Theory of Consumer Behaviour: Cardinal Utility Approach

Two Techniques of analysis of Consumer Behaviour

1) Cardinal Utility Approach OR Marshallian Approach OR Marginal Utility Analysis --- Given
by Alfred Marshall
2) Ordinal Utility Approach OR Indifference Curve Approach OR Hicks and Allen theory of
Consumer Behaviour ---- Given by Hicks & Allen
Assumption of Cardinal Utility theory
1) Cardinal Measurement of Utility:
--Utility is measurable and quantifiable entity means consumer can express the satisfaction
derived from consumption of commodity in term of unit
--Cardinal measurement means the person can compare the utilities
derived from the different goods in respect of size
--According to Marshall utility can measured in terms of money
-- Money is measuring rod of utility
-- the economists measure the utility by imaginary unit ‗Utils‘
2) Hypothesis of independent utilities:
--Utilities of different goods are independent of one another
--utility that consumer obtain from one goods is the utility of that goods
only it not affected by the utility obtained from consumption of other
goods
--Utility are additive i.e. the utility of different goods can be added to
obtain the total sum of the utilities of all goods purchased
3) Constant Marginal Utility of Money
--Marginal utility of money remains constant even though quantity of money with
the consumer diminished by the successive purchase made by him
--this assumption is necessary because the marginal utility of commodity is measured
in terms of money
4) Introspection:
--the theory assumes that from one‘s experience, it is possible to draw inference about
another person
--Introspection is the ability of the observer to reconstruct the events which go on in the mind
of another person with help of his self observation and experiences
Cardinal Utility Analysis includes:
 Law of Diminishing Marginal Utility
 Law of Equi-marginal Utility
 Consumer‘s Surplus
Important Terms in Cardinal Utility Analysis:
Marginal Utility (MU):
Change in total utility resulting from one unit change in consumption of commodity per unit time
OR
Addition to the total utility by consumption of last unit considered just worth while
Change in total utility
MU= ---------------------------------------------------
Change in consumption of commodity
MU & Price:
 Price measured by MU
 MU only indicate the price but does not determine the price
 MU & Price move up and down together
 MU & Price governed by forces of demand and supply

MU & Supply:
 MU & Supply are inversely proportional
 Greater the supply, less the MU
Dr.R. D. Vaidkar 1
 In case of free goods where supply is unlimited MU is zero or negative
In case of scarce goods where supply is limited MU is positive
MU & Related Goods:
 MU of goods decreases, as the quantity of the substitute goods increases
 MU of goods increases, as the quantity of the complementary goods increases
Total Utility:
Sum of utilities derived from consumption of different units of the commodity
Initial Utility:
Utility derived from consumption of first unit of the commodity
Zero Utility:
When consumption of commodity make no addition to the total utility then the point called as zero
utility
Negative Utility:
If the consumption of commodity carried out excess, instade of giving satisfaction it gives
dissatisfaction, the utility derived in this case is called as negative utility
Law of Diminishing Marginal Utility:
• The law of diminishing marginal utility explains an ordinary experience of a consumer.
• If a consumer takes more and more units of a commodity, the additional utility he derives from an
extra unit of the commodity goes on falling.
• Thus, according to this law, the marginal utility decreases with the increase in the
consumption of a commodity.
• When marginal utility decreases, the total utility increases at a diminishing rate. Therefore,
this law is called The Law of Diminishing Marginal Utility.
• It describes a familiar and fundamental tendency of human nature.
• Definition according to Marshall, “The additional benefit which a person derives from a given
increase of his stock of a thing diminishes with every increase in the stock that he already
has”.
Units of Marginal
Total Utility
Apple Utility
1 20 20
2 15 35
3 10 45
4 5 50
5 0 50
6 -5 45
7 -10 35

Dr.R. D. Vaidkar 2
 Saturation Point

MU = 0

Graphical presentation of Law of Diminishing Marginal Utility

Why the Marginal Utility falls when the quantity of commodity with consumer increases?
Because of two reasons
1) Human wants are unlimited and any particular want is satiable. For satisfaction of this want he go
on consuming more and more units of commodity. As his want satisfied he does not desire more
units of that commodity
2) Different goods are not perfect substute of each other in satisfying the want. If any commodity
satisfy any particular want, the MU decreases as he consumes more of that commodity. If that
commodity is substituted by other commodity to satisfy other want, same thing happen.
Limitations of Law of Diminishing Marginal Utility:
 Dissimilar units
 Very small units
 Too long an interval
 Rare collection
 Abnormal person
 Change in another person‘s stock
Change in income, habit and tastes
Importance of Law of Diminishing Marginal Utility:
 In Taxation: Principle of progressive taxation
is based on LDMU
 In determination of prices: LDMU is basis of
theory of value
 Basis of distribution of wealth in socialism
 Useful in household expenditure
 Basis of formulation of different economic laws like law of demand, law of substitution,
consumer‘s surplus, elasticity of demand etc.
Law of Equi-marginal Utility:
 This principle explain the consumer‘s equilibrium
 This law explain how the consumer spent his limited money income on purchase of different
goods so that he obtain the equal satisfaction for each goods
Law assume that :
 the consumer is „rational‘ means he carefully calculate utilities derived
from each goods
 Consumer substitutes one goods for another so as to maximize his utility or satisfaction
 Statement of Law:
 The Law of Equi-marginal Utility states that “the consumer will allocate his money among the
various goods in such a way that the marginal utility of money spent on each goods is equal.”

Dr.R. D. Vaidkar 3
 OR
 “Consumer will distribute his money income in between the goods in such a way that the
utility derived from the last rupee spent on each good is equal”
 --Consumer is in equilibrium position when marginal utility of money
 expenditure on each good is same
 Marginal Utility of Money Expenditure(MUm) is equal to the marginal utility (MUx) of goods
divided by its price(Px)
MUx
MUm = -----------
Px
If the consumer is purchasing two goods ‗X‘ & ‗Y‘.
Then according to Law of equi-marginal utility he is in equilibrium position when marginal utility
of money expenditure of goods ‗X is equal to marginal utility of money expenditure of goods ‗Y‘
MUx MUy
MUm = ----------- = ----------
Px Py

MUx MUy
If ----------- > ---------- then consumer will substitute goods X for Y
Px Py

MUx MUy
If ----------- > ---------- then consumer will substitute goods Y for X
Px Py
And thus remain on equal equilibrium position
 If the consumer purchasing more than two goods then
MUx MUy MUn
MUm = ----------- = ---------- = …………………= ---------
Px Py Pn
Explanation of law
Example: A consumer has Rs. 140 with him which he wants to spend on Brinjal (X) and
Tomato (Y). The Marginal Utility of Brinjal and Tomato is given below. The price of Brinjal and
Tomato is Rs. 20/kg and Rs. 30/kg respectively. How much quantity of Brinjal and Tomato he
should buy to maximize his satisfaction?

Kg MUx MUy
1 200 240
2 180 210
3 160 180
4 140 150
5 120 120
6 100 90
7 80 60

Dr.R. D. Vaidkar 4
• First of all, let us calculate Marginal Utility of Money Expenditure for X and Y as under.
Kg MUMx MUMy
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
7 4 2

• Now, compare quantity purchased for equal MUMx and MUMy.

• Here, consumer has Rs.140 with him. So, he should buy 4 kg of Tomato and 3 kg of Brinjal to get
maximum satisfaction.
• Here his Marginal Utility of Money Expenditure is 7
MUM qty of X qty of Y Money required
(MUMx = MUMy) (kg) (kg) (Rs)
8 3 1 3*20 + 1*30 = 90
7 4 2 4*20 + 2*30 = 140
6 5 3 5*20 + 3*30 = 190
5 6 4 6*20 + 4*30 = 240
4 7 5 7*20 + 5*30 = 290

• Now, let us check whether the total utility he gains is maximum or not?
• For Rs. 140, he can have different combination of Tomato and Brinjal as under.
• Here, total satisfaction is highest (1130) in case of combination no.2 (4 kg X and 2 kg Y).
• Thus, the combination of X=4 and Y=2 has MUM=7 which is equal in case of X and Y i.e.
MUMx=MUMy. Thus, it is the state of maximum satisfaction.
qty of Money required Total Utility
qty of Y
Combination X (Rs.) ( TUx + TUy)
(kg)
(kg)
1 7 0 7*20 + 0*30 = 140 980 + 0 = 980
2 4 2 4*20 + 2*30 = 140 680 + 450 = 1130
3 1 4 1*20 + 4*30 = 140 200 + 780 = 980

Dr.R. D. Vaidkar 5
 • Graphical presentation of Law of Equi-marginal Utility

9
12
8
E
10 7
B Loss H
8
6 Gain
C

MUm
5
MUm

6 4

4 3
2
2 1
A D F G
0 0
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

Quantity with goods X Quantity

Consumer Equilibrium Consumer Equlibrium with goods Y

Limitations of Law of Equi-marginal Utility

 Consumers are governed by habits and customs, so he does not calculate and compare MU from
various goods
 For applying this law consumer has to equate MU derived from various goods cardinally , which
is not possible to ordinary consumer
 Because of un-divisibility of certain goods we can not calculate MU of money spent on them
Importance of Law of Equi-marginal Utility
 It applies to consumption
 It applies to production
 It applies to exchange
 It applies to distribution
 It applies to public finance

Theory of Consumer Behaviour: Ordinal Utility Approach

OR
Indifference Curve Technique
INDIFFERENCE CURVE TECHNIQUE
 The technique of indifference curve was first invented by Classical economist ‗Edgeworth‘
 Hicks and Allen put forward the theory of Indifference Curve to criticise the Marshallian Cardinal
utility approach in a well known paper ‗A Reconsideration of Theory of Value‘
 In 1939 Hicks again reproduced the Indifference Curve theory in his book ‗Value and Capital‘
 Indifference Curve theory also called as Ordinal Utility Approach
• Ordinal Utility:
• According to Indifference theory utility is a psychic entity and it cannot be measured in
quantitative term
• Utility is a psychological feeling and is not quantifiable
• The ordinal utility implies that the consumer is capable of simply comparing the different levels
of satisfaction
• Scale of preference:
 Consumer ranks his preferences
 He having different combinations of goods in his mind and he arrange them according to scale of
preference
 On the basis of scale of preference, consumer decide his purchase plan
 Consumer‘s scale preference depends on the ruling prices of goods in the market
Assumptions of Indifference Curve Analysis
1) Completeness:
The consumer having complete scale of preference

Dr.R. D. Vaidkar 6
He is able to choose any one of the two combinations of goods presented to him or he is indifferent
between them
2) Non- satiation:
Consumer never reach to the points of satiety in the consumption of any goods
He prefer more of the commodity than the less
3) Consistency or transitivity:
Suppose consumer having three combinations of goods A,B and C.
If the consumer is indifferent between A & B and also indifferent between B & C, then he will be
indifferent between A & C.
i.e. consumer‘s choice is consistent
4)Indifference curve assumes diminishing marginal rate of substitution
Indifference Curve:
“It represent all possible combinations of two goods which gives equal satisfaction to the consumer”
• Consumer is indifferent in between the different combinations on indifference curve
• i.e. all the combinations laying on indifference curve are equally preferred or desired by the
consumer
• Indifference curve also called as Iso-utility curve

Indifference schedule & Curve:

14
Combi Good Good Y IC1
12 A
nation X
10
A 1 12 B
Goods Y

B 2 8 6 C
4 D
C 3 5 E
2

D 4 3 0
0 1 2 3 4 5 6
E 5 2 Goods X
Indifference curve

 All the combination gives equal satisfaction shown on indifference curve and schedule
 If the consumer purchase 1 unit of goods X and 12 unit of goods Y, it will gives same satisfaction
when he purchase 2 units of X and 8 units of Y.
 Thus all the combinations i.e. A, B, C, D and E gives him equal level of satisfaction
 Consumer is indifferent in between all the combinations of X & Y
 Indifference curve shows all the combination which gives equal satisfaction to the consumer, but
it does not provide exactly how much of satisfaction he derived from consumption or purchase of
two goods
Indifference Map
• A set of indifference curve presented on a graph showing different level of satisfaction called as
indifference map
• The higher indifference curve shows the higher level of satisfaction and vice versa
• Bust it does not indicate how much of satisfaction
• Indifference map portray the consumer‘s scale of preference

Dr.R. D. Vaidkar 7
 25
Goods Y 20
15
10
IC1
IC2
5 IC3
IC4
0
IC5
1 2 3 4 5
Goods X

Marginal Rate of Substitution:

 The rate at which the consumer is prepared to exchange goods X and Y is known as marginal rate
of substitution (MRS)
 MRS of X for Y can defined as the amount of Y whose loss can just compensate the consumer for
one unit of gain in X
 MRS shows how much of one commodity is substituted for how much of another
Combination Good X Good Y MRS of X for Y
A 1 15 1:4
B 2 11 1:3
C 3 8 1:2
D 4 6 1:1
E 5 5 --

Principle of Diminishing Marginal Rate of Substitution:

“As more and more of a goods, say X is substituted for another good, say Y, the marginal rate of
substitution diminishes”
• This is due to the fact that as consumer has more and more of good X, he goes on losing interest
therein and he is prepared to give less and less of the other good Y for it.

Reasons of Diminishing Marginal Rate of Substitution:

 The want for particular goods is satiable. So that as the consumer has more and more of good, the
intensity of his want for that goods goes on declining.
 Goods and imperfect substitute for each other:

Dr.R. D. Vaidkar 8
If goods are perfect substitute they regarded as one and same good, so any change in quantity of that good
would not any difference in marginal significance. So the MRS remain same in perfect substitute. But in
case imperfect substitute it is not possible
Properties of Indifference Curve
1)Indifference Curve slopes downward to the right
 IC having negative slope
 When amount of one good in combination is increased, the amount of other good reduced
2) Indifference curve is convex to the origin
Convexity of Indifference Curve shows diminishing marginal rate of substitution

3) Indifference Curves 4) Higher indifference curve shows

never intersect each other higher level of satisfaction than
lower one

Indifference curve for Indifference curve for perfect

perfect substitute Complementary goods

Budget Line
• Knowledge of budget constraints is important for understanding the theory of consumers
equilibrium
• Consumer attempt to maximize his satisfaction and always try to remain on higher indifference
curve
• While doing this he has to face two constraints
1) he has to pay price for the goods
2) he has limited money income
• With this limited money income he tries to get maximum satisfaction at given price of goods
• Budget line represents various combinations of two goods that can be purchased with the given
amount of money.

Dr.R. D. Vaidkar 9
 • It is known as Price line or Iso-cost line or Budget constraints line or price opportunity line
or price-income line or expenditure line

• It can be drawn by locating the end points of X and Y that can be purchased from the given
amount of money.
• It plays an important role in determining the combination of goods that the consumer should
purchase to minimize his total cost.
• Definition: The line or the curve which shows all possible combinations of two goods which
can be purchased with given amount of money income at their given prices
• Suppose, a consumer has a fund of Rs 50 which he wants to spend on two goods viz., Coffee (X)
and Biscuit (Y). The price of X is Rs. 10/packet and that of Y is Rs. 5/packet. Given the prices
of X and Y, he can purchase a maximum 5 packets of Coffee or 10 packets of Biscuit. To draw
Budget line we need two extreme points A and B on X and Y which can be obtained as under:
Extreme Point X (Packet) Y (Packet) Total Cost (Rs)
F 5 0 50
A 0 10 50

• When these two points F(5,0) and A(0,10) are joined, we get budget line (Fig.).
• The consumer can also buy the different combination of two goods with given prices and money
income
A :10Y and 0X
B: 8Y and 1X
C: 6Y and 2X
D: 4Y and 3X
E: 2Y and 4X
F: 0Y and 5X

 All the combinations i.e. A, B, C, D, E and F lie on the budget line AF

 He can buy all these combinations with given prices and money income
 The combination laying right to the budget line are unattainable because income of consumer is
not sufficient to buy these two goods
 The combination laying left to the budget line are attainable because income of consumer is
sufficient to buy these two goods, but total money income of consumer will not be used for
purchase of goods
 The intercept OA on Y axis is equals to the amount of entire income (M) divided by price of
commodity Y (OA= M/Py)
 The intercept OF on X axis is equals to the amount of entire income (M) divided by price of
commodity X (OF= M/Px)

Dr.R. D. Vaidkar 10
  The budget line algebraically written as PxX + PyY = M

Budget Space:
 it shows all the combinations of two goods that can be purchased by spending the whole or a
part of given income
 The combination lie on budget line algebraically shown as
PxX + PyY = M
 The combination lie below or left of budget line algebraically shown as
PxX + PyY ≤ M
 The combination lie above or right of budget line algebraically shown as
PxX + PyY ≥ M

Characteristics of Budget line

• It is always a straight line.
• The slop of budget line shows the inverse price ratio of two goods.
• Change in input prices will change the slop of the budget line.
• When the total outlay or budget is increased, the budget line shifts upwards to the right and it
moves farther away from the origin and vice-versa.
• budget lines are parallel to one other, since relative price ratio remains constant.
• Shift in Budget line:
• There are two determinants of Budget line
• * Price of goods
• * Income of consumer
• Budget line shift due to
• * Change in price of goods
• * Change in income of consumer
Change in price and shift of Budget line
 With fall in price of good X, the consumer‘s money income and price of good Y remaining
constant, the Budget line will shift to the right to the new position BL‘
 With raise in price of good X, the consumer‘s money income and price of good Y remaining
constant, the Budget line will shift to the left to the new position BL‖

Dr.R. D. Vaidkar 11
  With fall in price of good Y, the consumer‘s money income and price of good X remaining
constant, the consumer will purchase more of good Y and the Budget line will shift to the new
position LB‘
 With raise in price of good Y, the consumer‘s money income and price of good X remaining
constant, the consumer will purchase less of good Y and the Budget line will shift to the new
position LB‖

Change in income and shift of Budget line

 If the consumer‘s income increases, while the prices of goods X & Y remain constant, the budget
line will shift upward to the right to new position B‘L‘
 This is because as the income of consumer increases, consumer is able to purchase more quantity
of good X by spending total income on good X
 Also as the income of consumer increases, consumer is able to purchase more quantity of good Y
by spending total income on good Y

 If the consumer‘s income decreases, while the prices of goods X & Y remain constant, the budget
line will shift downward to the left to new position B‖L‖
 This is because as the income of consumer decreases, consumer is purchase less quantity of good
X by spending total income on good X
 Also as the income of consumer decreases, consumer is purchase more quantity of good Y by
spending total income on good Y
Consumer’s Equilibrium With Indifference Curve:
Assumptions to explain Equilibrium of consumer
1) Consumer is rational i.e. he tries to maximize his satisfaction
2) Consumer having indifference map showing his scale of preference for different combinations of
two goods X & Y
3) Consumer having fixed money income to spend on these two goods
4) Price of goods are given and constant.
5) Goods are homogeneous and divisible
Consumer is in equilibrium when he satisfy following conditions

Dr.R. D. Vaidkar 12
  The Budget line should be tangent to the Indifference curve i.e. the MRS of goods X for good Y
must equal to the ratio between the prices of two goods
MRSxy = Px/Py
 The Indifference curve must be convex to the origin at the point of tangency i.e. MRSxy must be
diminishing at the point of tangency

Income Effect: Income Consumption Curve

• Income effect means the change in consumer‘s purchase of the goods as a result of a change in
his money income
• Income effect shows the effect of change in income on consumer’s equilibrium while the price
of goods remaining same or constant
• At a given prices of goods and at given money income consumer is at equilibrium at point Q1, i.e.
at a point of tangency of Indifference curve IC1 and price line P1L1. Here he purchasing OM1 of
good X and ON1 of good Y

• If the income of consumer increases and price of goods remain same. Now consumer is at
equilibrium at point Q2, i.e. at a point of tangency of Indifference curve IC2 and price line P2L2.
Here he purchasing OM2 of good X and ON2 of good Y
• Like this at different income levels consumer is at equilibrium at point Q3, Q4
• If we joined together the different points of consumer‘s equilibrium, we get a curve called as
income consumption curve (ICC)
• Thus income consumption curve is the locus of equilibrium points at various levels of income of
consumer
• Income Consumption Curve trace out the income effect on quantity consumed of the goods
• The line or the curve which shows the points of equilibrium at various levels of income is
called as Income Consumption Curve (ICC)
• ICC shows how the consumption of two goods changes as the income of consumer changes,
while prices of goods remaining constant
• Income effect may be Positive or Negative
• Income effect may be Positive or Negative

Dr.R. D. Vaidkar 13
Positive Income Effect:
 Income effect of goods is said to be positive when with the increase in income of the consumer,
his consumption of goods also increases
 Positive income effect is seen in case of normal goods
 In positive income effect ICC slope upward to the right
 Positive income shown in fig.

Negative Income Effect:

 Income effect of goods is said to be negative when with the increase in income of the consumer,
consumer reduces his consumption of goods
 Negative income effect is seen in case of Inferior goods
In Negative income effect ICC slope backward to the right or left

 If the X is the inferior good, the ICC slope backward i.e. bends towards Y-axis as shown in figure
Negative Income Effect:
 If the Y is the inferior good, the ICC slope downward to the right i.e. bends towards X-axis as
shown in figure
 In case of inferior goods, the ICC is normal at a starting point of equilibrium, but as the income of
consumer increases it start bending backward
 As the income of consumer increases, consumer substitute superior goods for them and consume
superior goods. Due to this the quantity consumed or purchased of inferior goods falls

 The goods for which the income effect is negative are called as inferior goods. E.g. jowar, Bajara,
maize etc.
ICC for inferior goods:
• If the income effect for good X is negative, the income consumption curve for goods X will slope
backward to the left or bend towards Y axis
• If the income effect for good Y is negative, the income consumption curve for goods Y will bend
towards X axis

Dr.R. D. Vaidkar 14
ICC for Normal goods:
• Normal goods include Necessary goods and Luxury goods
• If the quantity purchased of goods is less than the proportionately to increase in income then the
goods are necessary
• If the quantity purchased of goods is greater than the proportionately to increase in income then
the goods are Luxury

• Normal goods include Necessary goods and Luxury goods

• If the quantity purchased of goods is less than the proportionately to increase in income then the
goods are necessary
• If the quantity purchased of goods is greater than the proportionately to increase in income then
the goods are Luxury
Substitution Effect:
“Substitution effect means change in the quantity purchased of a good as a consequence of a change
in its relative price alone, real income or level of satisfaction remain constant.”
there are two different concepts of substitution effect:
 Hicksian Substitution effect: given by J R Hicks
 Slutsky Substitution effect: given by E. Slutsky
Hicksian Substitution effect:
 In Hicksian substitution effect price change is accompanied by a so much change in money
income that the consumer remains on same level of satisfaction
 Money income of consumer is changed by an amount which keep the consumer on the same
indifference curve on which he was before the change in price.
 The amount by which the money income of the consumer is changed so that he remains on same
level of satisfaction is called compensating variation in income
Hicksian Substitution effect:
Dr.R. D. Vaidkar 15
  PL is the price line
 The consumer is at equilibrium at point Q on indifference curve IC
 Now he is purchasing OM of good X and ON of goods Y

 Now if the price of goods X falls

 The real income or purchasing power of consumer increases
 In order to find out substitution effect, the raised purchasing power of consumer should be
reduced.
For this purpose we have to reduce the money income of consumer by such a amount so that he will
remain on same indifference curve IC
 with fall in price of goods X, the new price line will be obtained PL‘
 The purchasing power or real income of consumer can be reduced by taking away some money
income from him.
 As the money income from consumer has taken away the price line shift downward side but
parallel to PL‘
 Draw a budget line AB parallel to PL‘ at a distance so that it touches to IC
 It show that the income of consumer reduced by PA (For goods Y) and L‘B (For goods X)
 PA and L‘B shows the compensating variation in income

 As compare to earlier budget line PL, now the goods X is cheaper

 Now consumer rearrange his purchase of both goods and substitute X for Y
 As goods X is cheaper and goods Y is dearer, he purchase more of X and less of Y
 With budget line AB consumer is equilibrium at a point T
 Now he is buying OM‘ of X and ON‘ of Y
 i.e. he purchasing MM‘ more of X and NN‘ less of Y
 This is due to change in relative price of goods
 Therefore movement from point Q to T represents the substitution effect
 In Hicksian substitution effect consumer remains on same indifference curve
 fall in price of commodity always leads to increase in quantity demanded due to substitution
effect
 The substitution effect is always negative

Dr.R. D. Vaidkar 16
 Negative substitution effect implied that decline in relative price of commodity always causes
increase in its quantity demanded

Price Effect:
 “Price effect shows the effect of change in price of good on consumers equilibrium or quantity
purchased of that good, while price of other good and income of consumer remain constant.”
 Price consumption curve (PCC) traces out the Price effect
 PCC shows how the purchase of good X changes as the price of X changes, while price of good
Y, his money income, taste etc remain same
 PCC sloping downward shows that as the price of X falls, the consumer purchase larger quantity
of X and smaller of Y
 In this case demand is elastic
 Price elasticity > 1

 PCC sloping upward shows that as the price of X falls, the consumer purchase larger quantity of
both X and Y
 Price elasticity < 1
 PCC sloping Backward shows that as the price of X falls, the consumer purchase smaller
quantity of X after a point and larger of Y is purchased
 Found in case of Giffen goods
 PCC sloping horizontal straight line shows that as the price of X falls, the consumer purchase
larger quantity of X and same quantity of Y
 Price elasticity = 1

Decomposing the price effect in Substitution effect and income effect by compensating
variation approach
Price effect = MN
Sub. Effect = MK
Income effect = KN
MN = MK + KN
Price effect = Sub. Effect + Income effect

Dr.R. D. Vaidkar 17
 CONSUMER‟S SURPLUS

The concept

 The concept of consumer‘s surplus was first introduced by Alfred Marshall.

 When a consumer is prepared to buy a commodity, he always calculates the utility he is going to
derive from its consumption.
 Every rational consumer compares the utility he derives from the consumption of a commodity,
against the price he has to pay. If the utility is more than the price paid, he prefers it and if it is
vice-versa, he does not buy the same good.
 The surplus of utility he derives is consumer‟s surplus.

In nutshell, consumer‟s surplus is the difference between what the consumer is willing to pay
and what he actual pays.

Consumer‟s Price that a consumer is Price he

Surplus willing to pay actual pays

Suppose, a consumer wants to buy a shirt. He is willing to pay `250for it. But the actual price is
only `200. Thus he enjoys a surplus of`50.

Thus, Consumer‘s Surplus= `250 - `200 = `50

Consumer‘s surplus is experienced in commodities which are highlyuseful but relatively cheap.
For example, newspaper, salt, match box,postage stamp etc. For these commodities, we are ready to pay
more than what we actually pay.

Dr.R. D. Vaidkar 18
 Marginal utility explains the price which a consumer is willing to pay forthe unit of the
commodity. As more and more units of a commodity ispurchased, the marginal utility declines. Therefore
the price, which theconsumer is willing to pay, also decreases. Thus, the difference between marginal
utility and the market price (actual price) also gives the consumer‟s surplus.

Example : Estimation of Consumer‟s surplus

Units of Apple Marginal Utility Actual Price of Consumer‟s surplus

(willingness to pay) Apple
1 20 5 15
2 15 5 10
3 10 5 5
4 5 5 0
Total Units Total Utility Total Money Total Consumer‟s
Purchased = 4 = 50 Spent = ` 20 Surplus = ` 30

Here,Consumer‘s Surplus foreach unit is the difference between respective Marginal Utility and
Market Price. The total consumer‘s surplus for all the units canbe calculated as total utility minus the total
amount of money spent on thecommodity i.e. Total Consumer‘s Surplus = ` 50 – ` 20 = ` 30.

A rise in the market price reduces the consumer‟s surplus and vice-versa. If price of apple
increases to `10, consumer will buy only 3 units and in such case consumer‘s surplus will be decreased to
` 15 only.

25

A
20
Marginal Utility / Price (Rs./unit)

15 MU Curve

10 Consumer’s
Surplus
E
5
P
Total Expenditure M
O
0
1 2 3 4 5
Units of Apple

Fig. 7: Consumer‟s Surplus

Here, MU is the marginal utility curve. OP is the priceand OM is the quantity purchased.
For OM units (4 apples): Total Utility = Willingness to pay = OAEM
The actual amount he pays (total expenditure) = OPEM.

Thus, consumer‘s surplus =OAEM – OPEM

= PAE (shaded area in the figure).

Dr.R. D. Vaidkar 19
Assumptions

1. Utility of a commodity is measured in money terms.

2. There is definite relationship betweenexpected satisfaction (utility) and realized satisfaction
(actual).
3. Marginal utility of money is constant.
4. Income, tastes, fashion, etc remains constant.
5. Demand for a commodity depends on its price alone; it excludesother determinants of demand.

Importance

1. It is useful to the Finance Minister in formulatingtaxation policies.

2. It is helpful in fixing a higher price by a monopolistin the market, based on the extent of
consumer‘s surplus enjoyed byconsumers.

3. It enables comparison of the standard of livingof people of different regions or countries.For

example, a middleclass personin New York enjoys more consumers‘ surplus than a similar person
in Anand.

Demand and Demand Function

What is Demand?
Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a
given price in a given time period.
It is necessary to distinguish between demand and desire or need. Demand in economics must be
effective. It means that when a consumers' desire to buy a product is backed up by an ability and
willingness to pay for it, then only it actually affect the market. If a person below poverty line wants to
buy a car, it is only a desire but not a demand as he cannot pay for the car. If a rich man wants to buy a
car, it is demand as he is able and willing to pay for the car. Thus, desire backed by willingness and
ability to pay is called demand.
Definition:
Various quantity of goods and services that consumer would purchase in a market in a given period of
time at various prices or at various income or at various prices of related goods called as demand
Demand schedule is a tabular statement showing how much of a commodity is demanded at different
prices.
The demand of the individual consumer for a particular good or service at different prices is called
Individual Demand.
The sum of the individual demand for a product in the market is called Market Demand.
Demand for commodity and Quantity Demanded:
Demand for commodity: The quantity of a commodity which consumer plan to purchase at various prices
of a goods during a period of time
Quantity demanded: The quantity of a commodity which consumer plan to purchase at a particular price
of a goods during a period of time
Types /Kinds of Demand
1. Price demand
2. Income demand
3. Cross demand
Dr.R. D. Vaidkar 20
Demand Function
The demand for any commodity mainly depends on the price of that commodity.
The other determinants include price of related commodities, the income of consumers, tastes and
preferences of consumers, wealth of consumers etc. Hence the demand function can be written as
under:
Qd = f (Px, Ps, Y, T, W, …)
Where,
Qd = demand for good X
Px = price of good X
Ps = price of related goods (other thanX)
Y = income of the consumer
T = tastes and preferences of the consumer
W = wealth of the consumer.
 For many purposes in economics only the relationship between the quantity demanded of goods
and its price is described while all other factors are kept constant.
 With this we can write demand function as
Qd = f (Px)
i.e. quantity demanded of goods X is a function of its own price.
 There is inverse relationship between quantity demanded and price of goods
 The above demand function does not provide the information regarding how much of quantity
demanded at a particular price of goods
 For this purpose we need a specific form of demand function
Generally the demand function is in Linear form and written as
Qd = a – bPx
Where Qd = demand for good X
Px = price of good X
a = Intercept
b = Slope
Suppose the estimated regression line for the data related to the demand of goods is
Qd = 5000 - 8P
 Suppose if the price of product or fuel wood is Rs 1 /- per quintal then the quantity demanded will
be 5000 - 8 (1) = 4092 quintals.
 The value of intercept in regression equation is 5000. This indicate that if the price of product is
zero then the quantity demanded will be remains 5000 quintals.
 The value of slope in given regression equation is 8. This shows that the quantity demanded will
be 8 quintals when the price of product raised by Rs 1/- per quintal.
Law of Demand:
“A rise in price of commodity and services followed by reduction in demand and a fall in prices is
followed by extension in demand, while other factors remaining constant “
 Other factors remaining constant (ceteris paribus) there is an inverse relationship between the
price of a good and its demand.
 Demand varies inversely with price, not necessarily proportionately.
 If the price falls, demand will extend and vice-versa.

 Demand thus is a function of price. i.e. it varies with price.

 Constancy of other factors which is generally stated as ceteris Paribus is an important
qualification of law of demand

Dr.R. D. Vaidkar 21
 Demand Curve and Law of Demand:
Price of Quantity 8
Milk demanded 7
D
(Rs/Lit)
6
50 1
5

Price
45 2 4

40 3 3
2
35 4 D’
1
30 5
0
0 10 20 30 40 50 60
25 6
Quantity
20 7 Demand Curve

• A demand curve shows the relationship between the price of a product and the quantity demanded
over a period of time.
• The curve slopes downwards from left to right showing that, when price rises, less is demanded
and vice versa.
• Thus the demand curve represents the inverse relationship between the price and quantity
demanded, other things remaining constant.
Why demand curve slopes downward?
• Generally, the demand curve slops downwards. This is in accordance with the law of diminishing
marginal utility. The purchases of most of us are governed by this law.
• When the price falls, new purchasers enter the market and old purchasers will probably purchase
more.
• Since, this particular commodity has become cheaper, it will be purchased by some people in
preference to other commodities.
Why people buy more when the price falls?
 A unit of money goes farther and one can afford to buy more. He is willing and able to buy more
because the thing being cheaper, his real income (i.e. income in terms of goods) increases. It is
called Income Effect. For example, a person demands 2 lit milk at a price Rs. 30/lit. It means he
spends Rs. 60 on milk. With the same amount of money he can buy 3 lit when price falls to Rs.
20/lit.
 When the commodity becomes cheaper, it tends to be substituted wholly or partly for other
commodities. This is called Substitution Effect. For example, a person demands 2 kg tomato and
2 kg brinjal every day (total 4 kg). If price of tomato falls (and price of brinjal remaining the
same), he will buy more tomato say 3 kg and only 1 kg of brinjal (total 4 kg) to minimize his cost.
 A commodity tends to be put to more uses or less urgent uses when it becomes cheaper. For
example, additional qty of milk can be used for making sweets, ice-cream, etc.
Exceptions to the Law of Demand
• As we have said above, generally the demand curve slops downwards from right to left.
• But sometimes the demand curve, instead of sloping downward, will rise upwards.
• In other words, sometimes people will buy more when the price rises. Such cases are very rare.
The following is the list of few exceptions to the law of demand.
 Veblen Effect
• Veblen has pointed out that there are some goods demanded
by very rich people for their social prestige.
• When price of such goods rise, their use becomes more
attractive and they are purchased in larger quantities.
• For example, demand for diamonds from the richer class will go up if there is increase in price. If
such goods were cheaper, the rich would not even purchase.
Dr.R. D. Vaidkar 22
  Giffen Paradox
• Sir Robert Giffen discovered that the poor people will
demand more of inferior goods if their prices rise and
demand less if their prices fall.
• Inferior goods are those goods which are cheaper as compared to their substitutes.
• For example, in case of rice, normal rice is cheaper than basmati.
• Now, a middle class family demands 1 kg of basmati and 9 kg normal rice (total 10 kg) per
month.
• If price of rice falls, he will demand more basmati say 2 kg and only 8 kg normal rice (total 10
kg).
• Thus, as price of rice decreases, demand of normal rice (inferior quality) also decreased.
• This is called ‗Giffen Paradox‘. In these cases, the law of demand has an exception.
Change in Demand (Extension / Contraction of Demand)
• The demand curve does not change its position here.
• When change in demand for a commodity is entirely due to a change in its price, it is called
extension or contraction of demand.
• The extension or contraction in demand are movements on or along the given demand curve.
• When the price of a good is OP1, demand is OQ1. If the price of good falls to OP3, demand
expands to OQ3. Thus extension in demand is OQ3. On the other hand, when the price of good
rises to OP2 demand contracts to OQ2. Thus contraction in demand is OQ2.

Shift in Demand (Increase / Decrease in Demand)

 One of the basic assumptions of economic theory is ‗other things being equal‘.
 Other things are income, tastes, population, government policy, technology, price of related
goods etc.
 Change in such factors will bring about increase or decrease in demand.
 In Fig., The increase in demand is shown by the shift to the right from D1 to D2 and OQ2
indicates increase in demand. The decrease in demand is shown by the shift to the left from D1 to
D3 and OQ3 indicates decrease in demand.

Dr.R. D. Vaidkar 23
Market Demand Function:
The sum of the individual demand for a product in the market is called Market Demand.
Apart from the different factors affecting on demand like price, income, teste, etc, market demand for
product depends on an additional factor, viz. number of consumer in the market consuming that
commodity.
Mathematically market demand function expressed as
Qd = f (Px, Ps, Y, T, W, N)
Where N is the number of consumers or population
For estimation of market demand the Linear form of demand function is
Qd = a + b1Px + b2Ps + b3Y + b4T + b5W + b6N
‗a‘ is intercept and b1 b2, b3……. are the coefficient which shows how much market demand changes as
a result of a unit change in variable
By considering all other factors constant except price the market demand function can be written same as
individual demand function
Qd = a - b1Px
Deriving market demand function from Individual demand function:
The individual demand function mathematically expressed in term of own price of goods, while other
factors remaining constant.
Let the individual demand function for consumer ‗A‘ is
consumer ‗A‘ is QdA = 40 - 2Px
consumer ‗B‘ is QdB = 25.5 – 0.75Px
consumer ‗C‘ is QdC = 36.5 - 1.25Px
Now market demand is the sum of the individual demand for a product in the market
QdM = QdA + QdB + QdC
= (40 - 2Px) + (25.5 – 0.75Px) + (36.5 - 1.25Px) = 102 – 4Px

Market Demand Curve:

The lateral summation of individual demand curves gives the market demand curve

Dr.R. D. Vaidkar 24
Factors determining the demand:
 Tastes and preference of consumer
 Income of people
 Change in price of related goods
 Advertisement expenditure
 No. of consumers in market
 Consumer‘s expectation regarding future price
 Saving
 Change in money supply
 Condition of trade

Perfect Competition
• It is essential to know the meaning of firm and industry.
• Firm is an organisation which produces and supplies goods that are demanded by the
people with the goal of maximising its profits.
• According to R.L.Miller, “Firm is an organisation that buys and hires resources and sells
goods and services.”
• According to Lipsey, “Firm is the unit that employs factors of production to produce
commodities that it sells to other firms, to households, or to the government.”
• Industry is a group of firms producing homogeneous products in a market.
• According to Lipsey, ―Industry is a group of firms that sells a well-defined product or closely
related set of products.‖
• For example, Raymond, Maffatlal, Arvind, etc., are cloth manufacturing firms, whereas a group
of such firms is called the textile industry.
Meaning and Definition of Perfect Competition:
A Perfect Competition market is that type of market in which the number of buyers and sellers is very
large, all are engaged in buying and selling a homogeneous product without any artificial restrictions and
possessing perfect knowledge of the market at a time.
In other words it can be said—‖A market is said to be perfect when all the potential buyers and sellers are
promptly aware of the prices at which the transaction take place. Under such conditions the price of the
commodity will tend to be equal everywhere.‖
In this connection Mrs. Joan Robinson has said—‖Perfect Competition prevails when the demand for
the output of each producer is perfectly elastic.”
Characteristics of Perfect Competition:
1. Large Number of Buyers and Sellers:
• The first condition is that the number of buyers and sellers must be so large that none of them
individually is in a position to influence the price and output of the industry as a whole.
• In the market the position of a purchaser or a seller is just like a drop of water in an ocean.
• A firm in perfect competition is a price- taker and output adjuster

2. Homogeneity of the Product:

Dr.R. D. Vaidkar 25
 • Each firm should produce and sell a homogeneous product so that no buyer has any preference
for the product of any individual seller over others.
• If goods will be homogeneous then price will also be uniform everywhere.
• The control over the price is completely eliminated only when the firm is producing
homogeneous products
• The homogeneity of product depends on the buyers consideration that the product is homogenous
3. Perfect Knowledge of the Market or perfect information of prevailing prices in market:
• Buyers and sellers must possess complete knowledge about the prices at which goods are being
bought and sold and of the prices at which others are prepared to buy and sell.
• If the buyer know the current price in market, seller can not charge him more price than the
prevailing one.
• If the seller know the current price in market, no one seller in market will charge less than the
prevailing price
• This will help in having uniformity in prices.
4. Free Entry and Exit of Firms:
• The firm should be free to enter or leave the firm in long run only.
• If there is hope of profit the firm will enter in business and if there is profitability of loss, the firm
will leave the business.
• In short run is it not possible to the firm to change the size of plant or new firm can enter or old
one leave the industry
The Equilibrium of the Firm under Perfect Competition:
• The short run means a period of time within which the firms can alter their level of output only by
increasing or decreasing the amounts of variable factors such as labour and raw materials, while
fixed factors like capital equipment, machinery etc. remain unchanged.
• Moreover, in the short run, new firms can neither enter the industry, nor the existing firms can
leave it.
• Before explaining competitive equilibrium we assume that a firm tries to maximize money
profits.
• We shall explain the equilibrium of a perfectly competitive firm in two stages: firstly, by
assuming that all firms are working under identical cost conditions and, secondly, by assuming
that they are working under differential cost conditions.
Short-run Equilibrium of the Firm (Identical Cost Conditions:
• Identical cost conditions implies that all firms are facing same cost-conditions, that is, their
average and marginal cost curves are of the same level and shapes.
• Under perfect competition, an individual firm is a price taker, that is, it has to accept the
prevailing price as a given datum.
• It cannot influence the price by its individual action.
• As a result, demand curve or average revenue curve of the firm is a horizontal straight line (i.e.,
perfectly elastic) at the level of the prevailing price.
• Since perfectly competitive firm sells additional units of output at the same price, marginal
revenue curve coincides with average revenue curve. Marginal cost curve, as usual, is U-shaped.
• The marginal revenue curve of a perfectly competitive firm equals price or average revenue can
mathematically shown as
• ΔTR
• MR = ---------
• ΔQ
ΔTR = Δ (P.Q)
• Since the price in perfectly competitive firm is independent of output
• ΔTR = P. ΔQ
• Thus
• ΔTR P. ΔQ
• MR = --------- = ------------- = P
• ΔQ ΔQ
Dr.R. D. Vaidkar 26
Now, in order to decide about its equilibrium output, the firm will compare marginal cost with marginal
revenue.
It will be in equilibrium at the level of output at which
1) marginal cost equals marginal revenue and
2) marginal cost curve is cutting marginal revenue curve from below.
At this level it will be maximising its profits.
Since marginal revenue is the same as price (or average revenue) under perfect competition, the firm will
equalise marginal cost with price to attain equilibrium output.
• OP is prevailing in the market.
• PL would then be the demand curve or the average and marginal revenue curve of the firm.
• It will be seen from Fig. that marginal cost curve cuts average and marginal revenue curve at two
different points, F and E.

• F cannot be the position of equilibrium,

• since at F second order condition of firm‘s equilibrium, namely, that marginal cost curve must cut
marginal revenue curve from below at the point of equilibrium, is not satisfied.
• The firm will be increasing its profits by increasing production beyond F because marginal
revenue is greater than marginal cost.
• The firm will be in equilibrium at point E or output OM since at E marginal cost equals marginal
revenue (or price) as well as marginal cost curve is cutting marginal revenue curve from below.
• As under perfect competition marginal revenue curve is a horizontal straight line, the marginal
cost curve must be rising so as to cut the marginal revenue curve from below.
• Therefore, in case of perfect competition the second order condition of firm‘s equilibrium
requires that marginal cost curve must be rising at the point of equilibrium.
Hence the twin conditions of firm‟s equilibrium under perfect competition are:
(1) MC=MR = Price
(2) MC curve must be rising at the point of equilibrium.

Profit maximization under short run in perfect competition:

But the fulfillment of the above two conditions does not guarantee that the profits will be earned by the
firm.

In order to know whether the firm is making profits or losses and how much of them, average cost curve
must be introduced in the figure.
In Figure SAC and SMC curves are short-run average cost and short-run marginal cost curves
respectively.
• Profit per unit of output is the difference between average revenue (price) and average cost.
• In Fig., at the equilibrium output OM, average revenue is equal to ME, and average cost is equal
to MF.
• Therefore, the profit per unit of output is EF the difference between ME and MF.

Dr.R. D. Vaidkar 27
• The total profits earned by the firm will be equal to EF (profit per unit) multiplied by OM or HF
(total output).
• Thus, the total profits will be equal to the area HFEP. Because normal profits are included in
average cost, the area HFEP indicates super-normal profits.
• Since we are assuming that all firms in the industry are working under same cost conditions and
also for all of them price is OP, all will be earning super-normal profits equal to the area HFEP.
• Thus, while all firms in the industry will be in short-run equilibrium, but the industry will not be
in equilibrium since there will be a tendency for the new firms to enter the industry to complete
away the super-normal profits.
• But the short run is not a period long enough for the new firms to enter the industry.
• The existing firms will therefore continue earning super-normal profits equal to HEFP in the short
period.
• It is evident that in the situation depicted in Fig. all firms will be in equilibrium at E and each will
be producing OM output, but the tendency for the new firms to enter the industry will be present,
though they cannot enter during the short period.
Short run equilibrium of firms in case of loss in perfect competition:
• Now suppose that the prevailing market price of the product is such that the price line or average
and marginal revenue curve lies below average cost curve throughout.
• This case is illustrated in Fig. where the ruling price is OP‘ which is taken as given by the firm.

• P‘ L‘ is the price line which lies below AC curve at all levels of output.
• The firm will be in equilibrium at point E at which marginal cost is equal to price (or marginal
revenue) and marginal cost curve is rising.
• Firm would be producing OM‘ output but would be making losses, since average revenue (or
price) which is equal to ME‘ is less than average cost which is equal to MF.
• The loss per unit of output is equal to E‘F‘ and total loss will be equal to P‘E‘F ‗F which is the
minimum loss that a firm can make under the given price-cost situation.
• Since all the firms are working under the same cost conditions, all would be in equilibrium at
point E‘ or output OM‘ and every one will be making losses equal to P‘E‘F‘H.
Dr.R. D. Vaidkar 28
 • As a result, the firms will have a tendency to quit the industry in order to search for earning at
least normal profits elsewhere.
The Long-Run Equilibrium of the Firm under Perfect Competition
• The long run is a period of time which is sufficiently long to allow the firms to make changes in
all factors of production.
• In the long run, all factors are variable and none fixed.
• The firms, in the long run, can increase their output by changing their capital equipment; they
may expand their old plants or replace the old lower-capacity plants by the new higher-capacity
plants or add new plants.
• Besides, in the long run, new firms can enter the industry to compete the existing firms.
• On the contrary, in the long run, the firms can contract their output level by reducing their capital
equipment
• Moreover, the firms can leave the industry in the long run.
• The long-run equilibrium then refers to the situation when free and full adjustment in the capital
equipment as well as in the number of firms has been allowed to take place.

• It is therefore long-run average and marginal cost curve which are relevant for deciding about
equilibrium output in the long run.
• Moreover, in the long run, it is the average total cost which is of determining importance, since
all costs are variable and none fixed.
• As explained above, a firm is in equilibrium under perfect competition when marginal cost is
equal to price.
• But for the firm to be in long-run equilibrium, besides marginal cost being equal to price, the
price must also be equal to average cost.
• For, if the price is greater or less than the average cost, there will be tendency for the firms to
enter or leave the industry.
• If the price is greater than the average cost, the firms will earn more than normal profits. These
supernormal profits will attract outer firms into the industry.
• With the entry of new firms in the industry, the price of the product will go down as a result of
the increase in supply of output and also the cost will go up as a result of more intensive
competition for factors of production.
• The firms will continue entering the industry until the price is equal to average cost so that all
firms are earning only normal profits.

• On the contrary, if the price is lower than the average cost, the firms would make losses.

• These losses will induce some of the firms to quit the industry. As a result, the output of the
industry will fall which will raise the price.
• On the other hand, with some firms going out of the industry, cost may go down as a result of fall
in the demand for certain specialised factors of production.
• The firms will continue leaving the industry until the price is equal to average cost so that the
firms remaining in the field are making only normal profits.
• It, therefore, follows that for a perfectly competitive firm to be in long-run equilibrium, the
following two conditions must be fulfilled.
1. Price = Marginal Cost
2. Price = Average Cost
If price is equal to both marginal cost and average cost, then we have a double condition of long-run
perfectly competitive equilibrium:
Price = Marginal Cost – Average Cost

But from the relationship between marginal cost and average cost we know that marginal cost is equal to
average cost only at the minimum point of the average cost curve.
Therefore, the condition for long-run equilibrium of the firm can be written as
Dr.R. D. Vaidkar 29
 Price = Marginal Cost = Minimum Average Cost.
• Fig. represents long-run equilibrium of firm under perfect competition.
• The firm cannot be in the long-run equilibrium at a price greater than OP.
• This is because if price is greater than OP, then the price line (demand curve) would lie
somewhere above the minimum point of the average cost curve so that marginal cost and price
will be equal where the firm is earning supernormal profits.
• Since there will be tendency for new firms to enter and compete away these profits, the firm
cannot be in long-run equilibrium at any price higher than OP.

• Likewise, the firm cannot be in long-run equilibrium at a price lower than OP

• If price is lower than OP, the average and marginal revenue curve will lie below the average cost
curve so that the marginal cost and price will be equal at the point where the firm is making
losses.
• Therefore, there will be tendency for some of the firms in the industry to go out with the result
that price will rise and the firms left in the industry make normal profits.
• We therefore conclude that the firm can be in long-run equilibrium under perfect competition
only when price is at such a level that the horizontal demand curve (that is, AR curve) is tangent
to the average cost curve so that price equals average cost and firm makes only normal profits.
• It should be noted that a horizontal demand curve can be tangent to a U-shaped average cost
curve only at the latter‘s minimum point.
• Since at the minimum point of the average cost curve the marginal cost and average cost are
equal, price in long-run equilibrium is equal to both marginal cost and average cost.
• In other words, double condition of long-run equilibrium is fulfilled at the minimum point of the
average cost curve.
• We therefore conclude that the firm can be in long-run equilibrium under perfect competition
only when price is at such a level that the horizontal demand curve (that is, AR curve) is tangent
to the average cost curve so that price equals average cost and firm makes only normal profits.

Price & Output Determination under Monopoly

Meaning and Definition of Monopoly:
• The word monopoly has been derived from the combination of two words i.e., ‗Mono‘ and
‗Poly‘. Mono refers to a single and poly to control.
• In this way, monopoly refers to a market situation in which there is only one seller of a
commodity.
• There are no close substitutes for the commodity it produces and there are barriers to entry.
• The single producer may be in the form of individual owner or a single partnership or a joint
stock company.
• In other words, under monopoly there is no difference between firm and industry.
• Monopolist has full control over the supply of commodity.
• Having control over the supply of the commodity he possesses the market power to set the price.
• Thus, as a single seller, monopolist may be a king without a crown.
Dr.R. D. Vaidkar 30
 • If there is to be monopoly, the cross elasticity of demand between the product of the monopolist
and the product of any other seller must be very small.

Definition of Monopoly:
• “Monopoly is a market situation in which there is a single seller. There are no close substitutes
of the commodity it produces, there are barriers to entry”. –Koutsoyiannis
• “Pure or absolute monopoly exists when a single firm is the sole producer for a product for
which there are no close substitutes.” –McConnel
• “A pure monopoly exists when there is only one producer in the market. There are no dire
competitions.‖ -Ferguson
Features of monopoly :
• 1. One Seller and Large Number of Buyers:
• The monopolist‘s firm is the only firm; it is an industry. But the number of buyers is assumed to
be large.
• 2. No Close Substitutes:
• There shall not be any close substitutes for the product sold by the monopolist. The cross
elasticity of demand between the product of the monopolist and others must be negligible or zero.
• 3. Difficulty of Entry of New Firms:
• There are either natural or artificial restrictions on the entry of firms into the industry, even when
the firm is making abnormal profits.
• Features of monopoly :
• 4. Monopoly is also an Industry:
• Under monopoly there is only one firm which constitutes the industry. Difference between firm
and industry comes to an end.
• 5. Price Maker:
• Under monopoly, monopolist has full control over the supply of the commodity. But due to large
number of buyers, demand of any one buyer constitutes an infinitely small part of the total
demand. Therefore, buyers have to pay the price fixed by the monopolist.
Sources of Monopoly:
1) Patents or Copyrights:
if a firm may posses a patent or copyright which prevent the others
to produce the same product or use a particular production process
2) Control over essential raw material:
if a particular firm gain control over essential raw material or input
used in production of commodity, monopoly exists.
3) Grant of franchise by the government:
if a firm granted exclusive legal rights to produce a given product or services in a particular area or
region, monopoly may occur
4) Advertising and Brand loyalty of the established firm:
Heavy advertising campaigns and brand loyalties of a particular
product promote the brand of firm and prevent entry of new
competitors.
5) Economies of scale:
If the cost structure of an industry is such that economies of scale matter a lot, a single large firm might be
able to produce at a significantly lower cost than other small and medium-sized firms. This enables the
largest player to price other firms out of the market. Many utility companies are able to monopolize a
market owing to economies of scale. Such a monopoly is called a natural monopoly.

The Nature of Demand and Marginal Revenue Curves under Monopoly:

• In monopoly one firm constitutes the whole industry.
• Therefore, the entire demand of the consumers for a product faces the monopolist.
• Since the demand curve of the consumers for a product slopes downward, the monopolist faces a
downward sloping demand curve.
Dr.R. D. Vaidkar 31
• a monopolist can lower the price by increasing his level of sales and output, and he can raise the
price by reducing his level of sales or output.
• In Fig. DD is the demand curve facing a monopolist. At price OP the quantity demanded is OM,
therefore he would be able to sell OM quantity at price OP.
• If he wants to sell a greater quantity ON, then price to the OL.
• If would he restricts his quantity to OG, fall price will rise to OH.
• Thus every quantity change by him entails a change in price at which the product can be sold.
• Thus the problem faced by a monopolist is to choose a price-quantity combination which is
optimum for him, that is, which yields him maximum possible profits.

• Demand curve facing the monopolist will be his average revenue curve.
• Thus, the average revenue curve of the monopolist slopes downward throughout its length.
• Since average revenue curve slopes downward, marginal revenue curve will lie below it.
• This follows from usual average- marginal relationship. The implication of marginal revenue
curve lying below average revenue curve is that the marginal revenue will be less than the price
or average revenue.

• When monopolist sells more, the price of his product falls; marginal revenue therefore must be
less than the price.
• In Fig. AR is the average revenue curve of the monopolist and slopes downward.
• MR is the marginal revenue curve and lies below AR curve.
• At quantity OM, average revenue (or price) is MP and marginal revenue is MQ which is less than
MP.
The Price-Output Equilibrium under Monopoly:
• Monopolist, like a perfectly competitive firm, tries to maximize his profits.
• monopolist faces a downward-sloping demand (or AR) curve and his marginal revenue curve lies
below the average revenue curve
• In monopoly the monopolist will go on producing additional units of output so long as marginal
revenue exceeds marginal cost.
• This is because it is profitable to produce an additional unit if it adds more to revenue than to
cost.
Dr.R. D. Vaidkar 32
• His profits will be maximum and he will attain equilibrium at the level of output at which MR =
MC.
• If he stops short of the level of output at which MR equals MC, he will be unnecessarily forgoing
some profits which otherwise he could make.
• In Fig. MR = MC at OM level of output.
• The firm will be earning maximum profits and will therefore be in equilibrium when it is
producing and selling OM quantity of the product.
• If he increases his output beyond OM, marginal revenue will be less than marginal cost, that is,
additional units beyond OM will add more to cost than to revenue.
• Therefore, the monopolist will be incurring loss on the additional units beyond OM and will thus
be reducing his total profits by producing more than OM.

• Thus he is in equilibrium at OM level of output at which marginal cost equals marginal revenue
(MC = MR)
• It will be seen from the AR curve in Fig. that he will be getting the price MS or OP by selling
OM quantity of output. The total profits earned by him are equal to the area HTSP.
• in monopoly equilibrium when marginal cost is equal to marginal revenue, it is less than price (or
average revenue).
• From Fig. it will be noticed that at equilibrium output OM, marginal cost and marginal revenue
are equal and both are here equal to ME, while price fixed by monopolist is MS or OP.
• It thus follows that price under monopoly is greater than marginal cost.

Price & Output Determination under Monopolistic competition

• in 1933 a revolution in the approach to price theory was initiated by the publication of two works
of modern economists, Chamberlin and Mrs. Joan Robinson.
• E.H. Chamberlin‘s work was entitled ―The Theory of Monopolistic Competition‖ and Mrs.
Robinson‘s “The Economics of Imperfect Competition”.
• Both economists challenged the concept of perfect competition and monopoly as unrealistic and
attempted to present a new theory which is more realistic of the two new approaches, the view of
Chamberlin‘s theory of monopolistic competition received wide acclamation.
• Concept of Monopolistic Competition:
• Monopolistic Competition refers to the market situation in which there is a keen competition, but
neither perfect nor pure, among a group of a large number of small producers or suppliers having
some degree of monopoly because of the differentiation of their products.
• Thus, we can say that monopolistic competition (or imperfect competition) is a mixture of
competition and a certain degree of monopoly, on the basis of a correct appraisal of the market
situation.

Dr.R. D. Vaidkar 33
Definition:
• Monopolistic Competition refers to competition among a large number of sellers producing close
but not perfect substitutes for each other.
• According to Prof. Lerner – “The condition of imperfect competition arises when a seller has
to face the falling demand curve.”

Features of monopolistic competition:

1. Large Number of Buyers and Sellers:
• There are large number of firms but not as large as under perfect competition.
• That means each firm can control its price-output policy to some extent. It is assumed that any
price-output policy of a firm will not get reaction from other firms that means each firm follows
the independent price policy.
• If a firm reduces its price, the gains in sales will be slightly spread over many of its rivals so that
the extent to which each of the rival firms suffers will be very small. Thus these rival firms will
have no reason to react.
2. Free Entry and Exit of Firms:
• Like perfect competition, under monopolistic competition also, the firms can enter or exit freely.
• The firms will enter when the existing firms are making super-normal profits.
• With the entry of new firms, the supply would increase which would reduce the price and hence
the existing firms will be left only with normal profits.
• Similarly, if the existing firms are sustaining losses, some of the marginal firms will exit. It will
reduce the supply due to which price would rise and the existing firms will be left only with
normal profit.
3. Product Differentiation:
• Product differentiation refers to a situation when the buyers of the product differentiate the
product with other.
• Basically, the products of different firms are not altogether different; they are slightly different
from others.
• Although each firm producing differentiated product has the monopoly of its own product, yet he
has to face the competition.
• This product differentiation may be real or imaginary. Real differences are like design, material
used, skill etc. whereas imaginary differences are through advertising, trade mark and so on.
• E.g toothpaste, soap
4. Expenditure on advertisement and other Selling Cost:
• Another feature of the monopolistic competition is that every firm tries to promote its product by
different types of expenditures.
• Advertisement is the most important constituent of the selling cost which affects demand as well
as cost of the product.
• The main purpose of the monopolist is to earn maximum profits; therefore, he adjusts this type of
expenditure accordingly.
5. Lack of Perfect Knowledge:
• The buyers and sellers do not have perfect knowledge of the market. There are innumerable
products each being a close substitute of the other. The buyers do not know about all these
products, their qualities and prices.
• Therefore, so many buyers purchase a product out of a few varieties which are offered for sale
near the home. Sometimes a buyer knows about a particular commodity where it is available at
low price. But he is unable to go there due to lack of time or he is too lethargic to go or he is
unable to find proper conveyance. Likewise, the seller does not know the exact preference of
buyers and is, therefore, unable to get advantage out of the situation.
6) Influence over the price:
• In monopolistic competition variety of product produced which are close substitute to each other.
• Therefore if the firm lower the price of particular product variety, some new consumer of other
variety will switch over to it and vice versa.
Dr.R. D. Vaidkar 34
• Thus if firm fix lower price, it will able to sell more quantity and if it fix higher price, it will able
to sell less quantity
• Thus the firm has to choose a price output combination which will maximize their profit
The Nature of Demand and Marginal Revenue Curves under Monopolistic Competition
• a firm working under monopolistic competition enjoys some control over the price of its product
since its product is somewhat differentiated from others.‘
• If a firm under monopolistic competition raises the price of its product, it will find some of its
customers going away to buy other products.
• As a result, the quantity demanded of its product will fall.
• On the contrary, if it lowers the price, it will find that buyers of other varieties of the product will
start purchasing its product and as a result the quantity demanded of its product will increase.
• It therefore follows that the demand curve facing an individual firm under monopolistic
competition slopes downward.
• DD is the demand curve facing an individual firm under monopolistic competition.
• At price OP the quantity demanded is OM. Therefore, the firm would be able to sell OM quantity
at price OP.
• If it wants to sell greater quantity ON, then it will have to reduce price to OL.
• If it restricts its quantity to OG, price will rise to OH.

• Demand curve facing the monopolist will be his average revenue curve.
• Thus, the average revenue curve of the monopolist slopes downward throughout its length.
• Since average revenue curve slopes downward, marginal revenue curve will lie below it.
• The implication of marginal revenue curve lying below average revenue curve is that the
marginal revenue will be less than the price or average revenue.
• When monopolist sells more, the price of his product falls; marginal revenue therefore must be
less than the price.
• In Fig. AR is the average revenue curve of the monopolist and slopes downward.
• MR is the marginal revenue curve and lies below AR curve.
• At quantity OM, average revenue (or price) is MP and marginal revenue is MQ which is less than
MP.

Dr.R. D. Vaidkar 35
 Price-Output Equilibrium under Monopolistic Competition:
• Under monopolistic competition, to attain equilibrium organizations need to make
 ----------optimum adjustments in the prices and output sold.
 ----------need to pay attention toward the design of the product and
 ----------the way the product is promoted in the market.
• Moreover, an organization under monopolistic competition is not only required to study its
individual equilibrium, but group equilibrium of all organizations existing in the market.
Individual’s Firm Equilibrium under Monopolistic Competition:
• As we know every seller, irrespective of the market structure, is willing to maximize his/her
profits.
• In monopolistic competition, profits are maximized at a point where marginal revenue is equal to
marginal cost (MR = MC).
• The price determined at this point is known as equilibrium price and
• the output produced at this point is called equilibrium output.
• If MR > MC, then he/she may plan to expand his/her output.
• If MR < MC, it would be profitable for the seller to reduce his/her output to the level where MR
= MC.
Equilibrium in Short Run:
• The short-run equilibrium of a monopolistic competitive organization is the same as that of an
organization under monopoly.
• In the short run, an organization under monopolistic competition attains its equilibrium where
MR = MC and sets its price according to its demand curve.
•
• This implies that in the short run, profits are maximized when MR=MC.

Since close substitutes for its product are available in the market, the demand curve for the
product of an individual firm working under conditions of monopolistic competition is fairly elastic.
Thus, although a firm under monopolistic competition has a monopolistic control over its variety of the
product but its control is tempered by the fact that there are close substitutes available in the market and
that if it sets too high a price for its product, many of its customers will shift to the rival products.
• in Fig. DD is the demand curve for the product of an individual firm, the nature and prices of all
substitutes being given.
• This demand curve DD is also the average revenue (AR) curve of the firm.
• AC represents the average cost curve of the firm,
• while MC is the marginal cost curve corresponding to it.
• It may be recalled that average cost curve first falls due to internal economies and then rises due
to internal diseconomies.
• Thus a firm in order to maximise profits will equate marginal cost with marginal revenue.
• In Fig.,the firm will fix its level of output at OM,
• at OM output, MC = MR.
• The demand curve DD facing the firm in question indicates that output OM can be sold at price
MQ – OP.
Dr.R. D. Vaidkar 36
 • Therefore, the determined price will evidently be MQ or OP.
• In this equilibrium position, by fixing its price at OP and output at OM, the firm is making profits
equal to the area RSQP which is maximum.
• Thus, the area RSQP indicates the amount of supernormal or economic profits made by the firm.
• In the short-run, the firm, in equilibrium, may make losses too if the demand conditions for its
product are not so favourable relative to cost conditions.
• Fig. depicts the case of a firm whose demand or average revenue curve DD for the product lies
below the average cost curve throughout indicating thereby that no output of the product can be
produced at positive profits.

• However, the firm is in equilibrium at output ON and setting price NK or OT, for by adjusting
price at OT and output at ON, it is rendering the losses to the minimum.
In such an unfavourable situation there is no alternative for the firm except to make the best of the bad
bargain.

Price & Output Determination under Oligopoly competition:

Curnot‟s and Chemberlin‟s Model
• The term ‗Oligopoly‘ is coined from two Greek words ‗Oligoi meaning ‗a few‘ and ‗pollein
means ‗to sell‘.
• It occurs when an industry is made up of a few firms producing either an identical product or
differentiated product.
• Oligopoly refers to a market situation in which there are a few firms selling homogeneous or
differentiated products.
• ―An oligopoly is a market of only a few sellers, offering either homogeneous or differentiated
products. There are so few sellers that they recognize their mutual dependence.‖ – PC. Dooley
Example of Oligopoly:
• In India, markets for automobiles, cement, steel, aluminium, etc, are the examples of oligopolistic
market. In all these markets, there are few firms for each particular product.
• DUOPOLY is a special case of oligopoly, in which there are exactly two sellers.
• Under duopoly, it is assumed that the product sold by the two firms is homogeneous and there is
no substitute for it.
• Examples where two companies control a large proportion of a market are: (i) Pepsi and Coca-
Cola in the soft drink market; (ii) Airbus and Boeing in the commercial large jet aircraft market;
(iii) Intel and AMD in the consumer desktop computer microprocessor market.
Features/ characteristics of Oligopoly:
1) Interdependence:
• Firms under oligopoly are interdependent in decision making as the few firms make industry
• In it the number of firms are few, therefore a change in competitors price design, output etc will
affect on product

Dr.R. D. Vaidkar 37
 • For example, market for cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford,
Honda, etc.). A change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce
other firms (say, Maruti, Hyundai, etc.) to make changes in their respective vehicles.
2) Advertising and selling cost:
• Due to severe competition ‗and interdependence of the firms, various sales promotion techniques
are used to promote sales of the product.
• Advertisement is in full swing under oligopoly, and many a times advertisement can become a
matter of life-and-death. A firm under oligopoly relies more on non-price competition.
• Selling costs are more important under oligopoly than under monopolistic competition.
3) Group Behaviour:
• Under oligopoly, there is complete interdependence among different firms.
• So, price and output decisions of a particular firm directly influence the competing firms.
• Instead of independent price and output strategy, oligopoly firms prefer group decisions that will
protect the interest of all the firms.
• Group Behaviour means that firms tend to behave as if they were a single firm even though
individually they retain their independence.
4) Indeterminate Demand Curve:
• Under oligopoly, the exact behaviour pattern of a producer cannot be determined with certainty.
• So, demand curve faced by an oligopolist is indeterminate (uncertain). As firms are inter-
dependent, a firm cannot ignore the reaction of the rival firms.
• Any change in price by one firm may lead to change in prices by the competing firms.
• So, demand curve keeps on shifting and it is not definite, rather it is indeterminate.

Classical models of Oilgopoly: Cournot‟s Duopoly Model

• Augustin Curnot, a French Economist, published a theory of duopoly in 1838.
• Curnot take the case of identical two water springs operated by two owners who are selling
mineral water in same market.
The Cournot model is based on the following assumptions:
• There are two independent sellers. In other words, interdependence of the duopolists is ignored.
• They produce and sell a homogeneous product, mineral water.
• The total output must be sold out, being perishable and non-storable.
• The number of buyers is large.
The Cournot model is based on the following assumptions:
• Each seller knows the market demand curve for the product.
• The cost of production is assumed to be zero.
• Both have identical costs and identical demands.
• Each seller decides about the quantity he wants to produce and sell in each period.
• But each is ignorant about his rival‘s plan about output.
• At the same time, each seller takes the supply or output of its rival as constant.
• Each seller aims at obtaining the maximum net revenue or profit.
suppose there are two mineral water springs exploited by two firms, A and B.
• The market demand curve is DD1, and
• its marginal revenue curve is MR,
• The marginal costs of both A and В are assumed to be zero so that they coincide with the
horizontal axis.

Dr.R. D. Vaidkar 38
• Suppose firm A is the only producer in which case it produces and sells OA (=½ OD1) quantity
when it‘s MR, equals its marginal cost curve (horizontal axis) at point A.
• It charges the monopoly price AS (=OP) and earns ОASP as monopoly profits
• Now firm В enters the market and expects that A will not change its output level OA.
• It, therefore, regards SD1 segment of the market demand curve as its demand curve.
• Its corresponding marginal revenue curve is MR2 which intersects the horizontal axis (its
marginal cost curve) at point B.
• Thus it produces and sells AB (= ½ AD1 = BD1) quantity at BG (=OP1) price and it expects to
earn BGTA profits.
• Firm A finds that with the entry of B, price has fallen to OP1 from OP.
• As a result, its expected profits decline to OP JA.
• In this situation, it tries to adjust its price and output.
• Accordingly, assuming that В will continue to sell the same quantity AB (=BD1), it regards the
remaining portion of the market OB available to it.
• It thus sells ½OB. The reduction in its output from OA (=½OD1) to AB (= ½ OB) causes the
price to rise
• As a result of A‘s reduction in output, В thinking that A will continue to produce less, reacts by
increasing its output to ½(OD1-AB) which causes the price to fall.
• In this way, A‘s reducing its output and causing the price to rise, and B‘s reaction in increasing its
output and causing the price to fall, will ultimately lead to an equilibrium price OP2.
• At this price, the total output of mineral water is OF, which is equally divided between the two
firms.
• Each duopolist sells 1/3 of the market i.e. A sells ОС and В sells CF.
• At this price, A‘s OCLP2 equal that of B‘s profits CFRL.
• It is evident that both the producers sell 2/3 of the total output, OD1 and each is producing 1/3 of
OD1.
• Thus in Curnot’s Duopoly model, stable equilibrium is reached when total output produced is
2/3rd of OD1 and each producer is producing 1/3rd of OD1

Classical models of Oilgopoly : Chemberlin‟s Oligopoly Model

Chemberli‘s Oligopoly model makes an advance over the classical models of Cournot,
Edgeworth and Bertrand
His model is based on the assumption that the oligopolists recognise their interdependence and
act accordingly.
Chamberlin criticises the behavioural assumption of Cournot, Bertrand and Edgeworth that the
oligopolists behave independently in the sense that they ignore their mutual dependence and
while ‗deciding about their output or price assume that their rivals will keep their output or price
constant at the present level.
• According to him, oligopolists behave quite intelligently as they recognise their interdependence
and learn from the experience when they find that their action in fact causes the rivals to react and
adjust their output level.
Dr.R. D. Vaidkar 39
• This realisation of mutual dependence on the part of the oligopolists leads to the monopoly output
being produced jointly and thus charging of the monopoly price.
• In this way, according to Chamberlin, maximisation of joint profits and stable equilibrium are
achieved by the oligopolists even though they act in a non-collusive manner.
• Given identical costs, they will also equally share these monopoly profits.
Chamberlin‟s Approach to Stable Joint Profit-Maximising Equilibrium under Oligopoly:
• Chamberlin considers the case of a duopoly with zero cost of production of the two producers, A
and B.
• Like Cournot he also assumes that the market demand curve for the product is linear.

• In Figure, MD represents this linear market demand curve for the homogeneous product of the
duopolists.
• As in Cournot‘s model, suppose producer A is the first to start production. He will view the
whole market demand curve MD facing him and corresponding to it MRa is the-marginal revenue
curve.
• In order to maximise his profits he will equate marginal revenue with marginal cost (which is
here taken to be equal to zero).
• It will be seen from Fig. that he will be in equilibrium by making MR = MC when he produces
OQ output (i.e. half of OD) which is in fact the monopoly output, and will fix price equal to OP.
• Now, suppose producer B enters the market.
• He thinks, as in Cournot‘s model, that producer A would continue to produce OQ output and
• therefore views ED portion of the market demand curve as the relevant demand curve facing him
and corresponding to it MRa is the marginal revenue curve.
• With marginal cost being equal to zero, for maximum profits he will produce half of QD, that is,
QL or at point L at which his marginal revenue curve MR intersects the .Y-axis along which
output is measured.
• With aggregate output OL(OL = OQ of A + QL of B), price will fall to the level LK or OP ‗with
the result that profits earned by producer B will be equal to the area of rectangle QLKT, and
• due to the fall in price the profit of producer A will decrease from OPEQ to OP‘TQ.
• However, from this point onward Chamberlin‘s analysis deviates from Cournot‘s model.
• Whereas in Cournot‘s model, the firm A will readjust his output and will continue to assume that
his rival will keep his output constant at QL level,
• but in Chamberlin‘s model producers learns from his experience that they are interdependent.
• With the realisation of mutual dependence, producer A decides to produce output OH equal to
output QL of producer B and
• And half of monopoly output OQ so that the aggregate output of both of them is the monopoly
output (OQ = OH of A + QL of B).
• With OQ as the aggregate output level, price will rise to QE or OP.
• Firm B also realises that in view of interdependence it is in the best interest for both of them to
produce half of monopoly output and will therefore maintain output at the QL or OH level which
is half of the monopoly output.
• Thus, each producer producing half of monopoly output will result in maximisation of joint
profits though they do not enter into any formal collusion.

Dr.R. D. Vaidkar 40
 • In this way Chamberlin explains that duopolists behaving intelligently and realising their
interdependence reach a stable equilibrium and together produce monopoly output and charge
monopoly price each sharing profits equally.

General Equilibrium Analysis

Partial Equilibrium:
We have analysed how the equilibrium price and quantity of product is determined through the
demand and supply, assuming that only the price is variable while other factors remaining same.That
means in this theory we not considered the effect of change in price of commodity on demand for other
commodities. Such type of analysis in which we do not take in to account the inter-relationship or inter-
dependence between prices of commodities or between the prices of commodities and factors of
production is called as partial equilibrium analysis.
General Equilibrium Analysis Concept:
Partial equilibrium analysis is not useful when there is strong inter relationship between commodities
or between factors.When markets for various commodities and factors are interdependent i.e. change in
price of commodity or a factor have important repercussions or effect on demand for other commodities
or factors, partial equilibrium analysis would not yield correct results.In such case General Equilibrium
analysis is employed.When there is significant inter relationship between various markets or that the
changes in one market would affect the other, the general equilibrium analysis employed which consider
simultaneous equilibrium of all markets
In it take in to account all effect of change in price in one market over the other markets.When there
exist inter-relationship and inter-dependence of the markets for goods (whether they are complements or
substitutes), the General Equilibrium analysis is used.
In economic system as whole there is inter-dependence and inter-relationship between various
markets for commodities and factors and there is large numbers of decision making agents like producer,
consumers, workers.All these agents are self interested and would behave to maximize their goals. A
comprehensive analysis of economic system when prices and quantities of all commodities and factors
are considered variable and which would take in to account inter-dependence and inter-relationship is
possible through General Equilibrium analysis. The general equilibrium would occur when markets for all
commodities and factors and all decision making agents are simultaneously in equilibrium.
• Partial equilibrium analysis focuses on explaining the determination of price and quantity in a
given product or factor market when one market is viewed as independent of other markets.
• General equilibrium analysis deals with explaining simultaneous equilibrium in all markets
when prices and quantities of all products and factors are considered as variables.

The General Equilibrium of Exchange and Consumption: A pure exchange economy model
• First, we shall explain general equilibrium in a pure exchange economy.
• In this pure exchange system, we assume that there is no production.
• That is, we consider the case when two goods are provided to the individuals in the economy
from outside the system.
To keep our analysis simple we assume that there are:
1. Two goods, specific bundles of which have been made available to the individuals for
consumption; and
2. There are two individuals between whom exchange of goods has to take place and equilibrium
reached with regard to the distribution of the specific amounts of these two goods.
Edge-worth Box and General Equilibrium of Exchange:
In these two goods, two individuals (2×2) model of pure exchange, the famous Edge-worth Box
diagram has been employed to explain the general equilibrium of distribution of two goods
between two individuals.

Dr.R. D. Vaidkar 41
 • Along the X-axis we measure the commodity X and along the Y-axis, the commodity Y.
• The total available amount of commodity X is OX0 and of commodity Y is OY0.
• The available amounts of the two commodities, OX0 and OY0 determine the dimension of the
box.
For Individual A
• The quantity of X available with the individual A is measured from left to right along the X-axis
with bottom left-hand corner OA as the origin.
• And, quantity of commodity Y available with the individual A is measured along the Y- axis
from bottom upwards with the origin 0A.
For Individual B
• For individual B, the top right hand corner OB has been taken as the origin
• and with the given quantities of X and Y, the quantity of X available for consumption for
individual B is measured, right to left, with the origin OB
• and the quantity of Y available for B is measured, from top to bottom, from the origin OB.
• It follows from above that Edgeworth Box has fixed dimensions representing the maximum
available quantities of X and Y to be distributed between the two individuals.
• We further assume that the two individuals between them will entirely consume all the available
quantities of the two goods.
• It may be noted that a point in the Edgeworth Box represents a particular distribution pattern of
two goods between the two consumers.
• This implies that if the two individuals trade goods with each other and accordingly move from
one point in the Edgeworth Box to another, the quantities purchased and sold of each good would
be equal.
• Thus, with trade or exchange of goods, it is the distribution or consumption of two goods of the
two individuals that will change, the total quantities of the two goods remaining constant.
In the Edgeworth Consumption Box we also draw the indifference curves of the two individuals A
and B depicting their scale of preferences between the two goods.
• As we move upward from bottom-left to top right, the satisfaction of individual A increases and
that of B decreases, that is, A- moves to successively higher indifference curves and individual B
to successively lower indifference curves.

Dr.R. D. Vaidkar 42
 • We can now show that the general exchange equilibrium would lie somewhere on the contract
curve, that is, the curve QT in Fig.
• QT passes through the tangency points of indifference curves of two individuals.
• At these tangency points of indifference curves, MRSXY of individual A equals that of individual
B.
• Thus, the general equilibrium of exchange will occur when the following condition holds
good:-

MRSAXY =MRSBXY
• Since a point on the contract curve lies within the Edgeworth box with the fixed quantities of the
two goods, the equilibrium reached after exchange or trading between the two individuals
• This implies that the distribution for consumption of the two goods between the two individuals
would just exhaust the available quantities of the two goods.
• However, if we know the initial distribution of two goods between the two individuals we can
pinpoint the boundaries within which the general equilibrium of exchange would lie.
• Consider Figure If the initial distribution of two goods between the two individuals is represented
by point C where individual A has XA1 amount of good X and YA1 amount of good Y.
• The remaining quantity of good X, that is, X0 – XA1 = XB1 would be allocated to individual B and
• the remaining Y0 – YA1=YB2 amount of good Y would go to individual B.
• At this initial distribution of goods X and Y between the two individuals A and B, the
indifference curves of two individuals are intersecting.
• Now, this initial distribution at point C cannot be the position of equilibrium for the two
individuals, since the two individuals can become better off if they exchange some amounts of the
goods possessed by them and move to the contract curve.
If the individuals think that they can benefit from trading or exchange, they will trade with each others.
As long as they think there are possibilities of becoming better off, they will exchange goods and end up
at the contract curve.
• With the initial distribution of two goods as implied by point C, if the two individuals through
exchange of goods between them move to the point R on the contract curve, individual B reaches
on his higher indifference curve B4 and therefore becomes better off and A is no worse off as he
remains on the same indifference curve A2 as on the initial distribution point C.
• On the other hand, if through exchange they move to point S on the contract curve, individual A
becomes better off and individual B no worse off as compared to the initial position C.
• And if through exchange of goods they move to any point between R and S on the contract curve
both the individuals will gain from exchange of goods as they will be reaching their respective
higher indifference curves.
• With initial distribution at point C and through exchange of goods nearer they move to point R on
the contract curve, individual B will benefit more and
Dr.R. D. Vaidkar 43
 • nearer they move to point S on the contract curve, the individual A will gain more as compared to
the initial distribution position C.
• Where exactly on the contract curve, their equilibrium position of exchange will lie depends upon
the bargaining power of each individual.
• With their almost equal bargaining power, their equilibrium position of exchange on the contract
curve may lie at point E where the two individuals gain almost equally as a result of exchange.
• Thus, if the initial distribution of two individuals is not on the contract curve, there will be
tendency on the part of individuals to trade or exchange goods between themselves and to move
to a point on the contract curve because in doing so they will be increasing their satisfaction.
• It is evident from the foregoing analysis that the position of exchange equilibrium can be some-
where between R and S on the contract curve. On all points between R and S, the exchange
equilibrium can exist.
• Although equilibrium will exist at a point on the contract curve, there is no unique position of
exchange equilibrium; all points between R and S on the contract curve are possible equilibrium
positions.
Features of General Equilibrium Exchange:
• Individuals maximise their satisfaction by equating their MRSXY subject to their initial
endowments of goods.
• Since the equilibrium point E lies within the Edgeworth Box, drawn with the given amounts of
two goods, the exchange of goods between the two individuals when they move to the
equilibrium point E on the contract curve would imply that quantity sold of each good equals the
quantity purchased of the good.
• The general equilibrium of exchange does not lead to the determination of absolute prices of
goods but only relative prices of goods.
• The general equilibrium of exchange must lie on the contract curve
• The equilibrium can lie anywhere between R and S on the contract curve, that is, general
equilibrium of exchange in this bargaining is not unique.
The General Equilibrium of Production
• We now extend our analysis of general equilibrium to the sphere of production. Production of
goods requires the use of inputs or factors of production. The level of production of goods
depends upon the allocation of resources to them.
• As emphasised in the beginning, the general equilibrium analysis takes into account the mutual
inter-dependence of markets. In it, we are not only concerned with the mutual inter-dependence
of markets for goods between themselves but also between product markets and factor markets.
• To keep our analysis simple we shall assume that two factors or inputs labour and capital, are
required for the production of two goods X and Y.

Assumptions of General Equilibrium of Production:

• All units of labour are homogeneous so that they receive equal remunerations for their contri-
bution to the production of goods. So is the case with all units of capital.
• The available quantities of the two factors labour and capital are fixed in the economy and both of
them are fully employed and utilised.
• There is smooth production function for each good so that production factors labour and capital,
can be freely transferred from one good to the other.
• Technology is given which together with the factor endowments limits the production possi-
bilities.
• It may be mentioned here that there are four markets in the model considered here: two factor
markets of labour and capital, and two product markets of goods X and Y.
• With the above assumptions we shall analyse the general equilibrium of production under con-
ditions of perfect competition in all the markets. It may be emphasised again that the various
markets are inter-related. For example, if more labour is employed in the production of good X,

Dr.R. D. Vaidkar 44
 then, given its fixed supply, some labour will have to be withdrawn from the production of good
Y.
Edge-worth Production Box and General Equilibrium of Production:
• In case of Edgeworth Production Box, dimensions of the box represent the available fixed
quantities of the two factors, labour and capital.
• Thus, in the Edgeworth Production Box as shown in Figure, along the horizontal axis we measure
the quantity of labour and along the vertical axis we measure the quantity of capital.

• In this box various isoquants are also drawn for the products X and Y.
• For good X, various isoquants representing successively higher levels of output such as X 0, X1,
X2 etc. are drawn with the bottom left hand corner Ox as their origin.
• For good Y, various isoquants such as Y0, Y1, Y2 representing- successively higher levels of
output of Y are drawn with top right hand corner Oy as the origin.
• It is important to note that any point in the Edgeworth Box represents a particular allocation of
labour and capital between the two industries, one producing good X and the other producing
good Y.
• Various points in the box represent different alternative allocations of factors between the two
commodities.
• For example, point T in the box shows that OxL1 (or K1T) amount of labour and OxK1 (or L1T)
amount of capital are allocated to the production of X and
• the remaining amount of labour TF and the remaining amount of capital TC are allocated to the
production of good Y.
• It will be seen from Figure that the points M, Q, N etc, represent different allocations of factors
from the point T.
• Now, a smooth curve RH joining the tangency points of isoquants of A and Y has been drawn.
• This is called the production contract curve.
• It can be shown that the general equilibrium of production under competitive conditions in the
factor markets would lie somewhere on this production contract curve.
• The allocation of factors implied by the point away from the contract curve such as point T
cannot be the possible competitive equilibrium position.
• This is because from the point T where X-isoquant and Y-isoquant are intersecting, the economy
can move by re-allocating resources between the two goods to a point M or N on the contract
curve where the output of one good increases without the reduction in output of the other.
• And, if through reallocation of factors, the economy moves to any point between M and N on the
contract curve, say to point Q the outputs of both the goods X and Y would be higher than at T.
• Thus, resource allocation implied by a point on the contract curve leads to greater output than
those not on the contract curve.
• Since the production contract curve is the locus of the tangency points of the isoquants of X and
Y, slopes of isoquants of the two goods are equal to each other at various points on it.

Dr.R. D. Vaidkar 45
 • Since slope of an isoquant measures marginal rate of technical substitution between the two
factors (MRSLK), on the various points on the contract curve, MRTSXLX = MRTSSLK.
• It is at the production efficient points of the contract curve that general equilibrium of production
would lie.
• Now, what ensures that the general equilibrium of production would lie at a point on the contract
curve? If the two firms or industries find themselves away from the contract curve, they will trade
or exchange the factors and move to a point on the contract curve because in doing so they will be
increasing their output and will have therefore incentive to move to the contract curve.
• It should be noted that if the firms produce the goods at a point on the contract curve, one firm
can increase output only at the cost of output of the other firm.
• Thus, if in Fig. the firms move from point M to N on the contract curve, the production of good X
increases, the production of good Y decreases.
• It is worth mentioning that point of general equilibrium of production is not unique because it
may occur at any point on the contract curve, depending on the starting point, that is, the initial
allocation of factors labour and capital to the production of goods.
• For example, if the initial allocation of factors is denoted by point T in Fig., then with reallocation
through trading of factors, the two firms can move to and attain general equilibrium at any point
on the segment MN of the production contract curve.
• Further, with a different initial allocation of a given amount of factors, say point G in the
Edgeworth Box, there will be a different point of general equilibrium of production anywhere on
the segment HN of the contract curve.
• It will be observed from Fig. that given the initial factor allocation point T, if the general
equilibrium of production occurs at point Q on the contact curve RH, it will determine not only
allocation of factors between the two goods but also the equilibrium amount of the two goods
produced.

Welfare Economics
We have seen how the prices of products and factors are determined and on the basis of these
prices how the allocation of resources is made in the economy. Now we have to see weather this
allocation of these resources is efficient or not. By the efficiency means in economics that use of these
resources maximizing social welfare or not. These criteria or norms serve as basis for recommending
economic policies which will increase social welfare.
According to Baumol welfare economics means ―welfare economics concerned itself mostly with
the policy issues which arise out of the allocation of resources, with the distribution of inputs among the
various commodities and the distribution of commodities among the various consumers‖
The central problem in welfare economics related to weather a particular change in resources
allocation will increase or decrease social welfare. For this purpose the Pareto Optimality Criteria is used.
Dr.R. D. Vaidkar 46
 According to Parroto criteria of Optimality or efficiency, any change that make at least one
individual better off without making any other worse off is an improvement in social welfare. By this
criteria we can define a state of maximum welfare or known as Pareto Optimality or Economic efficiency.
“Economic state or situation is said to be Pareto-optimal or efficient in which allocation of
resources is such that by any rearrangement of them it is not possible to make any individual better off
without making any other worse off.”

Individual Welfare and Social Welfare:

Individual Welfare: An individual welfare at any given time or during a period of time is measured by
the amount of satisfaction that he enjoy at a given period of time.
The consumer always tries to maximize his satisfaction. While doing this he gives his preference.
He obtain maximum satisfaction when he is in his preferred position. If a person choose position A rather
than position B, his welfare is higher in A than B. Thus individual choice reflects the individual‘s welfare
because whatever he ha choosen gives him maximum satisfaction. The individual‘s welfare is affected by
various economic and non-economic variables.

Social Welfare: Social welfare composed of two words i.e. social and welfare. Social is derived from the
word society. A society means, when people helps one another to satisfy their wants, they are said to form
a society in respect of the satisfaction of those wants. These wants known as socialized wants.
The term welfare means to satisfaction of wants. Therefore social welfare refers to satisfaction of
these socialized wants. Welfare is subjective thing. It reside in human mind. Welfare means the
satisfaction obtained by an individual. The social welfare is defined as ― a sum total of the satisfaction of
all the individuals in a society‖

Pareto Optimality: Concept and Conditions:

Velfredo Pareto given the optimality criteria for social welfare. Pareto‘s concept of maximum
social welfare is based on ordinal utility and he detached welfare economics from interpersonal
comparison of utilities. The Pareto Optimality or Economic efficiency criteria is “ Pareto Optimum or
economic efficiency is a position form which it is impossible to make any one better off without making
someone worse off by any reallocation of resources and output.”
The concept of Pareto Optimality has following three aspects:
1) Exchange efficiency
2) Production efficiency
3) Product mix efficiency
1) Exchange efficiency: it means the distribution of a given output of goods between individuals in
a society should be such that it should not be possible to make some one better off without
making anyone elese worse off. Perfect competitive market ensure the achievement of exchange
efficiency
2) Production efficiency: Production efficiency means when it is not possible to reallocate
resources to produce more of some goods without producing less of some other goods.
Production efficiency related to two aspects
i) Production efficiency related to allocation of resource within each firm
ii) Production efficiency related to allocation of resources among the firms producing same
or different firms
In relation to first aspect use of resources by a firm for production of goods is efficient when it
produce any given output at a minimum possible cost.
In relation to second aspect allocation of resources among the firms is efficient when all firms
producing a product has same marginal cost.
3) Product mix efficiency: It means that allocation of resources among the production of various
goods and services is in accordance with the preference of the people.

Pareto Criteria of social welfare:

Dr.R. D. Vaidkar 47
The concept of Pareto optimum or economic efficiency stated above is based on a welfare
criterion put forward by V. Pareto. Pareto criterion states that if any reorganisation of economic
resources does not harm anybody and makes someone better off, it indicates an increase in social
welfare. If any reorganisation or change makes everybody in a society better off, it will,
according to Pareto, undoubtedly mean increase in social welfare.

Thus, in the words of Prof. Baumol ―any change which harms no one and which makes some
people better off (in their own estnuauon) must be considered to be an improvement.‖ Parto
criterion can be explained with the help of Edgeworth Box diagram which is based on the
assumptions of ordinal utility and non-interpersonal comparison of utilities.

Suppose two persons A and B form the society and consume two goods X and Y. The various
levels of their satisfaction by consuming various combinations of the two goods have been
represented by their respective indifference curves.

In Figure 39.1 Oa and Ob are the origins for the utilities of two persons A and B respectively.
Ia1, Ia2, Ia3, Ia4 and Ib1, Ib2, Ib3, Ib4 are their successively higher indifference curve. Suppose
the initial distribution of goods X and Y between the members of the society, A and B, is
represented by point- K in the Edgeworth Box.

Accordingly, individual A consumes OAG of X + GK of Y and is at the level of satisfaction

represented by indifference curve Ia3. Similarly, individual B consumes KF of X+ KE of Y and
gets the satisfaction represented by indifference curve Ib1.

Thus the total given volume of goods X and Y is distributed between A and B. In this
distribution, individual A consumes relatively large quantity of good Y and individual B of good
X. Now, it can be shown with the aid of Pareto‘s welfare criterion that a movement from the
point K to a point such as S or R or any other point in the shaded region will increase social
welfare.

Any movement from K to S through redistribution of two goods between two individuals
increases the level of satisfaction of A without any change in the satisfaction of B because as a
result of this A moves to his higher indifference curve Ia4, and B remains on his same
indifference curve Ib1 (K and 5 lie on B‘s same indifference curve Ib1).

Dr.R. D. Vaidkar 48
In other words, as a result of the movement from K to S, individual A has become better off
whereas individual B is no worse off. Thus, according to Pareto criterion, social welfare has
increased following the movement from K to S and therefore K is not the position of economic
optimum.

Similarly, the movement from K to R is also desirable from the point of view of social welfare
because in this individual B becomes better off without any change-in-the satisfaction of
individual A. Therefore, both the positions S and R are better than K. The tangency points of the
various indifference curves of the two individuals of the society are the Pareto optimum points
and the locus of these points is called ‗contract curve‘.

Marginal Conditions of Pareto Optimum:

Learner and Hicks given the marginal conditions to attain the Pareto Optimum. These conditions
based on following assumptions.

1) Each individual has his own ordain utility

2) Production function of every firm is constant
3) Goods are perfectly divisible
4) A producer tries to produce product at least cost
5) Every individual wants to maximize satisfaction
6) Every individual purchases some quantity of goods
7) All factors of production are perfectly mobile

Following are the conditions of Pareto Optimum

1) The optimum distribution of products among the consumers: efficiency in exchange:

According to this conditions the marginal rate of substitution between any two goods
must be the same for every individual who consume them both.
2) Optimum allocation of factors: Efficiency in production:
According to this condition the available factors of production should be used by the
society in production of different goods in such manner that it is impossible to increase
the output of one good without a decrease in output of another or to increase the output of
both the goods. This situation would be achieved if marginal rate of substitution between
any pair of factors mist be the same for any firms producing any tow products and using
both the factors to produce the products.
3) The optimum direction of production: Efficiency in product mix:
This condition related to the production of goods in accordance woth consumer
preference. This also called as overall condition of the Pareto Optimality. This condition
determine the optimum quantities of different commodities to be produced with given
factors of production. This condition state that ―the marginal rate of substitution between
any pair of products for any person consuming both must be the same as the marginal rate
of transformation between them.
4) Optimum degree of specialization:

Dr.R. D. Vaidkar 49
 This condition necessary for determining the optimum level of output for every product
by every firm. If a firm produce two goods, it has to decide the proportion of resources to
be used for production of two goods. According to this condition Pareto Optimality
attained if the marginal rate of transformation between any two goods must be same for
any two firms that produce both. This condition tells to which degree any firm should
specialize in order to maximize the total output of that product by all firms.
5) The optimum factor-product relationship:
According to this condition the marginal rate of transformation between any factors and
any product must be the same for any pair of the firms using the factor and producing the
product.

Market failure, Externalities and Public Goods

According to Pareto Optimality in perfectly competitive market system to achieve the maximum
welfare any reallocation of resource can not make some people better off without reducing the welfare of
someone else. However, under some circumstance this Pareto Optimality would not achieved. ―These

Dr.R. D. Vaidkar 50
circumstances to with the market fail to achieve economic efficiency or maximum social welfare, called
as market failure.

There are the following main reason which causes market failure

1) The existence of monopoly or imperfect competition

2) The presence of externalities
3) The consumption of public goods
4) Increasing return to scale
5) Indivisibility

1) The existence of monopoly or imperfect competition:

In monopoly there is misallocation of productive resources and thus hinder the achievement of
maximum social welfare. To achieve social welfare the Pareto condition is that the marginal Rate of
Transformation (MRT) of the community of two goods must be equal to the marginal rate of
substitution (MRS) between these commodity for every consumer. The perfect competition satisfy
these condition but the monopoly does not satisfy this condition of Pareto Optimality. Therefore
monopoly does not ensure allocation of resources and services to attain the maximum social welfare.
2) The presence of externalities (External Economies and diseconomies):
The Pareto Optimality will not achieved in perfect competition if there existence of the externalities
i.e. external economies and diseconomies. Externalities refers to the beneficial and detrimental effect
of an economics unit i.e. a firm, a consumer or an industry, others.
External Economies: The beneficial externalities created by a consumer or a firm for others is known
as external economies. “ when economic unit creates benefits for others for which he does not
receive any payments there exist external economies”. When there exist external economies i.e.
beneficial external effects the private marginal cost of firm will be higher than the social marginal cost
and the market price is fixed on the basis of private marginal cost.
External Diseconomies: The detrimental externalities imposed on the others by the productive firm or
consumer are known as external diseconomies. External diseconomies occurs when an economic unit
inflicts costs on other for which he is not required to pay. When the external diseconomies occur with
the firm, then the private marginal cost will be lower than the social cost and the price fixed on the
basis of private cost which is lower than social cost.

3) Consumption of Public Goods:

Another cause of market failure is the existence of public goods. A public good is one
whose consumption or use by one individual does not reduce the amount available for others.
Examples are city parks, defence, police, ocean or lake fishing, etc. Public goods have two
characteristics: non-excludable and non-rivalrous. A good is non-excludable if it can be
consumed by any one. It is non-rivalrous if no one has an exclusive right over its
consumption. Its benefit can be provided to an additional consumer at zero marginal cost.
Thus public goods being both no excludable and non-rivalrous are not sold in a free market
like private goods. They lead to market failure

4. Increasing Returns to Scale:

There are increasing returns to scale or decreasing costs due to technical externalities that lead to
market failure under perfect competition. When there are increasing returns to scale in a
perfectly competitive market, they either lead to monopoly or to losses.

5. Indivisibilities:

Dr.R. D. Vaidkar 51
The Paretian optimality is based on the assumption of complete divisibility of products and
factors used in consumption and production. In reality, goods and factors are not infinitely
divisible. Rather, they are indivisible. The problem of indivisibility arises in the production of
those goods and services that are used jointly by more than one person. An important example is
the use of a particular road by a number of persons in a locality.

Every person residing there uses the road. But the problem is how to share the costs of repairs
and maintenance of the road. In fact, none will be interested in its repairs and maintenance. Thus
marginal social costs and marginal social benefits will diverge from each other and Pareto
optimality will not be achieved.

6. Common Property Right:

Another cause of market failure is a common property resource. It most common example is fish
in a lake. Anyone can catch and eat it bout no one has an exclusive property right over it. It
means that a common property resource is non-excludable (any one can use it) and non-rivalrous
(no one has an exclusive right over it).

The lake is a common property for all fishermen. When a fisherman catches more fish, he
reduces the catch of other fishermen. But he does not count this is a cost, yet it is a cost to
society.

Because the lake is a common property resource where there is no mechanism to restrict entry
and to catch fish. The fishermen who catch more fish impose a negative externality on other
fishermen so that the lake is over exploited.

This is called the tragedy of the commons which leads to the elimination of social gains due to
the overuse of common property. Thus when property rights are common, indefinite or non-
existent, social costs will be more than private costs and there will not be Pareto optimality.

7. Asymmetric or Incomplete Information:

Consumers, producers and resource owners have perfect knowledge about market conditions
under perfect competition. But in the real world, there is asymmetric or incomplete information
due to ignorance and uncertainty on the part of buyers and sellers of goods and services.

Thus they are unable to equate social and private benefits and costs this is because consumers are
ignorant about the quality of goods that they buy benefits of goods.

Similarly, firms are ignorant and uncertain about future prices costs sales, actions of rivals, etc.
In some cases, information about market behaviour in the future may be available but that may
be insufficient or incomplete. Thus market failure is inevitable.

8. Incomplete Markets:

Markets for certain things are incomplete or missing under perfect competition. The absence of
markets tor such things as public goods and common property resources is a cause of market
Dr.R. D. Vaidkar 52
failure. There is no way are benefits and costs either in the Present or in the future because their
markets.

Measures of Correct Market Failure:

To correct market failure in each case discussed above, economists suggest the following
measures:

1. Control of Monopoly Power:

Monopoly power can be controlled by the government by anti-monopoly laws and restrictive
trade practices legislation. These aim at removing unfair competition, preventing unfair price
discrimination and fixing prices equal to competitive prices.

The governments can also being down monopoly price to the competitive level by price
regulation and taxation. It may impose price ceiling so that monopoly price should be near or
equal to competitive price regulating authority of commission which fixes a pie tor the monopoly
product below the monopoly price.

Taxation is another way of controlling monopoly power. The tax may believe Lump sum without
any regards to the output of the monopolist. Or it may be proportional to the output, the amount
of tax rising with the increase in output. In either case, the aim is to bring monopoly price to the
competitive level. Lastly Prof Pisou favoured nationalisation of monopoly to put an end to
monopoly power.

2. Externalities:

To achieve optimal allocation of resources in the face of externalities, Pigou suggested social
control measures and the use of taxes and subsidies. The state can interfere in all cases of
external diseconomies of production to remove the divergence between private and social costs
and benefits.

For instance it can ask the factory owner to move out of the residential area by providing
appropriate facilities to the smoke emitting factory. In the case of external diseconomies of
consumption, the state can put an end to noise nuisance by banning the use of loud speakers
except for special occasions during specific hours with prior permission.

Pigou further suggested that the state should encourage production of goods with positive
externalities by the subsidy on per unit of commodity to the producer. It can be help consumers
in maximizing their satisfactions by tax concessions so that they consume more commodities. It
can help consumers in maximising their satisfactions by tax concessions so that they consume
more commodities.

In the case of negative externalities it should discourage their consumption and production by
leaving taxes. For instance, the state can levy a tax on every family in the area and pay the sum
so collected to the smoke matting factory to move away Thus taxes and subsidies help to bridge
the gap between private and social costs and benefits.

Dr.R. D. Vaidkar 53
Another measure commonly suggested is internalisation or unitization of externalities in
production For example firms that are engaged in oil operations in the same filed lead to
inefficient over-drilling and over pumping. With unitization or merger of firms, oil is produced
most efficiently without diseconomies of production.

3. Public Goods:

Because public goods are non-excludable and non-rivalrous, they are not sold in a free market
like private goods. Therefore, they cannot be provided by private firms. In this situation, they can
be provided by some public authority.

As the benefits of public goods are indivisible, the state should make people share the costs of
public goods so that everyone is made better off. ―One way to pay for a public good is to charge
each person the same proportion of the maximum amount he or she would be prepared to pay
rather than go without the good, while fixing that proportion so as to cover the total costs of
production‖.

In the case of some public goods such as materials for defence, the government can either itself
produce them or it can pay private firms to produce them. So far as the free rider problem is
concerned whereby such services as defence, police, etc. are provided free to every user, they
can be provided by the government out of tax revenue.

4. Increasing Returns to Scale:

For the problem of increasing returns to scale (or decreasing costs), opinions differ concerning
government‘s role in providing solution to market failure. Some economists opine that
government should nationalise such industries which operate under decreasing cost and lead to
over production.

Others do not approve of it because they feel that government control would make conditions
worse. Still others suggest that private firms should produce goods and government should
enforce price regulation and tax them so that social and private costs and benefits are equalised.

5. Indivisibilities:

The solution to the problem of indivisibility in the case of goods and services used jointly by
more than one person such as street lighting or road, the local body such as Municipal
Corporation should either spend on its repairs and maintenance or tax the residents or users of
the road or street lighting.

6. Property Rights and the Coase Theorem:

Common property rights lead to externalities. Property rights relate to ―who owns property, to
what uses it can be put, the rights people have over it and how it may be transferred.‖ One
solution is to extend property rights so completely that everyone has the right to prevent people
from imposing any costs on them.

Dr.R. D. Vaidkar 54
This can be done in the case of public property like parks, libraries, etc. The second solution is to
distribute the property of the rich to the poor. But it is more a question of altering property rights
rather than extending the ownership rights. But such a solution will be impractical.

The third solution is for the government to charge the damages and compensate for the damages.
But it involves the problem of compensating those who acquired property at a lower cost because
of the damage. The fourth solution is to file a legal suit for monetary damages by the party that
has been harmed by the externality (say smoke).

Another solution has been suggested by Prof. Ronald Coase (who received the Nobel Prizein
Economics in 1991). According to him, market failure due to property rights can be eliminated
through private bargaining among the affected parties.

He points out that if property rights are clearly defined and marketable and transaction costs are
zero, a perfectly competitive economy will allocate resources optimally, even under externalities.

This is called the Coase Theorem. By transactions costs he means costs of negotiating or
enforcing a contract. According to Coase, if it is possible to carry out such negotiations at little
or no cost, the parties responsible for an external benefit or cost can negotiate with the parties
affected by an externality.

The sufferer from an externality should levy a charge or offer a bribeto the party which is getting
the maximum benefit from the common property. Thus in the absence of transaction costs, the
externality will be internalised and the socially optimal level of output will be achieved.

7. Aymmetric or Incomplete Information:

Market failure can be eliminated when rules are framed by regulating authorities by requiring
producers to describe correctly about their products and prices. This will provide people with
correct and relevant information about products.

Market failure can also be corrected if produces produce high quality standard products and offer
guarantees and warranties to buyers. This requires widespread publicity on the part of sellers so
as to provide correct information to consumers.

In case where ignorance is the reason for incomplete information, the direct provision of
information by the government may help to correct market failure. For example, employment
exchanges provide information on jobs to those looking for work and ask firms to get in touch
with them for the supply of suitable labour.

This will help the labour market to work efficiently. Similarly, government providing statistics
on prices, costs, employment, sales trends, exports, imports, etc. help firms to plan their
production with greater certainty. Some private organisations can also help in providing useful
data on them.

8. Missing Markets:

To correct market failure in the case of missing or incomplete markets where two goods are
jointly produced two Nobel laureates K. Arrow and G. Debreu suggest a separate market for
Dr.R. D. Vaidkar 55
each in which each good and service can be traded to the point where the social and private
marginal benefit equals the social and private marginal cost. This condition will lead to optimal
allocation of resources.

Dr.R. D. Vaidkar 56