price, marginal cost and minimum long run average cost are equal lo each
other. Therefore, Normal price = LMC = Minimum Long Period Average Cost. This
proposition can be explained with the help of a figure. The determination of normal price
is explained with the help of Fig. 17.3

Fig. 17.3
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17.7 SUMMARY
Perfect Competition is a form of market in which there is a large number of buyers and
sellers. They sell homogeneous goods. Firm produces only a small portion of the total
output produced by the whole industry. Firm is only a price taker and not a price-maker.
Mrs. Joan Robinson defined perfect competition like this: "Perfect competition prevails
when the demand for the output of each producer is perfectly elastic. This entails, first that
the number of sellers is large so that the output of any one seller is a negligible small
proportion of the total output of the commodity and second, that buyers are alike in respect
of their choice in respect of rival sellers, so that the market is perfect".
Different definitions given by different economists point out the distinct features of perfect
competition. These conditions are: Large number of small, unorganised firms, A large
number of small, unorganised buyers, Homogeneous products, Free entry and free exit
for firms, Perfect knowledge among buyers and sellers about market conditions, Perfect
mobility, Absence of transport cost, Absence of selling cost.
Economists often distinguish between pure and perfect competition. If a market situation
satisfies the four conditions of largeness of sellers and buyers, homogeneous goods and
free entry and exit of firms, it is called pure competition. Perfect competition includes
some conditions of perfection in addition to the four conditions of purity. Perfect knowledge
among buyers and sellers about the market conditions, Perfect mobility among factors of
production. It should be noted that pure competition is a more practical concept than
perfect competition.
There are large number of firms under perfect competition. Firm is only a price-taker and
not a price-maker. Price is determined by the industry. Industry is a group of firms producing
identical goods. The equilibrium price is determined at a point where the demand for and
supply of the total industry are equal to each other. Marshall propounded the theory that
price of a commodity is determined by both demand and supply. Marshall gave much
importance to the time element in the determination of price. Before Marshall, there was
much controversy over whether it is demand or supply that is more important in determining
price. Marshall resolved this controversy with the introduction of time element in the theory
of value. Marshall discussed three time periods in which price would be different. These
time periods are; Market Period, Short Period, Long Period.

231
In perfect competition, short-period price is determined by the short-period demand and
short-period supply of the commodity produced by the industry. Demand for the commodity
is the summation of demand schedules of all the consumers. It slopes downward from left
to right. The supply curve of an industry is the summation of the outputs produced by all
the firms of the industry. It has an upward slope. Price is determined by the interaction of
the forces of demand and supply of the industry. This equilibrium price is given to all the
firms in the industry.
Long period is a time period which is long enough to adjust industry supply fully to the
changes in demand. In this time period employment of all the factors of production can be
changed. New machines can be installed. If the existing firms are earning supernormal
profits, new firms will be attracted to enter the industry. It will increase the industry supply
and thus price will fall. In this way, due to the free entry and exit of the firms in the long run,
all firms earn normal profits. In the long period, since all factors are variable; there is no
fixed cost of production. Average cost of production plays an important role in determining
the long period price. An outstanding proposition in this regard is that the price under
perfect competition in the long run is equal to the minimum long run average cost of
production.
17.8 SELF ASSESSMENT QUESTIONS
1. Does price never change under perfect competition, given the fact that a firm
under perfect competition is a price taker?
2. Why is the demand curve facing a firm under perfect competition is Perfectly
elastic?
3. What is equilibrium price? How it is determined?
17.9 SUGGESTED READINGS
 Advanced Economic Theory. Micro Economic Analysis, 2012, Ahuja, H.L., S.
Chand and Company Ltd, New Delhi.
 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,
New Delhi.

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B.Com. Semester-I Unit-IV
C. No. BCG-103 LESSON No. 18

PRICE-OUTPUT DETERMINATION
UNDER MONOPOLISTIC COMPETITION
STRUCTURE
18.1 INTRODUCTION
18.2 OBJECTIVE
18.3 MONOPOLISTIC COMPETITION
18.3.1 Definition
18.3.2 Features
18.4 NATURE OF DEMAND SCHEDULE
18.4.1 Problems of Equilibrium of the Firm and Group
18.5 DETERMINATION OF PRICE AND OUTPUT
18.5.1 In the Short Period
18.6 LONG PERIOD PRICE OUTPUT DETERMINATION
18.6.1 Assumptions
18.6.2 Subjective and Objective Demand Curves
18.6.3 Long Run Equilibrium of the Group
18.7 SUMMARY
18.8 SELF ASSESSMENT QUESTIONS

233
18.9 SUGGESTED READINGS

18.1 INTRODUCTION
Monopolistic competition is a market structure quite similar to perfect competition in that
vigorous price competition among a large number of firms and individuals is present. The
major difference between these two market structures is that at least some degree of
product differentiation is present in monopolistically competitive markets. As a result, firms
have at least some discretion in setting prices. However, the presence of many close
substitutes limits the price-setting ability of individual firms, and drives profits down to a
normal rate of return in the long-run. As in the case of perfect competition, above-normal
profits are only possible in the short-run before rivals are able to take effective counter
measures. Examples of monopolistically competitive market structures include a broad
range of industries producing clothing, consumer financial services, professional services,
restaurants, and so on.
18.2 OBJECTIVES
The objectives of this chapter are:
 To define and characterised monopolistic competition.
 To explain the concept of equilibrium of firm and group.
 To determine short and long rum price and output.
18.3 MONOPOLISTIC COMPETITION
One of the sub-divisions of imperfect competition is monopolistic competition. It is that
sub-category of the many possible market situations under imperfect competition which is
the nearest to pure competition. It has a large number of small unorganised sellers in the
market and a large number of small unorganised buyers, but what differentiates it from
pure competition is product differentiation by sellers. The products of different sellers is
close but not complete substitutes. “Products are not homogeneous, as in perfect
competition, but neither are they remote substitutes, as in monopoly. What this really
means is that in monopolistic competition there are various 'monopolists' competing with

234
each other. These competing monopolists do not produce identical goods. Neither do
they produce goods which are completely different. Product differentiation means that
products are different in some ways but not altogether so.”
18.3.1 Definition
According to Joe S. Bain, “Monopolistic competition is found in the industry where there
is a large number of small sellers, selling differentiated but close substitute products”.
H.H. Liebhafsky writes, “Monopolistic Competition has today come to mean a state of
affairs in which there is a large number of sellers selling non-homogeneous or slightly
differentiated products and in which freedom of entry exists.”
Leftwitch describes monopolistic competition like this, “Monopolistic competition is a
market situation in which there are many sellers of a particular product, but the product of
each seller is in some way differentiated in the minds of consumers from the product of
every other seller.”
18.3.2 Features
The products of different sellers have a very high, though not infinite, cross elasticity of
demand. It is this feature of product differentiation that introduces an impurity in the otherwise
pure competition. The main features of monopolistic competition are:
(1) A Large number of Sellers- The number of sellers is sufficiently large that there is
no feeling of mutual interdependence among them. Each firm acts independently
without caring for any effect which its action may have upon those of its competitors.
(2) Differentiated Products- There is large number of buyers who are offered
differentiated products and consequently have preference for the products of
particular sellers. Different sellers may use different methods for creating preference
for their own products in the minds of buyers. Differentiation of a particular product
may be linked with the conditions of his sale, the location of his shop, the courteous
and smiling disposition of its salesman, or a reputation for fair dealing etc.
(3) Unrestricted Entry- Entry into the industry is unrestricted. New firms are able to
commence production of very close substitutes for the existing brands of the

235
 product even though they cannot make items which are exactly identical in the
eyes of the purchasers of the existing brands.
(4) Selling Costs- An important feature of monopolistic competition is that every firm
tries to promote its own product among the consumers through different types of
expenditures on advertisement. The advertisement expenditure may be done on
different methods of appealing to the consumers to purchase its brand of the
product. The effect of these advertisement expenditures or selling cost may be to
attach particular consumers to particular brands. In this way firms with particular
brands become monopolists of their brands in the market for their consumers.
Sometimes it may create slight differences in price also.
(5) Imperfect Knowledge- The existence of monopolistic competition depends upon
imperfections in the knowledge of the buyers. Much of selling cost is simply meant
to create imaginary superiority in the minds of consumers. The products may
really be the same but consumers may come to know a particular brand name
more than the others. This divides the whole market into sub-markets where
individual firms have monopolistic conditions.
(6) Non-Price Competition- Another very important feature of monopolistic
competition is the non- price competition through which firms in the market try to
win over customers. There are definite methods of competing rivals other than in
price. It may be a guarantee for repairs within a particular time, after sales service,
a gift scheme with particular purchases, a discount not declared in the price list or
transport free of cost.
18.4 NATURE OF DEMAND SCHEDULE
1. Less than perfectly-elastic. The firm under monopolistic competition is one in a
large number. No single firm, therefore, dominates the industry. Each firm produces a
product which is a close substitute to, though not a perfect substitute of the products of his
rivals. The elasticity of demand for the product of a firm is quite highly and differs from firm
to firm. In a group of sellers, some have succeeded in creating strong consumers preferences
for their products with the result that their elasticities of demand are somewhat less than
those of the products of their rivals.

236
2. A gently sloping demand curve. The demand curve of a firm under monopolistic
competition is the result of the environment in which the firm is set. The demand curve is
the one whose points show high elasticities. But it is not a horizontal straight line as under
perfect competition since various customers are attached to the products of particular
sellers. Under these conditions every seller is somewhat a monopolist; he can raise his
price above that generally prevailing in the market without losing all his customers, since
some will prefer his product to those of his competitors and will be willing to pay a higher
price for it. In the same way he faces quite hard competition; price reductions will not
bring an infinite volume of business, since other buyers will be attached to the products of
competing sellers. Thus at each price the firm can sell a definitely limited quantity and its
demand curve is a gently sloping one from left down to the right.
3. Individual nature of a firm's demand curve. While the general nature of demand
curve in monopolistic competition is that it slopes gently from left down to the right, it must
be emphasized that every firm has its own particular sales curve that may differ in its
elasticity at a particular price from that of other firms. The demand curve reflects consumer's
tastes for its product, given their incomes and prices of the products of other firms. The
greater the intensity of preference for its product, the lower will be the elasticity of demand.
4. Changeability of the Sales Curve. An important contribution and
achievement of Professor Chameberlin was that he did not assume the
demand curve for product of the firm as simply a given datum to which the
firm has to adjust its price and output. He held that under monopolistic
competition, sales curve is capable of manipulation by variation in the
product and by advertisement for sales promotion.
18.4.1 Problems of Equilibrium of the Firm and Group
(1) Three types of Adjustment- Professor Chamberlin has classified all the
adjustments that a firm can make under three headings. They are price, product
and selling effort. In its attempt to maximise profits, the firm can review its price
policy or policy on the quality of its product, or it can review its policy on advertising
or other sales effort. The three types of adjustments of policies can be made
independently or at the same time.
237
(2) Non-use of 'marginal revenue' and 'marginal cost' approach- It must be
pointed out at this juncture that it is Professor Chamberlin who drew the economists'
attention to the non-price competition (product variation and advertisement) which
is a common feature of the actual, monopolistic markets. For the first time, an
analysis of product variation and selling costs was introduced in the literature of
economics by him in his classic Theory of Monopolistic Competition. Most of the
economists, trained in the classical marginalist tradition, found his analysis awkward
in that he had not used marginal cost and marginal revenue curves in it. We shall,
therefore, use Chamberlin's exposition, as far as possible.
(3) Primarily a short-period analysis of the firm- Another comment on Professor
Chamberlin's analysis is also necessary. His theory looked at from the viewpoint
of the neatness of perfect competition theory of the firm is somewhat lopsided
albeit more rigorous. It is primarily a short-run theory of the firm; long period
analysis is introduced only in a perfunctory way; equilibrium of the industry is
possible only in an informal way. This is owing to the diversity of assumptions that
can be made about costs and revenues of individual firms from changing their
products and advertisement expenditures.
(4) Difficulty of identifying the industry- There are many difficulties of graphic
representation of ideas under monopolistic competition. It is difficult to identify
the industry itself. Firms produce different products which are not complete
substitute for each other. As such it is not possible to identify the industry and it is
still more difficult to draw a supply curve for the industry. In fact, we cannot talk
of a price for the various firms producing differentiated products. Among various
firms there are some whose products are nearer substitutes than those of others.
Tubes of tooth paste differ from cans of tooth powder. Bottles of liquid dentifrice
are still different. All of these are put to the same use. Yet we cannot find a common
denominator for all of them and put them on the same axis in the industry diagram.
To avoid this difficulty, Professor Chamberlin has introduced the concept of a “group” in
place of an “industry”, A group is a cluster of firms producing products having a high cross
elasticity of demand, being very near substitutes; it is a combination of firms producing
products that compete highly, yet imperfectly, among them. Examples given by Chamberlin

238
are : a number of automobile manufacturers, producers of pots and pans, of magazine
publishers, or retail shoe dealers. In the long period, the number of firms in a group may
increase on account of the entry of new firms with competing brands of the product. He
has discussed equuibrium of the firm and of the group in all the three cases of price,
product and, advertisement-expenditure variations.
18.5 DETERMINATION OF PRICE AND OUTPUT
The direct effect of the monopolistic nature of competition is that every firm has some
monopoly power, some initiative in price setting. If we assume away product variation and
selling cost, the analysis of price determination by a firm reduces to that of price
determination by a monopolist. The only difference that arises here is the change in demand
conditions from short run to the long-run.
18.5.1 Short Period price output determination
In the short period, the firm faces a demand curve that slopes down from the left to the
right, the elasticity of the demand for its product at various prices being dependent on the
distinction its product has over and above those of other firms. Every firm has a particular
demand curve of its own. Some firms may be having more elastic demand while others
have less elastic demand. If two firms produce different varieties of the product, they will
be having different cost conditions. Accordingly, equilibrium prices and outputs will also
be different for these firms.
Figures 18.1 (a) and (b) and Figures 18.2 (a) and (b) show the equilibrium price-output
determination for four different firms, (i) The firm with demand and cost conditions shown
in Figure 18.1 (a) is a 'marginal firm' because it has the equilibrium output OM at price MP
that gives it only normal profit. Price MP is just enough to cover its average costs. In case
the demand for the brand falls, the firm will suffer losses and may leave the industry in the
long-run. Since point P lies to the left of the minimum point of the short-run average cost,
the firm is operating at sub-optimum capacity (ii) Figure 18.1(b) on the other hand, shows
the firm working with excess capacity. But it is earning surplus (supernormal) profits shown
by the area QPCR.

239
Figure 18.1 (a & b): The Marginal Firm Working with Excess Capacity with Normal
Profits and Super Normal Profits
It is not necessary that every firm in the short-run need work at less than optimum capacity.
If the demand and cost functions (curves) of the firms so warrant, the firm can work at or
beyond its capacity also. Figure 18.2 (a) is designed to show the firm having supernormal
profits yet working at its optimum capacity. The Output OM is such as is produced at the
minimum average cost. Figure 18.2 (b) shows the equilibrium output of a firm working
beyond its plant-capacity, for point C lies to the right of the minimum point of the average
cost curve.

Figure 18.2 (a & b): Firm with Supernormal Profits Working with Optimum and
Beyond Optimum Capacity
240
18.6 Long Period Price-Output Determination
Equilibrium price under monopolistic competition in the long period is difficult to discuss
because of the differences in products, costs and revenues of the different firms in the
industry. Firstly, Chamberlin observed that there are gaps in the chain of substitute 'products'
of the constituent firms wide enough to allow us to demarcate distinctive 'groups' of firms
with very near substitute 'products'. Existence of these gaps helps us to identify the group.
Equilibrium of the whole group can be discussed only with reference to a typical firm in it,
for the changes that occur in the long period in the number of substitutes of the product of
the firm have a direct impact on the firm's demand. It is not possible to draw the group's
supply and demand curves.
Entry or exit of the firms in the group affects cost of production of every existing firm in it.
18.6.1 Assumptions
To clear the difficulties of varying costs and product differences, chamberlin makes the
two assumptions.
i. The uniformity assumption. The firms in the group have identical cost "curves that
do not Change with the expansion or contraction of the group. This has been
referred to as the "uniformity assumption". The demand for the products of various
firms in the group is uniform throughout the group; this means that consumer's
preferences be evenly distributed among different varieties and that differences
between them be not such as to give rise to differences in cost.
ii. The symmetry assumption according to which an individual firm's action regarding
price and output adjustment will have a negligible effect upon his numerous
competitors so that the individual firm need not worry about retaliation from other
firms. Explaining the meaning of symmetry assumption, Stigler has written, 'A
price cut, for instance, which increases the sales of the firm who made it draws
inappreciable amounts (of customers) from the markets of each of his many
competitors, achieving a considerable result for the one who cut, but without
incursions upon the market of any single competitor sufficient to cause him to do
anything he would not have done any way."
In the long run every firm within a group must get only normal profits.
241
18.6.2 Subjective and Objective Demand Curves
Professor Chamberlin made use of two demand curves in monopolistic competition. The
first is the "proportional demand curve" showing the amounts demanded of the firm's
'product at different prices when all its competitors follow exactly its price changes'. It tells
us the share of the firm in the total demand for the 'product' variety at different price levels.
The second demand curve is the ceteris paribus demand curve. It is the assumed demand
curve for the product of the firm if its price changes are not noticed and matched by its
rivals in the group. Figure 18.1 shows the two demand curves intersecting at the current
price level MP. If the entrepreneur contemplates a price reduction from the price level MP,
he would expect a substantial expansion in sales. First, sales to his existing customers will
expand. Second, and more important, if rivals do not reduce their prices, he would capture
some of the customers of each. Thus he can expect an appreciable expansion in his sales.
On the other hand, the firm expects a substantial loss of sales if it increases its price and
others do not follow. Thus, the firm's anticipated or expected demand curve is shown by
the relatively elastic demand curve dd in Figure 18.1.
Anticipating highly elastic demand, each firm has an incentive to reduce price; and thus all
firms in the group have this incentive. But if all prices are reduced at the same time, each
firm will gain only that increment in sales which is attributable to the general price reduction.
No one will be able to capture his rival's customers. Thus if the actions of one entrepreneur
are matched by all other entrepreneurs in the product group, the individual firm's demand
will be far less elastic. If all rivals follow a firm's price reduction, the firm's demand curve
would be such as is shown by the curve in Figure 18.1. In other words, DD is the curve
showing the consumers' quantities demanded from any one seller at various prices under
the assumption that his rivals' prices are always identical with his.

Figure 18.1: The two Demand Curves Under Monopolistic Competition

242
It must be mentioned here that in perfect competition also we use two demand curves, one
the negatively-sloped industry demand curve and the other, the horizontal demand curve
facing an individual firm. In the analysis of monopoly we find that the two curves-that of
the industry and the firm's demand curves-are the same. We take it as the monopoly firm's
sales curve.
18.6.3 Long Run Equilibrium of the ‘Group’
Given the three assumptions of the existence of a group, identical costs and the absence of
retaliation among firms, Chamberlin proceeded to analyse the equilibrium of the group of
firms producing close substitutes. His explanation of the group equilibrium can be described
more clearly through the marginal cost-marginal revenue diagram given below, although
Chamberlin himself used only average cost and average revenue.
In figure 18.2, it is assumed that the firm representing the group has the long run average
cost and the long run marginal cost curves which are U-shaped. These curves are common
to all the firms. Moreover, these cost curves stay fixed even when the existing firms leave
the group or new firms enter it.
The AR and MR curves are assumed to be straight lines for simplicity purposes. The AR
is a gently-sloping line showing the highly elastic nature of the individual firm's demand. It
is sloping downwards snowing that the elasticity is not infinite. Likewise the firm's MR
curve is also gently sloping.
Equilibrium of the group implies that super-normal profits are wiped out through competition.
When the group is in equilibrium, it will be found that the AR line is tangent to the LAC
curve. This means that in the long period no firm in the group can earn super-normal
profits and no firm suffers a loss. The normal profits are included in the LAC. We can
explain the earning of normal profits through changes in the AR curve in the long period as
firms enter or leave the group. Let us suppose that firms are earning super-normal profits
within a particular group. Firms working in other groups having lower profits or losses will
try to enter this super-normal profits-making group by producing a similar product. In the
long run they will occupy some place in the group and take away customers from the
existing firms. Increased competition within the group shall make the AR curve more and
more elastic thereby reducing the per unit supernormal profits. The process of reduction

243
of super normal profits shall continue as long as new firms enter the group. The entry into
the group will stop only when profits are reduced to normal. In terms of our diagram given
below (figure 18.2), we can say that the entry into the group will stop only when the AR
curve will have moved to a position so as to be tangent to the LAC. This is the tangency
solution of monopolistic competition shown at the point T in the figure 18.2.

Figure 18.2: Long Run Equilibrium of a Firm under Monopolistic Competition

18.7 SUMMARY
One of the sub-divisions of imperfect competition is monopolistic competition. It is that
sub-category of the many possible market situations under imperfect competition which is
the nearest to pure competition. In monopolistic competition there are various 'monopolists'
competing with each other. These competing monopolists do not produce identical goods.
According to Joe S. Bain, "Monopolistic competition is found in the industry where there
is a large number of small sellers, selling differentiated but close substitute products".
The main features of monopolistic competition are: A Large number of Sellers, Differentiated
Products, Unrestricted Entry, Imperfect Knowledge, and Non-Price Competition. These
features of monopolistic competition ensure that each seller acts independently, basing his
policies upon his estimate of his demand and cost conditions, and taking the policies of
other firms as given and unaffected by the policies which he follows. The individual seller
has a small part of the total market so that the price and output policies of one seller are

244
not of concern to any other seller, and therefore do not evoke any retaliatory action from
him. In other words, a monopolistically competitive firm follows an independent price
policy. The independence in price policy is the result of the fact that when one particular
seller lowers his price, the gain in customers he makes thereby is spread over a large
number of sellers to whom the loss of their sales is not noticeable.
The direct effect of the monopolistic nature of competition is that every firm has some
monopoly power, some initiative in price setting. The only difference that arises here is the
change in demand conditions from short run to the long-run.
In the short period, the firm faces a demand curve that slopes down from the left to the
right, the elasticity of the demand for its product at various prices being dependent on the
distinction its product has over and above those of other firms. If two firms produce
different varieties of the product, they will be having different cost conditions. Accordingly,
equilibrium prices and outputs will also be different for these firms.
It is not necessary that every firm in the short-run need work at less than optimum capacity.
If the demand and cost functions (curves) of the firms so warrant, the firm can work at or
beyond its capacity also.
Equilibrium price under monopolistic competition in the long period is difficult to discuss
because of the differences in products, costs and revenues of the different firms in the
industry. Equilibrium of the whole group can be discussed only with reference to a typical
firm in it, for the changes that occur in the long period in the number of substitutes of the
product of the firm have a direct impact on the firm's demand. It is not possible to draw the
group's supply and demand curves. In the long run every firm within a group must get only
normal profits.
Professor Chamberlin made use of two demand curves in monopolistic competition. The
first is the "proportional demand curve" showing the amounts demanded of the firm's
'product at different prices when all its competitors follow exactly its price changes'. The
second demand curve is the ceteris paribus demand curve. It is the assumed demand
curve for the product of the firm if its price changes are not noticed and matched by its
rivals in the group.
The group equilibrium can be described more clearly through the marginal cost-marginal

245
revenue cost curves, although Chamberlin himself used only average cost and average
revenue. Equilibrium of the group implies that super-normal profits are wiped out through
competition. When the group is in equilibrium, it will be found that the AR line is tangent to
the LAC curve.
18.8 SELF ASSESSMENT QUESTIONS
1. What is the basic difference between perfect competition and monopolistic
competition with regard to: 1) nature of the product sold in the market; 2) control
over price?
___________________________________________________________
___________________________________________________________
2. Compare demand curves under monopolistic competition and monopoly?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. To what extent firm under monopolistic market can influence the price of its
product? On what factors does it depend?
___________________________________________________________
___________________________________________________________
___________________________________________________________
18.9 SUGGESTED READINGS
 Advance Economic Theory, Ahuja, H.L., S. Chand & Sons, New Delhi.
 Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
 Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.
-----

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B.Com. Semester-I Unit-IV
C. No. BCG-103 LESSON No. 19

PRICE-OUTPUT DETERMINATION
UNDER MONOPOLY
STRUCTURE
19.1 INTRODUCTION
19.2 OBJECTIVES
19.3 MEANING OF MONOPOLY
19.3.1 Features
19.4 PRICE AND OUTPUT DETERMINATION
19.4.1 In Short period
19.4.2 In Long Period
19.5 SUMMARY
19.6 SELF ASSESSMENT QUESTIONS
19.7 SUGGESTED READINGS

19.1 INTRODUCTION
Earlier we had studied the price determination under perfect competition. We also know
that perfect competition does not exist in the real world. In this chapter, we will study the
other extreme form of the market called monopoly. A monopoly is a market structure in
which there is only one producer/seller for a product. In other words, the single business

247
is the industry. Entry into such a market is restricted due to high costs or other impediments,
which may be economic, social or political. For instance, a government can create a
monopoly over an industry that it wants to control, such as electricity. Another reason for
the barriers against entry into a monopolistic industry is that oftentimes, one entity has the
exclusive rights to a natural resource. For example, in Saudi Arabia the government has
sole control over the oil industry. A monopoly may also form when a company has a
copyright or patent that prevents others from entering the market. Pfizer, for instance, had
a patent on Viagra.
19.2 OBJECTIVES
After reading this chapter, you will be able:
• To define monopoly structure of market
• To explain how price and output is determined under this market structure.
19.3 MEANING OF MONOPOLY
The word ‘monopoly’ is a Latin word. It is composed of two words: (i) Mono, which
means single, (ii) Poly, which means a seller. Thus, monopoly is a form of market organisation
for a commodity in which there is-only one seller of the commodity. There is no close
substitute for the commodity sold-by the only seller. The seller being the sole seller has full
control over the supply of the commodity. The buyer can either purchase the commodity
from the seller who is the only supplier of commodity or go without it. Thus if the buyer is
to purchase the commodity, he can purchase it only from that seller. The seller dictates the
price to consumers. A monopolist is thus a price-maker. He is not afraid of the actions of
the rivals.
According to P.C. Doojcy, “A monopolist's a market with one seller”.
Leftwhitch observes, “Pure monopoly is a market situation in which a single firm sells a
product fcr which there, isjio good substitute.”
According to A.J. Braff, “under pure monopoly there is a single seller in the market. The
monopolist's demand is the market demand. The monopolist is a price-maker. Pure
monopoly suggests a no-substitute situation.”

248
Therefore, monopoly is a market organisation in which there is only one seller of the
product. The monopolist's product has no close substitute in the market. Further, there are
strong barriers to entry into the industry. As a result, seller has full control over the supply
of the commodity. Thus, he is the price-maker.
19.3.1 Features of Monopoly
The various features or conditions of a monopoly form of market are:
1. One seller and large number of buyers. Monopoly is said to exist when there is only
one seller of a product. A monopolist may be the only person, a few partners or in the form
of joint stock company. The existence of single seller of one product rules out or eliminates
the difference between the firm and the industry. The monopolist is a firm as well as an
industry. The demand for the monopolist is the market demand. In simple monopoly the
number of buyers is assumed to be large. No one buyer can influence the price by his
individual actions.
2. No close substitute. The second condition of monopoly is that there should not
be any close substitute of the product sold by the monopolist. If it is not so, the monopolist
cannot charge a price according to his own desire. So he cannot be a price-maker. Prof.
Boulding has remarked, "A pure monopolist, therefore, is a firm producing a product
which has no effective substitutes among the products of any other firm". In other words,
monopoly cannot exist when there is competition. For example, a firm producing Signal
toothpaste cannot be said to be a monopolist firm since there are many other firms which
produce close substitutes of this toothpaste such as Colgate, Pepsodent etc. So, a firm is
a monopolist only if it is the only supplier of the product having no other close substitute of
its products.
3. Restriction on the entry of new firms. In a monopoly type of market, there is
a strict barrier on the entry of new firms. Monopolist faces no competition. According to
J.S. Bains, "Single firm monopoly occurs when one seller sells a product for which there is
no close competitor or rival."
4. Informative selling costs. In monopoly, selling costs are informed in the beginning.
This is done to give information to the buyer about the product.

249
5. Nature of demand curve. In monopoly, there is only one firm producing a product.
The aggregate demand of all buyers of the product of a rnonopolist is his demand. We also
know that the demand curve of an individual slopes downward from left to right. Since the
demand curve of a monopolist is the summation of the demand curves of all the buyers of
the product sold by the monopolist, the demand curve of a monopolist slopes downward:
it means that a monopolist can sell more of his output only at a lower price. On the contrary,
if he raises the price of his product, his sales will be reduced.
The downward-sloping demand curve tells us that average revenue or price goes on falling
as sales are increased. When average revenue (AR) slopes downward, marginal revenue
(MR) always lies below AR. In other words, MR curve of a monopolist also slopes
downward from left to right and it lies below the AR curve. This follows from the relationship
between AR and MR.
19.4 PRICE AND OUTPUT DETERMINATION
Monopoly price-output determination can be studied under two different time periods: (i)
Short period, (ii) Long period.
19.4.1 Short Period Price-Output Determination
Short period is a time period in which there are two types of factors of production. The
fixed factors and the others are the variable factors. In the short period, production can be
changed only by changing the variable factors of production. Fixed factors of production
cannot be changed. In other words, in the short period supply can be changed but only to
some extent. In this period volume of production can be changed but capacity of the plant
cannot be changed. We can increase the supply only with the help of existing machines
and plants. New factories and plant-equipment cannot be installed.
The aim of a monopolist is also to earn maximum profits or suffer minimum losses if he is
compelled to do so. Monopolist, being single seller of his product, can fix his price equal
to, above or less than the short period average cost of the product. Thus he can earn
normal profits, supernormal profits or losses even in the short period. This depends upon
the nature and extent of the demand for his product. In order to earn maximum profits or
suffer minimum losses, a monopolist compares his marginal revenue (MR) and marginal

250
cost (MC). If marginal revenue exceeds the marginal cost of a product, the producer or
monopolist can minimise his profit by increasing his production. On the contrary, if MC
exceeds MR at a particular level of output, the monopolist can increase his losses by
reducing his production. So the monopolist is said to be in equilibrium when his MC curve
cuts the MR curve. In other words, the correct point of price-output determination for a
monopolist is that where marginal revenue is equal to marginal cost.
In the short-period, a monopolist firm can earn supernormal profits, normal profits or
supernormal losses. In case of losses, price must be covering at least the average variable
costs. Otherwise the firm will stop production, The maximum loss can be equal to fixed
costs. The three cases of monopoly equilibrium can be shown through the figures drawn
below (Fig. 19.1).

Figure 19.1 Price and Output Determination in the Short Period under Monopoly
In figure (a) a monopolist is in equilibrium at point E. His equilibrium output is OM. In this
situation, he is earning supernormal profits shown by the shaded area PQRS since the AR
exceeds SAC which is equal to QM.
In the figure (b), E is the point of equmbrium where Mi? = MC. OM is the equilibrium
output. Price PM is equal to the SAC. The firm is earning normal profits, since normal
profits are included in SAC.
In figure (c), the firm is shown earning losses. Minimisation of losses is achieved by the
equality between MR and MC at point E, OM is the equilibrium output. Price is fixed at

251
PM. Monopolist firm is earning losses shown by the shaded area PQRS since SAC exceeds
price. At this price (PM) the firm will continue production since price is higher than AFC.
This is how a monopolist firm can earn supernormal profits, normal profits or even losses
in the short period.
19.4.2 Long Period Price-Output Determination
Long period is a time period which is long enough to fully adjust the supply to the demand
of a product. In this period, all factors of production are variable. Volume as well as
capacity of production can be changed. The Monopolist firm in the long run is also in
equilibrium at a point where his marginal revenue is equal to its marginal cost. In the short
period, we observed that a firm can earn profits as well as losses. But in the long period,
a monopolist firm strives and plans to earn only profits. Firm can make all necessary
changes in its costs when there are strict barriers on the entry of new firms. Monopolist
firm can fully exploit exclusive the situation. The long period equilibrium or price-output
determination of a monopolist firm can be shown through a figure 19.2.

Figure 19.2: Price and Output determination under Monopoly in the Long period
Under the given market conditions, price PM is fixed by the equality between MR and
LMC at point E. OM is the output determined in the equilibrium state. Firm is earning
supernormal profits equal to PQRS since its AC exceeds AR by PQ. It is earning profits
even in the long period. This is due to the monopoly power of the firm. This is why the long

252
period supernormal profits are sometimes called 'monopoly profits'.
19.5 SUMMARY
The word 'monopoly' is a Latin word. It is composed of two words: (i) Mono, which
means single, (ii) Poly, which means a seller. Thus, monopoly is a form of market organisation
for a commodity in which there is-only one seller of the commodity. There is no close
substitute for the commodity sold-by the only seller. According to A.J. Braff, "under pure
monopoly there is a single seller in the market. The monopolist's demand is the market
demand. The monopolist is a price-maker. Pure monopoly suggests a no-substitute
situation."
The various features or conditions of a monopoly form of market are, One seller and large
number of buyers., No close substitute, Restriction on the entry of new firms, Informative
selling costs, and Nature of demand curve.
Price-Output determination under can be studied under two different time periods: (i)
Short period, (ii) Long period.
Short period is a time period in which there are two types of factors of production. The
fixed factors and the others are the variable factors. In the short period, production can be
changed only by changing the variable factors of production. In the short period supply
can be changed but only to some extent. In this period volume of production can be
changed but capacity of the plant cannot be changed. The aim of a monopolist is also to
earn maximum profits or suffer minimum losses.
Monopolist, being single seller of his product, can fix his price equal to, above or less than
the short period average cost of the product. Thus he can earn normal profits, supernormal
profits or losses even in the short period. This depends upon the nature and extent of the
demand for his product. In other words, the correct point of price-output determination
for a monopolist is that where marginal revenue is equal to marginal cost.
Long period is a time period which is long enough to fully adjust the supply to the demand
of a product. In this period, all factors of production are variable. Volume as well as
capacity of production can be changed. The Monopolist firm in the long run is also in
equilibrium at a point where his marginal revenue is equal to its marginal cost. In the long
period, a monopolist firm strives and plans to earn only profits.

253
To sum up, the existence of a monopoly in the long run depends upon the condition that
there is no entry into the market of a monopolist of any rival. Thus, for a profitable monopoly
to survive there must be barriers to entry. Sometimes the barriers or impediments to entry
are created at the time the monopoly is established. For example, the firm may be given
the sole franchise or charter of law. In other cases, the barriers are created by the, monopolist
through threats and coercion. If a monopolist has a cost advantage over its rivals, then it
can do pre-emptive price cutting to deter rivals from entering the market.
19.6 SELF ASSESSMENT QUESTIONS
1. How monopolies are formed?
___________________________________________________________
___________________________________________________________
2. Explain the relationship between average revenue, marginal revenue and price
elasticity of demand under the conditions of monopoly?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. How are price and output determined under monopoly? Show that under monopoly
price is higher and output is smaller than under perfect competition?
___________________________________________________________
___________________________________________________________
___________________________________________________________
19.7 SUGGESTED READINGS
 Advanced Economic Theory. Micro Economic Analysis, Ahuja, H.L., 2012, S.
Chand and Company Ltd, New Delhi.
 Principles of Economics, Mishra and Puri, 2007, Himalaya Publishing House,
New Delhi.
 Economic Theory, Chopra, P.N., 2005, Kalyani Publishers New Delhi.

254
B.Com. Semester-I Unit-IV
C. No. BCG-103 LESSON No. 20

PRICE-OUTPUT DETERMINATION
UNDER OLIGOPOLY
STRUCTURE
20.1 INTRODUCTION
20.2 OBJECTIVES
20.3 OLIGOPOLY
20.3.1 Meaning and Definition
20.3.2 Characteristics
20.3.3 Causes
20.3.4 Types of Oligopoly Models
20.4 MODELS OF DUOPOLY
20.4.1 The Cournot Model
20.4.2 Edgeworth Model
20.4.3 Chamberlin
20.5 SWEEZY'S MODEL
20.6 PRICE LEADERSHIP MODEL
20.7 COLLUSSIVE OLIGOPOLY
20.8 SUMMARY

255
20.9 SELF ASSESSMENT QUESTIONS
20.10 SUGGESTED READING
20.1 INTRODUCTION
Oligopoly is a market structure where only a few large rivals are responsible for the bulk,
if not all, industry output. As in the case of monopoly, high to very high barriers to entry are
typical. Under oligopoly, the price/output decisions of firms are interrelated in the sense
that direct reactions from leading rivals can be expected. As a result, the decision making
of individual firms is based, in part, on the likely response of competitors. This "competition
among the few involves a wide variety of price and non price methods of inter firm rivalry,
as determined by the institutional characteristics of a particular market setting. Although
fewness in the number of competitors gives rise to a potential for excess profits, above-
normal rates of return are far from guaranteed. Competition among the few can sometimes
be vigorous. Examples of the oligopoly market structure include such industries as: bottled
and canned soft drinks, brokerage services, investment banking, long distance telephone
service, pharmaceuticals, ready-to-eat cereals, tobacco, and so on.
20.2 OBJECTIVES
The specific objectives of this chapter are:
• To Define Oligopoly.
• To Explain causes and features of oligopoly.
• To Describe different models of oligopoly.
20.3 OLIGOPOLY
20.3.1 Meaning and Definition
Oligopoly the market situation with a few sellers competing with each other is a market
structure that is widely found in present day industry. Oligopoly is that form of imperfect
competition in which there are only a few firms in the industry producing either an
homogeneous product or producing products which are close but not perfect substitutes
for one another; the number of firms is more than one but is not so large that any one seller
be in a position to take decisions regarding his price, output, product and selling effort

256
without taking any note of the reactions which his rivals may have to his actions. In case
there are only two sellers in the market, it may be called Duopoly, but this is also a special
form of oligopoly because from the point of view of price theory the nature of problem is
the same whether there are two or a few sellers.
The actual market situations bear more resemblance to oligopoly than to either monopoly
or monopolistic competition. Generally, in industries we find more than one firm but not so
many as to warrant the assumption that the actions of one of them are of no concern to
others. Thus oligopoly is commonly found in the real world, it has not been so far possible
to build up a satisfactory, integrated and general theory of oligopoly behaviour. A satisfactory
oligopoly theory would consist of a few related generalisations commanding substantial
agreement and capable of application to policy.
20.3.2 Characteristics of Oligopoly
Building up a theory of oligopoly presents certain problems that are characteristic of this
type of market structure. Certain features are peculiar to this form of the market that
complicate its analysis. These characteristics of the oligopoly markets from which difficulties
arise are:
1. Varying Institutional Arrangements- The industries exhibiting oligopolistic
organisation differ widely in their institutional arrangements for different firms. In
practice, there may be as 'many varieties of arrangement as the number of industries.
"The theory of oligopoly has been aptly described as a ticket of admission to
institutional economies." As William Fellner has also pointed out, there is a strong
tendency towards some kind of understanding or collusion among the few firms
under oligopoly. There may be tacit or gentleman's agreement among them to
follow particular policies; firms may decide to follow a dominant or a low cost
leader firm; or they may act independently in other spheres taking an established
price as given. Empirical investigations have led economists to recognise that each
oligopolistic industry is to some extent unique. The institutional arrangement of the
oligopolistic industry will depend on many factors. .
First, the stage of development of the industry will to some extent, determine entrepreneur's
knowledge of market conditions, "the probable reactions to be expected from rival
enterprises and, in general, the intensity of competition.
257
Secondly, it depends upon the relative sizes of various firms in the industry and the motivation
of those in control- whether they are ambitious to expand their shares of the market, or are
content to let sleeping dogs lie.
Thirdly, the existence or lack of price leadership has also to be taken into account. If there
are facilities for the spread of knowledge of the market, it may act as an establishing
element, reducing discrimination or price-cutting; corresponding to each management in
the market, a model can be built.
2. Oligopolistic Interdependence- The most important feature that differentiates
an oligopoly from monopolistic competition is the interdependence between various
firms in their decision-making; if any one seller decides to cut his price or improve
his product or embark on a tremendous advertising campaign, it leads to
countermoves on the part of his competitors; thus, his individual actions do not go
unnoticed by his rivals. Every firm under oligopoly knows that at least some of his
rival's decisions depend on his own behaviour, and it must take this fact into
account in his own decision-making.
3. Oligopolistic Uncertainty- A very serious analytical difficulty under oligopoly
arises directly out of a firm's need to take account of its competitor's reaction
patterns. When a firm's manager thinks about making a decision, he takes into
account the likely response of his competitors to it, but he has to recognise that his
competitor too, is likely to take this interdependence phenomenon into account.
The firms, thus, attempt to outguess one another..
4. Price Rigidity and Non-price Competition- Oligopoly markets are characterised
by rigid prices. Once a price comes to prevail, it continues for years as such in
spite of changes in costs and demand. Firms tend to stick to the established price
and limit their competitive efforts to non-price competition i.e., change in the design
and advertising of the product. Maintaining quoted prices constant, firms try to
improve their position in the market through various types of concessions to the
customers, viz. free delivery through rail, guarantee for some time, repair facilities,
some kind of gifts with the product etc. Stickiness of prices under oligopoly could
not be understood and explained for a long time.

258
5. Conflicting Attitudes of Firms- Under oligopoly, firms do not always have a
co-operative attitude towards each other, rather the attitudes are conflicting. At
one time, the rival firms may realise the disadvantages of hostile competition and
may have a desire to unite in a combine so as to maximise their joint profits, the
tendency at such a time is towards collusion to serve their common interests.
After some time, dissatisfaction of one firm or the other may lead to conflict and
cut throat competition; firms may come down to fight each other to death. In
oligopolistic industries, price stability prevails most of the time but price wars also
occur. Firms may come into clash on the questions of distribution of profits and
allocation of markets. Thus two conflicting attitudes are at work under oligopoly-
one of co-operation and united action and the other of conflict and antagonism.
6. Existence of Non-profit Motives- The marginalist economic theory built so far
gives good results on the basis of the fundamental assumption that every firm
strives to get maximum profits by equating its marginal costs with marginal revenue.
This in turn requires that it is possible to calculate marginal cost and marginal
revenue and that businessmen actually do so. Under oligopoly situations, it has
been established through empirical surveys that entrepreneurs have many other
motives than profit-maximization such as security and sales maximization, risk
minimization etc. It has not been possible so far to combine these non-profit aims
with profit maximisation and to find out the way the firm makes its price-output
decision
7. Indeterminate Solutions- As oligopoly is characterised by price rigidity.
Marginahst profit-maximisation approach has tried to rationalise this peculiar
oligopolist behaviour. Concept of the 'kinked demand curve' under oligopoly has
been used to demonstrate the fact of price rigidity on the one hand and its
reconcilability with the rules of thumb which businessmen employ in practice on
the other. However, all this effort has not given any neat, analytically unassailable
solutions: rather marginal analysis gives indeterminate solutions.

259
20.3.3 Causes
A. Historical Factors
Exactly how do oligopolies come into being is an interesting study. Historically, oligopolies
in industry have come into existence in two ways. First, the industry may have been atomistic
in structure but in the course of time a few firms may have expanded either with the overall
market for the industry or at the cost of other smaller firms into large firms. These large
firms may have been motivated by the desire to keep a dominant part of the market with
them. Secondly, the industry may have been controlled from the beginning by a few firms
who had the power to keep potential competitors out. In the industrially advanced
economies, oligopoly may have emerged in both these ways.
B. Economies of Scale
The most important factor encouraging oligopolistic control of the market is the economies
of scale. As technological progress takes place, there is more scope for greater
mechanisation, division of labour and progressive reduction of costs. Naturally, larger
firms are in a position to reduce costs much more than the small ones. As larger firms
expand, small ones are driven out of the market. Examples of such oligopolies are steel
industry, automobiles, cement, petroleum etc . It, however, needs to be borne in mind that
oligopolies need not only be found in large industries: they are found in local markets also.
In small towns, a few efficient business units may be all that are necessary to satisfy local
demand, such as dealers of hardware and building material. The market being small, it can
accommodate only a few firms.
C. Superior Entrepreneurs
Another factor responsible for the emergence of oligopoly is the existence of superior
entrepreneurs who, motivated by the desire for large gains or power, prestige or leadership,
follow aggressive policy of ruthless competition against weaker rivals to force them to
either go out or merge with them.
D. Patent Rights
Another source of emergence of oligopoly is the patent rights and other exclusive franchise
which a few firms may have acquired in the matter of production of some product.

260
E. Control on Indispensable Resource
Few firms may have come to possess control of some indispensable resource used in the
manufacture of the product. This may have enabled the firms to secure a big advantage in
cost over all other firms and to operate at a price at which other firms could not survive. As
a result, other firms which had to buy this costly resource could not survive the competition
and a few firms came to dominate the industry.
F. Difficulties of Entry into the Industry
At last oligopoly may come to exist because of difficulties of entry into' the industry. One
big difficulty in some industries is the large requirements of capital. Businessmen do not
like to venture into those industries entry to which, even of one firm, is likely to depress
prices to such an extent as to make it unprofitable for all. They may also be afraid of the
price war that their entry may provoke from the established firms in the industry. Prospective
entrants to an industry are also deterred by the difficulty of marketing new products or
new brands in the presence of already well-established, well entrenched brands.
20.3.4 Types of Oligopoly Models
Oligopoly can be classified on various bases. The main aim behind classification of oligopoly
situations is to tackle the complexities and diversities of oligopoly by dividing the analysis
of price and output determination in such markets into several segments. It is easier to
build up separate models for different classes of oligopoly.
I. Pure Versus Differentiated Oligopoly
Oligopoly situations can be classified as pure and differented on the basis of absence or
presence of differentiation. If the products of various firms arc homogeneous, the term
pure oligopoly is applied. This model is approximated in some of the capital-goods
industries, such as cement production. Mutual interdependence will be greater when
products are identical than when they are differentiated since any price change by one firm
is certain to produce substantial effects upon the sales of competitors and cause them to
change their prices.
On the other hand; in differentiated oligopoly, in which products jate not homogeneous,
price changes will have less direct effect upon competitors because of the practical isolation

261
of the market of each firm. The stronger the differentiation, the weaker will be the feeling
of mutual inter-dependence. Differentiated oligopoly is characteristic of a very large portion
of the economy including most consumer goods manufacturing industries, and retail trade
in most areas. The degree of differentiation and strength of a feeling of mutual
interdependence vary widely among industries however.
II. Collusive versus Competitive Oligopoly
Oligopolistic market structures induce collusion among the firms in the industry, but at the
same time collusive arrangements are difficult to maintain. There are at least three major
incentives for oligopolist toward collusion. In the first place, by decreasing the amount of
competition among the firms, it can enable them to act monopolistically and increase their
profits thereby. In the second place, it can decrease oligopolistic uncertainty. If the firms
act in concert they can reduce the possibility of one firm taking action detrimental to the
interests of the others. In the third place, collusion among the firms already working in an
industry will facilitate blocking of entry of newcomers. These forces of collusion and co-
operation, agreed or tacit, can be classified into different types so as to facilitate building
representative models. If there is collusion, it may perfect or imperfect oligopoly; if there is
none, firms may follow their independent policies.
This classification of collusive oligopoly, suggested by Fritz Machlup, will be followed in
the oligopoly models. Three main types of models will be discussed: (a) Perfect collusion,
where firms act on complete concert for the maximisation of joint profits: (b) Imperfect
collusion, where firms do not have any explicit agreement but have a tacit understanding;
and (c) Independent action on the part of firms.
20.4 MODELS OF DUOPOLY
There are different models of oligopoly and in oligopoly more than two firms are found; as
a result, the analysis will be multidimensional. The only way out to restrict it to two dimensions
is to study the simplest analytical form of oligopoly which is duopoly. Therefore, we shall
do well to choose as our starting point the study of the three classical duopoly models
given by Cournot, Edgeworth and Chamberlin. These models employ highly simplified
assumptions about interdependence of decision-making between the two firms. The first
two models are drastically simplified by assuming that in deciding his price-output policy,

262
one duopolist does not take into consideration the possible reactions which his rival may
have to his actions. This assumption of ignoring completely the mutual interdependence of
the two rivals has been called by Fritz Machlup Zero Conjectural Variation . This assumption,
of course, ignores the problem of oligopolistic interdependence which is at the heart of
oligopoly problem. Chamberlin has not ignored the problem. Since the three models employ
different assumptions about their behaviour they accordingly differ in their conclusions
about price and output of the two firms.
20.4.1 The Cournot Model
At the outset, we shall look at perhaps the oldest formal model of duopoly behaviour, a
model suggested by the French economist, AA. Cournot in 1838. It is instructive to note
here that in the Cournot model it is the rival's output which is assumed to remain the same
as one duopolist plans a change in his output. Cournot began his analysis with the basic
assumption that duopolist A believes that duopolist B will not change his (B's) quantity of
output, irrespective of the actions of the duopolist A. Furthermore, the assumption is entirely
symmetrical so that A and B may be interchanged in the statement above. To give form to
his model, Cournot supposed that A and B are entrepreneurs who own identical mineral
wells, located side-by-side. The mineral water coming from these springs can be bottled
and sold without cost to the entrepreneurs. Thus we have the simplest possible duopoly
case. Since there are no costs of production at all, we have only to analyse the demand
side of the market.
Assume that the straight line DB in figure 20.1 is the market demand curve for the mineral
water. Further, suppose that OA = AB is the maximum daily output of each spring. Thus if
the total output of the two duopolists (OA + AB = OB) is put on the market each day, the
price will be exactly zero. We might also mention at this point that if the market were
purely competitive, the long-run equilibrium price would be zero (because costs are zero,
price must be zero to yield the no-profit equilibrium solution).

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 Figure 20.1 The Cournot Duopoly Model
Suppose the duopolist A is temporarily a monopolist: he goes into business first. A will
accordingly bottle his entire possible output OA and sell it for the monopoly-profit-
maximising price OC per bottle. His total profit is, therefore, OAPC, the maximum attainable.
Now let B enter the market. He finds that A is producing OA units. Therefore, the best B
can do, under the assumption that A will continue to produce OA units, is to regard the
segment PB as his (B's) demand curve. He will accordingly produce AH( =1/2 AB) units.
Total supply is now OA + AH = OH units. This output will bring a price of ON per unit.
Total profit decreases to OHQN, of which OAKN is B's profit.
Now that B has entered the market, A must reappraise his position. Under the assumption that
B will continue to produce AH units, the best that Acan do is to produce 1/2 (OB - AH) = OF
units. He accordingly reduces his output from OA to OF units. Total supply is OF + AH = OG
units, this amount fetching a price of OM per unit. Total profit now increases to OGRM, of
which OFTM > OAKN is A's profit and FGRT > AHQK is B's profit.
By reducing his output, B must revalue the situation. Continuing with the assumption that A
will hold his output constant, the best that B can do is to produce 1/2 (OB - OF) = 1/2
FB. Thus B increases his output, presumably to A's surprise. Then A must again consider,
producing one half of OB minus B's output. This process continues until a total of OE units
are produced, selling for OL per unit. A produces OS units and B produces SE = OS
units.
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If A and B had formed a coalition, each could have produced 1/2 Q/4 = VA units, thereby
gaining the maximum possible profit OAPC. They could then have divided this equally,
each obtaining OVWC in profit. As we can see, this coalition profit would be considerably
greater than the actual equilibrium profit OSZN received by each. Consequently, by
competing one with the other, price and profit are lower and output is greater than would
have occurred if there had been a coalition (that is, monopoly situation). In other words,
consumers are somewhat better off because of competition rather than coalition.
But consumers are worse off under competitive duopoly than they would be if the market
were purely competitive. In the latter case output would be OB and price would be zero.
In summary, Cournot duopoly equilibrium results in an output that is two-thirds of the
possible (purely competitive) output and a price that is two-thirds of the most profitable
(monopoly) price.
20.4.2 Edgeworth Model
F.Y. Edgeworth was not satisfied with Cournot's solution of the duopoly problem. He
criticized Counot's assumption that each entrepreneur and his rival will not adjust the price
at all. Edgeworth preferred to work with the premise that the duopolists change their
price. Entrepreneur A will probably assume that entrepreneur B will never change his (B's)
price, irrespective of A's action. Edgeworth then used this assumption in Cournot's 'mineral
wells' example to show that an equilibrium solution would not exist.

Figure 20.2: The Edgeworth Duopoly Solution

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Figure 20.2 is constructed to explain Edgeworth's model. The market, by assumption, is
evenly divided between the two duopolists. RC and RC accordingly represent the demand
lines for A and B respectively. OB and OB' are the maximum possible output of A and B
respectively. OP is the 'monopoly' price that would be set if A and B formed a coalition
and extracted the maximum possible profit. Similarly, OQ is the price obtainable if each
duopolist sells his entire output. Suppose that somehow both producers decide to charge
OP per unit, the output sales therefore amount to OA and OA' respectively. Now
entrepreneur A (say) believes that B will retain the price OP, despite whatever he (A)
does. A consequently recognises that by shading his price slightly below OP, he (A) can -
attract enough of B's customers to sell his entire output OB. This would certainly be more
profitable to A. For example, if he reduced his price from OP to 05, his profit would
increase from OARP to OBTS.
But when A does reduce his price to 05' B, must then reconsider his price-output policy.
A has attracted AB = A' Funits of sales from B, so that B's profit has fallen to OVRP. Now
B also assumes that A will hold his price constant at 05. He therefore realises that if he
reduces his price slightly below 05, say to 05', he can attract enough of A's customers to
sell his entire output OB'. When he does so, his (B's) profit increases from OVRP to
OBTS'. At the same time, A's sales are considerably reduced and his (A's) profit declines.
A then believes that if he shades his price slightly below 05', he can sell his entire output
OB by attracting customers from B, still believing that B will not change his price from 05'.
Such a competitive move will again temporarily increase A's profit. But B then sees that a
further price cut will enable him (B) to make a greater profit.
Thus according to Edgeworth, A and B will competitively bid down price until it reaches
the level OQ, at which point both A and B are selling the entire amount that they can
produce. Now, one of the entrepreneurs, say entrepreneur A, again realizes that his rival B
can supply no more than OB' units. At the price OQ, B sells his entire output. If B does not
raise his price from OQ, A can raise his price to OP and sell OA units. A's profit would
accordingly increase from OBWQ to OARP. Therefore, A makes the price increase,
knowing that B cannot attract any of the OA units of sale because he cannot supply them.
Then B realises that if he increases his price to a point slightly below P, he can still sell OB'
units, making a larger profit. So he jumps his price. But A then believes that he can increase

266
his profit by reducing his price slightly below B's etc. So around and around we go and
thus in the Edgeworth case we never stop. Price bounces back and forth between OP and
OQ, never stopping for more than a moment. Consequently, the Edgeworth duopoly
solution is one of perpetual disequilibrium, price constantly varying from the competitive to
the monopolistic level.
20.4.3 Chamberlin
What was wrong with Cournot and Edgeworth solution? Obviously the fault lay in the
extremely naive assumption that neither entrepreneur recognizes their mutual
interdependence, and the failure to allow A and B to change their responses. Chamberlin
criticized the Cournot and Edgeworth cases on precisely this ground. To quote him directly,
"None of the solutions yet given conforms perfectly to the hypothesis that each seller acts
so as to render his profit a maximum. In order to do this, he will take account of his total
influence on price, indirect as well as direct. When a move by one seller evidently forces
the other to make a countermove, he is very stupidly refusing to look further than his nose
if he proceeds on the assumption that it will not." A.H. Chamberlin then proceeded to
suggest a solution in which both sellers recognise their mutual interdependence. Let each
seller, then, in seeking to maximise his profit, reflect well, and look to the total consequences
of his move. He must consider not, merely what his competitor is doing now, but also what
he will be forced to do in the light of the change which he himself is contemplating".
Chamberlin's proposed solution can be shown in terms of either figure 20.1 or figure 20.2.
In figure 20.1, the duopolist A originally produce OA units, selling for OC price each.
Duopolist B enters the market and, just as in the Cournot solution, produces AH units, the
price falling to ON per unit. This is where the difference enters. Under Chamberlin's
competitive assumption, A no longer believes that B will produce AH units. Instead A
realises that B will competitively in an attempt to gain theigreatest possible profit. A recognizes
that the greatest profit obtainable is OAPC. He, therefore, immediately reduces his output
to OV units. B is aware of this potentially dangerous competitive situation. He therefore,
immediately reciprocates by producing VA units. Total output is thus OA and price-is OC.
A and B split the monopoly profit OAPC between themselves. Each is aware of the
dangerous consequences of a further move They consequently live together in harmony,
possibly growing fat on their monopoly profit.

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The same sort of thing would happen if the situation were as shown in fig 20.2 that price
anywhere between (including) QQ and OP. Then A (say) would immediately increase his
price to OP confident in his belief that B will follow suit. And B will do so because he
realizes that the maximum permanent profit can thus be made. Once price is OP, furthermore
neither duopolist has an incentive to change it because each realizes that the ultimate results
would be far less desirable than the monopoly-profit situation.
Chamberlin's model, as we can see, involves a kind of solution. The entrepreneurs do not
meet and plot their coalition. Indeed, they do not have to. Each is a reasonably intelligent
fellow who looks to the future. And each duopolist, looking a little beyond his nose, sees
that having monopoly profit is the best thing for him in the long run. Chamberlin's model, in
short, always guarantees an equilibrium solution-in particular, the monopoly equilibrium.
His model also embodies somewhat more sophisticated behaviour on the part of the rival
entrepreneurs. As a matter of fact, many oligopolies doubtless reach this (monopoly)
solution. But just as obviously, some do not. Thus the Chamberlin model, while making a
valuable contribution to oligopoly analysis, certainly is not a general description of oligopoly
behaviour. As we observed right at the outset, it is not possible to build one generalized
model of oligopoly market structure, but even then it has been possible to neatly classify
such situations and build up separate models for each such situation. It is to the consideration
of these models that ye can turn.
20.5 SWEEZY'S MODEL
In 1939 a theory of non-collusive oligopoly was developed by Prof. Paul Sweezy in
America. A similar theory was developed by Professors R.L. Halfarid C.J. Hitch in England.
This is known as the kinked demand theory. The model seeks to explain how it that even
when there is no collusion at all among oligopolists prices can nevertheless remain stable
The theory is based on two asymmetrical assumptions:
1. If an oligopolist cuts its price, its rivals will feel forced to follow suit and cut theirs,
to prevent losing customers to the first firm
2. If an oligopolist raises its price, however, its rivals will not follow suit because, by
keeping their prices the same, they will thereby gain customers from the first firm.

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In these assumptions, each obligopolist will face a demand curve, that is kinked at the
current price and output (Figure 20.3) given below. A rise in price will lead to a large fall in
sales as customers switch to the new relatively lower-priced rivals. The firm will thus be
reluctant to raise its price. Demand is relatively elastic above the kink. On the other hand,
a lowering of the price will bring only a modest increase in sales, because rivals lower their
prices too and therefore, customers do not switch. The firm will thus also be reluctant to
lower its price. Demand is relatively inelastic below the kink.
This price stability can be shown by reasoning with the help of fig. 20.3. In the figure 20.3,
the demand curve LKD is also the average revenue curve for the oligopolist. It has a kink
at the SSLM- Now if we draw the marginal revenue (MR) curve corresponding to this
AR curve, it would be having the shape of Lab with a gap from a to b. The gap in the MR
curve, a to b, lies exactly below K where the AR curve is kinked. From b onwards it is
again a continuous curve.

Figure 20.3: Kinked Demand Curve for a Firm under Oligopoly

But how do we draw the MR curve? To see how this is done, imagine dividing the diagram
into two parts either side of Q1. At quantities less than Q1 (the left hand part of the
diagram), the MR curve will correspond to the shallow part of the AR curve. At quantities
greater than Q1 (the right-hand part), the MR curve will correspond to the steep part of
the AR curve. To see how this part of the MR curve is constructed, imagine extending the
steep part of the AR curve back to the vertical axis.
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 Figure 20.4: Stable Price under Conditions of a Kinked Demand Curve
We suppose that firm wants to maximise its profits. Therefore, it produces output Q1
because at this output MC = MR i.e. MC1 cuts the MR curve in the gap portion of the
MR. If the costs of production go up and the marginal e takes the positionMC2, even then
the profit-maximizing price and output remain the same. The MC2 equals the MR at the
output Q1. Thus, the price will remain stable even with a considerable change in costs.
20.6 PRICE LEADERSHIP MODEL
One form of tacit collusion under oligopoly is where firms set the same price as an established
leader. The leader may be the largest firm which dominates the industry. This is known as
dominant firm price leadership. Alternatively, the price leader may simply be the one that
has emerged over time as the most reliable one to follow; the one that is the best barometer
of market conditions. This is known as barometric firm price leadership. Let us examine
each of these two types of price leadership in turn.
How in theory does the leader set the price? The leader will maximise profits where its
marginal revenue is equal to its marginal cost.
In Figure 20.5(a), the total market demand curve is shown as D. The supply curve of all
followers is also shown as S. These firms, like perfectly competitive firms, accept the price
as given, only in this case it is the price set by the leader, and thus their joint supply curve
is simply the sum of their MC curves-the same as under perfect competition.

270
20.5(a) Division of the market between 20.5 (b) Determination of price
leader and followers and output
The leader's demand curve can be seen as that portion of market demand which remains
unfilled by the other firms. In other words, it is market demand minus other firms' supply.
At P1 the whole of market demand is satisfied by the other firms, and so the demand for
the leader is zero (point a). At price P2 the other firms' supply is zero, and so the leader
faces the full market demand (Point b). The leader's demand curve thus connects points a
and b.
The leader's profit will be maximised where its marginal cost equals its marginal revenue.
This is shown in Figure 20.5(b). The diagram is the same as Figure 20.5(a) but with the
addition of MC and MR curves for the leader firm. The leader's marginal cost equals its
marginal revenue at an output of QL, (giving a point / on its demand curve). The leader
thus sets a price of PL, which the other firms then duly follow. They supply QF (i.e: at
point/on their supply curve). Total market demand at PL is QT (i.e. point t on the market
demand curve), which must add up to the output of both leader and followers (i.e. QL +
Qp).
In practice, however, it is very difficult for the leader to apply this theory. 'The leader's
demand and MR curves depend on the followers supply curve-something the leader will
find virtually impossible to estimate with any degree of accuracy. The leader will thus have
to make a rough estimate of what its profit-maximising price and output will be and simply
choose that. That is the best it can do.
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Figure 20.6: A Price Leader Aiming to Maximise Profits for a Given Market
Share
A simpler model is where the leader assumes that it will maintain a constant Market Share
(say, 50 per cent). This is illustrated in Figure 20.6, given below. It knows its current
position on its demand curve say point (a). It then estimates how responsive its demand
will be to industry-wide price changes and thus constructs its demand will be to industry-
wide price chnges and thus constructs its demand and MR curves on that basis.
It than chooses to produce QL at a price of PL determined at point I on its demand curve
(where MC = MR). Other firms then follow that price. Total market demand will be QT,
with followers supplying the absorption or the market not supplied by the leader, namely
QT - QL.
There is one problem with this model, means the assumption that the followers will want
to maintain a constant market share. It is possible that if the leader raises its price, the
followers may want to supply more, given that the new price (= MR for a price-taking
follower) may well be above their marginal cost. On the other hand, the followers may
decide merely to maintain their market share for fear of invoking retaliation from the leader
in the form of price cuts or an aggressive advertising compaign.
20.7 COLLUSSIVE OLIGOPOLY
Collusion among firms gives rise to cartels. Cartelisation arises because firms want to
eliminate uncertainty and improve profits by Stabilising market shares, stabilising prices,

272
reducing competition, putting excess capacity to work, or outlining spheres of interest and
eliminating unnecessary promotional costs. Cartelisation or collusion is most successful
when most, not all, of the following specific structural conditions are present in a market.
1. Small number of sellers. This makes it easier to reach and enforce an agreement.
2. Similar cost Conditions for all sellers- This makes for equitable profits.
3. Minimal or non-existent product differentiation. This makes it easier to agree
upon a set of rules and eliminates the need for exceptions to the rules.
4. Inelastic demand. This enables the cartel to increase the price of the product without
incurring a commensurate decrease in sales.
5. High barriers to entry. To avoid competition, new firms are deterred from entering
the market.
6. Stability of the industry. This enables the cartel to frame and enforce rules.
7. Depressed economic conditions. In hard times, firms seek ways to avoid cut-throat
competition, thus making cartelization more attractive.
8. Little or no excess capacity. This makes it easier for the cartel to allocate production
quotas without creating a temptation to cheat.
The establishment of a price and the subsequent allocation of market shares to members
of a cartel are similar to the allocation of production to multiple plants of a single firm; that
is, the optimal allocation occurs when MCA = MCB = ... = MCN = MR of the cartel, as
shown in figure 20.7.

Figure 20.7: Market Allocation in a two- firm Cartel

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The figure above shows a simple two-firm cartel. Firm A has the marginal cost curve
MCA and firm B has the marginal cost curve MCB. The cartel's total production is the
total produced by both firms. Hence the cartel's marginal cost curve, MCT, is just the
horizontal summation of MCA + MCB. In the total market, which has the demand curve
DM and the marginal revenue curve MRM, the intersection of MCT and MRM determines
the cartel's profit-maximizing output of QT units at a price of Pc. Each firm may receive an
allocated share of the profits by producing at the level at which the firm's marginal cost is
equal to marginal revenue for the cartel at the cartel's profit-maximizing level. This results
in the production of QA units by Firm A and QB units by Firm B. Since the cartel's price
is always higher than the average total cost of the least efficient member, all firms in the
cartel will make a profit, but the lower-cost (more efficient) firms will make more profit
than the higher-cost (less efficient) firms.
20.8 SUMMARY
Oligopoly the market situation with a few sellers competing with each other is a market
structure that is widely found in present day industry. Oligopoly is that form of imperfect
competition in which there are only a few firms in the industry producing either homogeneous
product or producing products which are close but not perfect substitutes for one another.
If there are only two sellers in the market, it may be called Duopoly.
Certain features are peculiar to this form of the market that complicate its analysis. These
characteristics of the oligopoly markets from which difficulties arise are: Varying Institutional
Arrangements, Oligopolistic Interdependence, Oligopolistic Uncertainty, Price Rigidity and
Non-price Competition, Conflicting Attitudes of Firms, Existence of Non-profit Motives,
and Indeterminate Solutions.
It is easier to build up separate models for different classes of oligopoly. These models of
oligopoly are: Pure Versus Differentiated Oligopoly and Collusive versus Competitive
Oligopoly.
The only way out to restrict it to two dimensions is to study the simplest analytical form of
oligopoly which is duopoly. Therefore, we shall do well to choose as our starting point the
study of the three classical duopoly models given by Cournot, Edgeworth and Chamberlin.
These models employ highly simplified assumptions about interdependence of decision-
making between the two firms.
274
In 1939 a theory of non-collusive oligopoly was developed by Prof. Paul Sweezy in
America. A similar theory was developed by Professors R.L. Halfarid C.J. Hitch in England.
This is known as the kinked demand theory.
One form of tacit collusion under oligopoly is where firms set the same price as an established
leader. The leader may be the largest firm which dominates the industry. This is known as
dominant firm price leadership. Alternatively, the price leader may simply be the one that
has emerged over time as the most reliable one to follow; the one that is the best barometer
of market conditions. This is known as barometric firm price leadership.
Collusion among firms give rise to cartels. Cartelisation arises because firms want to eliminate
uncertainty and improve profits by Stabilising market shares, stabilising prices, reducing
competition, putting excess capacity to work, or outlining spheres of interest and eliminating
unnecessary promotional costs.
20.9 SELF ASSESSMENT QUESTIONS
1. What is oligopoly? Explain the important features of oligopoly?
___________________________________________________________
___________________________________________________________
___________________________________________________________
2. Do you think price and output under oligopoly is indeterminate?
___________________________________________________________
___________________________________________________________
___________________________________________________________
3. There is no unique solution to the problem of determination of price and output
under oligopoly. Discuss?
___________________________________________________________
___________________________________________________________
___________________________________________________________
_________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

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20.10 SUGGESTED READINGS
• Advance Economic Theory, Ahuja, H.L., S. Chand & Sons, New Delhi.
• Economic Theory, Chopra P.N., Kalyani Publishers, New Delhi.
• Principles of Micro Economics, Misra & Puri, Himalaya Publishing House, New
Delhi.

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B.Com. Semester-I Unit-V
C. No. BCG-103 LESSON No. 21 - 25

SKILL DEVELOPMENT
(Specimen for Classroom Teaching and Internal Assessment)

InAss. 21.1 Diagrammatically present Production Possibility Curve?

Solution: As a society, we produce literally thousands of different goods & services. To
better understand the trade-offs faced by an individual or society, we are going to use an
economic model called production possibility curve (PPC), sometimes referred to as the
production possibilities frontier (PPF). Recall that an economic model is a simplification of
the real world and is designed to illustrate economic theories. In this case, we will assume
that only two different goods or services can be produced. The production possibilities
curve shows the maximum combination of these two goods or services that can be produced
given our present technology and resources.
Example 1: Let's assume that our class represented a country and we were going to
produce houses and software programs. Given our current technology and resources, the
table below shows the different combinations of houses and software programs that we
could produce as a society during the next year using all our resources in an efficient
manner. The curve on the graph is the production possibilities curve or frontier which
shows the maximum combination of houses and software programs we are capable of
producing.
Let us explain this PPC with the help of a diagram as under.
The PPC given here showed software programs on X- axis and Houses on Y-axis also
known as transformation curve.PPC has a bowed out or concave shape, since some

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resources are better at producing one item than they are another. A hammer is a great tool
for building houses, but has little use in developing a software program. Likewise, those
with programming experiences may do a great job computer programming, but lack
construction skills.

InAss. 22.1 Identify products and apply the concept of elasticity on them?
Solution: Elasticity tells us how much quantity demanded or supplied changes when there
is a change in price. The more the quantity changes, the more elastic the good or service.
Products whose quantity supplied or demanded does not change much with a change in
price are considered inelastic.
Person's decision regarding price changes and a price change might not affect a group.
For example, if 3 people shared a pizza, a $3 increase would only be a $1 per person
increase and might not affect their decision.
Comparing Gasoline and Restaurant Meals: This is a fill in the blank worksheet.
Students will be asked which of the two items would be the most inelastic, and what
factors make it more inelastic.
The price elasticity of demand, a measure of the responsiveness of quantity demanded to
a price change, may cause a change in price to have a small or large impact on quantity
demanded.

278
Inelastic goods such as gasoline are still purchased in approximately the same quantity
even when price rise. Elastic goods such as restaurant meals, movie tickets, and luxury
items usually follow the law of demand and will see a drop in quantity demanded when
prices rise.

Students should see the connection between the following factors and elasticity. These
factors are the number of good substitutes, the degree of necessity, the proportion of a
purchaser's budget consumed by the item, and the time period involved. If a good has a
large number of substitutes, the more elastic it is. The fewer the substitutes, the greater the
inelasticity. If the good is highly desired with few substitutes it may be more inelastic. If the
good represents a small proportion of a person's budget, price changes do not greatly
affect the amount purchased.
Gasoline is considered inelastic (meaning price changes have little effect on the quantity
we buy). Other inelastic goods are salt, matches, toothpicks, short-run airline travel,
gasoline, residential natural gas, coffee, fish, tobacco, legal services, physician services,
taxi service, and automobile.
Example 2: Restaurant meals, on the other hand, are very elastic (meaning price changes
greatly affect our purchase of them).

279
The price elasticity of demand is a useful indicator of how we would expect the quantity
demanded for a good to change if the price of the good changes. Producers would want
to know the price elasticity of demand before they changed the price. If they were
considering a price increase, they would prefer an inelastic demand so that consumers
would still buy approximately the same quantity at the higher price which would raise your
profits. If the good were very elastic and you raised prices, you would sell fewer goods
and possibly see a decrease in overall profits.
Another example: Public health experts believe that increased taxes on cigarettes can be
a major weapon in the battle to cut teenage smoking. Imagine yourself on a panel of
consultants helping a congressional committee draft new legislation to deal with this issue.
As the youngest member of the group, you are asked for your opinion about how effective
a big tax increase on cigarettes would be in persuading young people to stop smoking.
How would you respond? What sorts of statistical data, if any, would you use to help find
your answer? And how might you go about analysing the relevant numbers?
A tax on cigarettes may actually benefit teenagers' and other citizens' health. And it will, of
course, benefit government finances by bringing in more tax money. Nothing surprising so
far. Instead, the surprise is this: The more effective the tax is in curbing teenage smoking,
the less beneficial it will be to the government's finances, and vice versa; the more the tax

280
benefits the government, the less it will contribute to health. The concept of elasticity of
demand will make this point clearer. If that demand elasticity is high, the tax will be effective,
because a small increase in cigarette taxes will lead to a sharp cut in purchases by teenagers.
The opposite will clearly be true if this demand elasticity is small.
It turns out that young people are more sensitive to price increases than adult smokers.
The estimates of teenagers' price elasticity of demand for cigarettes range from about 0.7
all the way up to 1.65.3 This means that if, for example, a tax on cigarettes raises their
price by 10 percent, the number of teenage smokers will fall by somewhere between 7
and 16.5 percent. As we just noted, adults have been found to have a price elasticity of
demand for cigarettes of just 2-their response to the 10 percent increase in the price of
cigarettes will be a decrease of only 2 percent in the number of adult smokers. So we can
expect that a substantial tax on cigarettes that resulted in a significant price increase would
cause a higher percentage of teenagers than adults to stop smoking.
We said earlier that if a cigarette tax program failed to curb teen smoking, it would benefit
the government's tax collectors a great deal. On the other hand, if the program successfully
curbed teenage smoking, then government finances would benefit only a little. The logic of
this argument should now be clear. If teen cigarette demand were inelastic, the tax program
would fail to make a dent in teen smoking. That would mean that many teenagers would
continue to buy cigarettes and government tax revenue would grow as a result of the rise
in tax rate. But when elasticity is high, a price rise decreases total revenue (in this case, the
amount of tax revenues collected) because quantity demanded falls by a greater percentage
than the price rises. That is, with an elastic demand, relatively few teen smokers will remain
after the tax increase, so there will be few of them to pay the new taxes. The government
will "lose out." Of course, in this case the tax seeks to change behaviour, so the government
would no doubt rejoice at its small revenues.
InAss. 23.1 Select any product and apply a technique of demand forecasting?
Solution: Demand forecasting and estimation gives businesses valuable information about
the markets in which they operate and the markets they plan to pursue. Forecasting and
estimation are interchangeable terms that basically mean predicting what will happen in the
future. If businesses do not use demand forecasting and estimation, they are entering into
risk markets that have no need for the business's product. Managers and business owners

281
use multiple techniques for demand forecasting and estimation. Using historical data is one
method to determine the potential demand for a product or service. For example, businesses
with high-end merchandise might examine census information to determine the average
income of an area. Larger businesses might use test markets to estimate demand. Test
markets are micro markets in small cities that are similar to larger markets. If the demand
for a product is high in the test market, managers assume that the product will perform well
in the larger market. Once the manager and the forecaster have formulated their problem,
the forecaster will be in a position to choose a method.
There are three basic techniques/methods of demand forecasting these are: Qualitative
Techniques, Time series analysis and Projection and Causal models.
Time series analysis- These are statistical techniques used when several years' data for
a product or product line are available and when relationships and trends are both clear
and relatively stable. One of the basic principles of statistical forecasting-indeed, of all
forecasting when historical data are available-is that the forecaster should use the data on
past performance to get a "speedometer reading" of the current rate (of sales, say) and of
how fast this rate is increasing or decreasing. The current rate and changes in the rate
"acceleration" and "deceleration"-constitute the basis of forecasting.
A time series is a set of chronologically ordered points of raw data-for example, a division's
sales of a given product, by month, for several years. Time series analysis helps to identify
and explain:
• Any regularity or systematic variation in the series of data which is due to seasonality-
the "seasonals"
• Cyclical patterns that repeat any two or three years or more.
• Trends in the data.
• Growth rates of these trends.
In the early stages of product development, the manager wants answers to questions such
as these:
• What are the alternative growth opportunities to pursuing product X?

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• How have established products similar to X fared?
• Should we enter this business; and if so, in what segments?
• How should we allocate R&D efforts and funds?
• How successful will different product concepts be?
• How will product X fit into the markets five or ten years from now?
Forecasts that help to answer these long-range questions must necessarily have long horizons
themselves.
A common objection to much long-range forecasting is that it is virtually impossible to
predict with accuracy what will happen several years into the future. We agree that
uncertainty increases when a forecast is made for a period more than two years out.
However, at the very least, the forecast and a measure of its accuracy enable the manager
to know the risks in pursuing a selected strategy and in this knowledge to choose an
appropriate strategy from those available.
For a defined market
While there can be no direct data about a product that is still a gleam in the eye, information
about its likely performance can be gathered in a number of ways, provided the market in
which it is to be sold is a known entity.
First, one can compare a proposed product with competitors' present and planned products,
ranking it on quantitative scales for different factors. We call this product differences
measurement.
If this approach is to be successful, it is essential that the (in-house) experts who provide
the basic data come from different disciplines-marketing, R&D, manufacturing, legal, and
so on-and that their opinions be unbiased.
Second, and more formalistically, one can construct disaggregate market models by
separating off different segments of a complex market for individual study and consideration.
Specifically, it is often useful to project the S-shaped growth curves for the levels of income
of different geographical regions.
When colour TV bulbs were proposed as a product, CGW was able to identify the

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factors that would influence sales growth. Then, by disaggregating consumer demand and
making certain assumptions about these factors, it was possible to develop an S-curve for
rate of penetration of the household market that proved most useful to us.
Third, one can compare a projected product with an "ancestor" that has similar
characteristics. In 1965, we disaggregated the market for colour television by income
levels and geographical regions and compared these submarkets with the historical pattern
of black-and-white TV market growth. We justified this procedure by arguing that colour
TV represented an advance over black-and-white analogous to (although less intense
than) the advance that black-and-white TV represented over radio. The analyses of black-
and-white TV market growth also enabled us to estimate the variability to be expected-
that is, the degree to which our projections would differ from actual as the result of economic
and other factors.
The prices of black-and-white TV and other major household appliances in 1949, consumer
disposable income in 1949, the prices of colour TV and other appliances in 1965, and
consumer disposable income for 1965 were all profitably considered in developing our
long-range forecast for colour-TV penetration on a national basis. The success patterns of
black-and-white TV, then, provided insight into the likelihood of success and sales potential
of colour TV.
Our predictions of consumer acceptance of Corning Ware cookware, on the other hand,
were derived primarily from one expert source, a manager who thoroughly understood
consumer preferences and the house wares market. These predictions have been well
borne out. This reinforces our belief that sales forecasts for a new product that will compete
in an existing market are bound to be incomplete and uncertain unless one culls the best
judgments of fully experienced personnel.
For an undefined market
Frequently, however, the market for a new product is weakly defined or few data are
available, the product concept is still fluid, and history seems irrelevant. This is the case for
gas turbines, electric and steam automobiles, modular housing, pollution measurement
devices, and time-shared computer terminals.
Many organisations have applied the Delphi method of soliciting and consolidating experts'

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opinions under these circumstances. At CGW, in several instances, we have used it to
estimate demand for such new products, with success.
Input-output analysis, combined with other techniques, can be extremely useful in projecting
the future course of broad technologies and broad changes in the economy. The basic
tools here are the input-output tables of U.S. industry for 1947, 1958, and 1963, and
various updatings of the 1963 tables prepared by a number of groups who wished to
extrapolate the 1963 figures or to make forecasts for later years.
Since a business or product line may represent only a small sector of an industry, it may be
difficult to use the tables directly. However, a number of companies are disaggregating
industries to evaluate their sales potential and to forecast changes in product mixes-the
phasing out of old lines and introduction of others. For example, Quantum-Science
Corporation (MAPTEK) has developed techniques that make input-output analyses more
directly useful to people in the electronics business today. (Other techniques, such as
panel consensus and visionary forecasting, seem less effective to us, and we cannot evaluate
them from our own experience.)
X-11 Technique
One of the best techniques we know for analyzing historical data in depth to determine
seasonals, present sales rate, and growth is the X-11 Census Bureau Technique, which
simultaneously removes seasonals from raw information and fits a trend-cycle line to the
data. It is very comprehensive: at a cost of about $10, it provides detailed information on
seasonals, trends, the accuracy of the seasonals and the trend cycle fit, and a number of
other measures. The output includes plots of the trend cycle and the growth rate, which
can concurrently be received on graphic displays on a time-shared terminal.
Although the X-11 was not originally developed as a forecasting method, it does establish
a base from which good forecasts can be made. One should note, however, that there is
some instability in the trend line for the most recent data points, since the X-11, like
virtually all statistical techniques, uses some form of moving average. It has therefore proved
of value to study the changes in growth pattern as each new growth point is obtained.
In particular, when recent data seem to reflect sharp growth or decline in sales or any
other market anomaly, the forecaster should determine whether any special events occurred

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during the period under consideration-spromotion, strikes, changes in the economy, and
so on. The X-11 provides the basic instrumentation needed to evaluate the effects of such
events.
Generally, even when growth patterns can be associated with specific events, the X-11
technique and other statistical methods do not give good results when forecasting beyond
six months, because of the uncertainty or unpredictable nature of the events. For short-
term forecasts of one to three months, the X-11 technique has proved reasonably accurate.
We have used it to provide sales estimates for each division for three periods into the
future, as well as to determine changes in sales rates. We have compared our X-11 forecasts
with forecasts developed by each of several divisions, where the divisions have used a
variety of methods, some of which take into account salespersons' estimates and other
special knowledge. The forecasts using the X-11 technique were based on statistical
methods alone, and did not consider any special information.
The division forecasts had slightly less error than those provided by the X-11 method;
however, the division forecasts have been found to be slightly biased on the optimistic
side, whereas those provided by the X-11 method are unbiased. This suggested to us that
a better job of forecasting could be done by combining special knowledge, the techniques
of the division, and the X-11 method. This is actually being done now by some of the
divisions, and their forecasting accuracy has improved in consequence.
The X-11 method has also been used to make sales projections for the immediate future
to serve as a standard for evaluating various marketing strategies. This has been found to
be especially effective for estimating the effects of price changes and promotions.
As we have indicated earlier, trend analysis is frequently used to project annual data for
several years to determine what sales will be if the current trend continues. Regression
analysis and statistical forecasts are sometimes used in this way-that is, to estimate what
will happen if no significant changes are made. Then, if the result is not acceptable with
respect to corporate objectives, the company can change its strategy.
InAss 24.1 Present a case study showing economies and diseconomies of scale?
Solution: In the long run all costs are variable and the scale of production can change (no
fixed inputs). Economies of scale are the cost advantages from expanding the scale of

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production in the long run. Also, economies of scale are the key determinants of market
structure and entry for any organisation. The effect is to reduce average costs over a range
of output. Whereas, diseconomies are the result of decreasing returns to scale and lead to
a rise in average cost.
The phrase "Bigger is better" found in the history of economics which trace the history of
economics of scale. The close coordination of economies of scale with era when demand
of the products in the market starts increasing and mass production became the trend for
most economic processes.
Case study: The Case of US Airlines.
Even before the 9/11 events, US airlines were having problems because of scale economies.
The 9/11, event further impacted the situation. The sirline business runs under very deep
fixed costs. The fleet of aircraft is a very high fixed cost investment. There is an art to
making a decision about how many planes to actually own, and how many to lease. Then,
the fuel costs are very high and fixed. Depending on the type of plane and the route, the
amount of fuel consumed by each plane is high fixed cost. The selection of the aircraft
fleet, choosing the routes, and assigning aircraft to routes are some of the most important
problems solved by the airline industry. The labour contract specifies range of salaries
paid to each type of worker form pilots to mechanics and also specifies the workload and
restrictions on it. A number of operations research professionals are employed to optimise
the scheduling of the labour pool for each day, week, and month. After the fleet, route, and
labour schedules are set, one could say that the airlines fly each flight on a very large fixed
cost. The airline industry has always been in a struggle on a number of fronts. Airport
capacity, route structure, weather, technology, and most significantly, rising fuel and labour
costs cut into airline profits. In order to make profits, the airlines have to try and fill their
seats and increase their capacity usage on all routes, or find ways to reduce cost.
InAss 25.1 Select few products and show how their price is determined under
different market structure?
Solution:
OLIGOPOLY: A situation where there are only a few sellers in a particular economy who
control a particular commodity. They can, therefore, influence prices and affect the

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competition. In India, an example of this would be mobile telephony- There are only a
few operators, examples of which are: Airtel, Idea, BSNL, Reliance. Oligopoly is something
in between perfect competition, where a few suppliers have some control over the market
prices and supplies. However, this control is not complete control as enjoyed by monopolies.
PERFECT COMPETITION: This is an economic situation that really doesn't exist, in
which a bunch of conditions are met, not the least of which are free entry and exit from a
market, tons of sellers selling the exact same product, and tons of buyers for that product
who have perfect knowledge of what it does and how it works. An Indian fish market
might be an example of something close to this (though real "perfect competition" doesn't
really exist.) At the fist market, lots of sellers gather together to try to sell the same wares,
and lots of customers try to buy them with a good knowledge of what they are buying.
There is little to prevent someone from joining in on the selling or quitting the market
altogether. Perfect competition is a concept used to explain some economic concepts, but
it does not exist in real life anywhere. What does exits is a near perfect competition.
We know that the behaviour of an entrepreneur or a firm under perfect competition assuming
that a single firm or a producer cannot influence the price of his product by his own
individual action. A single firm, under perfect competition, then takes the market price as
given and adjusts its output so as to obtain maximum profits. Now the interaction between
these two forces of demand and supply determines price in the market. It is not the demand
and supply of the single buyer and firm respectively that determine price but it is the
demand of all the buyers taken together and the supply of all the firms taken together that
determine the price by their interaction.
This leads to the next question, is perfect competition in a market realistic in the real
world? Not really. There aren't any 100% perfect markets, but there are some industries
that come close. Like described above, street food vending (more common in developing
countries) has many of the factors required of a perfect market. Agricultural markets are
examples of nearly perfect competition as well. Imagine shopping at your local farmers'
market: there are numerous farmers, selling the same fruits, vegetables, and herbs. You
can easily find out the prices for the goods, but they are usually all about the same.

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Examples
Though there is no actual perfectly competitive market in the real world, a number of
approximations exist:
An example is that of a large auction of identical goods with all potential buyers and sellers
present. By design, a stock exchange resembles this, not as a complete description (for no
markets may satisfy all requirements of the model) but as an approximation. The flaw in
considering the stock exchange as an example of Perfect Competition is the fact that large
institutional investors (e.g. investment banks) may solely influence the market price. This
of course, violates the condition that "no one seller can influence market price".
Horse betting is also quite a close approximation. When placing bets, consumers can just
look down the line to see who is offering the best odds, and so no one bookie can offer
worse odds than those being offered by the market as a whole, since consumers will just
go to another bookie. This makes the bookies price-takers. Furthermore, the product on
offer is very homogeneous, with the only differences between individual bets being the
pay-off and the horse. Of course, there are not an infinite amount of bookies, and some
barriers to entry exist, such as a license and the capital required setting up.
Free software works along lines that approximate perfect competition as well. Anyone is
free to enter and leave the market at no cost. All code is freely accessible and modifiable,
and individuals are free to behave independently. Free software may be bought or sold at
whatever price that the market may allow.
Some believe that one of the prime examples of a perfectly competitive market anywhere
in the world is street food in developing countries. This is so since relatively few barriers to
entry/exit exist for street vendors. Furthermore, there are often numerous buyers and
sellers of a given street food, in addition to consumers/sellers possessing perfect information
of the product in question. It is often the case that street vendors may serve a homogenous
product, in which little to no variations in the product's nature exist.
DUOPOLY: A market in which two giant brands control most of the product being sold
and therefore have a great amount of influence over the factors involved in the selling.
This is the one I can't give you a great example of in relation to India. I just can't think of
one that is specifically "Indian." Some examples would be Visa & Mastercard and Reuters

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& Associated Press and International news agencies. Duopolistic market with exactly two
suppliers is not very common. However, there are number of products that have two
dominant suppliers plus a few smaller ones. For example, in aerated soft drinks market,
Coca Cola and Pepsi represent two dominant suppliers in many countries.
MONOPOLY: A market dominated by one seller. The cable company is an example of
this in India (sort of like it is in America.) The cable company in India, facing no competition,
is notorious for poor quality and poor service. Monopoly is, in a way, the opposite of
perfect condition, in which a single firm or supplier has complete control over market
prices and supplies. True Monopoly generally exist only in government controlled markets.
For example provision of civic services such as sewage disposal is generally monopoly of
local self government bodies such as municipal corporations. Railways is a government
monopoly in India.
MONOPOLISTIC COMPETITION: Here, there are lots of sellers selling similar
products that don't differ a whole lot in terms of characteristics or price. Think breakfast
cereals. In India, an example of this is the banking system. After financial sector reforms
in 1992, the banking system in India has become much more competitive with lots more
banks offering similar products at similar prices.

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