Economics PDF
Economics PDF
Module-1
Module – 1
Structure:
Learning Objectives
Introduction
1.1 Meaning of Economics
1.2 Meaning of Managerial Economics
1.3 Definitions of Managerial Economics
1.4 Characteristics of Managerial Economics
1.5 Distinction and Linkage between Economic theory and Managerial
Economics
1.6 Nature and Scope of Managerial Economics
1.7 Functions of Managerial Economics
1.8 Objectives and Uses of Managerial Economics
1.9 Role of Managerial Economists
1.10 Responsibilities of Managerial Economist
1.11 Summary
1.12 Questions
1.13 Answers
Learning Objectives:
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Managerial Economics - I
Introduction:
• M.C. Nair and Merian define thus, “Managerial Economics is the use
of economic mode of thought to analyze business situations.”
4. Profit management
5.Capital management
Decision making
Forward planning
3. To act as a thinker:
The Managerial economist acts as a thinker with his profound
knowledge, creative mind and a passion for new ideas. Economist should
study various factors, principles, define various concepts, classify them
and establish relevant relationship among them to arrive at proper
conclusions.
I)Internal factors
Internal factors are within the control of the management and
they are known as business operations. A business economist is
expected to play a significant role in the internal management of a
business firm, more specifically with regard to the following:
(c) Factors influencing the input cost of the firms. Input cost of
the firms. Input costs may be affected by
• Changing labour supply,
• Changing labour relations,
• Increasing demand for land in the region,
• Changing credit policies of the financial institutions, etc.
A Managerial economist would be expected to have up- to- date
knowledge of all these topics.
1.17 Summary:
Let us summarize all the topics that we have discussed in this unit.
The term economics is derived from the Greek words “Oikos” and
“Nomos” which put together mean “household management.”
Aristotle, the famous Greek philosopher, considered economics
to be “the art of household management”.
1) Internal factors
a) In deciding about production, sales and inventory schedules of the
firm
b) In determining the pricing and profit policies
c) In reaching investment decisions
1.18 Questions:
1.19 Answers:
Section 1
1. Narrow
2. Profit Maximization, Business Situation
Section 2
1. Oikos and Nomos.
2. Household
3. Business
4. Decision Making and Forward Planning
5. Both
6. Business
7. Best
8. Advance
Review Questions
2 Marks questions:
1. Define business economics.
2. What is decision making and forward planning?
3. Distinguish between business environment & business operation.
4. State the difference between economics and business economics.
5 Marks Questions:
1. Explain the objectives of business economics.
2. Explain the scope of business economics.
14 Marks Questions:
1. Explain the role and responsibility of business economist.
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Module – 2
Structure:
Objective
Introduction
2.1 Demand
2.2 Demand schedule and demand curve
2.3 Market demand schedule
2.4 Law of demand
2.5 Why does the law of demand operate?
2.6 Exceptions to the law of demand
2.7 Expansion and contraction in demand
2.8 Increase and decrease in demand
2.9 Factors affecting demand
2.10 Introduction
2.11 Meaning of elasticity of demand
2.12 Types of price elasticity
2.13 Price elasticity of demand
2.14 Classification of Price elasticity
2.15 Income Elasticity
2.16 Cross elasticity of demand
2.17 Factors influencing the price elasticity of demand
2.18 Demand forecasting
2.19 Introduction
2.20 Meaning
2.21 Objectives of demand forecasting
2.22 Types of demand forecasting
2.23 Steps involved in demand forecasting
2.24 Methods/ techniques of demand forecasting
2.25 Economic indicators
2.26 Condition for good forecasting method
2.27 Limitations of forecasting
2.28 Demand forecasting of new product
2.29 Importance of demand forecasting
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2.30 Summary
2.31 Questions
2.32 Answers
Objective
Introduction
Illustration: “If desires were horses, even the poor would wish to
ride them”. All individuals may want to possess all kinds of goods and
services, which they see and desire but may not be in a position to own
it. This is due to lack of purchasing power. Hence demand constitute
three important essentials
• Desire
• Ability
• Willingness
2.1 Demand
the ability and willingness to satisfy it. The concept demand refers to
the quantity of a good or service that consumers are willing and able to
purchase at various prices during a period of time. A beggar may desire
to have a car, but he lacks the means to purchase.
Demand = desire to buy + willingness to buy + ability to buy.
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This law is also known as the 1st law of purchase. The law of demand
expresses the relationship between price and quantity demanded. The
law can be stated thus
Assumptions
In other words, assuming that as the price of a commodity
increases demand for the same decrease and vice versa.
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other enjoy them only in a moderate degree while still others find them
extremely monotonous. The first category of persons will be prepared
to pay any price rather than go without the movies. But the second
category of movie goers will not be prepared to pay so much for the
seats. Hence if the movie owners desire to tap their demand, they must
be prepared to lower down the admission rates to a reasonable level.
a).Income effect
A fall in the price of a commodity results in a rise in the consumer’s
real income and vice versa. With a fall in the price he can purchase more
or after purchasing his usual quantity he will be left with some more
money. The consequent increase of his demand can be attributed to the
‘income effect.’
a rise in the price of the commodity, while the prices of its substitutes
being constant will make it unattractive to the consumers, who will now
demand less of it.
1) Giffen goods
The Giffen goods are considered to be an exception to the law of
demand. In the case of such goods a fall in its price reduces the demand
and rise in its price extends its demand. This phenomenon was first
reserved by Robert Giffen and has been named after him as “Giffen’s
paradox”. He discovered that when the price of bread increases, the
working class people were forced to reduce their expenditure on meat
in order to spend more on bread.
2) Veblen effect
The status symbol goods or articles of snob appeal are considered
to be another exception. Sometimes a commodity may be bought not
because of its intrinsic worth but because its possession confers a social
distinction on the holders.
3) Price Illusion
The law of demand may not apply to goods whose quality is judged
by its high price. The ignorant consumer may feel that a high priced
commodity is superior. As such they buy more of these products at
higher price than at lower prices.
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5)Emergency
During war, famine, floods, accidents people buy certain goods even
when the prices are high.
6)Necessaries
Consumers tend to buy more necessaries like food, clothing and
shelter inspite of their high price.
7) Fear of shortage
When people anticipate shortage they buy more commodities
even though the prices are high.
8) Change in fashion
When a commodity goes out of fashion, no reduction in its price is a
sufficient inducement for a buyer to purchase more of it.
When the price changes, while all other variables are held constant,
the resulting change is known as ‘change in quantity demanded’ or
‘expansion and contraction of demand.’ It is illustrated as a movement
on the given demand curve.
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1) Income
An increase in the consumers’ income increases the demand for
various goods, provided the prices remain unchanged. However, the
demand for Giffen goods may decline when consumers’ income increases
because the consumers then take to their substitutes.
3) Quantity of Money
In a country where there is inflation, prices will rise. But the
rise will not be uniform. Hence, the people will have to readjust their
expenditure. Demand for certain goods will be reduced and for others
stimulated. For example, shortage of cooking gas increases the demand
for kerosene oil and other fuels.
5) Change in savings
This also affects the demand schedule large savings means less
money available for the purchase of goods. If the level of savings
increases quantity, demand decreases and vice versa.
Types of Demand
1)Price Demand
This is the most important, of the three types of demand. It refers to
the various quantities of a commodity that a consumer would purchase
at a given time at various prices. Other things being equal (like tastes and
preferences, fashions and prices of related goods) more of a commodity
is demanded at a lower price than at a higher price.
2) Income Demand
It refers to the different quantities of a commodity which will be bought
at different levels of income. Income demand brings out the relationship
between change in income and the resultant change in quantity
demanded.
3) Cross demand
It refers to the different quantities of a commodity which will be bought
as a result of change in the price of related goods. In case of substitutes
a rise in the price of tea would increase the demand for coffee. In case of
complementary goods say bread and butter, a fall in the price of bread
will increase the demand for butter and vice versa.
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Summary
Let us summarize all the concepts that we have discussed in this unit
• Demand = desire to buy + willingness to buy + ability to buy
• Other things remaining constant as the price of a commodity increases
demand for the same decrease and vice versa
Demand curve slopes downwards
• Law of diminishing marginal utility.
• Principle of different uses
• Principle of ‘different devices’
• Principle of ‘different incomes’
• Income effect
• Substitution effect
Learning Objective:
Introduction:
Q -Q 1 P + P 1
Ep = ×
Q + Q 1 P - P1
Illustration: If the price of X commodities is Rs.1200, the annual
sales of the commodity X was recorded as 5000 units. If the price of X
commodities reduced to Rs.1000 , the annual sales would increase to
5500 units. Find PED.
− 500 2200
Ep = × Ep = -5.17
10500 200
2.14 Price elasticity can be classified into the following types:
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1. Degree of necessity.
Greater the degree of necessity, greater the inelasticity. The reason
is that the necessities must be bought whatever be the price.
2. Extent of luxuries
The demand for luxurious goods is highly elastic, because comforts
and luxuries can be dispensed with price.
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3. Existence of substitute
For substitutes the demand is elastic. The demand for a commodity
is more elastic if it has a number of substitutes. A small rise in the price
of such a commodity will induce the consumers to buy the substitutes,
assuming that the substitute’s price does not rise.
5. Habit
The demand for a commodity to which the consumer is accustomed
is generally inelastic for example; a person accustomed to smoking a
particular brand of cigarettes will not reduce his consumption in a short
period.
1)If with a fall in price the total expenditure increases or with a rise in
price the total expenditure falls in that case the elasticity of demand is
greater than one i.e., (Ed>1)
2)If with a rise or fall in price, the total expenditure remains the same,
the demand will be unitary elastic i.e. (Ed=1)
3) If with a fall in prices, the total expenditure also falls and with a rise
in price the total expenditure also rises, the demand is said to be less
elastic or elasticity of demand is less than one i.e., (Ed<1)
Table representation
Price (P) Quantity Total outlay Elasticity of
demanded (PQ) demand (Ed)
10 1 10 Ed >1
9 2 18
8 3 24
7 4 28
6 5 30 Ed = 1
5 6 30
4 7 28 Ed < 1
3 8 24
2 9 18
1 10 10
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3) Less elasticity demand .If the price is Rs. 5 demand is 6 and total
outlay is Rs. 30. Now price falls from Rs. 5 to Rs. 1. The demand increases
from 6 units to 10 units and hence the total expenditure falls from Rs. 30
to Rs. 10. Thus, it is clear that with the fall in price, the total expenditure
also falls and vice versa. In this case, the elasticity of demand is less than
one.
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Summary:
Let us know try to summarize the entire topic which we have discussed
in this unit.
Q − Q 1 P + P1
Ep = ×
Q +Q 1 P−P1
• Degree of necessity
• Extent of luxuries
• Existence of Substitute
• Proportion of income spent on the goods.
• Habit
• Several uses of the commodity
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POINT METHOD:
2.19 Introduction:
Learning Objective:
2.20 Meaning:
4) Arrangement of finance
Demand forecasting enables them to forecast the financial
requirements of the enterprise to have the desired output.
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2) Arrangement of finance
Assessing the long financial needs, the long term demand
forecasting enables the management to arrange the long term
finances on reasonable conditions.
3)Medium-term forecasts
Medium term forecast is intermediate between the short term
and long term situations. Its need is felt by a firm when the industry to
which the firm belongs, is subjected to the trade cycle of a medium term
(varying between say two to five years). When subject to a business
cycle, a firm has to assess its demand situation and plan its activities
accordingly. The firm may reduce its output level according to the
reduced demand conditions but will not disturb its long term plans.
Engineering goods industries and garment manufacturers often find
such patterns of demand behavior in the market.
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2)Selection of goods
Before forecasting the entrepreneur might have to select the goods
for which forecasting has to be made whether, it is for consumer or and
capital goods or for existing goods.
3)Selection of method
Another step involved in demand forecasting is the selection of
method according to which forecasting has to be made. In fact, the
scope and success of a particular method depends upon the area of
investigation, degree of accuracy required, availability of data, etc.
2) Collective Opinion
Under collective opinion methods the opinion of all the sales
representative are complied and future sales are estimated. The opinion
of the sales force of different segments will be pooled and the demand
is estimated. While arriving at the aggregate demand, certain factors
associated with the sales are to be considered. They are change in sales
price, product designs, publicity procedure, and expected change in
competition, purchasing power, income distribution, employment and
population.
3)Trend projection
It is based on statistical/mathematical analysis of the past data.
Under trend projection method the company uses its own data of
previous years regarding its sales in different points of time. This kind
of data gives periodic yield in time series. The past sale projects the
effective demand for a product under normal conditions. Such data can
be analyzed with statistical and mathematical tools. This is the most
popular method of analyzing time series. It is generally used to project
the time trend of the time series. For this a statistical tool viz. ‘method
of least squares’ can be adopted and a trend line can be fitted through
the series.
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In order to find out the trend values for the following years and for the
years 2003, 2004 and 2005, the following values are calculated
Year Sales Time Squares Time
deviation of time Deviation
deviation and sales
N Y X X2 XY
1998 240 -2 4 -480
1999 280 -1 1 -280
2000 240 0 0 0
2001 300 +1 1 300
2002 340 +2 4 680
N=5 ΣY = 1400 ΣX = 0 Σ X2=10 ΣXY=220
When the equation is y= a+bx, where a is an independent variable and b
shows the rate of growth. Now we have to find out the value of a and b.
2)Plausible
The management must be able to understand the assumptions made
and the techniques used in estimating the demand. If highly sophisticated
mathematical and statistical methods have been used, the management
must be helped through simple interpretation of the methods used and
the procedure followed so that the management must have confidence
in the demand forecast and formulates production and other decisions.
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3)Economy
The forecasting exercise should be economical, in the sense; it should
not involve too much money and managerial effort. It is important that
the extra cost of adopting ways and means to make the forecast accurate
should not exceed the extra gains from forecasting accuracy.
4)Quick results
The forecasting method should be capable of yielding quick and
useful results. Sometimes, the forecasting method may sometimes yield
very useful and also accurate results but it may take too long a time to
prepare.
6)Durability
The demand forecast should be durable and should not be changed
too frequently. The durability of demand forecast depends on two
important factors. It is based on the reasonableness and simplicity
of the relationships of the variables considered, as for instance, the
relation between price and demand, between advertisement and
sales, between the level of income and the volume of sales, and so on.
Secondly, durability of demand forecast depends upon the stability of
the underlying relationships measured.
7)Flexibility
The need for flexibility arises out of the need for durability in
demand forecasts. Flexibility implies that the co efficient of the variable
could be capable of being adjusted from time to time to meet changing
conditions.
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Prof. Joel Dean has suggested six approaches for forecasting demand for
a new product. They are as follows:
2.34 Summary
Let us summarize all the topics that we have discussed in this unit
Meaning
• Forecast is a prediction of a future event
Short term objective
• Regular Availability of Labour
• Price policy formulation
• Proper control of sales
• Arrangement of finance
• Regular supply of raw materials
• Formulation of production policy
Long-term objective
• Labor requirements
• Arrangement of finance
• To decide about future expansion
Types of Demand Forecasting
• Short term demand forecasting
• Long term demand forecasting
• Medium term forecasts
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Where y = sales
A and b = values to be estimated
X = unit of time.
In order to find out the trend values for the following years and for the
years 2003, 2004 and 2005, the following values are calculated
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B = Σ XY / Σ X2 = 220 / 10 = 22
Economic indicators
•Income of the individuals and demand for consumer goods
•Agricultural income and demand for agricultural inputs like manure,
implements, etc.
•Housing project s of the government and expected demand for
building materials
• Number of automobiles vehicles registered with transport authority
acting as an indicator to project demand for petrol and auto
spares
Limitations of forecasting
• Taste, fashion and preferences of consumers
• Non availability of past sales data in case of new products
• Growth elements
• Psychological factors
2.30 Questions:
1. What is Demand?
2. Mention the factors influencing demand.
3. Distinguish between increase and decrease in demand.
4. Explain expansion and contraction in demand.
5. Write note exceptional cases to law of demand.
6. Write a note on revealed preference in demand.
2.31: Answers:
Section 1
1.Income
2.First law of consumption
3.Thorstein Veblen
4.Inferior
5.Primary
6.Income
7.Consumer
Section 2
1. Luxury goods
2.Decrease in demand
3. Increase in demand
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Section 3
1. Income
2.First law of consumption
3.Luxury goods
4. Decrease in demand
5. Increase in demand
Section 4
1.Price, income, and price of related goods
2.Three
3.Price
4.Perfectly elastic
5.Relative elastic
6.Quantity
Section 5
1. Management
2. Preference
Section 6
1. Income, Agricultural income, Number of automobiles
2. Clarity of objectives, Selection of goods, Selection of method,
interpreting the recruitment
3. Economy and Accuracy
4. Past
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Section 2
1. Refer to section 2.11
2. Refer to section 2.11
3. Refer to section 2.12
4. Refer to section 2.12
5. Refer to section 2.14
6. Refer to section 2.16
7. Refer to section 2.17
Section 3
1. Refer to Section 2.20
2. Refer to Section 2.22
3. Refer to Section 2.21
4. Refer to Section 2.29
5. Refer to Section 2.27
6. Refer to Section 2.24
Review Questions:
2Marks questions:
1. What is demand forecasting?
2. What is collective opinion method?
3. What is survey of buyer’s intention?
4. State the law of demand.
5. Why demand curve slopes downwards?
6. What are Giffen goods?
7. What is Veblen’s paradox?
8. What is increase and expansion of demand?
9. What is cross elasticity of demand?
10. Mention three exceptional cases to law of demand.
11. Draw an imaginary demand schedule.
5 Marks Questions:
1. Explain the importance of demand forecasting.
2. Explain the survey method of demand forecasting.
3. What are the factors involved in demand forecasting?
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15 Marks Questions:
1. Explain survey and statistical method of demand forecasting.
2. What is elasticity of demand? Explain different concepts of elasticity
with appropriate diagram.
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MODULE – 3
Theory of Consumption
Structure:
3.1 Human Wants
3.2 Characteristics of Wants
3.3 Consumption
3.4 Types of Consumption
3.5 Limitations of Consumer Sovereignty
3.6 Is Consumer Sovereignty Desirable?
3.7 Consumer Behaviour
3.8 Utility Analysis
3.9 Proportionality Rule
3.10 Law of Equi- Marginal Utility: Gossen’s Second Law
3.11 Concept of Consumer Surplus
3.12 Consumer Surplus
3.13 Practical Importance of consumer surplus
3.14 Ordinal Approach of Consumption
3.15 Indifference Curve: Hicks and Allen Model: Ordinal
3.16 An Indifference Schedule and Indifference Curve
3.17 Indifference Curve
3.18.Marginal Rate of Substitution (MRS)
3.19 Properties of Indifference Curve
3.20 Consumer Equilibrium under Indifference Curves
3.21 Budget Line or Price Line.
3.22 Indifference Map
3.23 Consumer’s Equilibrium
3.24 Income Effect and Income Consumption Curve (ICC)
3.25 Substitution Effect
3.26 Price Effect and Price Consumption Curve (PCC)
3.27 Uses of Indifference Curve
3.28 Engel’s Curves
3.29 Summary
3.30 Questions
3.31 Answers
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Introduction:
Learning Objective:
Introduction
WANTS=>EFFORTS=>SATISFACTION
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• Primary Wants
• Secondary Wants
3.3 Consumption:
Features of consumption
• Consumption destroys the utility power of commodities.
• Consumption results in change of form of the commodity,
• Consumption may be harmful or beneficial.
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There are two opposite views held by the economists on the issue of
consumer’s sovereignty. The right attitude on the issue of sovereignty of
the consumer is to allow him freedom to choose about daily necessities
of life such as food, clothing etc. But so far as drugs and alcoholic liquors
and other harmful commodities are concerned the freedom of the
consumer needs to be curbed in his own interest.
a. Ordinal approach
b. Cardinal approach
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The law can be illustrated with the help of a table and the curve.
Table
Number Total utility Marginal
of units utility
consumed
1 15 15
2 28 13
3 38 10
4 44 6
5 44 0
6 42 -2
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When MU curve moves below the ‘x’ axis to the negative quadrant,
the total utility curve starts falling showing that total utility decreases
when the marginal utility is negative. The maximum point of total utility
and the minimum point of marginal utility is represented by the dotted
line in the diagram.
Criticism
The law has been criticized on the following grounds
1) Cardinal measure is impossible. Marshallian measurability of
utility that is numerically added or subtracted is not convincing.
This is because utility is a psychological phenomenon, incapable
of measurement. The feelings of the consumer cannot be
measured.
2) Unrealistic assumptions. The principle of diminishing marginal
utility is based on several unrealistic assumptions which are
difficult to find in real life.
3) Marginal utility of money is not constant. The constancy of
marginal utility of money, assumed to be constant is not true, as
value of money keeps changing.
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Statement of LEMU
Symbolically,
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In other words,
Based on these assumptions the law can be explained with the help of
a table.
Units of Marginal Utility Marginal Utility of B
money spent of A
1 20 24
2 18 21
3 16 18
4 14 15
5 12 09
6 10 03
Let us assume that price of A commodity is Rs.2 per unit and price of B
commodity is Rs. 3 per unit. Reconstructing the above table by dividing
them with price, the reconstructed table will be as follows:
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Price of A Price of B
Importance of LEMU:
As Marshall says, “The applications of this principle extend over almost
every field of economic enquiry”. Some of the applications are given as
follows:
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Limitations:
1) Masn does not always act in a rational manner.
2) Goods or commodities are indivisible.
3) Consumers are ignorant of the availability of substitutes.
4) Utility of a commodity can’t be measured.
5) Marginal utility of money does not remain constant.
Summary
Characteristic of Wants
• Human wants are unlimited.
• Wants are competitive.
• Wants are complementary.
• Wants are alternative.
• Wants are recurring.
• Wants are influenced by advertisement
• Wants differ from one place to another
CONSUMPTION
• Consumption refers to the use of commodity or service for the
satisfaction of human wants. It can also be defined as the
destruction of utility.
• According to Ely “Consumption in its broadest sense means the
use of economic goods and personal services in the satisfaction
of human wants”.
Features of consumption
• Consumption destroys the utility power of commodities.
• Consumption results in change of form of the commodity.
• Consumption may be harmful or beneficial.
Types of consumption
• Direct consumption
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• Indirect Consumption
• “Under capitalism, the consumer is the King”
Consumer Behaviour
Utility Analysis
• The term “Utility” refers to want satisfying power of a commodity.
Learning objective
In the previous chapter we learnt the behaviour of consumer in
different circumstances with one or more commodities. In the real life
of consumer he may not be very specific to the law of equi-marginal
utility i.e. the satisfaction what he gains may be more or less compared
to the price of commodities. Now let us try to understand why some
times consumer is willing to pay more for few commodities even though
the price is high. What makes them to pay more?
Introduction
The concept of consumer surplus was introduced by Prof. Dupuit in
the year 1844. In money economy most of the consumers link utility of
commodities to the price that they pay. If the product possesses higher
utility then it would command a higher price and vice versa.
Assumptions
The following assumptions were made by Marshall while developing
the concept of consumer surplus.
1) Marshall based this concept on the conditioning clause ‘ceteris
paribus’ i.e., all the changing factors remaining constant.
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In symbolic terms
CS= TU – (PxQ)
CS= price prepared to pay – price actually paid
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Summary
Consumer Surplus
Consumer surplus is measured by the difference between the price
which an individual is willing to pay and the price which he actually
pays.
In symbolic terms
CS= TU – (PxQ)
Learning objective:
In the last units we have discussed cardinal approach. In this chapter
we are going to study the alternative theory of consumer’s demand i.e.
indifference curve analysis. Here we try to understand the consumer
behavior and his equilibrium when the price and income increases or
decreases.
Introduction:
Two English economists, J.R.Hicks and R.G.D.Allen severely
criticized Marshal Cardinal utility analysis and developed Ordinal
approach as an alternative analysis in their paper “A Re consideration
of the theory of Value”. In 1939 Hicks reproduced the indifference
curve theory of consumer’s demand in his book ‘Value and Capital’. He
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Assumptions
1) Satisfaction is not measurable but only comparable. It is based on
ordinal analysis.
2) The prices of goods are given in the market and they remain
constant.
3) It assumes that the consumer is not interested in any one
commodity at a particular time but in a combination of goods.
4)It assumes the diminishing marginal rate of substitution.
5) The consumer aims at maximization of his utility.
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The budget line and indifference map are the tools essential for the
illustration of consumer equilibrium.
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Budget line is also called income line and it represents the maximum
quantities of the commodities A (apples) and M (mangoes) that can be
purchased by the consumer.
Suppose a consumer has Rs. 50/ and he spends the money for the
purchase of two commodities apples and mangoes. The price of an
apple is Rs. 5 and that of mangoes is Rs 2 each. By spending the entire
Rs. 50 on apples, he can get 10 apples. If he spends the entire money on
mangoes, he gets 25 mangoes. Apples can be measured on y axis and
mangoes along x axis. By joining the two extreme points one gets the
budget line as represented in the diagram.
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But he spends his income in such a way that he spends less on the
commodity, the price of which has gone up and more on the commodity
the price of which has fallen and such a change is called ‘substitution
effect.’
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The diagram shows the various price lines at different prices E1,
E2, E3 are points of equilibrium. By joining all the points one derives the
price consumption curve which shows the price effect.
When the price of one commodity falls it becomes cheaper than the
other commodity whose price has not changed. In this case there will be
a natural tendency to substitute the cheaper commodity for the costlier
commodity. This is called the substitution effect.
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Criticisms
1) Marginal utility of money in reality never remains constant.
When a consumer spends money on a particular commodity the
quantity of money is comparatively reduced with the result the
marginal utility of money increases.
2) The assumption that tastes, preferences, incomes and fashion
are constant is wrong.
3) Utility of a commodity according to Marshall depends on one
commodity alone. But in reality the utility depends on other
commodities which have no substitutes. In real life there is hardly
any commodity which has no substitutes.
4) The concept is derived from the demand curve. Therefore, it is
subject to all the assumptions on which the demand curve is
based. But in actual life demand is influenced by various other
factors and consumer surplus is also influenced by these factors.
3.29 Summary:
Consumer’s Equilibrium
Income effect and income consumption curve (ICC)
Substitution Effect
Price effect and price consumption curve (PCC)
Engel’s curves
3.30 Questions:
1. Define Utility.
2. Define Indifference curve.
3. What is Budget Line?
4. State the Properties of Indifference curve.
5. Explain the assumption of Indifference curve analysis.
6. Explain the consumer equilibrium under indifference curve
analysis.
7. Explain price effect.
8. Explain Income effect.
9. Explain substitution effect.
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3.31 Answers:
Section 2
1. Potential price
2. Prof. Dupuit
3. Alfred Marshal
4. AP=PP
Section 3
1. R.g.d.allen and hicks
2. Indifference map
3. Same satisfaction
4. Law of diminishing marginal utility
5. Income line of consumer
6. Marginal rate of substitution
Section 2
1. Refer section 3.12
2. Refer section: 3.13
Section 3
1. Refer to section 3.15
2. Refer to section 3.15
3. Refer to section 3.20
4. Refer to section 3.18
5. Refer to section 3.15
6. Refer to section 3.22
7. Refer to section 3.25
8. Refer to section 3.24
9. Refer to section 3.21
Review Questions
2 Marks questions:
1. What is consumer equilibrium?
2. Give the meaning of indifference curve.
3. Distinguish between Total Utility and Marginal Utility.
4. What is Marginal Rate of Substitution?
5. What is Budget Line?
6. What is consumer surplus?
5 Marks Questions:
1. Explain price effects, income effects and substitution effect.
2. Briefly explain the law of diminishing marginal utility.
3. Explain the limitations of Consumer Sovereignty
14 Marks Questions:
1.Explain the law of equi marginal utility with schedule and
diagram.
2.What is indifference curve? Explain the properties and consumer
equilibrium with the help of a diagram.
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Module- 4
Structure:
Learning Objective:
Introduction:
Supply side economics relates the physical relationship between
inputs and output. The process of production refers to the transformation
of inputs into outputs. Every firm has a production function which is
largely determined by the state of technology; with changes in technology,
production function of the firm also changes. Traditional economic
theory emphasizes the four factors of production- land, labour, capital
and organization. Modern economists focus on two additional factors
which include technology, and quality of management.
Mathematically
Q = f (L, l, k, O, t, M)
Where Q = quantity
L = labour
l = land
k = capital
O = organization
t= technology
M = management
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Production function may be short run or long run. The short run
is that period of time in which one of the factors of production remains
fixed whereas the long run is the period of time in which all factors are
variables.
The short run production function forms the subject matter of the
law of variable proportions. And the long run production function forms
the subject matter of what is referred to as returns to scale.
Statement:
Other things remain constant if only one variable factor input
increases to a fixed factor input first marginal productivity falls, when
total productivity reaches the highest point marginal productivity
is equal to zero. Marginal productivity becomes negative when total
productivity falls.
Assumptions
1) The state of technology is given and unchanged. If there is
improvement in technology then average product and marginal
product will rise.
2) Only one factor is varied and others are kept fixed.
3) The units of the variable factors are homogenous.
4) Techniques of production remain constant.
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Stage I
Stage of increasing returns or decreasing cost:
The total product increases at an increasing rate up to a point that is
up to point A. from the point A onwards the total product starts increasing
at a diminishing rate where marginal product falls but is positive. The
point A is called the point of inflection. Corresponding vertically to this
point inflection the marginal product is maximum, after which it slopes
downwards. Stage I ends where the AP reaches its highest point. During
this stage when MP o the variable factor is falling, it still exceeds its
average product and so continues to cause the average product curve to
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rise. Thus during stage I whereas MP curve rises in a part and then falls
the AP curve rises throughout. Stage I is the stage of increasing returns
because AP of the variable factor increases throughout this stage.
Stage II
The Stage of Diminishing Returns or increasing cost.
The total product continues to increase at a diminishing rate until it
reaches its maximum point c where the second stage ends. In this stage
both the MP and the AP of the variable factor are diminishing but are
positive. At the end of the second stage at point C, marginal product of
the variable factor is zero (corresponding to the highest point c of the
total product curve TP). This stage is known as the stage of diminishing
returns as both the average and marginal products of the variable factor
continuously fall during this stage.
Stage III
The Stage of Negative returns.
The total product declines and therefore the total product curve TP
slopes downwards. As a result MP of the variable factor is negative and
the MP curve goes below the x axis. In this stage the variable factor is too
much relative to the fixed factor. This stage is called the stage of negative
returns since the MP of the variable factor is negative in this stage.
will expand further. Even if the fixed factor is free the producer will stop
only at point L2 where the MP of the fixed factor is zero and the AP of
the variable factor is maximum. At the end point L2 of stage I he will be
making maximum use of the fixed factor.
Q = f (k, l)
Where Q = output
k = capital
l = labour
Example
0 man plus 3 machines → 10 units output
1 man plus 2 machines → 10 units output
2 man plus 1 machines → 10 units output
5 man plus 0 machines → 10 units output
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The link between cost curves and production function is very strong
because costs are dependent upon both the price paid for inputs and the
technical efficiency of the production process. The Iso-cost line denotes
all the combination of inputs x and y which may be purchased from the
firms budget funds. It is assumed that the entire budget is spent. The
Iso-cost line is constructed as shown in the diagram.
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To illustrate, assume
Available budget per period = Rs. 660
Price of capital = Rs. 110per unit
Price of labour = Rs. 165 per unit
The intercepts on the x and y axis are located by calculating the
quantity of the respective inputs which can be purchased if the total
budget is used to buy only one input. For example, if labour costs Rs. 165
per unit, 4 units can be purchased with the budget of Rs. 660. Therefore,
4 units mark the intercept on x axis. Likewise, since capital costs Rs. 110
per unit, 6 units can be purchased with the budget of Rs. 660. the 6 units
make the intercept on the y axis. The Isocost line is formed by drawing
a straight line connecting the two intercepts.
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The least cost factor combination can also be explained with the
help of the concept of marginal rate of technical substitution (MRTS)
and the price ratio of the two factors. The MRTS is given by the slope of
the equal product curve at its various points. The entrepreneur will not
choose to produce the given output at point R because at point R MRTS
of x for y is greater than the price ratio of the factors. Therefore if he is
at point R he will use more of x in place of y and go down on the equal
product curve. Likewise he will not step at points.
the factors and the entrepreneur will try to substitute factor y for factor
x and move upward on the equal product curve p until he reaches the
price ratio of the factors. It is thus clear that the entrepreneur will be
minimizing his cost when he is using the factor combination for which
his MRTS is equal to the price ratio of the factors.
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All the three phases can be shown by one diagram as given above.
2) Marketing economies
A large firm can reap the economy of buying and selling. It can
maintain a specialized marketing department. It buys its requirements
of various inputs in bulk and therefore is able to secure them at favorable
prices. It can also secure better quality inputs at concessional rates as
large firms have better bargaining, capacity. This results in economics
of purchase.’ Economy in advertisement and publicity expenses is also
available to a large firm.
3) Managerial economies
In a large firm there is specialization of function and the firm is
split into several departments. Every department has its own manager.
The large firm enjoys managerial economics arising from efficient
and specialized management. For example, the production manager
concentrates on production; while the job of the sales manager is to
attend to the sales side of the business.
4) Financial economies
Large funds are available to large firms as compared to small ones.
They reap financial economics. They can borrow from banks or any
financial institution and even raise money through sale of shares and
bonds to the public.
6) Economies of research
A large firm having large resource can establish its own research
laboratory and train employees in new methods of production.
7) Economies of welfare
Large firms can provide better facilities for education and health to
the workers. This improves their productive efficiency, raises production
and profits.
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1) Economies of concentration
Skilled labour is available to all the firms. The areas of transport and
communication are improved. Roads and railways may provide special
facilities to the firms. Banks and insurance companies set up offices in
the area and the firm is assured of cheap and timely finance. Adequate
power at concessional rates is available from the electricity board.
Subsidiary industries develop round the area to supply the localized
industry with tools and raw materials.
2) Economies of information
An industry can provide up to date information on techniques,
export possibilities etc., through establishment of research laboratories.
There is the possibility for the firms to exchange their views through
lectures, seminars, workshops, training camps, internet etc.
3) Economies of specialization
Specialization takes place with expansion of scale of production.
Firms start specializing in different processes. For example, firms of
a cotton textile industry may specialize in manufacturing thread or
printing.
6) Economies of infrastructures
Certain infrastructure facilities available and created by government
can encourage private sectors to develop.
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Summary:
Let us summarize the topics that we have discussed in this unit.
In simple words production function refers to the functional
relationship between the quantity of a commodity produced
(output) and factors of production (inputs).
Iso-quant curves
An Iso-quant shows a given amount of output produced, by various
combinations to two variable inputs.
Iso-cost line
The Iso-cost line denotes all the combination of inputs x and y
which may be purchased from the firms budget funds.
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4.11: Supply:
Learning objectives:
This unit helps us to understand the capacity of producer willing to
offer the goods to the market which depends on various factors. It also
provides necessary information on the actual supply side of economics.
Introduction:
As the term demand refers to quantity of goods that a consumer
is willing to buy at various prices during a particular period, the term
supply refers to the amount of goods that the producers are willing and
able to offer to the market at various prices during a period of time. The
two important points that apply to supply sides of economics are:
a)The supply refers to what firms offer for sale, not necessarily to
what they succeed in selling
b) Supply is a flow. The quantity supply is so much per unit of time,
per day, per week, or year.
The supply schedule shows that as price rises supply extends and
as price falls supply contracts.
Law of supply
S = f (P)
other things remaining constant
Where S = supply
F = function
P = price
Assumptions
Elasticity of supply is the rate at which supply will change when price
changes.
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Summary:
Supply
o Stock of a commodity refers to the total quantity of the
commodity available with seller at any given price.
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Law of supply
Elasticity of supply
Types of Elasticity
4.13 Cost
Learning Objectives
Introduction
Every Business firm by and large works for profit and it is the profit
which determines the success of the business, though the firm may have
many subsidiary objectives. When profit becomes the primary objective,
then it is obvious that decision making in business revolves around costs
and revenues. The manager of the firm takes decisions to see that costs
balance revenue in an optional way.
Real Cost
Real cost is a subjective concept which expresses the trouble,
turmoil and sacrifices involved in producing a commodity. The money
paid for securing the factors of production is money cost. The efforts
and sacrifice of the factors or its owners is the real cost.
2) Opportunity Cost :-
Resources available to any person, firm or society are scarce
but have alternative uses with different returns. Income maximizing
resource owners put their scarce resources to their most productive
use and thus, they forego the income expected from the second best use
of the resources. Thus, the OC may be defined as the expected returns
from the second best use of the resources which are foregone due to the
scarcity of resources.
The factors which are used in the manufacture of a product may also
be used in the manufacture of other products, for example, in agricultural
productivity the farmer who is producing paddy can also produce sugar
cane with the same factors. Therefore the opportunity cost of a ton of
paddy is the amount of the output of sugar sacrificed. Suppose the farmer
growing paddy in his land might have used his factors of production to
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grow sugarcane. Suppose that the farmer grows 100 tons of paddy on his
land, his next best alternative crop is sugarcane and that he could have
grown 140 tons of it with the factors he used for growing paddy. Then
140 tons of sugarcane or its value is the opportunity cost of paddy.
Hence cost varies with the change in the rate of input in the short
run and there is no scope to vary plant, machinery and management.
In the long run there is complete change, as the time is long enough to
effect total change because there is ample scope for changing all input
factors. These are the costs which vary completely with changes in rate
of output.
inputs which are exhausted by a single use for eg, raw materials, fuels
etc. The costs incurred in this way are called variable costs. Fixed costs
include rent on buildings, interest on capital, salaries to permanent staff,
insurance premium and taxes. These fixed costs have to be incurred
even if the plant is at a stand still. These costs will not vary with the
changes in output.
4.16 Total Cost, Total Variable and Total Fixed Cost Curves
(Short Run)
i.e., TC = TFC+TVC.
Total fixed cost (TFC) is the expenditure incurred on the purchase
of fixed inputs where as TVC is the sum spent on the variable inputs.
Thus, total costs (TC) are equal to TFC and total variable cost.
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The short run TC, TFC & TVC can be diagrammatically shown as
follows:-
In the above diagram the TFC is constant and it refers to the entire
obligation of the firm per unit of time for the fixed resources. This curve
is parallel to X axis showing that it is constant regardless of output per
unit of time. In the diagram it can be noticed that the TFC starts from
a point on the Y axis. This means that the TFC will be incurred even if
output is zero.
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Refers to the variable cost per unit of output. It is the TVC divided
by the number of units of output produced. Therefore AVC = TVC/Q. The
AVC curve will be generally U shaped. The AVC will fall as the output
increases from zero to the normal capacity output due to the operation
of increasing returns. But beyond the normal capacity output, the AVC
will rise up steeply due to the operation of diminishing returns.
AC is the sum of AFC and the AVC. As output increases and AFC
becomes smaller and smaller, the vertical distance between the ATC
curve and AVC curve goes on declining. When AFC approaches the X
axis, the AVC curve approaches the ATC curve.
Marginal Cost
Relationship of MC To AC
curve cuts the AC curve from below at the lowest point of the latter.
In the short run the firm is tied with a given plant. But in the long
run, the firm moves from one plant to another. As the scale of operation of
the firm is altered, a new plant is added. The long run cost of production
is the least possible cost of production of producing any given level of
output, when all inputs become variable, including the size of the plant.
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In the above figure there are five short run AC curves though
there may be infinite number of short run AC cost curves for a firm.
The successive short run AC curve indicates that they are at different
heights. Now the long rum AC curve can be drawn by a curve which
would be tangent to all the short run cost curves and envelope them.
In fact, the long run AC curve is the locus of all these tangency points.
If a firm desires to produce a particular output in the long run, it will
choose a point on the long run AC curve corresponding to that output
and then build up a relevant plant and operate on the corresponding
short run AC curve.
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From the above, it is understood that the LAC curve initially falls
with increases in output and after a certain point it rises making a
smooth curve. It is also called the planning curve of the firm as it helps
in choosing a plant on the decided level of output.
Geometrically the LAC curve cannot touch the lowest points of all
SAC curves, except the lowest SAC curve i.e. SAC3. Before the SAC3 the
LAC curve will be tangent at point before the lowest point, and after
SAC3 the LAC curve will be tangent at points after the lowest points of
SAC curves.
4.17 Summary
Cost of Production
The term means the expenses incurred in the production of a
commodity. This refers to the total amount of money spent on the
production of the commodity.
Real Cost
Real cost is subjective concepts which expressed in the time of
trouble, turmoil and sacrifices involved in producing a commodity.
Opportunity Cost
According to Benham,“ The opportunity cost of anything is the next
best alternative that could be produced instead of the same factor by an
equivalent group of factors consisting the same amount of money.
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Marginal Cost
MC may be defined as the addition made to the total cost by the
production of one additional unit of output.
4.18 Questions:
4.19 Answers:
Answers for the Self Assessment Questions:
Section 1
1. Outputs
2. Inputs and outputs
3. Land, labour, capital, and organization
4. Production
5. Knut wicksell
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6. Three
7. Equal Quantity
8. Income line of producer
9. Marginal rate of technical substitution
10. Law of returns
11.Marshal
Section 2
1. Producer
2. Goods
3. Change in other variable
4. Change in quantity supply
5. Change in price
6. Perfectly elastic
7. Perfectly inelastic
8. Relatively elastic
Section 3
1. Fixed cost
2. Variable cost
3. Avc, ac
4. Decreases
5. Lac
6. Tvc+tfc
7. Per unit cost
8. Opportunity cost
9. Variable cost
Section 2
1. Refer to section 4.12
2. Refer to section 4.12
3. Refer to section 4.12
4. Refer to section 4.12
5. Refer to section 4.12
Section 3
1. Refer to section 4.14
2. Refer to section 4.15
3. Refer to section 4.15
4. Refer to section 4.15
5. Refer to section 4.15
6. Refer to section 4.16
7. Refer to section 4.16
8. Refer to section 4.16
9. Refer to section 4.16
10. Refer to section 4.16
Review Questions
2 Mark questions:
1. Give the meaning of supply.
2. State the law of supply.
3. Distinguish between stock and supply.
4. What is elasticity of supply? State its influence on cost of
production.
5. What is production function?
6. What are economies of scale?
7. Distinguish between iso quant and iso cost.
8. What is MRTS?
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5 Marks Questions:
1. Explain the factors which determine the elasticity of supply.
2. Briefly explain external economies of scale.
3. Explain the factors which determine supply.
14 Marks Questions:
1. Explain the law of variable proportion with schedule and
diagram.
2. Explain the types of internal economies of scale
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Module 5
MARKET STRUCTURE
Structure
Learning Objectives
The objective of this concept is to understand how the incurred cost
in the production unit can be recovered by studying different revenue
concepts under different market structure.
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Introduction
In the previous module we have discussed production and cost which is
an integral part of every business units. The concept of revenue varies
from one market structure to another market structure. For example all
perfect competitors accept the price fixed by the market forces whereas
all imperfect competitors enjoy the freedom of fixing the price. This part
of module five helps us to understand the slope of AR, MR and TR in
different market situations.
Revenue means the sale receipts of the output produced by the firm.
It depends on the market price. The amount of money which the firm
receives by the sale of its output is termed as revenue.
1. Total Revenue: Total revenue refers to the total amount of money that
the firm receives from the sale of its products.
TR= PXQ
AR = TR/ Q
MR= TRn-TRn-1
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Summary
Revenue Concepts:
AR = TR/ Q
MR= TRn-TRn-1
Learning Objectives:
This unit helps us to understand the behavior of different market
structures which behave differently in different market situations.
Illustration
1. Imagine a situation where you go to a local market to buy a pair
of shoes. You enter one shop which sells shoes, where the price
is around 400. But you think that they are not worth more than
300. You offer 300 to the shopkeeper, but he does not agree to
give the shoes for less than 250. Finally both agree at 250 and
exchange takes place, where both the shopkeeper and you are
happy.
3. Imagine you are a farmer. Even though you spend money on the
production of vegetables, you don’t have the power to fix the
price which is decided by market forces of demand and supply.
Introduction
In the economic theory, the term market is the sum of buyers and
sellers of any good and services and their interaction. Economists
classify the market in terms of their structure, that is, the number and
size of buyers and sellers, the degree to which products differ from one
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another, and the ease with which new producers can enter a market.
In this chapter we will discuss different types of markets in which each
seller follows certain features.
Market Structure:
Market in economics refers to contact established between buyer
and seller. The contact can be established over a telephone, post card or
any media. Market is not held in a place, region or a building. There is no
need for the physical presence of buyer and seller.
Perfect competition refers to the market where there are large number
of buyers and sellers engaged in buying and selling homogeneous
products, at uniform prices which is determined by the market forces
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of demand and supply. The seller in this market is a price taker and no
individual seller is in a position to influence the prevailing price.
should be from the buyer’s view. The buyers should feel that
the products offered by different sellers are the same in quality,
size, taste, etc so that the product of different firms is a perfect
substitute in the eyes of the buyers.
4) Free Entry and Exit Conditions: The fourth important condition
in perfect competition is that there are no artificial restrictions
either preventing the entry of new firms into the market or
compelling the existing firms to have full liberty to choose either
to continue or go out of the industry. If new firms decide to enter
the field, they can do so without restrictions. The condition of free
entry ensures that the number of firms in the market is always
large. Of course it is assumed that the new entrants produce
identical products.
5) Perfect Knowledge on The Part of Buyers and Sellers: An
essential condition of a perfectly competitive market is the
existence of perfect knowledge on the part of buyers and sellers
about market conditions. The buyers know in full about the
commodity sold and the price prevailing in the market. The sellers
know the potential sales at various price levels in the market.
When the producers and customers have full knowledge
of the prevailing price for the commodity sold nobody will offer
more price and no seller will accept less price than the one
prevailing in the market.
6) Perfect Mobility of Factors of Production: The existence of
perfect competition depends on perfect mobility of factors of
production. The factors should be free to move from one use to
another easily depending on the remuneration they get.
They are free to come out of the industry if they consider the
remuneration inadequate and they could get better remuneration
elsewhere. If the demand for a product increases in the market,
additional factors have to move to the industry as the firms will
be employing more factors and new firms will have to employ
more of factors to enter the industry. Similarly in the event of the
firms going out, the factors will have to move out of the industry.
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25 4 8
30 2 10
35 1 12
Pressure on price:
D > S - Excess demand.
D = S - Equilibrium.
D < S - Excess supply.
Analysis:
1. From the table it is clear, that equilibrium price is Rs.20/- when
demand equals supply.
2. When there is excess demand, demand is greater than supply
which implies that there is a shortage. This causes an upward
pressure on the prices and price goes up till it reaches the
equilibrium. When price rises demand contracts and supply
expands.
3. When there is excess supply i.e., supply is greater than demand
it implies there is surplus. This causes a downward pressure on
the price and the price goes down till it reaches the equilibrium.
This downward pressure leads demand to expand and supply to
contract.
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Analysis:
1. In the figure “E” is the equilibrium point and “OP” is the
equilibrium price determined by the forces of demand and
supply.
2. If price is “OP1” then there is excess supply, which leads to
surplus, and there is downward pressure on the price, which
reaches equilibrium price “OP1” again.
3. If price is “OP2” then there is excess demand, which implies
shortage and there is upward pressure on the price, which
reaches equilibrium price “OP2” again.
1) Market period:
Market period refers to that type of competitive market in
which the commodities are perishable and supply of commodities
cannot be changed at all, so the market period supply is almost
fixed. It cannot be increased or decreased because skilled labour,
capital and organization are fixed which means all factors of
production are fixed in the market period. During this period
the demand plays a decisive role in determining the price of
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In the above diagram, the market period supply curve and market
period demand curve intersect at point E and the price is OP. Suppose
the demand increases to D1 on that particular day, the equilibrium point
will shift to E1 and the price will go up to OP1.If the demand decreases
to D2 as shown in the figure, the price in the market will fall down to
OP2. So, in a very short period market, the demand decides the price as
the supply is not only fixed but the commodities are perishable.
However the demand exceeds the supply and the short period
price will be more than normal price and less than market period
price.
3) Long Period:
Long period is period in which the commodity in consideration
is durable and the supply of the commodity is also variable by
employing more capital. A long period price is the period in
which supply of a commodity can be increased or decreased.
The price ruling in the long period is called long period price or
normal price. This is determined not by demand alone but forces
of demand and supply. In the long run the producer has enough
time to alter factors of production and meet the increasing
demand and accordingly the price gets adjusted. Thus in the long
run the price attains the normal level where the supply equates
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the demand.
During the short period firms under perfect competition are exposed
to three conditions, that is losses, supernormal profits and normal
profits. This is due to the fact that those firms which face supernormal
profits have favorable cost conditions and thereby are able to maximize
profits. At the same time some firms are able to earn just normal profits
because their cost conditions are just favorable. On the contrary some
firms face losses because of unfavorable cost conditions. Hence, firms
with loss, supernormal and normal profits co-exist in the short run.
The following figure shows the short run equilibrium of the firm.
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In the above diagram, panel (a) shows the market forces of demand
and supply determining the price, panel (b) shows the profit maximizing
firms and panel (c) shows firms making losses. In panel (a) OP price
is determined when the short run supply curve intersects short run
demand curve at point E when OQ quantity is demanded and supplied.
The firms as shown in the diagram take this price, which is set by
the market. In panel (b) OP is the price represented by AR/MR or price
line. The firm adopts the price set by the industry and compares its
average cost and average revenue. It is observed that the AR>AC, when
OQ is the output produced. Hence the shaded rectangle PABC shows the
area of supernormal profits.
Panel (c) shows the firms incurring losses when AC > AR represented by
the shaded rectangle PABC.
Long run is a time period in which the firms can alter their production
unit in such a way so as to meet the total demand in the market and
supplying to the desired extent. This can be done by changing all fixed
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The market forces of long run demand and long run supply
determine the long run equilibrium price. When the price determined
by the market is adopted by the industry, all firms follow the same price
and there are no tendencies to change from the equilibrium price.
In the above diagram, panel (a) shows the long run equilibrium price
OP and when the same is adopted by the industry. At this price, all firms
compare their average revenue with average cost and happens to find
that AR=AC. The equilibrium output is determined at the point where
MC=MR. Hence the industry is in equilibrium when AC=AR=MC=MR. At
this point the price is equal to cost.
popularized by___.
6. In long run perfect competitor earns ____.
Summary
Learning Objective
In this Unit let us study about realistic market structures like
monopoly, monopolistic, duopoly and duopoly. Perfect competition is
absent; monopoly is rare and monopolistic competition is reality. Yes we
are going to discuss these market structures which more or less exist.
Introduction
“Perfect competition is absent, monopoly is rare and monopolistic
competition is reality”
Under imperfect competition each and every seller can fix their
own price and they are engaged in producing close substitute products.
Imperfect competition is categorized into
Features of Monopoly:
The price at which this output OM is sold is known from the demand
or the average revenue curve, AR. It can be seen from the diagram that
corresponding to equilibrium output EM, the price on the demand or
AR curve is AM (=OP). Thus in equilibrium, the monopolist firm will be
in equilibrium, when producing output OM at price OP; therefore the
total profits earned by the monopolist is the area OPBM (price-OP X
quantity OM) at output OM. It is clear that average cost is EM. Therefore
total cost of the monopolist is given by the area OCEM (average cost
–EM X quantity OM) given that price is greater than average cost, the
monopolist earn supernormal profits. Now a total profit is equal to TR-
TC. That is area OPBM-OCEM=CPBE
Output
Diagram 6.6(c)
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In the long run the marginal revenue is equal to long run marginal
cost curve as well as short run marginal cost curve. At the equilibrium
point both the LRMC curve and the SRMC curve intersect the MR curve
at the same point.
In the diagram the short run average cost and the long run average
cost at which the monopolist can produce OM level of output is MB. The
price at which the monopolist will sell OM level of output is (OD).
Given that price is greater than average cost, the monopolist earns
supernormal profits. This is equal to the area ABED. The monopolist
earns supernormal profits in the long run, due to barriers for other
firms to enter the markets.
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a) When the nature of the goods is such that it is possible for the
monopolist to charge different prices. For e.g. Services of a doctor,
beauty treatment that is consumed by the buyers and cannot be
resold.
b) When consumers have certain preferences and prejudices, for
eg., irrational feeling of consumers =>higher the price they pay,
better the commodity.
c) When consumers are separated by distance, which make reselling
impossible.
d) Government regulations permitting price discrimination, for
eg., differences in electricity rates for domestic and commercial
buyers.
e) When the monopolist supplies goods to special orders.
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From the above diagram, panel (a) represents the conditions for
market I. AR1 represents its demand curve, which is relatively inelastic.
AR1/MR1 are the respective average/marginal revenue curves of market
I. Panel (b) represents market II. Its demand curve is elastic. AR2/MR2
is its average average/marginal revenue curves. Panel (c) represents
the condition of aggregate market of monopoly firm. ΣMR represents
the combined marginal revenue curves. ΣMR=MR1+MR2. The MC curve
represents the marginal cost of output. At point E, the MC curve intersects
MR curve. It is profit maximizing equilibrium condition. Thus OQ is the
equilibrium output. The monopolist allocates his output OQ in such a
way that profits are maximized in each market. Thus in each market
he must equate marginal revenue and marginal cost. The marginal cost
is the same, irrespective of the market in which it is sold. The profit in
each market is maximized by equating MC with corresponding MR. To
determine this a horizontal line AE parallel to X axis is drawn. The line
AE passes through MR1 curve at point a and MR2 at point b. Thus profits
are maximized when MC=MR1=MR2. Correspondingly OQ1 and OQ2
quantities of output are determined in these two markets. When OQ1 is
sold in market I, price OP1 is obtained. When OQ2 is sold in market II,
price OP2 is obtained.
that, MR1 for OQ1, MR2 for OQ2 output . Again OQ1+OQ2=OQ and ΣMR.
For OQ is EQ=OA. Thus MR=MR1=MR2.
the same product under slightly differentiated forms. For instance there
is a large number of sellers selling different brands of toilet soap. Each
firm in monopolistic competition accounts for a very small share in total
output of the market. The firms are bound to be small in size when found
in such large number in the market. Since such firms control only an
insignificant proportion of total market output, any action on its part by
way increase/decrease in production/price will have minimum effect
on other firms.
4) Free entry and exit of firms: Under this market, there are no entry
barriers. Firms can enter or quit freely. This makes competition stiff
because of close substitutes produced by new entrants with their own
brand names.
Given the cost and revenue curves the short run equilibrium is shown
in the figure (6.9). The demand or AR curve is also called the price
curve. MR is the marginal revenue curve. SAC and SMC are short run
cost curves. Given these cost/revenue conditions the firm will produce
that level of output, which will maximize its profits. This is the point E
where MR=MC and slope of MC.MR. The firm will thus fix its output at
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Managerial Economics - I
The firm may also make losses in the short run if the demand conditions
for its product are not so favorable relative to cost conditions. In the figure
below the average cost is higher than average revenue throughout.
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In the long run the firm’s demand curve becomes tangent to the
LAC curve. The firm only earns normal profits. The firm is in equilibrium
at the level of output where LMR=LMC. The corresponding price for
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Managerial Economics - I
Meaning:
Oligopoly market structure is a condition where there are a few
sellers. The word Oligopoly is derived from two Greek words- oligi
means ‘few’ and polien means ‘sell’.
Features
1)Few sellers
2)Interdependence
3) Indeterminate demand curve
4)Conflicting attitude of firms
5) Price Rigidity
6)Lack of Uniformity
(a) Cartel:
Cartel is an organization of suppliers of a commodity aimed at
restricting competition and increasing profit. It is a group of firms that
retain their individual identity but come together to co-ordinate the
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5.19 Summary:
Features of Monopoly:
Single Seller
Large number of buyers
No close substitutes
Independent pricing
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Barriers to entry
Downward sloping demand curve
Price discrimination:
Discriminating Monopoly
Price discrimination exists when the same product is sold at
different prices to different buyers. Although a monopolist more easily
implements price discrimination, because he controls the whole supply
of a given commodity, any firm under perfect competition could practice
this price policy
Features
Few seller
Interdependence
Indeterminate demand curve
Conflicting attitude of firms
Price Rigidity
Lack of Uniformity
Collusive Oligopoly
One way of avoiding uncertainty arising from oligopolistic
interdependence is to create mutual agreement among firms.
5.20 Questions:
monopoly market.
4. Explain the long run price and output determination under
monopoly market.
5. Explain price and output determination under discriminating
monopoly.
6. What is monopolistic competition?
7. What is production differentiation?
8. Give the meaning of selling cost.
9. Explain short equilibrium under monopolistic competition.
10.Explain long run equilibrium under monopolistic competition.
11. Write a note on kinked demand curve.
12. Mention the features of oligopoly.
13. What is collusive and non-collusive oligopoly?
14. Mention the features of duopoly.
5.21 Answers:
Section 2
1. Seller
2. Homogenous product
3. Price taker
4. Demand and supply
5. A marshal
6. Normal profit
Section 3
1. Single
2. Monopoly
3. Monopoly
4. Super normal profit
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Managerial Economics - I
5. Monopoly
6. Monopolistic market
7. Substitute
8. Super normal
9. Duopoly
10. Oligopoly
11. Oligopoly
12. Oligopoly
13. Oligopoly
Section 2
1. Refer to section 5.5
2. Refer to section 5.6
3. Refer to section 5.7
4. Refer to section 5.8
5. Refer to section 5.10
6. Refer to section 5.12
7. Refer to section 5.12
8. Refer to section 5.12
9. Refer to section 5.13
10.Refer to section 5.14
11.Refer to section 5.16
12. Refer to section 5.15
13. Refer to section 5.16
14. Refer to section 5.16
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Review questions
2 Marks Questions:
5 Marks Questions:
1. What are pricing methods? Explain different methods of pricing
policy.
2. Explain ‘price determination’ under perfect competition
3. Explain different types of Price discrimination.
4. Explain price and output determination under discriminating
monopoly.
5. Explain the features Oligopoly.
5 Marks Questions:
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Managerial Economics - I
Jain University
Model Question Paper
Managerial Economics – I
Time 3 Hours
Marks: 80
Section A
Answer any Two. Each carries 2 marks.
Section B
Section C
Answer any three questions from the following. Each question carries
14 marks:
187
Managerial Economics - I
Jain University
First Semester B.com Examination, November 2009
Managerial Economics
Time 3 Hours
Marks: 80
Section A
Answer any nine questions. Each carries 2 marks:
Section B
Answer any Four each carries 5 marks:
6. With the help of the following data, find out the trend values for
each year by using the method of least square and estimate the
annual sales for the next five years
Section C
Answer any three questions from the following. Each question carries
14 marks:
189
Managerial Economics - I
Jain University
First Semester B.com Examination, December 2009
Managerial Economics
Time 3 Hours
Marks: 80
Section A
Answer any nine questions. Each carries 2 marks:
Section B
Answer any Four. Each carries 5 marks:
5 60
2 250
190
4 100
5 80
3 200
4 100
5 120
2 150
5.Find out the trend values of each of the five years by using the method
of least square. Estimate the trend of export sales for the next two
years.
Year 2005 2006 2007 2008 2009
Sales in 240 280 300 280 340
crores
Section C
Answer any three questions from the following. Each question carries
14 marks:
191