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Economics PDF

This document provides an introduction to managerial economics. It discusses the meaning and definitions of economics and managerial economics. Managerial economics applies economic theories and analysis to business decision making to help solve problems. It bridges the gap between economic theory and business practice. The scope of managerial economics includes demand analysis, cost and production analysis, pricing decisions, profit management, and capital management. The functions are decision making and forward planning.

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0% found this document useful (0 votes)
220 views192 pages

Economics PDF

This document provides an introduction to managerial economics. It discusses the meaning and definitions of economics and managerial economics. Managerial economics applies economic theories and analysis to business decision making to help solve problems. It bridges the gap between economic theory and business practice. The scope of managerial economics includes demand analysis, cost and production analysis, pricing decisions, profit management, and capital management. The functions are decision making and forward planning.

Uploaded by

shivani
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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MANAGERIAL ECONOMICS

Module-1

Module – 1

Introduction to Managerial Economics

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:

The objective of this chapter is


• To understand the basic principles, tools and techniques of
Economics
• To understand the application of the same in the competitive
business world.
• To understand the characteristics of Economics
• To understand the role and responsibilities of the Economists

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Managerial Economics - I

Introduction:

Economics is the logic of choice, when confronted with scarcity. It


helps us to choose the best out of various alternatives. Economics is of
significant use in modern business. We can say economics is the mother
of commerce. So all the economic theories which help a successful
business are separated and so we have Business economics. Many do
not differentiate between managerial and business economics.

1.1 Meaning of Economics:

Before knowing the meaning of business economics, let us try to


understand the historical background of economics. 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.”

Economics is a science which studies the economic activities of


man and of the society. Economics can also be called a science of choice
as economics studies that aspect of the individual and society in which
limited resources are used to satisfy unlimited wants. Economics is
concerned with the satisfaction of human wants.

1.2 Meaning of Managerial Economics:

Managerial economics is a science, which deals with the application


of economic theories, techniques, principles and concepts to business
management in order to solve business and managerial problems.
Economics formulates various laws. They are examined and put into
application in business. For example, there are limited resources
and unlimited wants. These limited resources have alternative uses.
Therefore, the business economist has to take suitable decision with
regard to the relation of resources like raw materials, labour, place of
2
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production, marketing devices and thereby produce and market the


product at a price which is favorable to the buyers.

Managerial economics fills up the gap between economic theory


and business practice. It shows how economic analysis can be useful in
formulating business policies. It lies mid way between economic theory
and business management and serves as a connecting link between the
two.

1.3 Definitions of Managerial Economics

Now let us take a few definitions of Managerial economics given by


various economists:

• M.C. Nair and Merian define thus, “Managerial Economics is the use
of economic mode of thought to analyze business situations.”

• Prof. Joel Dean says that “use of economic analysis in formulating


policies is known as Managerial Economics.

• According to Hail Stones and Rathanel, “Managerial Economics is


the application of economic theory and analysis to the practice of
business firms and other situations.

1.4 Characteristics of Managerial Economics:

The main characteristics of Managerial Economics are as follows.


They are
1. It is micro in nature due to the study of business economics mainly
at the level of the firm. It does not study the economic problems of
an economy as a whole.
2. A business unit operates within the economy. Therefore, a
business manager must know the external forces working over
3
Managerial Economics - I

his environment. He has to adjust himself to the uncertainties of


his business in a wise manner. Managerial economics falls within
the realm of both micro and macro economics. Individual business
firms can flourish only when the economy as a whole is flourishing.
Decision making in business economics is entirely micro in
character.
3. Managerial economics largely uses the theory of markets and
private enterprises.
4. Managerial economics is pragmatic in its approach. It takes note of
the particular economic environment in which a firm works.
5. It is also called normative economics as business economics is
prescriptive rather than descriptive in nature

1.5 Distinction and Linkage between Economics Theory and


Managerial economics:

The main differences between economic and Managerial economics


are

Economics Managerial economics


Wider scope Limited scope
Positive Normative
Theories, principles and concepts Practical implementation
General problem Specific problem
All theories Theory of profit
Payment to factors Payment of organization

Economic theory provides a variety of concepts, principles, and tools


to analyze modern business economic problem. Basically economics
is a positive science containing a code of theoretical knowledge about
economic Behaviour. Economics helps us in arriving at some conclusion
and formulating an appropriate policy and measures to deal with a
specific problem.
4
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Economics deals with almost all the economic problems whereas


Business economics deals with the practical application of economic
theory into business practice.

Economics gives guidelines for policy makers to formulate a suitable


policy. In business, decision making process the real situation tends to
be quite different from theoretical assumptions due to the multiple
goals, lack of certainty due to dynamic changes etc., and hence economic
theory cannot provide a clear cut solution to business problems.

1.6 Nature and Scope of Managerial Economics:

Managerial economics is concerned with the application of economic


theory and methods to the analysis of decision – making problems faced
by business firms.

The scope of Managerial Economics covers all those fields, which


come under the realm of business. Business economics concerns itself
with solving all problems pertaining to business affairs. The subject
matter of business economics is classified as follows:

1. Demand analysis and forecasting

A business firm is an economic unit which transforms productive


resources into saleable goods. As such a firm must decide its total output
before preparing its production schedule and deciding on the resources
to be employed. Demand forecast serves as a guide to the management
for maintaining its market share in competition with its rivals, thereby
maximizing its profits.

Demand analysis facilitates the indemnification of the various


factors affecting the demand for a firm’s product. This, in turn helps the
firm in manipulating the demand for its output. Infact, demand forecasts
are the starting point for a firm’s planning and decision making.
5
Managerial Economics - I

2. Cost and production analysis

A firm’s profitability depends much on its cost of production. Cost


analysis deals with cost concepts, classification, cost-output relation,
cost controls, etc. It identifies the factors causing variations in costs and
chooses the cost-minimizing output level.

Production analysis deals with production function, laws of


returns, economies of scale etc. It is concerned with proper production
scheduling. It advices the organisation to combine the required factor
at the right proportion to produce a given level of output. This has to be
done in physical terms while cost analysis is done in financial terms.

3. Pricing decisions, policies and practices

Since a firm’s income and profit depends mainly on the price


decision, the pricing policies and all such decisions are to be taken after
careful analysis of the nature of the market in which the firm operates.
The topics covered in this field of study include market structure
analysis, pricing practices and price forecasting.

4. Profit management

It is profit which provides the chief measure of success of a firm


in the long period. A successful business manager is one who can form
more or less correct estimates of costs and revenues at different levels
of output. The more successful a manager is in reducing uncertainty,
the higher are the profits earned by him. It is therefore, profit planning
and profit measurement which constitute the most challenging area of
business economics.

5.Capital management

Investments made on plant, machinery and buildings are very high.


Therefore, capital management requires top level decisions. It means
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planning and control of capital expenditure. It deals with cost of capital,


rate of return and selection of projects.

1.7 Functions of Managerial Economics:

The two main functions of Managerial economics can be broadly


classified as
1. Decision making 2. Forward planning

Decision making

Decision making involves a process. All decisions must have


reference to some kind of problems of choice. A decision problem is
often an economic problem because it involves a choice from among a
set of many alternatives.

Decision making is essentially a process of selecting the best out of


many alternative opportunities that are open to management.

Forward planning

“Forward planning implies planning in advance for the future.”


The analysis of market behavior of firms and industry brings out
clearly the significance of business risks and uncertainty. Any producer
while deciding the future course of action of a firm takes into view the
past and present experiences of a firm; future events can’t be predicted
accurately.

However, a business economist must be sufficiently intelligent enough


to think in advance and prepare solutions to meet all types of problems
in future business.

Planning means tackling the future limitation in a systematic


manner
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Managerial Economics - I

1.8 Objectives and Uses of Managerial Economics:

The main objectives of business economics are as follows


1. Managerial economics deals with issues connected with selection
of resources available to a firm, method of production, and
effective management of business firms.
2. Managerial economics aims at integrating traditional economic
theories with practice.
3. It helps the business firms to set the goals as realistically as
possible. e.g. Profit maximization.
4. It avoids abstract economic principles, which cannot be put into
practice. e.g. Monopoly
5. It serves as a practical guide to businessmen in future planning,
policy formulation and decision making.
6. Economic theories, concepts and economic tools are used by
business economists in solving various business problems.
7. Profit Maximization and maintenance of economic viability over
a long period of time
8. The most important, but difficult task of the firm is to mobilize
capital at different stages of progress. Setting up of a firm depends
upon capital. Any decisions to increase the output results in
mobilization of additional capital. Therefore capital management
is another important function of business economics.
9. It aims at both sales and profit maximization.

Uses of Managerial Economics:

Every businessman in fact, every person makes economic decisions


everyday. We will always face problems of sacrifice and consequently
must make choices. Knowledge of economics helps us make wise
choices.
1. In business, economics is particularly useful. It is extremely useful
in making decisions to increase the firms’ profit and enable the
firm to operate more efficiently.
8
Module-1

2. Economics is useful to decision makers to decide how to adapt to


external changes in economic variables.
3. Appropriate levels of advertising and investment decisions are
also very important, and an understanding of economic theory
helps the businessman to make the most profitable decisions.
4. Knowledge of business economics is useful also to people who
work for government agencies or non-profit institutions. For
example, a government agency may be required to allocate a
given budget to attain the maximum benefit in education, health
care, and so forth, permitted by the size of the budget. Or it may
be charged with attaining a certain goal at the lowest possible
cost.
5. It helps in understanding the modern requirements of business.

These are economic problems, and business economics provides


the tools needed to solve these problems.

Self assessment questions - Section 1


1. Economics is wider where Managerial Economics is ____
2. Mention the uses of Business Economics.

1.9 Role and Responsibilities of Managerial Economists:

Let us first differentiate the business economist and management.


A Business economist is an employee of an organization, who advises
the management about the business environment and helps them to
take right decisions at the right time.

Role of Managerial economists


The term role refers to the behavior and action of an individual
in accordance with specified functions. A Managerial economist plays
a significant role both in solving the problems of decision making and
forward planning.
9
Managerial Economics - I

More generally, the role of Managerial economists in a business


firm can be studied under following headings:

1. To identify various business problems – causes and


consequences:
The main objectives of Managerial economists is to identify various
business problems that are confronting a business firm, find out the main
causes for the existing problems of business and analyze their effect on
the existing environment and suggesting the best possible solution.

2. To provide a Quantitative base for decision making and forward


planning:
The Managerial economist with his vast knowledge has to provide
a quantitative base for decision making, policy making and forward
planning in a business. He should help in business planning, adopting
organizational models, and management systems and find out different
techniques to maximize output and minimize cost of production.

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.

4. To act as an economic advisor:


By virtue of his expertise and in-depth knowledge of economics he
can help the firm to analyze various problems pertaining to the volume
of investment, sales promotion, and competitive conditions.

5. To act as an economic researcher:


A Managerial economist who is well equipped and trained in the
art of business administration and management, responds and reacts
quickly to dynamic changes in the modern business horizons. As a
researcher he should analyze the various cost benefit analyses, projects
and recommend the most economical one to the management.
10
Module-1

6. To Task of making specific decisions:


A Managerial economist has to help a business firm to find solutions
to varied complex problems faced by it. These problems may relate to
day-to-day operational issues, or they may relate to long-term planning.
More specifically, a business economist undertakes the following
functions:
(a) Production scheduling
(b) Demand forecasting
(c) Market research
(d) Economic analysis of the industry
(e) Investment appraisal
(f) Security management analysis
(g) Advice on foreign exchange management
(h) Advice on trade
(i) Pricing and the related decisions, and
(j) Analyzing and forecasting environmental factors.

6. General task to use available information


A business firm is affected by two sets of factors, viz.,
(I) internal factors, and (II) external factors.

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:

(a) In deciding about the production, sales and inventory


schedules of the firm: A business economist not only provides
information regarding their present level but also forecasts their
future trend.

(b) In determining the pricing and profit policies: In a multi


product firm, it also involves decision on product mix and the
different prices at which each product should be sold to maximize
the profits of the firm.
11
Managerial Economics - I

(c) In reaching investment decisions: The business economists


would be required to make an assessment of the total cost required
on an investment project, and, to make a forecast about the amount
of returns that can be expected over the life-time of the project.

(II) External factors:


These factors are outside the control of the management and
they are known as business environment. External factors constitute
the macro economic environment of a business firm. A business firm
has little or no control over these factors. A business economist has to
make an intelligent study of these factors, predict their future course
and guide the business firm in decision – making. The various external
factors that have a bearing on a business firm are as follows:
(a) General economic Conditions: These cover such areas as
the level and rate of growth of national income, regional income
distribution, influence of international factors on the domestic
economy, the business cycle, etc.

(b) Future demand for the product A business economist has to


keep track of the various factors that affect the demand for a firm’s
product in the long run.

(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.

(d) Market conditions: A business firm is affected by the market


conditions related to its raw materials and other intermediate
products. The market conditions are also related to its finished
product.
12
Module-1

It is the job of the business economists to keep the management


well informed about the emerging trends and also keep the firm
informed about the future course of action.

(e) Market share: The market share of a business firm is also


influenced by the policies and decisions implemented by the rival
firms. It is the job of the business economist to develop complete
knowledge about the future course of action likely to be taken by
the rivals.

(f) Government’s economic policies: Different aspects of monetary


policy, fiscal policy, trade policy, industrial policy, agricultural policy,
exchange rate policy, policy towards foreign capital have a different
impact on different business firms. A Managerial economist has to
play a multi dimensional role in a business firm. He is the centre of
the decision making mechanism.

1.10. Responsibilities of Managerial Economist:

The business economist is responsible for the success of the


business. Some of the important responsibilities and obligations of a
business firm are as follows:
1. Common Objectives:
A Managerial economist should work with the same frame of mind
and should have the same goals to pursue as are being pursued by the
business firm.

2. Ability to make correct forecasts:


A correct forecast brings prosperity for the business. A wrong
forecast spells doom. A Managerial economist should intellectually and
emotionally equip himself with the ability to make correct forecasts.

3. Ability to adapt to changing environment:


If any of the internal or external environment factors are undergoing
13
Managerial Economics - I

a change, the Managerial economists should be able to foresee these


changes. He should advise the management regarding these changes.

4. Willingness to take up challenging tasks:


It is for the business economists himself that he makes his services
indispensable and most sought after, both with the help of his ability,
training and experience.

Self assessment questions – Section 2

1. Economics is derived from the two Greek words ___________ and


_____ .
2. Economics is the art of _______ management.
3. Business economics is that branch of economics which deals with
the problems of _______.
4. Mention the two functions of Business economics.
5. Is Business economics positive or normative?
6. Use of economic analysis in formulating ______ policies is known as
Managerial Economics.
7. Decision making is essentially a process of selecting ______
alternatives that are open to management.
8. Forward planning implies planning in _________.

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”.

 Business economics is an integration of economic theories into


business practice. Economics is a science, which studies the
14
Module-1

economic activities of man and the society.

 Managerial economics fills up the gap between economic theory


and business practice.

 The main characteristics of Managerial Economics are


It is micro in nature
Managerial economics is pragmatic in its approach.
It is also called normative economics.

 The main differences between Economics and Managerial


economics are

Economics Managerial Economics


Wider scope Limited scope
Positive Normative
Theories, principles and concepts Practical implementation
General problem Specific problem
All theories Theory of profit
Payment to factors Payment of organization

Scope of Managerial economics:

• Demand analysis and forecasting


• Cost and production analysis
• Pricing decisions, policies and practices
• Profit management
• Capital management
• Decision making is essentially a process of selecting the best out of
many alternative opportunities that are open to management.
• “Forward planning implies planning in advance for the future.”
15
Managerial Economics - I

Objectives of Managerial Economics:

The main objectives of business economics are as follows


• Effective management of business firms.
• Managerial economics aims at integrating traditional economic
theories with practice.
• It helps the business firms to set the goals as realistically as
possible.
• It avoids abstract economic principles, which cannot be put into
practice. e.g. Monopoly.
• It serves as a practical guide to businessmen in future planning,
policy formulation and decision making.
• Economic theories, concepts and economic tools are used by
business economists in solving various business problems.
• Profit Maximization
• The most important, but difficult task of the firm is to mobilize
capital at different stages of progress.

Uses of Managerial Economics

Every businessman – in fact, every person makes economic decisions


everyday. We will always face problems of sacrifice and consequently
must make choices. Knowledge of economics helps us make wise
choices.

• In business, economics is particularly useful. It is extremely useful


in making decisions to increase the firms’ profit and enable the
firm to operate more efficiently.
• Economics is useful to decision makers to decide how to adapt to
external changes in economic variables.
• Appropriate levels of advertising and investment decisions are
also very important, and an understanding of economic theory
helps the businessman to make the most profitable decisions.
• Knowledge of business economics is useful also to people who
work for government agencies or non-profit institutions.
16
Module-1

Role of Managerial economists:

• To identify various business problems – causes and consequences


• To provide a Quantitative base for decision making and forward
planning
• To act as a thinker
• To act as an economic adviser
• To act as an economic researcher
• Task of making specific decisions
• General task to use available information.

A business firm is affected by the two sets of factors, viz.,


(1) internal factors, and
(2) external factors.

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

(2) External factors:


(a) General economic Conditions
(b) Future demand for the product
(c) Factors influencing the input cost of the firms. Input costs may be
affected by
• Market conditions
• Market share
• Governments economic policies

Responsibilities of Managerial Economist


• Common Objectives
• Ability to make correct forecasts
• Ability to adapt to changing environment
• Willingness to take up challenging tasks
17
Managerial Economics - I

1.18 Questions:

Terminal Questions – Section 1


1. What is decision making?
2. What is forward planning?
3. Define Managerial Economics.
4.Mention two functions of Managerial Economics.
5. Role and responsibilities of a Business Economist.
6. Write a note on the scope of managerial economics.
7.Explain the objectives of managerial economics?

1.19 Answers:

Answers for the Self Assessment Questions:

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

Answers for the Terminal Questions:


1. Refer to section 1.7
2. Refer to section 1.7
3. Refer to section 1.1
4. Refer to section 1.7
18
Module-1

5. Refer to section 1.9


6. Refer to section 1.8
7. Refer to section 1.8

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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Managerial Economics - I

Module – 2

Theory of Demand and Demand Forecasting

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
20
Module - 2

2.30 Summary
2.31 Questions
2.32 Answers

Objective

The objective of this chapter is to understand that


•Consumer preferences determine consumer demand for
commodities.
•Consumer demands are influenced by various factors in the
society.
•Consumer demands are governed by some fundamental principles
of demand.

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

Two students walking on the road saw a decorated market; they


entered the market and saw a variety of commodities with different
features. They wanted to buy the commodities but they could not buy
due lack of purchasing power. Hence, wants appear and disappear but
demand means our desire should be backed by income.

It should be understood that demand is not the same thing as desire


or need. A desire does not become a demand unless it is backed up by
21
Managerial Economics - I

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.

2.1 Demand schedule and demand curve:

An individual demand schedule shows the various quantities of


a commodity which an individual consumer purchases at different
prices. It represents a functional relationship between the price and the
quantity demanded. The table shows the imaginary demand schedule
of an individual.
Price Rs. Quantity
Demanded
7 1
6 2
5 3
4 4
3 6
2 8
1 10

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Module - 2

Individual demand curve


In the diagram ‘x’ axis measures the quantity demanded and
‘y’ axis the price. DD represents the demand curve, which shows the
relationship between price and quantity demanded. The demand curve
slopes downwards from left to right showing that as price falls quantity
demanded increases and vice versa.

2.2 Market demand schedule:

Price Quantities demanded by Individuals Total Market


Rs (A + B + C ) Demand
A B C
5 1 6 12 19
4 2 7 13 22
3 3 8 14 25
2 4 9 15 28
1 5 10 16 31

The demand schedule for the entire market is known as market


demand schedule.

2.3 Law of Demand:

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

Other things remaining constant as the price of a commodity


increases demand for the same decrease and vice versa.

Assumptions
In other words, assuming that as the price of a commodity
increases demand for the same decrease and vice versa.
23
Managerial Economics - I

1) Consumers’ income remains constant.


2) Consumers’ taste and preferences remain constant.
3) Prices of other related goods remain constant.
4) No substitutes are available for the commodity
5) Consumers do not expect further change in the price of the
commodity.
6) The commodity is not one of prestige value e.g. Diamonds.

2.5 Why does the law of demand operate?


Demand curve slopes downwards mainly because

1) Operation of the law of diminishing marginal utility


The law states that as a consumer consumes more units of a
commodity, it yields him lesser and lesser marginal utility. Even though
an average consumer does not calculate the marginal utility, he is
influenced by the fact that the additional expenditure brings him less
satisfaction. This limits his purchases unless its price is also reduced
correspondingly.

2) Principle of different uses


The law of demand operates because of the working of the principle
of ‘different uses’. Some commodities have several uses. Some uses are
more important than others. If the price of the commodity is high its use
will be restricted to that purchase which the consumer considers to be
more important. But if the price declines the consumer will employ to
less important uses. For example, if the price of mustard oil is very high,
it will be used only as a cooking medium, if its price falls, it will be used
even as hair oil.

3) Principle of ‘different devices’


Thirdly, the law of demand operates due to the working of the
principle of different desires. People have different requirements, tastes
and temperaments. This fact contributes to the working of the law of
demand. For example, some people are passionately fond of movies,
24
Module - 2

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.

4) Principle of ‘different incomes’


Fourthly, the law of demand operates on account of the working of
the principle of different incomes. A rich mans purchasing power is high
and therefore he can offer a higher price for a commodity than a poor
man, though his desire for the commodity is not as urgent as the poor
man. Under such a situation if the supply of a commodity is small the
whole of it will be sold to the rich people who can afford to pay a high
price for it.

But if the supply is large and then some of it has to be sold to


consumers of small means, the price will have to be lowered to a
reasonable level to attract them.

The working of the law of demand can also be explained in terms of


income effect and substitution effect.

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.’

b). Substitution effect


A fall in the price of the commodity while the prices of its
substitutes remain constant will make the demand for the former
attractive and hence consumer will buy more. This extension of demand
for the commodity is attributed to the ‘substitution effect.’ Conversely
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Managerial Economics - I

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.

2.6 Exceptions to the law of demand:

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.

4) Fear of future risk in prices


If the price of a goods is increasing and is expected to rise further the
consumers will buy more of the commodity at a higher price than they
did at a lower price. Thus, an increase in price may not be accompanied
by decrease in its demand and vice versa.

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Module - 2

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.

Self Assessment Questions – Section 1

1. Demand means interest backed by _______.


2. Law of demand is also known as the __________.
3. Snob effect was given by ________.
4. Giffen goods relates to __________.
5. Law of demand doesn’t operate for _____ goods.
6. Income effect is because of change in ______.
7. Market demand deals with too many ________________ in the market.

2.7 Expansion and Contraction in demand:

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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Managerial Economics - I

In the diagram, original demand curve is DD quantity demanded at


price OP equal to OQ. With fall in price to OP2, the quantity demanded
expands to OQ2, the co-ordinate point moves from E to E2, with a rise
in price quantity demanded contracts to OQ1. The co-ordinate point
moves from E to E1. That is, the curve remains the same up movement
is known as a contraction in demand. The down movement is known as
expansion in demand.

2.9 Increase and Decrease in demand:

When demand increases due to change in the conditions of


demand there is a recasting of the demand curve to the right hand side
indicating greater purchases or demand and this is shown by the curve
D to D2 in the diagram.

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Module - 2

In the diagram DD is the original demand curve at the price


OP. OQ is the quantity demanded. At the same price P, more quantity
demanded OQ2 and less quantity demanded OQ1is called increase and
decrease demand.

2.9 Factors Affecting Demand:

Change in demand means a change in the conditions of demand.


It is a change in the consumers’ scale of preferences. Such a change is
brought about not merely by a change in price but several other factors
such as.

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.

2) Climate or Weather conditions


It is obvious that demand must change with the season. For example,
in winter there will be a greater demand for warm clothes. In summer
demand for electric fans, cool drinks etc, may increase.

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.

4) Changes in income redistribution


This is done through the instrument of public finance for example,
by taxing the rich and spending the money on the poor, wealth is
redistributed. There is transfer of spending power and this is bound to
affect the demand.
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Managerial Economics - I

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.

6) Prices of related goods


Goods maybe either substitutes (like tea and coffee) or components
(like car and petrol). In the case of substitutes an increase in the price of
one will lead to an increase in the demand for the other but in the case
of complementary goods an increase in the price of one will lead to a
decrease in the demand for the other.

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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Module - 2

Self Assessment Questions – Section 2


1. Status symbol goods or articles of snob appeal relates to ______.
2. At same price less units are purchased means _______.
3. A right side shift in demand curve relates to ______.

Self Assessment Questions – Section 3


1. Demand means interest backed by _______.
2. Law of demand is also known as the __________.
3. Status symbol goods or articles of snob appeal relates to ______.
4. At same price less units are purchased means _______.
5. A right side shift in demand curve relates to ______.

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

Exceptions to the law of demand


• Giffen goods
• Veblen effect
• Price Illusion
• Fear of future risk in prices
• Emergency
• Necessaries
• Fear of shortage
• Change in fashion
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2.10 Elasticity of Demand:

Learning Objective:

In the previous chapter we tried to understand the close relationship


between price and quantity demand. The objective of this chapter is to
understand the responsiveness of quantity demand to price, income
and price of related goods.

Introduction:

The law of demand explains the inverse relationship between price


and demand. This statement does not indicate specifically how much
demand varies for given change in price. Elasticity of demand helps us to
understand the quantitative change between price and quantity demand
in respect to change in price, income and price of related goods.

2.11 Meaning of Elasticity of demand:

Elasticity refers to responsiveness of quantity demand to a given change


in price, income and price of related goods. It indicates the rate at which
the demands change for any given change in Price, Income and Change
in the price of related goods.

2.12 Types of Elasticity

Elasticity of demand can be classified into three categories


• Price Elasticity of demand
• Income Elasticity of demand
• Cross Elasticity of demand

2.13 Price elasticity of demand (EP)

Measures the responsiveness of quantity demanded of a commodity to


a change in its price. It can be expressed as follows
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Module - 2

Percentage change in quantity demanded of the commodity


Ep=
Percentage change in the price of the commodity

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.

5000 − 5500 1200 + 1000


Ep = ×
5000 + 5500 1200 − 1000

− 500 2200
Ep = × Ep = -5.17
10500 200
2.14 Price elasticity can be classified into the following types:

Different degrees of PED

1. Perfectly elastic or absolutely elastic demand

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Any small change in price leads to infinite change in quantity


demanded. In the diagram at OP price the quantity demanded continues
to increase from OQ to OQ1, Q2.

2. Perfectly inelastic or absolutely inelastic demand

Change in price leaves quantity demanded unchanged. In the diagram


the quantity demanded at prices P, P1 and P2 is the same i.e., OQ
Eg: Essential goods Salt, Medicines

3. Relatively elastic demand or more than unit elastic

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Module - 2

Percentage change in quantity demanded exceeds the percentage


change in price. In the diagram when prices are decreased from P1 to P2
quantity demanded increases from OQ to OQ1.
Ex: Luxurious goods, gold.

4. Relatively inelastic or less than unit elastic.

Percentage change in quantity demanded falls short of the


percentage change in price. In the diagram when the prices are reduced
from P to P1 the quantity demanded increases from only OQ, to OQ1 Ex:
Habituated goods.

5. Unitary elastic demand

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Managerial Economics - I

Percentage change in quantity demanded equals the percentage


change in price.

In the diagram when the prices are reduced by P to P1 quantity


demanded also increased by the same amount Q to Q1.
Eg: comfort goods

2.15 Income Elasticity of demand ( YED)

The extent to which demand is influenced by a change in income is


called income elasticity of demand.

It is a corresponding proportionate change in the quantity demanded


to a corresponding proportionate change in income. Generally when
income increases demand also increases in the same direction. In case
of inferior goods demand may change in the opposite direction.

Proportionate change in demand


YED =
Proportionate change in income
Y = Income
E= Elasticity
D= Quantity Demand

2.16 Cross elasticity of demand:

Cross elasticity of demand for a commodity is the extent to which its


quantity demanded changes as a result of change in the price of related
goods.
Thus,

Proportionate change i n demand o f X


Cross E =
Proportionate change i n price o f Y
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Module - 2

Cross elasticity can be positive, negative or zero.

1) It will be positive if the two commodities are substitutes.


2) It will be negative if the two commodities are complementary.
3) If the two commodities are not inter related, that is, a change in
the price of y does not cause a change in the demand for x, their
cross elasticity would be zero.

• In case of substitutes like tea and coffee if the price of tea


increases the demand for coffee increases and vice versa.
• In case of complementary goods like car and petrol if the price
of car increases the demand for petrol decreases and vice versa.
• In case of unrelated goods like car and tea if the price of car
increases the demand for tea does not get affected as the two
goods are not related.

2.17 Factors influencing the price elasticity of demand:

It is not possible to classify goods according to the nature of their


demand. One cannot lay down rigid rules to determine whether demand
in any particular case is elastic or inelastic.

Elasticity is a relative factor. The demand may be elastic for one


person at one place and for another person at another place it may
be inelastic. Whether the demand for a commodity will be elastic or
inelastic will be determined by various factors such as

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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Managerial Economics - I

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.

4. Proportion of income spent on the goods


The demand for a commodity on which consumer spends only a
small portion of his income is less elastic. For example: salt and matchbox.
A fall or rise in the prices of these goods does not affect the demand to a
great extent because people spend very little on these goods.

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.

6. Goods that can be postponed


Demand for goods, the use of which can be postponed. Most people
during war periods postpone their purchases. For example, building of
houses, buying of furniture etc such things are bought in large quantities
only when they are cheap. Demand for such goods is thus elastic.

7. Several uses of the commodity


Demand for goods having several uses. The demand for goods is said
to be more elastic when it can be put to a variety of uses. For example, a
fall in its price will result in a substantial increase in its demand. It will
be put to those uses where it was not being used due to its high price.

Measurement of price elasticity by total outlay method or


expenditure method
Prof. Marshall has evolved the total expenditure method to
measure the price elasticity of demand. According to this method,
Elasticity of demand can be measured by considering the change in
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Module - 2

price and subsequent change in the total quantity of goods purchased


and the total amount of money spent on it.

Total outlay = price x quantity demanded

There are three possibilities:

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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Managerial Economics - I

In the above table we find three possibilities.


1) More Elastic demand. When price is Rs 10 the quantity demanded
is 1 unit and total expenditure is 10. Now price falls from Rs. 10 to Rs. 6,
the quantity demanded increases from 1 to 5 units and correspondingly
the total expenditure increases from Rs 10 to Rs. 30. Thus, it is clear that
with a fall in prices, the total expenditure increases and vice versa so
elasticity of demand is greater than one or Ed > 1.

2) Unitary elastic demand. If price is Rs. 6, demand is 5 units so the


total outlay is Rs. 30. Now price falls to Rs. 5 the demand increases to 6
units, but the total expenditure remains the same i.e., Rs. 30. Thus it is
clear that with the rise or fall in price, the total expenditure remains the
same. The elasticity of demand in this case is equal to one or Ed = 1.

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.

Measurement of price elasticity through total expenditure method


can be shown with the help of a figure

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Thus it is clear that the changes in total expenditure due to changes in


price also affect the elasticity of demand.

POINT METHOD: Point method is also known as geometrical method.


This method is used to find elasticity on demand curve.

lower Segment o n the demand curve (lS)


Ep =
upper Segment o n the demand curve (uS)

Self assessment Questions – Section 4


1)Elasticity refers to responsiveness of quantity demand to a given
change in ____
2)Elasticity of demand can be classified into three categories _______
3)Price elasticity of demand refers to change in quantity demand to
a given change in _____
4) Change in price leads Infinite change quantity demand relates to
________
5)Proportionate change in quantity demand is greater than
proportionate change in price relates to _________
6) Total outlay = price x _______
7) Ep= _________________________________________________

Summary:
Let us know try to summarize the entire topic which we have discussed
in this unit.

Meaning of Elasticity of demand


• Elasticity refers to responsiveness of quantity demand to a given
change in price, income and price of related goods. It indicates the rate
at which the demands change for any given change in Price, Income and
Change in the price of related goods.
Elasticity of demand can be classified into three categories
• Price Elasticity of demand
• Income Elasticity of demand
• Cross Elasticity of demand
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Managerial Economics - I

Price elasticity of demand

Percentage change i n quantity demanded o f a commodity


Ep =
Percentage change i n the price o f the commodity

Q − Q 1 P + P1
Ep = ×
Q +Q 1 P−P1

Price elasticity can be classified into the following types

Different degree of PED


• Perfectly elastic or absolutely elastic demand.
• Perfectly inelastic or absolutely inelastic demand
• Relatively elastic demand or more than unit elastic

Unitary elastic demand

proportionate change in demand


YED =
proportionate change in income

Cross elasticity of demand

Proportionate change i n demand o f X


Cross E =
Proportionate change i n price o f Y

Factors influencing the price elasticity of demand

• 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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Module - 2

Total outlay method

Total outlay = price × quantity demand

More Elastic demand Ed > 1


Unitary elastic demand Ed = 1
Less elastic demand Ed < 1

POINT METHOD:

lowerSegmen t o n the demand curve (lS)


Ep =
upper Segment o n the demand curve (uS)

2.18 Demand Forecasting:

• Meaning – levels – objectives- importance


• Method of estimation – Survey method and Statistical method
• Forecasting for new product
• Role of demand forecasting to Business Management

2.19 Introduction:

After understanding the concept of demand in the previous chapter


now let’s try to understand one of the modern exercises to judge the
probabilities of the market. In modern economic activity production
should be ‘BY CHOICE BUT NOT CHANCE’, that is I am talking about
Demand Forecasting.

Learning Objective:

This chapter main deals with Demand forecasting which an


important management tool. Demand forecasting enables a firm
to assess the probable demand for its product and plan its future
production accordingly. Thus, it helps in better planning and allocation
of resources.
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Managerial Economics - I

2.20 Meaning:

Forecast is the prediction of a future event. Passive forecasting


assumes a static business environment in future. It means the current
external and internal dimensions of the demand for his products will
continue in the future without a change.

The active forecasting on the contrary assumes a change in the future


business environment through policies of the firm, its competitors and
governments.

2.21 Objectives of Demand Forecasting:

The objectives of demand forecasting may be recorded as


(A) Short-term objective (B) Long-term objective

(A) Short term objectives


1) Regular Availability of Labour
Demand forecasting enables us to properly arrange the skilled
as well as unskilled workers to meet the production requirement
scheduled during a given period of time.

2)Price policy formulation


Sales forecast enables the management to evolve a suitable
price strategy. It is done so that price does not fluctuate so much
during the periods of inflation.

3) Proper control of sales


It also helps in formulating suitable sales strategy according to
the changing pattern of demand as well as the extent of competition
prevalent among the firms.

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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Module - 2

5) Regular supply of raw materials


By determining the volume of production during a given period
of time the entrepreneur can forecast the raw material required in
future.

6) Formulation of production policy


Sales forecasting enables to formulate the appropriate
production policy to overcome the problems related to over
production and under production.

(B) Long term Objectives


If the period of forecasting is more than one year then it is termed as
long term forecasting.
1) Labor requirements.
Expenditure is the most important component in cost of
production. In the long run, techniques of production may change.
Therefore, trained and skilled labours are needed for new type of
job responsibilities. Thus, demand forecasting helps to arrange the
skilled labour.

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) To decide about future expansion


The long term demand forecasting enables to plan for a new
project, as well as expansion and modernization of the existing
unit.

Self Assessment questions – Section – 5


1.Demand forecasting is one the modern tools of ______
2.Demand forecasting is process of estimating future _______ of
consumer
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Managerial Economics - I

2.22 Types of Demand Forecasting:

Demand forecasting may be forecasted at three levels. It includes


• Macro-level forecasting or at aggregate level
• Industry level forecasting
• Firm level forecasting

Further demand forecasting can be viewed in the following stages


1) Short-term demand forecasting
Short term demand forecasting is concerned with short time period
usually of less than one year. This is required for current production
scheduling, purchases of raw materials and inventory of stocks, etc.
the seasonality of sales and its impact on production planning, stock,
distribution of products in markets is taken care of by short term
demand forecast.

2)Long-term demand forecast


Long term demand forecast is needed for capacity expansion i.e.,
growth of the firm, recruitment and diversification policies, for all these
decisions have long-run implications in making such a forecast a firm has
to take into account a variety of factors such as population, competition
in the market, technology, government policies. Sometimes it would be
difficult to get precise data about all such factors which affect long term
demand for industrial products.

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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Module - 2

2.23 Steps involved in Demand forecasting:

In order to have an efficient, accurate and meaningful forecasting,


the management should proceed according to a systematic plan. The
various steps involved in demand forecasting are
1) Clarity of Objectives
To have an efficient forecasting one should have clarity of objectives.
It will remove the difficulties involved in the way of forecasting. A firm
may use the concept to determine various things viz., allocation of funds
for sale promotion, fixation of price, inventory control etc. the forecasting
will differ for each and every approach.

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.

4)Interpreting the results


The last step involved in demand forecasting is the interpretation
of results. It is based on certain assumptions. If there happens to be
a change in the assumptions involved in forecasting, the revision of
forecast will become almost inevitable.

2.24 Methods/ techniques of demand forecasting:

Demand forecasting is a difficult exercise as consumers’ behaviour


is most unpredictable. It is motivated and influenced by multiplicity of
factors. Economists and statisticians have tried best to develop several
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methods of demand forecasting. Generally there are objective and


subjective techniques of demand forecasting in use at present.

An objective method provides the projection of demand using a


statistical or mathematical technique.

In subjective method, estimates are made about the demand using


intuition i.e., using experience, intelligence and judgment.

1) Survey of buyers’ intention or consumers’ survey.


According to this method the potential buyers will be contacted,
preferably on fact to fact basis. Buyers being the most useful source
of information, they will tell what their proportions of their total
requirement would be bought from a particular firm and what
motivates them to stick on to that particular product. This information
acts as an ideal base for forecasting and the firm can make a demand
estimate. The greatest limitation of this method is that the cost of
estimate is prohibitive. Although the firm can contact every potential
buyer in person, the number of consumers being large, contacting them
individually is expensive and time consuming. Further many a times the
consumers do not reveal their buying intentions.
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The following conditions are also essential to adopt this method:

(1) The consumers should be less in number


(2) The cost in reaching them should be less
(3) The consumers should have clear buying intentions and follow
them implicitly.
(4) Finally they should reveal their intentions.

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.

But there is an apprehension in this method that all sales


representatives will not be having objective look at the problem. Some
of them are biased for their own personal reason. Their opinion might
be positive or negative. This biased opinion will not help in projecting
true demand position.

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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Managerial Economics - I

The equation for the line of best fit is


Y=a + bx
Where y = sales
A and b = values to be estimated
X = unit of time.

In order to solve the equation, we have to make use of the following


straight-line equations
Y=a+bx

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.

A = y/n = 1400/5 = 280


B = Σ XY / Σ X2 = 220 / 10 = 22

Now applying values to regression equation, the equation will be y =


280 + 22 X
From this, we can ascertain sales projection for the year 2003, 2004 and
2005
For the year 2003 = 280 + 22 (3) = Rs.346
2004 = 280 + 22 (4) = Rs. 368
2005 = 280 + 22 (5) = Rs. 390
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Module - 2

2.25 Economic indicators:

The demand for a product can be assessed based on certain


economic indicators. These economic indicators are given by the
specialized economic and statistical organizations like central statistical
organization or national council of applied economic research. According
to this method, the forecaster should establish the relationship between
the sale of the product and economic indicators to assess correct demand
and to measure to what extent these indicators affect the demand.

a. Income of the individuals and demand for consumer goods


b. Agricultural income and demand for agricultural inputs like
manure, implements, etc.
c. Housing projects of the government and expected demand for
building materials
d. Number of automobiles vehicles registered with transport
authority acting as an indicator to project demand for petrol and
auto spares

There are certain limitations in this method.


a. A specific and an appropriate indicator cannot be secured to
project the demand. The selected indicator may not fit into the
particular forecasting.
b. As the past data are not available for certain products, this will
not fit well.

Forecasting demand for a new product


Demand forecasting for new products is quite different from that
for established products, for the simple reason that the firm has no past
experience or past sales data for this purpose. Many business managers
attempt to make intelligent guess estimates.

1) The new product may be regarded as an out growth of an existing


product and the demand for the new product may be taken as an
outgrowth of the demand for the existing product.
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2) The new product may be taken as a substitute for the existing


product and the demand for the new product may be estimated
accordingly.
3) The manager should carefully analyze the pattern of growth of
the existing product and then estimate the rate of growth and the
possible volume of demand for the new product.
4) He can arrange to contact the ultimate buyers directly or through
the use of samples of new product, find out their responses and
make an estimate of the demand for the new product.
5) He can attempt to find out the consumers responses to the new
product indirectly through getting in touch with some specialized
and informed dealers who have good knowledge about the market,
about the different varieties of the product already available in
the market. The consumer’s preferences etc.
6) The company can test market the product in a sample market,
find out the reactions of the market and then make an estimate
of demand for the whole country for the short period and for a
longer period.

2.26 Conditions for good forecasting method:

1)Accuracy in method forecast


The demand forecast should be accurate, as far as possible, even
though cent per accuracy about the future cannot be assured.

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.

5) Availability and timeliness


The forecasting method should be capable of maintaining forecast
on an up to date basis, which implies that the data regarding the demand
functions should be available readily and that the forecasting method
should permit changes to be made in the demand relationships as they
occur.

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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2.27 Limitations of forecasting:

The factors impeding the demand forecasting are


1)Taste, fashion and preferences of consumers
2)Non availability of past sales data in case of new products
3)Growth elements
4)Psychological factors

2.28 Demand Forecasting of New Product:

Prof. Joel Dean has suggested six approaches for forecasting demand for
a new product. They are as follows:

•Project the demand for a new product as an outgrowth of an


existing old product
•Analyze new products as substitute for some existing product or
services.
•Estimate the rate of growth and ultimate level of demand for the
new product on the basis of the pattern of growth of an established
product.
•Estimate demand by direct enquiry of ultimate purchasers
•Offer the new product for the same in a sample market

2.33 Importance of Demand Forecasting:

Demand forecasting is of great importance to business managers due to


following reasons:

•Demand forecasting is a pre-requisite for planning production


decisions of a firm
•A firm intending to expand its capacity needs to forecast demand
for its output
•Sales forecast depends on demand forecast.
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Module - 2

•A well planned budgeting is possible only through demand


forecasting
•Control on business inventories, intermediate goods, and semi-
finished goods, greatly depend on regular estimates of future
demand
•Demand forecasting is essential for stabilizing the production and
employment within the firm.

Self Assessment questions – Section 6


1. Mention different methods under Economic indicators
2. Mention the steps involved in Demand forecasting
3. The main conditions for demand forecasting are ________ and ____
4. Statistical methods depend on the data of _______ years.

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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Managerial Economics - I

Steps involved in Demand Forecasting


• Clarity of objectives
• Selection of goods
• Selection of method
• Interpreting the results

Methods of Demand Forecasting


• Survey of buyers’ intention or consumers’ survey.
• Collective opinion
• Trend projection

The equation for the line of best fit is


Y=a + bx

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

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 find out the value of a and b.

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A = y/n = 1400/5 = 280

B = Σ XY / Σ X2 = 220 / 10 = 22

Now applying values to regression equation, the equation will be y =


280 + 22 X
From this, we can ascertain sales projection for the year 2003, 2004 and
2005
For the year 2003 = 280 + 22 (3) = Rs.346
2004 = 280+ 22 (4) = Rs. 368
2005 = 280 +22(5) = Rs. 390

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

Forecasting demand for a new product


• The new product may be regarded as an outgrowth of an existing
product and the demand for the new product may be taken as an
outgrowth of the demand for the existing product.
• The new product may be taken as a substitute for the existing
product and the demand for the new product may be estimated
accordingly.
• The manager should carefully analyze the pattern of growth of
the existing product and then estimate the rate of growth and the
possible volume of demand for the new product.
• He can arrange to contact the ultimate buyers directly or through
the use of samples of new product, find out their responses and
make an estimate of the demand for the new product.
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• He can attempt to find out the consumers responses to the new


product indirectly through getting in touch with some specialized
and informed dealers who have good knowledge about the market,
about the different varieties of the product already available in
the market. The consumer’s preferences. etc.
• The company can test market the product in a sample market,
find out the reactions of the market and then make an estimate
of demand for the whole country for the short period and for a
longer period

Condition for good forecasting method


• Accuracy in method forecast
• Plausible
• Economy
• Quick results
• Availability and timeliness
• Durability
• Flexibility

Limitations of forecasting
• Taste, fashion and preferences of consumers
• Non availability of past sales data in case of new products
• Growth elements
• Psychological factors

Demand Forecasting of New Product


• Project the demand for a new product as an outgrowth of an existing
old product
•Analyze new product as substitute for some existing product or
services.
•Estimate the rate of growth and ultimate level of demand for the new
product on the basis of the pattern of growth of an established
product.
•Estimate demand by direct enquiry of ultimate purchasers
• Offer the new product for same in a sample market
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Module - 2

Importance of Demand Forecasting


•Demand forecasting is a pre-requisite for planning production
decisions of a firm
•A firm intending to expand its capacity needs to forecast demand
for its output
•Sales forecast depends on demand forecast.
•A well planned budgeting is possible only through demand
forecasting
•Control on business inventories, intermediate goods, and semi-
finished goods, greatly depend on regular estimates of future
demand
•Demand forecasting is essential for stabilizing the production and
employment within the Firm

2.30 Questions:

Terminal Questions – Section 1

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.

Terminal Questions – Section 2

1. What is elasticity of demand?


2. Mention different concepts of elasticity of demand.
3. What is Price elasticity of demand?
4. Write a note on different degrees of PED.
5. What is Income Elasticity of demand?
6. What is Cross Elasticity of demand?
7. Explain Total outlay method with the help of illustration.
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Terminal questions – Section 3

1. What is demand forecasting?


2. What are the criteria of a good forecasting method.
3. Mention the objectives of demand forecasting.
4. Mention the importance of Demand forecasting.
5. Mention the limitation of demand forecasting.
6. Using the following information calculates the sales of fertilizers
during 2004 using the method of least square.
Year Sales
N Y
1998 240
1999 280
2000 240
2001 300
2002 340

2.31: Answers:

Answers for the Self Assessment Questions:

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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Module - 2

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

Answers for the Terminal Questions:


Section 1

1. Refer to section 2.1


2. Refer to section 2.9
3. Refer to section 2.8
4. Refer to section 2.7
5. Refer to section 2.6

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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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Module - 2

4. Forecast the nature of demand by using method of least square.


5. Explain the factors influencing demand
6. Explain the different degrees of PED.
7. Calculate PED by using total outlay method

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:

Most of the time people confuse themselves in understanding the


meaning of demand and human wants. In the previous chapter we have
already learnt the meaning of demand where income and willingness
of the consumer backing each other. But Human wants have the unique
feature of appearing and disappearing. Let us try to understand the
theory of consumption in relation with consumer behavior.

Learning Objective:

The main objective of this chapter is to understand the meaning


of human wants and consumption. It also helps in understanding the
rational behavior of consumer with one commodity and more than one
commodity.

3.1 Human Wants:

Introduction

Human beings have wants which need to be satisfied everyday.


Goods and services are necessary to satisfy the various wants of human
beings. The basis of all economic activities is the existence of human
wants. Every man has certain wants. Wants, efforts and satisfaction
together form our economic life. Wants lead to economic efforts and
efforts result in satisfaction.

WANTS=>EFFORTS=>SATISFACTION

Wants refer to human desires and motivations in life. Erich Roll


defines wants as “an experience of lack of satisfaction which leads to
action designed to provide that satisfaction.”

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3.2 Characteristic of Wants:

• Human wants are unlimited


• Wants are competitive.
• Wants are complementary.
• Wants are alternative.
• Wants are recurring.
• Wants are influenced by advertisements.
• Wants differ from one place to another.

Wants are broadly classified into two categories

• Primary Wants
• Secondary Wants

Primary Wants include


• Necessaries of life
• Necessaries of efficiency
• Conventional necessaries

Secondary wants include


• Comforts
• Luxuries

3.3 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. The end of all economic activity is consumption.

According to Ely “Consumption in its broadest sense means the use


of economic goods and personal services in the satisfaction of human
wants”
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Module -3

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.

3.4 Types of consumption:

Direct consumption: When goods and services are directly used to


satisfy human wants, it is termed as direct consumption.

For example goods such as food, cloth etc.

Indirect Consumption: When goods and services are used indirectly


to satisfy human wants, it is termed as indirect consumption.

For example machinery, tools and implements etc.

Role of consumer under Open and Closed Economy

“Under capitalism, the consumer is the King”


- Frederic Benham

What does the concept of consumer’s sovereignty or the sovereignty


of the consumer under capitalism mean? It is said that “Under capitalism
the consumer is the king,” He is free to spend his income in the manner
he thinks best. He enjoys perfect freedom of consumption. The entire
productive activity in the country is meant to satisfy the consumer.
Big business organizations in western countries maintain separate
departments for the purpose of studying the wants of the consumer and
produce exactly those goods which are desired by the consumers. It is in
this matter that the consumer is the master, the king and the sovereign
who rules the capitalistic economy.

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3.5 Limitations of Consumer Sovereignty:

The various limitations on the sovereignty of the consumer in


a capitalistic economy may arise because of certain circumstances in
the economy itself which may have the effect of limiting his freedom of
choice.
1. Productive powers: If the economy lacks the natural resources
and equipment necessary for the production of a particular
commodity, to that extent the sovereignty of the consumer
shall become limited in scope. The consumer may desire that
commodity but it cannot be produced due to the inherent
limitations of the economy.
2. State of technical knowledge: The extent of consumer sovereignty
also depends on the state of technology the country enjoys. If the
consumer desires for a commodity which cannot be produced
with the present technical know-how, then his choice is restricted
to that extent.
3. Low purchasing power: Every consumer has limited amount
of income and he cannot buy unlimited quantities of goods. An
additional quantity of one commodity can be bought only at the
expense of another commodity. So to that extent the sovereignty
of the consumer is limited.
4. Restriction by the state: State may prohibit the production and
consumption of certain commodities that are injurious to health
like opium or other injurious drugs; to that extent sovereignty of
the consumer is curtailed.
5. Taxation: Imposition of heavy taxes by the state results in reduced
purchasing power of the consumer and also his freedom of
consumption.
6. Monopoly: Under monopoly there is no freedom of consumption for
the consumers. He has to accept the type of commodity produced,
also has to pay the price demanded by the monopolist.
7. Fashions and customs: Acceptance of new fashion, expenditure
on social and religious ceremonies also curtails consumer
sovereignty.
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8. Standardized production: The capitalistic economy is


characterized by standardized production. It produces cheap, but
standardized goods on a mass scale. It does not cater to individual
tastes. The consumers are forced to buy sub standard goods. As
such they have very little choice left in the matter.
9. Advertising: The continuous, persistent high pressure
advertisement ultimately results in curtailing, indirectly of
course, the consumer’s freedom of choice. There is not much force
in this argument. No doubt, the rival business firms advertise
and publicize their goods but ultimately it is the consumer who
decides which product to buy.
10. Rationing: During war time, even the capitalistic countries may
have to resort to rationing of essential commodities, such as food-
stuff, sugar, kerosene oil, cloth etc. under rationing, each citizen
is given a fixed quantity of those essential commodities on his
ration card. No one is allowed to buy more than the fixed quota.
11. Inflation: If the price of commodities is constantly increasing,
then the consumer has to make necessary changes in his budget.

3.6 Is Consumer Sovereignty Desirable?

It is a controversial issue. One school of thought holds the view


that in matters of consumption the consumer should be allowed perfect
freedom to make his choice, i.e., there should be no restrictions imposed
by the state on his consumption.

The socialists are opposed to the very idea of granting perfect


freedom of choice to the consumers. They argued that
1. The concept of consumer sovereignty turns out to be a myth in
capitalistic economy. For example, there exists a vast economic
inequality wherein the richer sections may exercise freedom
of consumption. Whereas the majority of poorer people do not
possess any such freedom of choice due to lack of purchasing
power.
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2.If the consumers are allowed perfect freedom of consumption, it


will result in wrong and uneconomic utilization of the resources
of the country and resources would flow more rapidly into lip
stick making industry than steel and chemical.

3. Socialists oppose on the ground that the consumer does not


understand his own interests and if he is allowed freedom of
choice he is likely to injure himself in the process. For example
consumption of alcohol.

4. It has been argued against freedom of choice saying that the


consumer is a poor judge of things. He lacks even the minimum
knowledge necessary to make a rational choice.
For example, even in the purchase of a refrigerator or TV, he
cannot make an independent choice because it is a highly a
technical matter. He has to seek the expert opinion to make the
right choice in such matters.

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.

3.7 Consumer Behaviour:

Consumer behavior refers to the study of consumer while engaged


in the process of consumption. The basic objective of a consumer is to get
highest possible satisfaction in the process of consumption. Consumer
equilibrium can be studied under two approaches:

a. Ordinal approach
b. Cardinal approach
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Module -3

Utility Analysis is also known as Marshallian or Cardinal approach and


Indifference analysis is called as modern Hicksian or ordinal approach.
Utility approach is based on the assumption that the volume of utility of
a commodity can be measured exactly in terms of numbers. It believes
that quantification of utility is possible. On the contrary Indifference
curve approach takes the level of satisfaction instead of measuring in
terms of Utility.

3.8 Utility Analysis:

The term Utility refers to want satisfying power of a commodity.


It is subjective in nature. It is a relative concept where it varies from
person to person, place to place, and time to time.

The Law of Diminishing Marginal Utility: Gossen’s First Law


The law of diminishing marginal utility is also known as Gossen’s
First law. It states that, other things being equal, with the increase in
the stock of a commodity consumed or acquired, its marginal utility
diminishes.

Statement of the Law


“If a consumer consumes more of a commodity the utility of
additional unit consumed diminishes”

Assumptions of the law


1. It is based on the cardinal concept which assumes that utility is
measurable and additive like weight and length of goods.
2. There is no time interval between the consumption of two units,
meaning that the consumption of various units of the commodity
is continuous.
3. The units consumed must be of a reasonable size. If the size is too
small the law may not apply.
4. The law assumes ‘ceteris paribus’ or other things being equal, i.e.,
there is no change in tastes, habits, preferences and incomes.
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5. The prices of goods are also assumed to be given.


6. The law is concerned with the rational economic man who acts 6.
normal and his aim is to maximize his satisfaction.
7. The units of the commodity are homogeneous, i.e., they are alike
in size and quantity.

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

Diagrammatic illustration of the law

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Module -3

In the diagram, ‘x’ axis represents the units of the commodity


consumed and the ‘y’ axis shows total utility and marginal utility. The
curve MU represents the marginal utility and the curve TU represents
the total utility. The MU curve slopes downwards indicating that MU
diminishes and the TU curve slopes upwards indicating that the total
utility increases but at a decreasing rate when the MU curve intersects
the ‘x’ axis which is the minimum point, the total utility curve is at its
peak or maximum. In other words, it means that when marginal utility
is zero, total utility is maximum.

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.

Exceptions to the law of diminishing marginal utility:


1. Alcoholics: It is said that the marginal utility of liquor instead
of diminishing actually rises with increased consumption. But a
careful consideration will show that after a certain stage even the
marginal utility of liquor to the drunkard will start declining and
ultimately becomes negative.
2. Wealth and riches: The law does not apply in the case of wealth
and riches. In the case of wealth it is said that the more one has
of it the greater is the desire to acquire still more. In this case,
marginal utility can never become zero or negative, i.e., the utility
curve neither touches the x axis nor falls below the x axis.
3. Hobbies and rare collections: Hobbies like collection of stamps,
old paintings and antiques, coins etc., are an exception to the law
of diminishing marginal utility. The greater the collection, the
greater is the desire to acquire more. But if the person spends
increasing amount of money in acquiring the same types of coins
or stamps, marginal utility will diminish.
4. Reading: More reading gives no doubt more knowledge but
only under heterogeneous conditions. If homogeneity condition
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is fulfilled then knowledge will not increase. Knowledge can


increase only by reading different books not the same book over
and over again.

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.

Importance of the law


The law of diminishing marginal utility is the basic law of
consumption. The law of demand, the law of equi-marginal utility, and
the concept of consumers’ surplus are based on it.

The principle of progression in taxation is also based on this law. As


a person’s income increases, the rate of tax rises because the marginal
utility of money to him falls with the rise in his income.

Why does the law of diminishing marginal utility operate?


There are two reasons for the operation of this law:
1) Commodities are not perfect substitutes. Had the perfectly
substitutability of goods existed; the law of diminishing utility
would not have operated. For example, bread and butter are
not perfect substitutes of each other. They tend to be consumed
in certain appropriate propositions. If the consumer goes on
increasing his quantity of butter with a constant supply of bread,
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Module -3

he will reach a stage where there is not enough bread to spread


his butter on. Successive increments of butter would add less to
his utility or satisfaction, and the law of diminishing marginal
utility comes into operation. If they had been perfect substitutes
of each other the law would not have let in.

2) Satiability of particular wants –the second reason for the


operation of the law of diminishing utility is that, although all
the wants of a man cannot be satisfied, one particular want is
satiable. The law would not operate if one particular want were
not satiable.

3.9 Proportionality Rule:


According to the proportionality rule, the utility derived from
spending an additional unit of money must be the same for all
the commodities. If the consumer derives greater utility from one
commodity, he can increase his level of satisfaction by spending more
on that commodity and less on the others, until the utility derived from
all the commodities are the same. The consumer stops spending his
money at the point where price equals utility. This can be illustrated
diagrammatically.

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In the diagram on x axis we measure quantity consumed and on y


axis we measure price and utility. MU is the marginal utility curve. At
point E, the consumer is in equilibrium as the marginal utility derived is
equal to the price paid to the commodity any point above E, the utility is
greater than price. And any point below E, the utility is less than price.

According to the proportionality rule the consumer stops consuming


the commodity at the point where utility is equal to the price paid to the
commodity.

3.10 Law of Equi- Marginal Utility: Gossen’s Second Law:

The law of equi-marginal utility is based on the proportionality rule.


The proportionality rule states that the consumer will spend his money
on different goods in such a way that marginal utility of each commodity
is proportional to its price.

Statement of LEMU

“Other things being equal, a consumer gets maximum satisfaction


when he allocates his limited income to the purchase of different goods
in such a way that the marginal utility derived from the last unit of
money spent on each item of expenditure tends to be equal”

Symbolically,

In case of equi-marginal utility we take two commodities into


account. The law of equi-marginal utility states that the consumer will
distribute his money between the goods in such a way that the utility
derived from the last rupee spent on each commodity is equal. In other
words, a consumer attains equilibrium when marginal utility of money
expenditure on each commodity is the same.

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In other words,

Marginal utility o f A Marginal utility o f B


×
Price o f A Price o f B
Assumptions
1) Utility is measurable in terms of money.
2) Income of the consumer is limited and constant.
3) Marginal utility of money remains constant.
4) Law of diminishing marginal utility operates.
5) Man acts rationally.

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:

Units of Marginal Marginal


money spent Utility of A / Utility of B /
Price of A Price of B
1 10 08
2 09 07
3 08 06
4 07 05
5 06 03
6 05 01

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If the consumer income is Rs. 19, he allocates to buy both commodity


A and B. Consumer purchase 5 units of commodity A and 3 units of
Commodity B to get the maximum satisfaction.

At 5 units of X commodity, Marginal Utility of A is equal to Marginal


Utility of B of 3rd unit of B commodity
Diagrammatic representation:

Price of A Price of B

In the diagram, Units of commodity A and B are measured on


the Horizontal axis and Marginal Utility on Vertical axis. The two MU
curve are sloping downwards indicating DMU. Consumer get maximum
satisfaction by consuming 5 units of commodity A and 3 units of
Commodity B, where he spends his entire income and obtains maximum
satisfaction where MU of commodity A equal MU commodity 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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• Helps in the determination of optimum budget for the consumer


• Helps in the distribution of earnings between savings and
consumption
• The entrepreneur can apply this law to maximize his profits
• It is applicable in public finance particularly in taxation.
• It helps the individual towards distributing his asset among various
alternatives.

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.

Self assessment questions – Section 1


1. WANTS=>EFFORTS=>_______
2. Mention the features of human wants
3. Primary wants includes _________
4. Consumption refers to_________.
5. Under capitalism, the consumer is the ____
6. Utility refers to ___________
7. State GOSSEN’S FIRST LAW
8. Mention the Exceptions to the law of diminishing marginal utility
9. State GOSSEN’S SECOND LAW

Summary

Let us summarize the topics that we have discussed in this chapter.


HUMAN WANTS
• Wants=>Efforts=>Satisfaction
• Wants refer to human desires and motivations in life.
• Erich Roll defines wants as “an experience of lack of satisfaction
which leads to action designed to provide that satisfaction.”
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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

Wants are broadly classified into two categories


• Primary Wants
• Secondary Wants
Primary wants include
• Necessaries of life
• Necessaries of efficiency
• Conventional necessaries
Secondary wants include
• Comforts
• Luxuries

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”

LIMITATIONS OF CONSUMER SOVEREIGNTY


• Productive powers
• State of technical knowledge
• Low purchasing power
• Restriction by the state
• Taxation
• Monopoly
• Fashions and customs..
• Standardized production
• Advertising
• Rationing
• Inflation

Consumer Behaviour
Utility Analysis
• The term “Utility” refers to want satisfying power of a commodity.

The Law Of Diminishing Marginal Utility: Gossen’s First Law


Statement of the Law
“If a consumer consumes more of a commodity the utility of
additional unit consumed diminishes”.
Proportionality Rule
According to the proportionality rule, the utility derived from
spending an additional unit of money must be the same for all the
commodities.
Law Of Equi- Marginal Utility: Gossen’s Second Law
Statement of LEMU
“Other things being equal, a consumer gets maximum satisfaction
when he allocates his limited income to the purchase of different
goods in such a way that the marginal utility derived from the
last unit of money spent on each item of expenditure tends to be
equal”.
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3.11 Concept of Consumer Surplus:

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.

3.12 Consumer Surplus

In ordinary purchase transactions the consumers may be prepared


to pay more but actually they pay less. There is thus a gap between what
they actually pay. This gap is in the nature of a surplus. Alfred Marshall
called it consumer surplus. It is the extra satisfaction that a consumer
gets.

In short consumer surplus is measured by the difference between
the price which an individual is willing to pay and the price which he
actually pays.

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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2) He also assumed that the marginal utility of money remains


constant.
3) He did not take into consideration the prices of other goods and
their quantities. He assumed a “one commodity world.”
4) He ignored the presence of the substitutes and felt that even
substitutes can be treated as a single commodity.
5) Concept of consumer surplus is derived from the law of demand
and has all those assumptions that hold good in the case of this
law.
6) Tastes and fashions are assumed to be constant.
7) Income remains constant.

When an individual purchases only one unit of a commodity, and


suppose a person is willing to pay Rs. 600 for a particular commodity
rather than go without it, actually the commodity is being sold at Rs.
500. In this case the consumer surplus is Rs. 100.

The concept can be expressed in the form of a formula.


CS = total utility – (price x quantity)

In symbolic terms
CS= TU – (PxQ)
CS= price prepared to pay – price actually paid

It is possible to measure the consumer surplus with the help of a table.


Units of Marginal utility Price Consumer
commodity surplus
1 45 10 35(45-10)
2 40 10 30(40-10)
3 34 10 24(34-10)
4 10 10 0(10-10)
4 units 129 40 89
CS = TU – (P XQ)
= 129 – (10 X 4) = 129 – 40
CS = 89
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In the diagram DD, is the demand curve of an individual curve. ON is


the price line and OM is the quantity demanded. TM is also the marginal
utility of the consumer. The total utility is given by the area OMTM while
the total price is OMTN. The difference MTN measures the consumer’s
surplus.

3.13 Practical Importance of consumer surplus:

The question which we have answered is where do we use the knowledge


of consumer surplus.

• It helps to know pleasure and pain economy.


• It helps to plan public finance.
• It helps in International Trade.
• It helps in introducing a new product.
• It helps in analyzing cost benefit of a commodity.

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Self Assessment questions – Section 2


1. Consumer surplus is difference between Actual price and ____.
2. Consumer surplus was introduced by _______.
3. Consumer surplus was popularized by _______.
4. Consumer surplus is zero when _____.

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.

CS = total utility – (price x quantity)

In symbolic terms
CS= TU – (PxQ)

CS= price prepared to pay – price actually paid

3.14 Ordinal Approach to Consumption:

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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believes that human satisfaction being a psychological phenomenon


cannot be measured quantitatively in monetary terms as was attempted
in Marshal’s utility analysis.

3.15 Indifference Curve: Hicks And Allen Model: Ordinal

The concept of Indifference curve was introduced by Edgeworth and


later it was popularized by RGD Allen and JR Hicks. Indifference curve
analysis measures utility ordinals. That is it explains consumer behaviour
in terms of his preference or rankings for different commodities. An
indifference curve is the locus of the various combinations of two
commodities which yield the same satisfaction to the consumer.

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.

3.16 An indifference schedule and indifference curve

An indifference schedule is a schedule of various combinations of


goods that will equally satisfy the individual.
Combinations Apples Mangoes MRS
A 20 1 -
B 16 2 4:1
C 13 3 3:1
D 11 4 2:1
E 10 5 1:1
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3.17 Indifference curve

An indifference curve represents satisfaction of a consumer from


two commodities. An indifference curve is got from the indifference
schedule of the consumer.

The number of apples is represented on the vertical axis y and


mangoes along the horizontal axis x. Every point on the indifference curve
is a combination of two commodities that will be equally satisfactory to
the consumer.

3.18. MRS: Marginal rate of substitution shows at what rate a


consumer is willing to substitute one commodity for another.

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3.19 Properties of indifference curve:


1.Indifference curve slopes downwards from left to right.

An indifference curve has a negative slope because, when the


consumer decides to have a greater amount of one commodity, he has
to reduce the number of units of the other commodity to remain on the
same indifference curve and to attain the same satisfaction.

2.An indifference curve is convex to the origin

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This property is derived from the law of diminishing marginal utility.


The consumer in order to increase the consumption of one commodity
which he has in less number will sacrifice more units of that commodity
which he has more in number. In this case the rate of substitution
decreases.

3. An indifference curve to the right hand side of another indifference


curve represents higher level of satisfaction.

An indifference curve at a higher level indicates higher satisfaction.


When IC curves shifts towards the right sides indicates higher satisfaction
and towards left indicates lower satisfaction.

4. Indifference curves do not intersect each other

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The diagram explains that two IC intersecting each other indicates


at one particular point ‘Q” that both the IC are equal. In the above
diagram there are 2 locations on IC1 and IC2 respectively. By definition,
any combination on IC2 shows greater level of satisfaction than on IC1.
If the curves intersect, there is a common point Q which lies on both the
curves

5.Indifference curves should not touch X axis or Y axis

In the diagram at a point the indifference curve touches the y axis.


The consumer consumes only com y and no com x. If it touches X axis,
the consumer consumes only com x and no comm. y

3.20 Consumer Equilibrium Under Indifference Curves:

The indifference curve helps us to understand how a consumer


reaches the position of equilibrium. A consumer is said to be in equilibrium
when he secures maximum satisfaction out of his expenditure.

The budget line and indifference map are the tools essential for the
illustration of consumer equilibrium.

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3.21 Budget line or Price line:

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.

3.22 Indifference map:

Represents a collection of indifference curves where each curve


shows a certain level of satisfaction to the consumer.

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3.23 Consumer’s Equilibrium:


The consumer is said to be in equilibrium position when he obtains
the maximum satisfaction from his purchases, given the prices in the
market and the amount of money he has for making purchases.
The following assumptions are made in analyzing consumer
equilibrium.
1) The consumer has an indifference map showing the scale of
preferences. In other words, the tastes of individuals are
assumed as given. This scale of preferences remains unchanged
throughout.
2) He has a given amount of money to spend. If he does not spend it
on one commodity he will spend it on another.
3) Market price of the commodity is given and constant.
4) The consumer acts rationally and maximizes satisfaction.

The position of consumer equilibrium is shown in the diagram.

In the diagram ic1, ic2, ic3 constitute the individual’s indifference


map. AB is the price line and C1, C2, C3 are the various combinations of
apples and mangoes. Indifference curve to the right i.e., IC3 represents
higher level of satisfaction. But he cannot choose a combination beyond

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the line AB because AB represents the budget line which is constant.


He will not select a combination to the left of C because he will be
on a lower indifference curve representing a lower level of satisfaction.
Thus he cannot have any combination to the right or to the left of C;
therefore at C, on the indifference curve IC2, the consumer will be in
an optimum equilibrium. He is in equilibrium at the point where the
price line coincides with the indifference curve. At the point C, the
indifference curve IC2, and the price line AB are tangent to each other
that is, they have the same slope. This point indicates the best position
of the consumer. He is in equilibrium at this point.

3.24 Income effect and income consumption curve (ICC):


The income effect is the effect on the purchase of the consumers
by a change in his income, the price of goods remaining constant with
every increase in income the consumer moves to a higher indifference
curve, since he is better off than before. But if the income decreases he
will have a smaller income to spend so he will be worse off. The result of
this type of change is described as income effect.

The diagram explains consumer equilibrium at point E where IC1


and Budget line of the consumer is tangent. When the Budget increases
from A1B1 to A2B2 consumer moves on to better equilibrium at point
E2 and so on.
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3.25 Substitution Effect:

It may so happen that the price of a commodity may change


and simultaneously income also may change at the same time in such a
way that he is neither better nor worse off as a result. He will however
find it worth his while to buy more of those goods whose relative price
has fallen. He will substitute the relatively cheaper commodity for the
relatively dearer one. The result of this type of change is known as the
‘substitution effect.’

In the diagram at the point Q the consumer is in equilibrium and


the given price line is AB, where AB is tangent to the indifference curve.
When the price of mangoes falls while the price of apples remains the
same, the new price line will be A,B. The consumer is in equilibrium at
point R where the new price line touches the new indifference curve.

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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3.26 Price effect and price consumption curve (PCC):

Price effect is the effect of a change in the price of a commodity


while the income and the price of other commodities remain the same.
The consumer’s equilibrium shifts and such an effect is known as price
effect, the price consumption curve (PCC) traces the price effect.

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.

In reality price effect is the combination of income effort and


substitution effect. When the price of the commodity falls, it is as if the
real income of the consumers increases and he is better off. With the
same amount f money he can now buy the same quantity of both the
goods and still have some money left. This is income 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.

3.27 Uses of indifference curve: Practical application of ordinal


approach to Business Management

The indifference curve technique has become today an important tool


of economic analysis.

• Prof. Edge worth applied this technique to explain exchange of


goods between two individuals.
• This technique is used to analyze the effect of subsidies on
consumers.
• It is used to judge the welfare effects of direct and indirect taxes
on individuals.
• It is also used to analyzing the theory of index numbers.
• It helps in formulating the law of demand without assuming
constancy of marginal utility of money. The indifference curve
technique gives a greater insight into the effect of the pricechanges
on the demand for a commodity by distinguishing between
income effect and substitution effect.
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Superiority of indifference curve technique to the utility


approach.
1) It is more realistic than the old approach since demand is studied
in terms of two or more goods and not in terms of one commod-
ity alone.
2) It assumes that utility or satisfaction can’t be measured. We can
only say that one satisfaction is higher or lower.

3.28 Engel’s curves:

Ernst Engel 19th century German statistician observed that as


a person’s income increases, the percentage of income spent on food
declines. This was termed as Engel law of consumption. The Engel curve
shows the relationship between a consumer’s level of income and the
amount of some commodity consumed.

Self Assessment Question – Section 3

1. Indifference curve was given by _______.


2. The consumer is in equilibrium at a point where the budget line is
equal to ____.
3. An Indifference curve slopes downwards towards right since more of
one commodity and less of another result in _____.
4. The second glass of juice gives lesser satisfaction to a thirsty boy
relates to ___.
5. Budget line is also called as ____.
6. MRS means

3.29 Summary:

Let us summarize the topics discussed in this unit:


Indifference Curve: Hicks and Allen Model: Ordinal
 An indifference curve is the locus of the various combinations of
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two commodities which yield the same satisfaction to the con-


sumer.
 MRS: Marginal rate of substitution shows at what rate a consum-
er is willing to substitute one commodity for another.

Properties of indifference curve


 Indifference curve slopes downwards from left to right..
 An indifference curve is convex to the origin.
 An indifference curve to the right hand side of another indiffer-
ence curve represents higher level of satisfaction.
 Indifference curves do not intersect each other.
 Indifference curves should not touch X axis or Y axis

Consumer’s Equilibrium
 Income effect and income consumption curve (ICC)
 Substitution Effect
 Price effect and price consumption curve (PCC)

Uses of indifference curve: Practical application of ordinal approach to


Business Management

The indifference curve technique has become today an important tool


of economic analysis.
• Prof. Edge worth applied this technique to explain exchange of
goods between two individuals.
• This technique is used to analyze the effect of subsidies on
consumers.
• It is used to judge the welfare effects of direct and indirect taxes on
individuals.
• It is also used to analyzing the theory of index numbers.
• It helps in formulating the law of demand without assuming
constancy of marginal utility of money. The indifference curve
technique gives a greater insight into the effect of the price
changes on the demand for a commodity by distinguishing
between income effect and substitution effect.
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Engel’s curves

Ernst Engel 19th century German statistician observed that as


a person’s income increases, the percentage of income spent on food
declines. This was termed as Engel law of consumption.

3.30 Questions:

Terminal Question – Section 1

1. What are human wants?


2. Mention the features of human wants.
3. What is ordinal and cardinal approach?
4. What is consumer equilibrium?
5. Distinguish between Total Utility and Marginal Utility.

Terminal Questions – Section 2

1. Write a note on Consumer Surplus with the help of diagram.


2. Mention the importance of consumer surplus.

Terminal question – Section 3

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:

Answers for the Self Assessment Questions:


Section 1
1. Satisfaction
2. Subjective, unlimited
3. Essentials or necessary
4. Destroying the utility power
5. King
6. Want satisfying power
7. Law of diminishing margenial utility
8. Money, wealth
9. Law of equi marginal utility

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

Answers for the Terminal Questions:


Section 1
1. Refer to section 3.1
2. Refer to section 3.2
3. Refer to section 3.8
4. Refer to section 3.8
5. Refer to section 3.8
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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

Theory of Production and Cost

Structure:

4.1 Production Function


4.2 The Law of Variable Proportion: Short Run Production Function
4.3 Iso-quant curves
4.4 Iso-quant map
4.5 Iso-cost line
4.6 Least cost combination of factors
4.7 Marginal rate of technical substitution
4.8 Law of Returns of Scale
4.9 Economies of scale: Internal and External
4.10 Types of external economies
4.11 Supply
4.12 Supply schedule and supply curve
4.13 Cost
4.14 Cost of Production
4.15 Concepts of Cost
4.16 Total Cost, Total Variable and Total Fixed Cost Curves
4.17 Summary
4.18 Questions
4.19 Answers

Learning Objective:

In the previous chapter we have discussed the behavior of consumer


and his equilibrium i.e., demand side economics. Now we are going to
discuss the topics relating to producer i.e., supply side economics. This
chapter provides a basis for the analysis of relation between costs and
amount of output x. It also helps in differentiating the rate of input used
and the rate of output produced.
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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.

4.1 Production Function:


Production is the result of co-operation of four factors of production
viz., land, labour, capital and organization.

The aim of the producer is to maximize his profit. He decides


to maximize the production at minimum cost by means of the best
combination of factors of production to increase his profits.

In simple words production function refers to the functional


relationship between the quantity of a commodity produced (output)
and factors of production (inputs).

Production function is an indicator of the physical relationship


between the inputs and outputs of a firm.

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.

4.2 The Law of Variable Proportion: Short Run Production


Function:

Production with one variable input explains a unique relationship


between inputs and outputs. We assume that inputs and outputs are
measured in physical quantities.

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.

The law of variable proportions operates by increasing the quantity


of the variable factors while keeping the other factor constant, the
marginal returns will display the following tendencies.
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1) Increasing returns (decreasing costs)


Initially as more and more units of variable factors are added to the
units of a fixed factor, the total returns will increase at an increasing rate
and thus the marginal product will go on increasing.
2) Constant returns (constant costs)
When still further units of a variable factor are added to the fixed
factor then total returns may increase at a constant rate and thus the
marginal returns will remain constant.
3) Decreasing returns (increasing cost)
If still more units of the variable factor are added to the fixed factors
then total returns may increase at a diminishing rate such that marginal
returns will decline.

Illustration of the law


To explain the laws of returns assume that a farmer has a fixed size
of land, say one acre and he applies more and more doses of a variable
factor say labour to produce wheat. The various factor combinations
yield total, average and marginal outputs as shown in the table.
Units of Total Average Marginal Stages
Labour output output Output
1 20 20 20
2 50 25 30 Increasing
3 90 30 40
4 120 30 30
5 135 27 15 Decreasing
6 144 24 9
7 150 21 6
8 153 19 3 Negative
9 153 17 0
10 150 15 -3
In the table, column 1 shows units of labour used from 1-10, column
2 indicated total output which is increasing at a diminishing rate. Column
3 and 4 shows the average and marginal output respectively. Column 5
indicates the various stages of production.

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There are three stages of the law of variable proportions. The


behavior of output when the varying quantity of one factor is combined
with a fixed amount of the other can be divided into three distinct stages
as shown in the diagram.

In the diagram OX measures the quantity of the variable factor and


OY measures the total product, average product and marginal product.
The product curve TP goes on increasing to the point ‘c’ and after that it
starts declining. Average and marginal product curves also rise and then
decline, the MP curve starts declining earlier than the AP curve.

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.

A rational producer will never choose to produce in stage 3 where


MP of the variable factor is negative. Even if the variable factor is free,
the producer stops at the end of the second stage where the MP of the
variable factor is zero. At L3 the producer will be maximizing the total
product and will thus be making use of the variable factor.

A rational producer will also not produce in stage I where the


marginal product of the fixed factor is negative. In this stage the
producer will not be making the best use of the fixed factors and he
will not be utilizing fully the opportunity of increasing production by
increasing the quantity of the variable factor whose AP continues to rise
throughout stage I. The rational producer will not stop at stage I but
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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.

Thus stage I and II represent the non economic region or irrational


stage in the production function. A rational producer will produce in
stage II where both MP and AP of the variable factor are diminishing.
Stage II thus represents the range of rational production decision.

4.3 Iso-quant curves:

A production function with two variable inputs can be represented


by an iso-quant. The word Iso-quant means equal quantities. An Iso-quant
shows a given amount of output produced, by various combinations to
two variable inputs.

Q = f (k, l)

Where Q = output
k = capital
l = labour

It may be possible to use the various factors, labour and capital, in


differing combinations to produce a given level of output.

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

These various alternative combinations of labour and capital all leading


to the same level of output can be ended to construct an iso-quant.
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In the diagram we have drawn the isoquant curve, and labeled it


as 1Q10. The number 10 along the IQ (IQ10) denotes that this isoquant
shows an output level of 10 units. The 10 units can be produced with
the help of either of the alternative combinations of labour and capital
marked A, B, C and D.

4.4 Iso-quant map:

We can also construct a table of inputs needed to produce 10, 20 or


30 or any number of units of output. Each of these would form a separate
isoquant. A set of isoquant is known as isoquant map.

Different combinations of labour and capital


Output = 10 Output = 20 Output = 30
K L K L K L
3 0 5 1 8 2
2 1 4 2 7 4
1 2 3 4 6 8
0 3 2 10 5 10
This information can be plotted graphically and the picture that
emerges is known as isoquant map.

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In the figure we have drawn three isoquant IQ10 represent the


output level if 10 units, IQ20 represents output level of 20 units and
IQ30 represents output level of 30. The three isoquant measure the
units of labour and capital in different combinations required to
produce the given respective levels of output.

4.5 Iso-cost line:

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.

The equation for the Iso-cost line may be written as :


C = PL + PK.

Where c represents the total expenditure, Pl is the price of labour


and Pk is the price of capital.

4.6 Least cost combination of factors:

An equal product map or isoquant map represents the various


factor combinations which can yield various levels of output. To produce
a given level of output, the entrepreneur will choose that combination
of factors which minimize his cost of production thus maximizing his
profits.

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Suppose the entrepreneur has decided to produce 500 units of


output which is represented by the isoquant curve. The 500 units of
output can be produced by any factor combination such as R, S, Q, L, K
etc. buying on the isoquant (equal product) curve P. For producing the
given level of output (500 units) the cost will be minimum at point Q at
which the Isocost line CD is tangent to the given equal product curve P,
at no other point such as R, S, L, K lying on the equal product curve P, the
cost is minimum. All other points on isoquant P, such as R, S, L, and K lie
on higher iso cost lines than CD meaning greater total cost or outlay for
producing a given output. Therefore, the entrepreneur will not choose
any of the combinations R, S, L and K factor combination Q is the least
cost factor combination for producing a given output. It is therefore an
optimum combination. The entrepreneur will choose factor combination
Q that is, OM units of factor X and ON units of factor y) to produce 500
units of output. It is thus clear that the tangency point of the given equal
product curve with an Isocost line represents the least cost combination
of factors producing a given output.

4.7 Marginal rate of technical substitution:

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.

When the entrepreneur reaches point Q, the MRTS of x for y is here


equal to the price ratio of the factors, since the slopes of the equal product
curve and the iso-cost line CD are equal to each other. The entrepreneur
will have no incentive to go further down. At points k and l on the equal
product curve P, the MRTS of x for y is smaller than the price ratio of
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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.

4.8 Law of Returns of Scale:

In Long run all factor inputs in the production function can be


changed. The behavior of output consequent to change in the quantities
of all factor inputs in the same proportion is known as returns to scale.
Returns to scale are classified into three categories.

Increasing Returns to Scale

Increasing returns to scale occur when a simultaneous increase


in all the inputs in the same given proportion result in a more than
proportionate increase in the output. For example, if input is increased
by 100% but the output increases by 125%.

Constant Returns to Scale

Returns to scale are said to be constant when a proportionate


increase in all the inputs results in proportionate increase in output.
For example if is increased by all 100% but the output also increases by
100%.

Diminishing Returns to Scale:

Diminishing returns to scale occur when simultaneous increases in


all inputs in the same given proportion result in a less than proportionate
increase in the output. For example, if input is increased by 100% but
the output increases only by 75%.

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All the three phases can be shown by one diagram as given above.

In the above figure from A and B, there is increasing return to scale


because MP is increasing and from B to C, there is constant return to
scale because MP is constant and from C to D there is decreasing returns
to scale because MP is decreasing.

4.9 Economies of scale: Internal and External:

Producers aim at maximizing profits. So to achieve this objective,


they increase all factor inputs, thus expanding the size of production or
increasing its scale. When firms produce on a large scale, they derive
certain economics, which help in lowering the costs of production and
in increasing their productive efficiency.

Alfred Marshall classifies economies of scale into internal and


external.

Internal economies are internal to a firm, when production costs


are reduced as a result of expansion of output. Internal economies are
special to each firm and differ between them. For instance, one firm
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may enjoy the advantage of good management, another advantage of


specialized labour. They are not the result of inventions of any kind but
are due to the use of known methods of production.

Types of internal economies


1) Technical economies
This is the most common type of internal economy which a firm
procures from the use of machines and better techniques of production.
A large firm can install and operate modern costly machinery at lower
cost. Technical economies may be of the following kinds.

(a) Economies of sophisticated technique


Large firms can install costly up-to-date machines, for
example, laser printers in the place of ordinary printer. Such
machines are more productive and even though they are costly,
the high cost gets spread over larger output produced.

(b) Economies of increased dimension


A firm secures many advantages by installing large machines
both in the way of cost of construction and cost of operation. For
example, one large printing machine can turn out large volume of
prints at one point of time being operated by a single person.

(c) Economies of linked process


A large firm by linking various processes of production can
reduce its per unit cost of production. For example, a transformer
manufacturing firm requires copper wire for production. It may
also manufacture copper wire.

(d) Economies of increased specialization


With expansion in size of a firm the principle of division
of labour may be employed. The larger the firm the greater the
specialization of men and machines. Besides, larger producers
can have specialized machinery for each type of job. Thus a large
unit can reduce its cost of production.
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(e) Economies by the use of the by-products


A large firm will be able to use some of its by-products which
small firms cannot use economically. This is because a large firm
has greater resources than a small firm and can set up ancillary
units to make use of waste products profitably. For example
molasses, the by-product of sugar mills can be converted into
confectionery products.

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.

5) Risk bearing economies


Firms face several types of risks. The most common one being the
risk of fall in demand for its product. Large firms can face this difficulty
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and can avoid risk by


a. Diversification of output. Produce more and multiple goods.
b. Diversification of markets. Sell goods in a wider market.
c. Diversification in the source of supply, buying from different
sources not depending on anyone.
d. Diversification in the process of manufacturing.

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.

8) Transport and storage.


A large firm enjoys both transport and storage economics. It can
have its own transport department and also possess its own storage go
downs thus reducing per unit costs.

9) Economies of overhead and vertical integration


The overhead cost per unit will be reduced if production is carried on
a large scale. Further the benefits from integration of the several stages
of production (i.e., vertical integration) also results in the reduction of
the costs of production.

External economies are those advantages that are general and


common for all the firms. They are shared by all the firms. They are
not monopolized by a single firm. When an industry is localized, it
usually gets better transport and communication, banking and financial
services. These are advantages that arise for an industry as a whole and
are known as external economies.

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4.10 Types of external economies:

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.

4) Economies of natural factors


The natural factors like climate, weather, fertility of soil etc, would
help all firms and reduce the cost of production.

5) Economies of government policy


Government may provide several concessions in the form of tax
holiday, subsidiaries, and tax concessions etc, to encourage private
enterprises to develop. These facilities would reduce the cost of
production.

6) Economies of infrastructures
Certain infrastructure facilities available and created by government
can encourage private sectors to develop.
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Self Assessment questions – Section 1


1. Production is the technological relationship between inputs and
____.
2. Production functions refer to functional relationship between ____.
3. Mention the four factors of production.
4. Tilling the soil is an example for________.
5. Cobb- production function was proposed by______.
6. Law of variable proportion experience ____ stages in production.
7. Iso-Quant means _____.
8. Iso-quantity means ----------.
9. MRTS __________.
10.LRS relates to____.
11.Who popularized economies of scale?

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).

 The Law of Variable Proportion Statement:


Other things remain constant if only one variable input is
increased to a fixed factor input. First MP falls, when TP reaches
the highest point. MP is equal to zero. MP becomes negative when
TP falls.
Increasing returns (decreasing costs)
Constant returns (constant costs)
Decreasing returns (increasing cost)

 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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 Least cost combination of factors


An equal product map or iso-quant map represents the various
factor combinations which can yield various levels of output.

 Marginal rate of technical substitution


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.

Economies of scale: Internal and External


Types of internal economies
 Technical economies
 Economies of sophisticated technique
 Economies of increased dimension
 Economies of linked process
 Economies of increased specialization
 Economies by the use of the by products
 Marketing economies
 Managerial economies
 Financial economies
 Risk bearing economies
 Economies of research
 Economies of welfare
 Transport and storage
 Economies of overhead and vertical integration

Types of external economies


 Economies of concentration
 Economies of information
 Economies of specialization
 Economies of natural factors
 Economies of government policy
 Economies of infrastructure
 Cobb-Douglas production function
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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.

4.11.1 Meaning of Supply


Stock of a commodity refers to the total quantity of the commodity
available with seller at any given price. But it is not necessary that the
seller may offer his entire stock of commodity for sale. The part of the
stock which a seller offers for sale at any price at a given time is called
supply.

4.12 Supply schedule and supply curve

An individual supply schedule


Price Quantities supplied
5 25
4 20
3 15
2 10
1 05
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An individual supply schedule represents the relation between


prices and quantities that the producers are willing to produce.

The supply schedule shows that as price rises supply extends and
as price falls supply contracts.

Individual supply curve

The supply curve is a graphical representation of the supply


schedule. The supply curve slopes upwards. The x axis measures the
quantities supplied and the y axis measures the price. At a higher price
more will be produced and vice versa. There is a price below which
the seller may, refuse to sell the commodity. This is called as ‘Reserve
Price.’

Market supply schedule


Price Quantities supplied by Total market
Rs. firms A + B + C supply
5 19 10 8 37
4 18 9 7 34
3 17 8 6 31
2 16 7 5 28
1 15 6 4 25
The total quantity of commodity supplied in the market by a group of
sellers is called as market supply schedule.
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Law of supply

Supply is a function of price. The law of supply states that “other


things remaining constant, as the price of a commodity rises its supply
extends and as price falls supply is contracted”

The quantity supplied has a direct relationship with price. The


functional relationship can be stated mathematically as

S = f (P)
other things remaining constant

Where S = supply
F = function
P = price

Assumptions

1) The cost of production i.e., the factors-prices, such as wages, rent,


interest etc are assumed not to change.
2) There is no change in technique of production with the improvement
of technique, if the cost of production is reduced, the seller would
supply more even at falling prices.
3) There must be a fixed scale of production. If there is a change in
scale of production the level of supply will change, irrespective
of changes in the price of the product.
4) Government policies like taxation policy, trade policies etc are
assumed to be constant.
5) There is no change in transport cost otherwise a reduction in
transport cost implies lowering of cost of production, so that
goods must be supplied even at a lowering price.
6) The law also assumes that the sellers do not speculate about the
future changes in the price of the product.
7)The prices of other goods are held constant.
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Exceptions to the law of supply

There may be situations where the direct relationship between the


price of a commodity and its quantity supplied does not happen:
1) Agricultural goods whose supply cannot be adjusted to market
conditions
2) Perishable goods that cannot be stored
3) Goods having social distinction
4) When the seller is badly in need of money, he will sell his product
even at a very low price
5) When the seller wants to get rid of his product he will be prepared
to sell his products at reduced rates.
6) When the seller feels that a further heavy fall in prices is
anticipated the seller may sell at the current lower price.
7) In case of an auction the price in auction is mostly determined by
the bidders.

Factors determining supply

1) Supply depends upon the price of the commodity, higher the


price of the commodity, the greater the production and more the
supply, assuming other things remaining constant.
2) Supply of the commodity depends upon the prices he may reduce
the present supply of the product and vice versa.
3) Government policy with respect to imposition of excise duty or
change in subsidy may also influence the supply.
4) Floods, droughts, etc., are bound to affect supply more particularly
the supply of agricultural goods.

Types of Elasticity of supply

Elasticity of supply is the rate at which supply will change when price
changes.

Elasticity of supply is a measure of the degree of responsiveness of


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quantities supplied to changes in the products own price.

Percentage change in quantity supplied


elasticity o f supply =
Percentage change in price
There are five types of elasticity of supply.

1) Perfectly elastic supply

Supply of a commodity is said to be perfectly elastic when the supply


of it may increase or decrease to any extent irrespective of any change in
price. Here supply curve takes a horizontal slope parallel to the x axis.

2) Perfectly inelastic supply

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Supply of a commodity is said to be perfectly inelastic if the quantity


offered for sale does not change with a change in price. Supply of stamps,
coins, etc is of this type. The supply of these commodities cannot change
in response to price change.

3)Relatively elastic supply

If the supply of the commodity changes much more than a given


change in price elasticity will be greater than one. This is known as
relatively elastic supply.

4)Relative inelastic supply

If a change in supply is less than the proportionate change in price, the


supply is said to be relatively inelastic; elasticity is said to be less than
one.

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5) Unitary elastic supply

If the proportionate change in supply is exactly equal to the


proportionate change in price, elasticity of supply will be equal to one.
Any straight line supply curve passing through the origin has unitary
elasticity throughout its length.

Expansion and Contraction of supply

Expansion in supply simply means that more is being offered for


sale at a higher price. Conversely contraction of supply means that less
is being offered for sale at a lower price. A movement along the same
supply curve indicates the changes in the quantities offered as a result
of a change in price alone assuming the other factors as constant.

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Increase and Decrease of supply

In reality supply changes due to changes in other factors. If supply


changes not because of price change, but various other factors, then it is
known as increase and decrease in supply. This is indicated by recasting
a new supply curve either to the left or to the right.

Self-assessment questions – Section 2


1. Supply relates to _______.
2. Supply refers to amount of ________ offered for sale.
3. An increase in supply of goods is caused by ____.
4. Elasticity of supply means ____.
5. Expansion of supply relates to ____.
6. A horizontal supply curve indicates ___.
7.PED= O relates to ____________.
8. PED>1 Relates to ____________

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

o Supply is a function of price. The law of supply states o that “other


things remaining constant, as the price of a commodity rises its
supply extends and as price falls supply is contracted”.

 Factors determining supply

o Supply depends upon the price of the commodity, higher the


price of the commodity, the greater the production and more the
supply, assuming other things remaining constant.
o Supply of the commodity depends upon the prices. He may
reduce the present supply of the product and vice versa.
o Government policy with respect to imposition of excise duty or
change in subsidy may also influence the supply.
o Floods, droughts, etc., are bound to affect supply more, particularly
the supply of agricultural goods.

 Elasticity of supply

o Elasticity of supply is a measure of the degree of o responsiveness


of quantities supplied to changes in the products own price.

 Types of Elasticity

o Perfectly elastic supply


o Perfectly inelastic supply
o Relatively elastic supply
o Relative-inelastic supply
o Unitary elastic supply
o Expansion and Contraction of supply
o Increase and Decrease of supply
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4.13 Cost

Learning Objectives

This unit helps us to understand the Cost analysis in relations to output,


scale of operation, prices of factors of production and other relevant
economics variables. In a manufacturing firm, total cost of materials,
labour, and overhead charged for producing a particular item. A clear
cost analysis is useful to know the financial aspects of production
relations as against physical aspects.

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.

4.14 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.

4.15 Concepts of Cost:

1) Money cost and real cost :


When an entrepreneur undertakes the act of production, he
has to pay prices for the factors of production, which he employs for
production. He pays wages to laborers, prices for the raw materials and
fuel, rent for buildings hired for production work, and interest on the
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money borrowed to conduct the business. An accountant will take into


account only the payment and charges made by the entrepreneur for
the supply of various production factors. But the economists’ concept of
cost of production is different from accountants’ COP.

Economists think that in addition to the above, there are other


items which ought to be included in the term money cost of production
such as:
a) Wages for the work performed by the entrepreneur,
b) Interest on the capital supplied by him,
c) Rent of land and building belonging to him,
d)Such profits as are considered usual or normal in that line of
business.

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.

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.

Importance of the concept of OC


1)It is useful in explaining the determination of relative prices of
goods.
2)It is useful in determining the minimum payment which a firm has
to make to its employees to retain his service.
3)It is of great use in decision-making about resource allocation by
a firm.

3) Explicit cost and Implicit cost


Explicit costs are those which fall under actual or business costs
entered in the books of accounts. The payments for wages and salaries,
raw material, power transport, insurance etc., are examples of explicit
cost. These costs involve cash payments and are recorded in normal
accounting practices. Explicit costs are also called Out of pocket costs.
These costs denote immediate current payments (Cash costs). In contrast
to explicit costs, there are certain other costs which do not take the form
of cash outlays, nor do they appear in the accounting system.

4)Incremental cost and Sunk Cost


Incremental cost refers to the additional cost incurred due to a
change in the level or nature of activity. A change in the activity connotes
addition of a product, change in distribution channel, expansion of
market etc. Incremental cost measures the difference between old and
new total costs. Sunk costs are the costs which remain unaltered even
after a change in the level of business activity. The best example of sunk
cost is depreciation.
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5) Shut down and Abandonment cost


Shut down cost is one which would be incurred in the event of
suspension of the plant operation and which would be saved if the
operations are continued, eg. Cost of constructing sheds for sheltering
plants and equipment and for storing exposed property. Further additional
expenses may be incurred when business operations are started in re-
employment of workers and giving them training. Abandonment costs
are the costs of altogether abandoning the plant from service. This will
create a problem of disposal of assets, for example, the cost involved in
closing down a mine.

6) Short Run cost and long Run cost


Based on the span of time in production, costs are classified into
short run and long-run costs. In the long run all input factors can be
made variable and adaptable to the changes in the rate of output. In the
short period, only certain inputs could be made variable and some other
factors could not be changed or adaptable. For eg, input factors like
plant, machinery and management are fixed and they are not adaptable
to changes in the rate of output. During the short period, only partial
adaptation could be made and in the long period, full changes could be
made.

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.

7) Fixed cost and variable costs


The inputs or factors of production used by a firm can be divided
into two classes. Some inputs can be used once for a period of time for
producing more than one batch of goods. The fixed capital of the firm
For eg, equipment, machinery, land, buildings and permanent staff come
within this class. These costs are called fixed costs. There are other
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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.

Summary of the difference between F.C and V.C


Fixed Cost Variable Cost
1. These costs are independent 1. These costs vary with the level
of output. of output.
2. These costs do not vary with 2. These costs directly vary with
output. output.
3. These costs exist or arise, even 3. These costs become zero at
at Zero level of output. zero level of output.
4. These costs are found only in 4. These costs are seen in short
the short Period. and long Periods.
5. These are the supplementary 5. These are called prime costs
costs.

4.16 Total Cost, Total Variable and Total Fixed Cost Curves
(Short Run)

Short run is a period of time in which certain inputs cannot be


increased or decreased. It means that in the SR there are certain inputs
whose amt cannot be changed regardless of the amount of output
produced. Similarly there are other inputs known as variable inputs
whose amt is related to change a firm’s short run. Total costs are split
up into, total fixed costs and total variable costs.

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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Total Fixed Costs


These are the costs incurred on factor inputs which cannot be
changed in the short run. They remain unaffected by changes in the
rate of input. Even when output is reduced to zero, these costs continue
unchanged. Fixed costs include rent, salaries, interest, and allowance
for depreciation, salaries and wages of permanent staff.

Total Variable Costs


These are the costs incurred on the purchase of VF. They 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. The costs are known
as variable costs because they change in response to a change in the rate
of output.

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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The curve indicating TVC, rises, as the firm’s output increases


since a larger output requires larger quantities of variable factors. The
TVC curves increase is not constant. At first it increases rapidly. Then
it increases at diminishing returns and beyond a point it increases at
an increasing rate. The TVC starts from the origin showing that when
output is zero the VC is also nil. The total cost is the result of variable
and fixed costs.

The TC curve lies above TVC curve by an amount equal to TFC at


all output levels. It is also observed that TC and TVC curves have the
same shape since each increase in output per unit of time increases total
cost and variable cost by the same amount as the TFC is constant at all
levels.

Short Run Average Cost Curves

The concept of costs has more significance only in the context of


per unit of production rather than total cost. The per unit cost are AFC
AVC, AC (total) and MC.

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Average Fixed Cost

AFC is derived by dividing TFC by the number of units of output


produced, ie. AFC = TFC /number of units of output produced. ie, AFC =
TFC/Q where Q represents the number of units per unit of output. The
greater the output of the firm, the smaller will be the AFC since TFC
remains constant irrespective of output. The fixed costs are spread over
when more units as produced and consequently each unit of output
bears a smaller share. The AFC diminishes as the output increases.
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Average Variable Cost

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.

Average Cost / Average Total Cost

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

MC may be defined as the addition made to the total cost by the


production of one additional unit of output. This means marginal cost
is the addition to the total cost of producing units instead of X-1 units
where ‘n’ is any given number. The cost curve is determined by the law
of variable proportion. If ‘increasing returns’ is in operation, the MC
curve will be declining as the cost will be decreasing with the increase
in output. When the diminishing return is in operation the MC curve will
be ascending, as it is a situation of increasing cost.

Relationship of MC To AC

The relationship between MC curve and AC curve is unique. The


relationship between these two is more a mathematical one rather than
that of economics. The two curves should start from the same point as
the MC and AC of a very small output must be the same. Both Marginal
and average curves will decline, but the former declines steeply at a
greater rate than the latter. After a certain stage, both costs rise and MC
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curve cuts the AC curve from below at the lowest point of the latter.

In the above diagrams, it is observed that when the short run MC


curve lies below the average cost curve the average cost curve is falling.
When MC lies above the AC and MC meet, both are equal and AC is neither
falling nor rising. The point where MC curve crosses the AC curve is the
minimum point of the AC curve. That is MC curve cuts the AC curve at
the latter’s minimum points.

Long Run Average Cost

Long run is a period in which there is sufficient time to alter the


equipment and the scale or organization with a view to producing
different quantities of output. In other words, in order to change output,
all factors of production can be changed. It is due to the reason that in
the long run, all factors are variable. In technical language, the indivisible
factors become divisible in the long run and therefore, they can be used
more economically.

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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Derivation of Lac Curve : Envolpe Curve

The long run average cost curve is constructed on the assumption of


variable returns to the scale which is explained below.

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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In the above figure, suppose the producer wants to produce OM


output. The corresponding point on the long run AC curve LAC is ‘k’
on SAC2 and will operate on this curve at point ‘k’. Similarly if the firm
wants to increase the output to OM1, the corresponding point on the
LAC is on SAC3 . The firm will build a plant to correspond to that short
run AC. The long run AC is called envelope curve, because it envelopes
or supports a family of short run AC curves from below.

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.

If the firm decides to have an output OM, by constructing the plant


relevant to SAC3 then it will be producing at minimum LAC and it is
similar to ‘optimum firm’ In this case, LAC curve touches, the lowest
point of the lowest SAC at point Q.

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.

Self assessment questions III

1. Which cost remains constant at all levels of output ___?


2. The cost directly varies with output ___.
3. Which cost is in U shape___?
4. In short run , if the output increase AFC ____
5. Which curve is known as planning curve____?
6. The formula for calculating TC is ____.
7. Average cost refers to ____.
8. The cost with alternatives.
9. Which cost is closely related to marginal cost?
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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.

Money cost and real cost


When an entrepreneur undertakes the act of production, he
has to pay prices for the factors of production which he employs for
production

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.

Importance of the concept of OC


• It is useful in explaining the determination of relative prices of
goods.
• It is useful in determining the minimum payment which a firm has
to make to its employee to retain him in its service.
• It is of great use in decision-making about resource allocation by
a firm.

Explicit cost and Implicit cost


Explicit costs are those which fall under actual or business costs
entered in the books of accounts. The payments for wages and salaries,
raw material, power,transport, insurance etc., are examples of explicit
cost.

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Total Fixed Costs


These are the costs incurred on factor inputs which cannot be
changed in the short run. They remain unaffected by changes in the rate
of input.

Total Variable Costs


These are the costs incurred on the purchase of VF. They change
when output is changed.

Average Fixed Cost


AFC is derived by dividing TFC by the number of units of output
produced, ie., AFC = TFC /number of units of output produced

Average Variable Cost


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.

Average Cost / Average Total Cost


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.

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:

Terminal Questions – Section 1


1. Define production.
2. Mention different factors of production?
3. State the law of returns to scale.
4. Define total product, marginal product and average product.
5. What is Iso quant?
6. Explain producer equilibrium under iso quant analysis.
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7. What is Budget line of producer?


8. Explain internal economies of scale.
9.Explain External economies of scale.

Terminal Questions – Section 2


1. Define supply.
2. Name the determinants of supply.
3. Give the law of supply.
4. Distinguish between change in supply and change in quantity
supply.
5. What is elasticity of supply? Explain the degree of elasticity of
supply.

Terminal Questions –Section 3


1. What is cost?
2. Distinguish between economic cost and accounting cost.
3. What is explicit and implicit cost?
4. What are fixed costs?
5. What are variable costs?
6. What is marginal cost?
7. State the relationship between average cost and marginal cost.
8. What is average fixed cost?
9. Explain short run cost concepts with help of a diagram.
10. Explain the long run cost concepts.

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

Answers for the Terminal Questions:


Section 1
1. Refer to section 4.1
2. Refer to section 4.1
3. Refer to section 4.8
4. Refer to section 4.2
5. Refer to section 4.3
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6. Refer to section 4.3


7. Refer to section 4.3
8. Refer to section 4.9
9. Refer to section 4.10

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

5.1 Meaning of Revenue


5.2 Concepts of Revenue
5.3 Relation between TR, AR and MR
5.4 Market Structure
5.5 Perfect Imperfect Competition
5.6 Imperfect Competition
5.7 Monopoly Market Structure
5.8 Short Run Equilibrium
5.9 Determination of Price and Output of Firm in Long Run
5.10 Discriminating Monopoly
5.11 Price and Output Determination under Discriminating
Monopoly
5.12 Monopolistic Market structure
5.13 Characteristics of Monopolistic Competition
5.14 Equilibrium of a Firm under Monopolistic Competition – Short
Period
5.15 Long Run Equilibrium
5.16 Oligopoly Market Structure
5.17 Collusive Oligopoly
5.18 Duopoly Market Structure
5.19 Summary
5.20 Questions
5.21 Answers

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.

5.1 Meaning of Revenue

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.

5.2 Concepts of 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

2. Average Revenue: It is the revenue earned after selling one unit of


output sold. AR is termed as price of commodity.

AR = TR/ Q

3. Marginal Revenue: It refers to the additional revenue earned by selling


one additional unit of output. It is defined as the addition made to the
total revenue after selling one additional unit of output.

MR= TRn-TRn-1

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5.3 Relation between TR, AR and MR

 MR falls as more units are sold


 TR is the highest when MR is zero
 TR increases as more units are sold but at a diminishing rate
 TR falls when MR becomes negative

Number of Total Average Marginal


units sold Revenue Revenue
Revenue
1 10 10 ---
2 18 09 8
3 24 08 6
4 28 07 4
5 30 06 2
6 30 05 0
7 28 04 -2

Under Perfect competition: Under perfect competition all firms


are termed as Price takers hence uniform prices exist. Both Marginal
and Average Revenue remain the same and the slope AR and MR is a
horizontal straight line.

Number of Total Average Marginal


units sold Revenue Revenue
Revenue
1 05 05 ---
2 10 05 5
3 15 05 5
4 20 05 5
5 25 05 5
6 30 05 5
7 35 05 5

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Summary

Revenue Concepts:

 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.

 Total Revenue: Total revenue refers to the total amount of money


that the firm receives from the sale of its products.

TR= PXQ

 Average Revenue: It is the revenue earned after selling one unit


of output sold. AR is termed as price of commodity.

AR = TR/ Q

 Marginal Revenue: It refers to the additional revenue earned by


selling one additional un it of output. It is defined as the addition
made to the total revenue after selling one additional unit of
output.

MR= TRn-TRn-1

Relation between TR, AR and MR


 MR falls as more units are sold.
 TR is the highest when MR is zero.
 TR increases as more units are sold but at a diminishing rate.
 TR falls when MR becomes negative.

Under Perfect competition: Under perfect competition all firms


are termed as Price takers hence uniform prices exist. Both Marginal
and Average Revenues remain the same and the slope AR and MR is a
horizontal straight line.
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Self assessment questions Section 1


1) Average revenue relates to _____.
2) Formula for Marginal Revenue ---------------------

5.4 Market Structure

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.

2. Imagine 10 of your friends enter a railway station to see your


friend who is leaving for USA for a contract for 10 years. To enter
the station you are supposed to purchase platform ticket. You go
to the counter and never bargain about the price because you
know bargaining is not allowed.

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.

Classification of Market Structure

Among the different market situations, perfect competition and


monopoly form two extremes. In between these two markets, lie the
imperfect market situations. The market situation varies in their
structure. Different market structures affect the behavior of buyers and
sellers and firms. Further, the volume of production level of prices is
influenced by different market conditions.

5.5 Perfect Competition:

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.

According to Prof. Boulding “Perfectly competitive market is a situation


where a large number of buyers and sellers are engaged in the purchase
and sale of identically similar commodities, who are in close contact
with one another and who buy and sell freely among themselves.

(a) Features of Perfect competition:


The following conditions must exist for a market structure to be perfectly
competitive.

1) Large Number of Sellers: A perfectly competitive market


structure is basically formed by a large number of actual and
potential firms or sellers. No single seller can affect the price. If
there is an entry or exit of firms in the market, there will be no
effect on the supply. The output of a single firm is only a small
portion of the total output and the change in the output of a single
firm will not affect the demand and price in the market
2) Large Number of Buyers: The number of buyers is so large,
that there are no possibilities for them to dictate conditions in
the market and influence the price by altering the demand. The
individual demand will be so small that it will be insignificant
if there is any change. So, the market price cannot be altered
either by sellers or by buyers by their actions individually; nor
are there possibilities for a few of them to combine. The market
price is unaltered by these actions and the price should be taken
as given.
3) Homogeneous Product: The third condition in the perfect
market is that the commodity offered should be homogeneous
and identical in all respects. All firms in the market produce the
same quality or variety of the commodity and practically there
will be no difference in the product of the two firms. This identity
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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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7) Absence of Transport Costs: In a perfectly competitive market,


it is assumed that there are no transport costs. It is assumed that
in perfect competition the firms work so close to each other that
they do not incur transport charges. Further from a homogeneity
point of view this is also essential. Even if similar product is
produced at different places and offered for sale in the market,
the homogeneity is lost from the side of the buyers, because of
the difference in place.
8) Absence Of Government Or Artificial Restriction: It is
assumed that there are no artificial restrictions from any quarter
hindering the smooth functioning of perfect competition there
are no government control or restriction on supply, pricing, etc,
and the price should be free to change in response to changes
in demand supply conditions. If all these conditions are fulfilled,
then the market can be termed perfect and this perfection cannot
be had in practical side.

(b) Price determination under perfect competition :


In ‘perfect competition’, there are larger numbers of buyers and sellers
and it is seen that the actions of the individual buyers and sellers cannot
influence the market price. The prevailing rice of the product in the
market is taken for granted. Though individuals cannot change the price,
the aggregate force of demand and supply can change the price. The law
of demand governs the demand side and the supply side is governed
by the cost of production. The law of supply operates. The interaction
of demand and supply determines the price of the commodity. Under
perfect competition the forces of demand determine price and supply.
Equilibrium price is that price which is obtained by the intersection of
the demand and supply.
This can be explained with the help of the following table
Price Demand Supply
5 12 1
10 10 2
15 8 4
20 6 6
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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.

This can be explained with the help of the diagram.

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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.

(c) Importance of time element:


The element of time in any business occupies a pivotal place in
the Marshallian theory of value. According to the theory, the forces
of demand and supply determine the price. The position of supply is
greatly influenced by the element of time taken into consideration.
Here time refers to the operational time period pertaining to economic
action and forces at work involved regarding adaptation of firms in their
production activity. Supply is thus adjusted in relation to the changing
demand in view of the time space given for such adjustment.

Accordingly the time element may be distinguished by the following


four time periods of varying duration namely.
1) Market period
2) short period,
3) long period

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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the commodity. In the following diagram SS supply curve is a


vertical straight line representing perfectly inelastic supply. DD
is the demand curve. The intersection between these two curves
determines the equilibrium price OP at which demand is equal to
supply (OQ).

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.

2). Short Period:


Short period market is more or less similar to the very short
period but with some variations. In this case, the commodity is
not perishable. In a short period market the commodity is non-
perishable and also reproducible. But this supply is fixed because
capital equipment is fixed. This implies that the sellers have little
influence on the price of the commodity. Thus in the short period
the factors of production can be altered only to a certain extent.
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However the demand exceeds the supply and the short period
price will be more than normal price and less than market period
price.

In the above diagram the short period price will be determined


at the point where short period demand curve D1 intersects the
short period supply curve. The quantity supplied marginally
increases from OQ to OQ1, due to which price decreases from
market period to short period price. In this case the supply curve
is slightly elastic.

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.

In the above diagram the long run normal price is determined


at the point where long period demand intersects long period
supply at E3. At this point the normal price is restored as was
at the initial equilibrium price. There are no tendencies for the
prices to change from the equilibrium price since the total supply
equates the total demand.

(A) Short Run Equilibrium Of Firm Under Perfection Competition


–Profit Maximization

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.

(B)Long Run Equilibrium of the Industry under Perfect


Competition

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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factors to suit the size of the unit.

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.

Self Assessment questions – Section 2


1. Market deals with buyers and ___.
2. Perfect competition deals with ___.
3.A Perfect competitor is called as _____.
4.Price under determined by market forces of ____.
5. The concept of time element under perfect competition was
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popularized by___.
6. In long run perfect competitor earns ____.

Summary

In the words of Jevons, “The word market has been generalized so


as to mean any body of persons who are in intimate business relations
and carry on extensive transactions in any commodity.

Perfect Competition: Perfect competition refers to the market


situation where there are a large number of buyers and sellers engaged
in buying and selling homogeneous products, at uniform prices which
are determined by the market forces of demand and supply.

Features of perfect competition:


 Large Number Of Sellers: Large Number Of Buyers
 Homogeneous Product
 Free Entry and Exit Conditions
 Perfect Knowledge on the part of buyers and sellers
 Perfect Mobility of factors of production
 Absence of transport costs
 Absence of government or artificial restriction

Importance of time element:


a) 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.
b) Short Period:
Short period market is more or less similar to the very short period
but with some variations. In this case, the commodity is not perishable.
In a short period market the commodity is non-perishable and also
reproducible. But this supply is fixed because capital equipment is
fixed.
c) Long Period:
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Long period is a 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.

5.6 Imperfect Competition

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

• Monopoly market structure


• Monopolistic market structure
• Oligopoly market structure
• Duopoly market structure

5.7 Monopoly market structure

Monopoly is a market structure where there is a single seller,


who controls the entire market supply. There are no close substitutes
for the commodity he produces and there are barriers to entry. Thus
the monopoly market model is the opposite extreme of perfect
competition.
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Features of Monopoly:

1) Single Seller: Monopoly consists of a sole seller for the product


and the single firm constitutes the whole industry. Therefore the
distinction between firm and industry disappears under these
conditions. Being the only seller for the product, he has complete
control over the market supply, as there is no possibility of a rival
firm.
2) Large number of buyers: There exists a large number of buyers
since there is one seller and the consumers have no choice of
any other. Either they have to buy from the monopolist or they
have to go without it. Further the consumers have no control
on the pricing decisions, but to accept the price fixed by the
monopolist.
3) No close substitutes: The commodity produced by the producer
must not have any closely competing substitutes if he is to be
called a monopolist. This ensures that there is no rival for the
monopolist for instance there is no substitute for water supplied
by local public authorities.
4) Independent pricing. The above two features ensure that a
monopolist can set the price for the product. Thus the monopolist
is a price maker. However the monopolist can either fix the price
or the quantity sold and not both.
5) Barriers to entry: There are strong barriers to entry of new
firms. These could be due to ownership of strategic raw materials
or exclusive knowledge of production techniques, patent rights
for a product or production process, government licensing and
other legal rights.
6) Downward sloping demand curve: A monopoly firm itself
being the industry, faces a downward facing demand curve, which
means it cannot sell more output unless the price is lowered.
7) Price discrimination: Price discrimination refers to a practice
wherein the monopolist charges different prices for the same
commodity. Price discrimination is made on the basis of personal
prejudice, age, place, time, sex, usage etc.
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5.8 Short Run Equilibrium/ Price and Output Distribution:

A monopolist is a price maker and not a price taker. Infact he is


independent in making his price decisions. He need not take into
account, while determining his own price the possible reaction of other
firms. Further, he has complete control over the supply of the product.
However, the monopolist can either fix the price or the level of output
and not both. Either he can fix the prices and leave the output to be
determined by the consumer, or produce the output that maximizes
his profits and leave the price to be determined by the consumer. We
assume that the monopolist is interested in producing the output that
maximizes his profits.

The cost curves and revenue curves are superimposed on each


other and the firm which seeks to maximize profits, is in equilibrium at
the level of output where marginal revenue=marginal cost.

In the figure given above, the monopolist is in equilibrium at point


D, with OM level of output where
a)Marginal revenue is equal to marginal cost.
b)The slope of the marginal cost curve is greater than marginal
revenue curve.
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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

It is not necessary that monopolist will always earn profits in the


short run. Monopoly position in itself is no guarantee of excess profit.
The figure shows a short run situation when the monopolist incurs
losses. Equilibrium position is attained when marginal revenues is
equal to marginal cost. The monopoly price corresponding to output
OM is OP. The monopoly price is lower than average cost i.e., KM. KM is
the average cost corresponding to output OM. Thus total revenue OPLM
and total cost is OAKM. Since price is lower than the average cost, the
firm incurs loss.

Output
Diagram 6.6(c)

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5.9 Determination of Price and Output of Firm in Long Run

In the short run the monopolist problem is to maximize his


profits subject to given size of the plant already built and operating.
In the long run the monopolist is in a position to make adjustments
in the size of the plant to suit the given level of demand and operate
most profitably. In the long run equilibrium will be at the level of output
where given marginal revenue curve cuts the long run marginal curve.
Thus the profit maximizing output is OM determined by intersection of
LMR curve and LMC curve. The most appropriate plant to produce this
level of output is given by SAC.

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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5.10 Discriminating Monopoly

Price discrimination exists when the same product is sold at


different prices to different buyers. A monopolist implements price
discrimination more easily, because he controls the whole supply of a
given commodity. Any firm under perfect competition could practice
this price policy.

The necessary conditions that must be fulfilled for the


implementation of price discrimination are-

1) The market must be divided into different sub markets with


different price elastic ties.
2) There must be effective separation of the sub markets so that no
reselling can take place from a low price market to a high price
market.

For the monopolist to keep his sub markets separate to


successfully practice price discrimination is possible under following
circumstances.

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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5.11 Price and Output Determination under Discriminating


Monopoly

The reason for a monopolist to apply price discrimination is to


obtain an increase in his total revenue, and his profits. By selling the
equilibrium output at different prices. The monopolist realizes higher
total revenue and hence higher profits as compared with the revenues
he would receive by charging uniform price.

The price discriminating monopolist thus has to decide,


1) The total output to be produced.
2) The distribution of supply of output in different markets, that is how
much to sell in each market with a view to maximizing profits.
3) The prices of the product in different markets=> a discriminating
monopolist is in equilibrium when
4) To determine total output, the monopolist equates marginal cost
with combined marginal revenue of different markets.
5)To maximize profits- the total output in different markets will be
distributed in such a way that marginal revenue in each market is the
same and equal to marginal cost.
6) Price in different markets will be decided in relation to the quantity of
output allocated for sale and position of the demand curve. Thus market
with inelastic demand will have a higher price and lower quantity sold
and market with elastic demand will sell a large quantity at lower
price.

To explain the equilibrium conditions of price discriminating monopolist


we assume that
a) The monopolist is facing two separate markets 1 and 2
b) The demand for the product in market 1 is relatively inelastic and the
demand in market 2 is elastic
c) The firms cost conditions are known.
d) The firms’ revenue curves are evident from the demand curves of the
two markets. By aggregating them, the combined revenue curves are
obtained.
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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.

Further MR1=MR2 means that if MR in one market was larger, the


monopolist could sell more in that market and less in other until the
marginal revenues in both market are equalized. It can be observed
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that, MR1 for OQ1, MR2 for OQ2 output . Again OQ1+OQ2=OQ and ΣMR.
For OQ is EQ=OA. Thus MR=MR1=MR2.

In short, OQ is the total output determined, where MC=. MR. It gives


total profit shown by the areas between MR and MC curves. Thus CBE
measures total profit. Of the total OQ output produced, OQ1 is supplied
to market I and sold at price P1. The rest OQ2 is supplied to market II
and sold at price P2. P1Q1>P2Q2. Demand is inelastic in market I so the
price charged is high and amount supplied is less. Demand being more
elastic in market II a large quantity is supplied at lower price.

5.12 Monopolistic market structure

Monopolistic competition refers to a market structure in which


there are a large number of small producers, producing goods which
are close substitutes of one another or where output is differentiated.
Thus monopolistic competition is a blending of monopoly and perfect
competition. Monopolistic competition is a more realistic reflection of
real world market situation. Conditions surrounding monopoly and
perfect competition are too stringent, making these market forms
rare. Monopolistic competition is commonly found in many fields
and especially service industry, some manufacturing industry, for e.g.
Garment industry, leather, cosmetic products, restaurant, beauty parlors,
fabrics etc.

5.13 Characteristics of monopolistic competition

Monopolistic competition, as the term suggests entails the attributes


of both monopoly and competition. The main features of monopolistic
competition are:

1) Large number of sellers: The first condition of monopolistic


competition is that there should be a large number of sellers who sell
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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.

2) Large number of buyers: There are a large number of buyers in


monopolistic market. However each buyer has a preference for a specific
brand of the product. Unlike perfect competition the buying habits of
the consumers are by choice and not by chance.

3) Production differentiation: Under monopolistic competition the


products are neither homogenous nor are they remote substitutes. But
the products are differentiated being different in some ways and not
altogether, eg. Toothpaste, readymade garments.

It may be noted that product differentiation could either be real or


implied. What is important is to create differences in the minds of the
consumers. Consumers’ preferences due to product differentiation is
what leads to monopolistic price control. Real differences could be in the
quality of the product, materials used and so on. Illusionary differences
could be through brands, names, advertising, packing, condition of sale
and so on.

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.

5) Selling costs: Selling costs are a unique feature of monopolistic


competition. Since products are differentiated and may vary from time
to time. Advertising and other forms of sales promotion become an
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integral part in marketing of goods. Cost so incurred is termed as selling


costs. Selling costs are required to expand the market of the product and
more primarily to create awareness about the products.

6)Two-dimensional competition: The nature of competition in this


market is both price and non-price. As the commodities are differentiated,
competition is not exclusively on price basis. The buyers are willing
to pay for their favorite product/brand, something more than other
products. This leads to monopolist price control. If he raises his prices it
may lead to loosing some of the customers, but not many. Similarly it is
with reduction of prices.

5.14 Equilibrium of A Firm Under Monopolistic Competition – Short


Period

A firm under monopolistic competition is a price maker. The firm


has to determine a suitable price for its product which yields a maximum
total profit. The firm adopts a policy with least consideration for the
prices charged by other producers. As the product is differentiated the
demand curve is downward sloping. The demand curve however is more
elastic than under monopoly. The slope of the demand curve depends on
the number of firms in the group and the extent of product production.
If the group has a large number of firms and if product differentiation
is relatively weak, the demand curve of the firm will be elastic. If the
group is relatively small, and product differentiation is significant, then
demand curve is less elastic. The demand curve is itself the AR curve.
MR curve is below the AR curve.

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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OM and corresponding prices as OP/TM. The average cost of producing


OM level of output is (SM=RO). Thus total revenue is equal to area OPTM
(OMxOP) and total cost is equal to area ORSM (Or x OM). The profits are
equal TR-TC=RPTS.

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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The equilibrium is at point E where MR=MC. The equilibrium


output is OM and corresponding price is (OR) =(SM). The average cost of
producing OM level of output KM = OC is higher than average revenue/
price, earned from the same. Thus the total revenue by the firm ORSM is
lesser than total cost OCKM leading the firm to make losses.

5.15 Long Run Equilibrium:

The monopolistic firms in the short run may earn supernormal


profits or losses, depending on the market conditions of the product
of the firm. However in the long run the position is likely to be similar
to that of perfect competition with firms only earning normal profits.
In situation of supernormal profits, there would be entry of new firms
and tendency to produce a product, which is similar to the product of
successful firms.

In situation of losses there is a tendency of exit of firms. Thus


monopolistic equilibrium in the long run will be one where firms earn
only normal profits.

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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producing OQ level of output is OR=PQ. The average cost for producing


the same is also PQ=OR. Thus total cost and total revenue for producing
OQ level of output is ORPQ. Total cost and total revenue both being equal,
the firm only earns normal profits.

5.16 Oligopoly Market Structure

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

5.17 Collusive Oligopoly

One way of avoiding uncertainty arising from oligopolistic


interdependence is to create mutual agreement among firms. The
process of entering into mutual agreement is called collusion. In modern
business world, trade associations usually perform many activities of
direct collusive agreements to achieve common goals. There are two
types of collusion, they are

(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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output and price, so as to act as a monopoly. Organization of Petroleum


Exporting Countries (OPEC) is a cartel consisting of 13 member
countries, controlling the supply of crude oil and indirectly controlling
the price of crude in the world.

(b) Price Leadership:


Price leadership is an informal collusion as a result of market forces.
A price leader is a seller who chooses hi9s profit maximizing price on
the assumption that other firms will accept the price and take it as given
in maximizing their own profit. In an oligopolistic market, the firm that
serves as the price leader initiates a price change and other firms in the
industry soon match the price. Price leadership is the result of a formal
collusion or due to market forces. Price leadership can be in the form of
dominant price leadership or barometric price leadership.

Kinked Demand Curve: Oligopoly Market


Paul Sweezy introduced the concept of Kinked demand curve in the
year 1939. He postulated that if an oligopolist raised its price, it would
lose most of its customers because other firms in the industry would
not follow by raising their price. According to Sweezy, oligopoly faces
a demand curve that has a kink at the prevailing market price, which is
highly elastic for price increase but much less elastic for price decreases.
The tendency of kink demand curve can be explained with the following
diagrams:

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5.18 Duopoly Market structure

It refers to a market where only two sellers are controlling the


entire market. According to Cohet and Cyret “When there are exactly
two sellers in the market there is a special case of oligopoly called
Duopoly”.

Self Assessment Questions – Section 3


1. The term mono means ----------.
2. Price discrimination is one of the features of ________.
3. Product produced by _____ does not have substitute.
4. In long run monopoly earns ____ profit.
5.In which type of market will entry be restricted _____?
6. Product differentiation and selling cost are the main features of ___
market.
7. Product produced by monopolistic will have a close_______.
8. In long run monopolistic firms earn ____ profit.
9. The simplest market structure is called as _____.
10.A market with only a few sellers in the market ____.
11.Kink demand curve is an important feature of _____.
12. Price leadership is one of the important features of ____.
13. Price rigidity is one of the features of _____.

5.19 Summary:

Monopoly market structure


Monopoly means single seller. The term Mono means ‘single’ and poly
means ‘seller’.

Features of Monopoly:
 Single Seller
 Large number of buyers
 No close substitutes
 Independent pricing
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Module - 5

 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

Monopolistic Market structure


Monopolistic competition refers to a market structure in which
there are a large number of small producers, producing goods which
are close substitutes of one another or where output is differentiated.

Characteristics of monopolistic competition


 Large number of sellers
 Large number of buyers
 Production differentiation
 Free entry and exit of firms
 Selling costs
 Two-dimensional competition

Long run equilibrium


In long run, a monopolistic firm earns normal profit mainly due
to new entry and more competition and the extent of selling list/
advertisement outlay will be comparatively higher compared to short
run.

Oligopoly Market Structure


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.
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Managerial Economics - I

Features
 Few seller
 Interdependence
 Indeterminate demand curve
 Conflicting attitude of firms
 Price Rigidity
 Lack of Uniformity

Kinked Demand curve: If an Oligopolist raised its price, it would


lose most of its customers because other firms in the industry would
not follow by raising their price.

Collusive Oligopoly
One way of avoiding uncertainty arising from oligopolistic
interdependence is to create mutual agreement among firms.

Duopoly Market structure:


Refers to a market where only two sellers are controlling the entire
market.

5.20 Questions:

Terminal Questions – Section 1


1. Define Market. Mention the component of Market.
2. Mention the classification of market.
3. What is Perfect competition?
4. State the features of perfect competition.
5. Explain the importance of time element of perfect competition.
6. Explain the short run equilibrium under perfect competition.
7. Explain the long run equilibrium under perfect competition.

Terminal Questions – Section 2


1. What is monopoly?
2. Mention the features of monopoly.
3. State the short run price and output determination under
182
Module - 5

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:

Answers for Self Assessment Questions:


Section 1
1. Revenue per unit
2. TRn - TRn-1

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
183
Managerial Economics - I

5. Monopoly
6. Monopolistic market
7. Substitute
8. Super normal
9. Duopoly
10. Oligopoly
11. Oligopoly
12. Oligopoly
13. Oligopoly

Answers for Terminal Questions:


Section 1
1. Refer to section 5.4
2. Refer to section 5.4
3. Refer to section 5.5
4. Refer to section 5.5
5. Refer to section 5.5
6. Refer to section 5.5
7. Refer to section 5.5

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
184
Module - 5

Review questions

2 Marks Questions:

1. What is Perfect Competition?


2. What are Identical Goods?
3. What is Price Discrimination?
4. Define ‘Product differentiation’ and ‘Selling cost’.
5. Give the meaning of Oligopoly Market Structure.
6. What is Price Rigidity?

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:

1. Explain the importance of time element under Perfect competition?


2. Explain short run and long run equilibrium under Monopolistic
competition?

185
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.

1. Give any four features of Business Economics.


2. Define MRTS.
3. What do you mean by a budget line?
4. What is consumer surplus?
5. Give the relationship between Totality Utility and Marginal Utility
6. What are Giffen’s Goods?
7. Define Market demand schedule.
8. What is cross elasticity of demand?
9. State the law of Equi-marginal utility.
10. Give the Iso Product Map.
11. Why does supply curve slope upwards?
12. State the law of constant returns.

Section B

Answer any four. Each carries 5 marks:

1. What are indifference curves? Explain the concept of Indifference


Map.
2. Briefly explain the various types of demand.
3. Explain briefly the total outlay method.
4. What is demand f
orecasting? What is the significance of demand forecasting?
5. What are exceptions to the law of supply?
6. Write a note on consumer sovereignty.
186
7. Analyse the main objectives of business economics.
8. Using the following data calculate consumer’s surplus for each unit
and give a graphic representation.
Commodities bought Price in Rs. Total Utility in Rs.
1 50 85
2 50 80
3 50 75
4 50 70
5 50 50

Section C

Answer any three questions from the following. Each question carries
14 marks:

1. What is meant by elasticity of demand? Discuss its significance and


factors governing price elasticity of demand.
2. State and explain the law of equi-marginal utility
3. What are indifferent curves? Discuss the various properties of
indifference curves with the help of diagrams.
4. Define, classify and explain the economies of large scale production.
5. Discuss the law of supply. Explain the various determinants of
supply.

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:

1. What is meant by Managerial Economics?


2. Distinguish between Business operation and environment.
3. What is meant by Marginal rate of substitution?
4. What is Cross elasticity of demand?
5. Mention the important managerial uses of demand forecasting.
6. What is the difference between Iso-quants and Iso-costs?
7. Mention the determinants of supply.
8. State the features of oligopoly.
9. What is meant by price discrimination?
10. Mention the objectives of pricing policy.
11. What do you mean by product differentiation?
12. Distinguish between total, average and marginal revenue.

Section B
Answer any Four each carries 5 marks:

1. Briefly explain the importance of managerial economics.


2. State the law of demand. Briefly explain the determinants of
demand.
3. What is demand forecasting? Explain the significance of demand
forecasting.
4. Explain the properties of indifference curves.
5. From the following data of the company, calculate TFC, TVC, AVC, AC
and MC
188
Output 0 1 2 3 4 5 6
(Units)
Total 500 580 650 690 720 750 830
Cost

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

Year 2004 2005 2006 2007 2008


Sales 35 40 30 60 50
(Lakh)

Section C
Answer any three questions from the following. Each question carries
14 marks:

1. Explain the role and responsibilities of managerial economist.


2. Explain the law of equi-marginal utility.
3. Describe the price elasticity of demand with the help of diagrams.
4. Explain price output determination under monopolistic competition.
5. What is pricing policy? Explain the general considerations involved
in the formulating pricing policy.

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:

1. Define Managerial Economics.


2. What is decision making and forward planning?
3. What is demand function?
4. What is Cross elasticity of demand?
5. Distinguish cardinal and ordinal utility.
6. Distinguish fixed factors and variable factors.
7. What is marginal revenue?
8. What is envelope curve?
9. What are the exceptions to the law of supply?
10. Classify market on the basis of competition.
11. Distinguish market period price and secular period price.
12. What are administered prices?

Section B
Answer any Four. Each carries 5 marks:

1. Explain the characteristic features of managerial economics.


2. Diagrammatically illustrate different types of elasticity of supply.
3. Explain kinked demand curve hypothesis.
4. With the help of the data given, adopting the total outlay method, find
out the PED and show the graphic representation

Price per unit in Rs. Quantity demanded in units


4 100

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

6. A Manufacturer has the following information regarding cost and


output. On the basis of this calculate TFC,TVC,AVC,AFC,AC and MC.
Output 0 1 2 3 4 5 6 7 8 9 10
TC 100 125 140 150 160 180 210 250 400 600 1000

Section C
Answer any three questions from the following. Each question carries
14 marks:

1. Define indifference curve. Explain how the consumer reaches


equilibrium with the help of indifference curve.
2. What is demand forecasting? Explain the important methods of
demand forecasting
3. What are economies of scale? Explain internal and external economies
of large scale production.
4. Explain the role of time element in the theory of value.
5. What is monopoly? State its features. With the help of diagrams, explain
how equilibrium price and output is determined under monopoly.

191

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