Sivagnanam PDF

Business Economics
About the Authors

Dr K Jothi Sivagnanam is Professor in Economics, University of Madras, and has
been engaged in teaching, research and extension activities for the last 23 years.
He has also served in the State Planning Commission, Government of Tamil Nadu
for a brief term. He is the chairman of the Review Committee of the text book on
Indian Economy for students of Tamil Nadu Higher Secondary Education. His areas
of interest are mostly teaching and public economics. He has published nearly 35
articles in national and international journals and three books. He is a member of the
Academic Council and the Board of Studies of various universities and colleges.
Dr R Srinivasan, Reader in Econometrics, University of Madras, has nearly 21 years
of teaching experience in various colleges and universities in Tamil Nadu. He has pub-
lished more than 40 articles in national and international journals and business news
papers. He has written a few chapters in the economics books published by NCERT,
New Delhi and Government of Tamil Nadu. Srinivasan has served in the Government
of Tamil Nadu as an economist in the Tax Reforms Committee (2002–03) and as full
time member in the State Planning Commission (2006-08). Currently he is a part-
time member of the State Planning Commission and is a member in the Academic
Council and Board of Studies of various universities and colleges in Tamil Nadu.
Business Economics
K. Jothi Sivagnanam
Professor in Economics
University of Madras
R. Srinivasan
Reader in Econometrics
University of Madras
Tata McGraw Hill Education Private Limited

NEW DELHI
McGraw-Hill Ofﬁces
New Delhi New York St Louis San Francisco Auckland Bogotá Caracas
Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal
San Juan Santiago Singapore Sydney Tokyo Toronto
Tata McGraw-Hill
Published by the Tata McGraw Hill Education Private Limited,
7 West Patel Nagar, New Delhi 110 008.
Business Economics
Copyright © 2010 by Tata McGraw Hill Education Private Limited.
No part of this publication may be reproduced or distributed in any form or by any means, elec-
tronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval
system without the prior written permission of the publishers. The program listings (if any)
may be entered, stored and executed in a computer system, but they may not be reproduced
for publication.
This edition can be exported from India only by the publishers,
Tata McGraw Hill Education Private Limited.
ISBN (13): 978-0-07-068215-3
ISBN (10): 0-07-068215-1
Managing Director: Ajay Shukla
Head—Higher Education Publishing and Marketing: Vibha Mahajan
Publishing Manager—B&E/HSSL: Tapas K Maji
Assistant Sponsoring Editor—B&E/HSSL: Hemant K Jha
Development Editor: Shalini Negi
Assistant Manager (Editorial Services): Anubha Srivastava
Senior Copy Editor: Sneha Kumari
Senior Production Manager: Manohar Lal
Production Executive: Atul Gupta
Product Manager: Vijay S Jagannathan
Senior Product Specialist: Daisy Sachdeva
General Manager—Production: Rajender P Ghansela
Assistant General Manager—Production: B L Dogra
Information contained in this work has been obtained by Tata McGraw-Hill, from sources
believed to be reliable. However, neither Tata McGraw-Hill nor its authors guarantee the
accuracy or completeness of any information published herein, and neither Tata McGraw-
Hill nor its authors shall be responsible for any errors, omissions, or damages arising
out of use of this information. This work is published with the understanding that Tata
McGraw-Hill and its authors are supplying information but are not attempting to render
engineering or other professional services. If such services are required, the assistance of
an appropriate professional should be sought.
Typeset at Bharati Composers, D-6/159, Sector-VI, Rohini, Delhi 110 085, and printed at
Adarsh Printers, C-50-51, Mohan Park, Naveen Shahdara, Delhi-110 032
Cover Design: Kapil Gupta
Cover Printer: SDR Printers
RADXRRAZRZXBB
The McGraw-Hill Companies

To
Chandru
Sana
Jeyanth
Preface
This book provides an introduction to the basic concepts and content of Business
Economics. The primary target for this book is the B. Com. (Second Year) students
of the University of Madras.
Though the book is designed based on the revised B. Com. syllabus (semester
pattern) of the University of Madras, it could also be used by students of all other
undergraduate courses (BA, BBA, BE) who study either Business Economics or
Managerial Economics as one of the papers.
The book is an undergraduate level textbook, in a lucid style without sacrificing
comprehension. Hence, for those who have not taken a basic university course in
economics, this book could be used as a beginner’s text.
The focus of this book is on explaining the basic concepts and tools of standard
microeconomics and their application in the process of business and management
decision making.
The authors are thankful to Dr V Loganathan, Emeritus Professor of Economics,
Sir Thyagraya College, Chennai for his helpful comments and suggestions he has
given during the course of writing the book.
The authors also thank Dr A Joseph Durai, Reader in Economics, Presidency
College, Chennai for his support and encouragement.
The authors wish to thank Mr M Palaniappan, Mr Ahamad, Mr M Murugan and
Mr Babu for their assistance.
The authors wish to place on record their deep appreciation of the publishers of
the book for their excellent cooperation and good team work. We are very grateful to
G Mark Pani Jino, Vibha Mahajan, Tapas Kumar Maji, Hemant Kumar Jha, Shalini
Negi, Anubha Srivastava, Sneha Kumari, Manohar Lal, Atul Gupta and Bhaskar
Bokolia for their collective effort and support.
The authors, along with the publishers, acknowledge the following reviewers for
their invaluable feedback without which this book would have not come out in its
present shape:
K Jayaraman, RKM Vivekananda College, Chennai
Vincent S Jayakumar, RKM Vivekananda College, Chennai
A Rohini Priya, SDNB Vaishnav College for Women, Chennai
The authors crave the indulgence of the readers for the errors that might have crept
in inadvertently.
Suggestions for improvement are welcome.
K Jothi Sivagnanam
R Srinivasan
Contents
Preface vii
1. Economics: An Introduction 1
Introduction 2
Economics: Meaning and Definitions 2
Nature and Scope of Economics 9
Basic Economic Problems 10
Positive and Normative Economics 12
Micro and Macro Economics 13
Key Terms and Concepts 15
Chapter Summary 15
Questions 15
2. Business Economics: Definition, Nature, Scope and Concepts 17
Introduction 18
Definitions 18
Nature of Business Economics 20
Scope of Business Economics 20
Role of Business Economists 21
Some Important Concepts 23
Efficiency 28
Time Element 30
Chapter Summary 33
Questions 34
3. Demand: Meaning and Determinants 35
Introduction 36
Demand 36
Law of Demand 40
Chapter Summary 46
Questions 46
x Contents
4. Elasticity of Demand 48
Introduction 49
Elasticity of Demand 50
Elasticity of Demand: Measurement 56
Factors Determining Elasticity of Demand 58
Importance of Elasticity 59
Chapter Summary 60
Questions 60
5. Demand Forecasting 62
Introduction 63
Objectives of Demand Forecasting 63
Methods of Demand Forecasting 64
Selecting Best Forecasting Method (or)
Qualities of Best Forecasting 74
Chapter Summary 76
Questions 77
6. Supply: Law, Determinants and Market Equilibrium 79
Introduction 80
Supply: Meaning and Definition 80
Law of Supply 80
Elasticity of Supply: Meaning 83
Determinants of Supply 86
Market Equilibrium or Price Determination 87
Chapter Summary 89
Questions 90
7. Theory of Consumer Behaviour: Demand, Diminishing 91
Marginal Utility and Equi-Marginal Utility
Introduction 92
Utility 92
Law of Diminishing Marginal Utility 94
Law of Equi-Marginal Utility 97
Cardinal and Ordinal Utility Theories and Theories of
Risk and Uncertainty 101
Chapter Summary 102
Questions 102
Contents xi
8. Theory of Consumer Behaviour: Indifference Curve Approach 104

Introduction 105
Indifference Curve Approach 105
Equilibrium Conditions 112
Chapter Summary 116
Questions 117
9. Laws of Production 119
Introduction 120
Production 120
Short Run and Long Run 122
Total, Average and Marginal Products 123
Producer’s Equilibrium 127
Chapter Summary 131
Questions 132
10. Cost and Break-Even Analysis 134
Introduction 135
Cost 135
Short Run Cost and Long Run Cost 135
Economies of Scale 145
Diseconomies of Scale 146
Break-Even Analysis 147
Chapter Summary 150
Questions 150
11. Market Structure 152
Introduction 153
Market Structure 153
Perfect Competition 155
Monopoly 162
Monopolistic Competition 166
Duopoly 169
Oligopoly 169
Chapter Summary 170
Questions 170
xii Contents
12. Pricing Techniques 172

Introduction 173
Price Discrimination 173
Cost Plus or Mark-Up Pricing 176
Peak-Load Pricing 177
Transfer Pricing 178
Skimming Price 179
Penetration Price 180
Chapter Summary 181
Questions 182
13. Managerial Theories of Firm 183
Introduction 184
Classical Theory of Profit Maximisation 184
Transaction Cost Theory of a Firm 185
Baumol’s Theory of Sales Maximisation 185
Williamson’s Managerial Utility Function 186
Marris Growth Maximisation Model 187
Cyert and March Behavioural Theory of a Firm 188
Chapter Summary 189
Questions 190
Madras University 191
(Semester Examination) Business Economics, April 2007 191
(Semester Examination) Managerial Economics, April 2007 192
(Semester Examination) Business Economics, April 2007 193
(Semester Examination) Business Economics, Nov 2006 194
(Semester Examination) Managerial Economics, Nov 2005 197
(Semester Examination) Managerial Economics, Nov 2004 198
(Semester Examination) Managerial Economics, April 2002 199
(Non-Semester Examination)
B.B.A. Business Economics, May 1999 200
(Non-Semester Examination) B.B.A.
Business Economics, May 1999 201
Chapter 1
Economics: An Introduction
‘The Age of Chivalry is gone; that of sophisters; economists, and calculators has
succeeded.’
—Edmund Burke
Learning Objectives
The aim of this chapter is to introduce the subject of economics and explain
its meaning, definition, nature and significance. At the end, the students will
be able to understand the subject alongwith significance and the basic problems
and concepts associated with it.
The specific objectives are:
• To understand the meaning and various definitions of economics
• To learn the nature, scope and the basic problems of economics
• To distinguish between positive and normative economics and micro and
macro economics
2 Business Economics
INTRODUCTION
To understand business economics, it is first necessary to know what economics
is about. Some minimum knowledge of the subject is necessary even for com-
mon people to function effectively as citizens in any economy. Such minimum
knowledge includes understanding of leading development challenges like poverty,
unemployment, inflation, the way economies and markets work, the benefits and
costs of various policy options and the necessity to allocate scarce resources
among competing uses.
There are hidden economic patterns of human behaviour that we encounter in
our daily lives. Many of the problems are economic in nature. We make tradeoffs
when resources have alternative uses. We take decisions in such a way as to get
more out of our limited resources (optimisation).
Thus, optimization is not the exclusive domain of economic activities. It is also
possible in everyday situations of our life, games, human relations, and even in
human emotions like love, and so on. In recent decades, economics increasingly
studies many non-monetary fields, such as politics, law, psychology, history, reli-
gion, marriage and family life and happiness. And economic principles not only
help us to ‘get more’ at individual levels, they do more so in societies at local,
provincial, national and global levels.
Incentive is the central aspect of economic approach and thinking. An incen-
tive is anything that encourages or motivates human behaviour in a particular
way rather than otherwise. Incentive may be just mundane reward like money or
bonus (monetary), or a smile or a note of recognition that encourages efficiency
at work.
What does economic theory precisely do for business? Standard economics,
more particularly micro economics, provides excellent conceptual basis and tools
to understand the market and its players such as consumers, producers, dealers
and labourers.
Economics helps us to understand the various aspects of business, viz., pro-
duction and distribution of commodities. Business students need to learn about
economic activity in order to understand the outcome of such activity. This will
help them to take better decisions in business and management. Hence, this chapter
introduces the basics of economics as a starting point followed by an exposition
of business economics, i.e. how the economic principles and tools are used in the
process of business and managerial decision making.
ECONOMICS: MEANING AND DEFINITIONS

Economics: Meaning
Economics is the science that deals with production, distribution and consump-
tion of goods and services in a society. From a technical perspective, economics
studies the process by which limited resources are allocated to satisfy infinite
human wants, that is, how different societies allocate scarce resources optimally
to satisfy the wants and needs of their members.
Economics: An Introduction 3
Economics mainly deals with making choices about production, distribution and
consumption of goods and services (commodities) to satisfy present and future
needs of the society. Economics also deals with money—how it is created, and
how its supply is regulated.
Definitions of Economics
So far we have given a general idea about economics and its central concern. The
following definitions give an appropriate description of economics.
The subject matter of economics has been ever expanding and more rapidly
in recent times. Hence, it is a bit difficult to precisely define what economics is
in the context of its continued expansion of scope that covers even information,
crime, sports and games, environment, human happiness, posterity, etc.
That is why one economist (Jacob Vainer) said ‘Economics is what economist
do’.
On Definitions
Definitions should be our tools and not masters. There is no right or wrong
about definitions, but there are customary usages. Problems arise when, as is
often the case, different definitions are customary in different branches of our
subject. Confusion can then occur when various people are unknowingly using
different definitions of the same term and, therefore, talking past each other.
—Richard G. Lipsey, An Introduction to Positive Economics.
Further, there is fear that defining economics may limit its scope. Modern
economists also do not use the definitions because the boundaries of the subject
have expanded greatly since Adam Smith. However, for a beginner and for a
functional purpose we need some exposition to famous definitions.
Economists have given many important definitions of economics. Adam Smith,
Alfred Marshall, Lionel Robbins and Samuelson are the leading economists who
gave the most important definitions of economics. They have focused on different
aspects of the subject as listed below.
Adam Smith (1776) : Wealth
Alfred Marshall (1890) : Welfare
Lionel Robbins (1935) : Scarcity and Choice
Paul Samuelson (1948) : Growth
Wealth Definition of Adam Smith

Adam Smith (1723-90) was one of the prominent classical economists. He con-
sidered wealth as the subject matter of economics. He considered economics as
the Science of Wealth.
Adam Smith, being the earliest classical economist, is considered as the father of
economics. He was the first economist who separated economics from philosophy
and gave an independent status of discipline to it. He arranged all economic ideas
systematically.
He published his famous book An Enquiry into the Nature and Causes of
Wealth of Nations in the year 1776. Adam Smith has not made any deliberate
attempt to define economics because it was viewed in his period as a part of
philosophy. In fact, economics has emerged as a separate discipline only in the
1880s and thereafter. However, as the title of Adam Smith’s book (An Enquiry
into the Nature and Causes of Wealth of Nations) itself provides his viewpoint
of economics in a nutshell, it is considered as his definition.
According to Adam Smith, economics is the science of wealth that deals with
the acquisition, accumulation and utilisation of wealth of nations. If his definition
is viewed as the reflection of his own contemporary conditions, his maiden effort
is no doubt a great accomplishment. He viewed society as a whole. According
to him wealth is not the society’s capital stock at a given time but the society’s
income flow during a year. Economic development, the leading theme of his book,
deals with the long term forces that govern the growth of wealth of nations.
Though it may be uncharitable, it is also necessary, for students’ sake, to view
his definition with an absolute perspective (i.e., against the modern standards). In
ordinary usage, wealth means money. But, in economics, the concept of wealth
refers to scarce goods, which satisfy human wants. There are many goods which
satisfy human wants. But all of them are not wealth because they may be avail-
able in abundance or they may not have money value. Air, for instance, is the
basic necessity of human existence but that is not wealth because it is available
in abundance and hence has no money value.
Thus, Adam Smith definition emphasises the problems of wealth creation. As
his definition gives prominence to wealth it is called as wealth definition.
Criticism
The wealth definition of Adam Smith has been criticised on certain counts. Most
of these criticisms are unsympathetic because they place the Adam Smith’s thought
out of context of his time.
Too Materialistic: Smith‘s conception of economics laid over emphasis on
national wealth. The exclusive stress on wealth as the ultimate end of humanity
has attracted criticisms. This made others to describe economics as the science
of bread and butter (or mamnomism). Social scientists like Mather Arnold, John
Ruskin and Carlyle called it a ‘dismal science’ and the ‘science of darkness’.
Restricts the Scope of Economics: Another drawback of this definition is that
it restricts the scope of economics. The over emphasis on wealth made people
think that this is all about making money. Hence, it is also called as the ‘sciences
of getting rich’. By overemphasising on wealth, this definition narrowed the scope
of economic enquiry.
Neglect of Welfare: Wealth is not an end itself. It is just a means to achieve some
end. The end is welfare, not the welfare of a few but society’s welfare, or collective
welfare. Thus, any society should aim to maximum social welfare (end) by means
of available wealth. That is, welfare is primary and wealth is secondary.
But wealth definition, by its exclusive stress on ‘material wealth’, neglected

social welfare which is the ultimate development objective of any modern society.
However, many of the criticisms against Smith are unsympathetic and unfair given
the historical settings of his time.
Welfare Definition of Alfred Marshall

Alfred Marshall (1842-1924) was a leading neo-classical economist. He shifted
the emphasis from ‘wealth’ to ‘welfare’ in his definition of economics. Alfred
Marshall published one of the most influential books in economics, Principles of
Economics, in the year 1890.
In it, he defines economics in terms of human welfare rather than material
wealth. Marshall defined economics as follows:
‘Economics is the study of mankind in the ordinary business of life; it examines
that part of a social action which is most closely connected with all attainment
and use of the material requisites of well being. Thus, it is on one side a study of
wealth, and on the other, the more important side, a part of the study of man’.
The following are the most important aspects of Marshall’s ‘welfare’
definition.
Emphasis on Welfare: Marshall’s definition has shifted the focus of economics
discipline from ‘wealth to welfare’. Marshall agrees that economics studies on one
side about wealth and on the other about material well being of man. That is, he
does not accept Smith’s view that economics is only about wealth.
Focus on Man: In Marshall’s definition, the primary focus is on man. Economics
studies mankind in ordinary business of life. According to him, study of man is
the most important aspect of economics. Thus, the subject matter of economics
deals with man’s efforts in gathering wealth to satisfy his wants.
Scope of the Subject: Marshall defined economics as a subject, not a method.
He was the first one to give a clear scope to the subject matter of economics.
Individual and social actions have several aspects, like social, political and
economic. But he has separated economic aspects from non-economic ones.
According to him, the subject examines only the individual and social actions that
are closely connected with wealth, gathering and wealth-using activities to attain
material well being.
Criticism
Marshall’s welfare definition, though a refinement over the wealth definition of
Adam Smith, could not escape from criticism. Lionel Robbins, spearheading the
attack, declared that the wealth definition misrepresents the science of economics.
The following are some of the criticisms against Marshall’s welfare definition.
Faulty Divide: The wealth definition classified human behaviour into economic
activity and non-economic activity. Marshall considered only those activities
which promote material welfare as economic activity. This has failed to cover
the whole field of economics that includes almost all activities, including that of
services, teaching, law, etc. If there is scarcity of a thing or any activity in rela-
tion to its demand, it becomes the subject matter of economics in modern days.
That way, even the availability of pure air in our cities is taken up for study in
economics.
Highly Narrow: Marshall’s idea that only material means promote economic
welfare is highly narrow. Amartya Sen’s Capability Approach has helped to con-
struct human development index with many non-material dimensions of human
well-being including literacy, health, freedom, empowerment, etc.
Vague Conceptualisation of ‘Welfare’: In Marshall’s definition, the concept
of welfare is not defined clearly. It is difficult to quantify human welfare; it is
basically a subjective phenomenon that varies from one individual to another. But
Marshall assumed that money was a unit to measure welfare. Money, whose value
is flexible, cannot be taken as a measuring rod for welfare. And recent researches
show that money is not the principal determinant of human happiness.
Not Analytical: According to the latter neo-classical economists, Marshall’s
definition is classificatory in nature and is not based on sound analytical reason-
ing. Robbins criticised Marshall’s consideration of only the so called ‘economic
activities’, i.e., those human activities that promote material welfare alone; many
other activities have been left out as ‘non-economic’. Robbins rejects such clas-
sification and analytically argues that any activity becomes ‘economic’ if it is
undertaken under conditions of scarcity. In war ravaged regions like Sri Lanka,
people value peace more than anything under the sun. Deep inside a desert, water
has more value than diamond.
Marshall viewed economics as a topic or as questions but not as a method. He
also viewed the society as a whole unlike the latter neo-classical economists who
viewed it as a simple collection of individuals. His definition is not being used
today by economists because the boundaries of economics have rapidly expanded
since the days of Marshall. Economists study more than exchange and production,
though exchange remains at the heart of economics. However, the greatness of
Marshall’s contribution needs to be seen in a relative perspective of his time.
Greatness of Marshall
Judged by the existing standards of present day theory, Marshall’s Principles is

an unsatisfactory book.
Nevertheless, if a man’s contribution is to be judged on the basis of his solution
of old problems as well as posing of new problems to the subsequent genera-
tions, Marshall’s Principles must be considered as one of the most durable and
viable books in the history of economics. It is the only 19th century treatise on
economic theory that still sells in hundreds every year.
—Mark Blaug, Economic Theory in Retrospect
Scarcity Definition of Lionel Robbins

Lionel Robbins’ (1898 – 1984) ‘scarcity’ definition is the most popular and used
even today. He was the first one to emphasise the scientific nature of economics.
His definition of economics, in effect, makes possible an extension of economics
beyond the traditional questions the discipline used to deal with. Though the basic
question remains the same (scarce means and unlimited wants), Robbins viewed
economics more as a method (how choices are being made) rather than as a topic
or questions. And unlike his predecessors he emphasised that economics studies
individuals rather the society as a whole.
He has defined economics in his book ‘An Essay on the Nature and Significances
of Economic Science’ in 1932.
‘Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses’.
The following are the fundamental aspects of Robbins’ scarcity definition.

1. Economics deals with ‘human behaviour as a relationship between ends
and scarce means’. The object is to get more (optimum) satisfaction out
of limited resources.
2. Human wants (or ends) are various and unlimited.
3. Means are scarce (or limited).
4. Scarce resources (like time, money and factors of production) can be sub-
jected to alternative uses. Water can be used for drinking through public
provision or it can be used to fill a private swimming pool in a five star
hotel. But, economics does not pass any judgement about the ends.
5. As scarcity is the central aspect of Robbins’ definition, it is also known
as scarcity definition of economics; and scarcity requires choice. Wants
differ in terms of importance or urgency. This particular aspect obviously
leads us to the problem of choice. Suppose, if all our wants are of equal
importance, then it is difficult to choose.
6. According to Robbins, economics deals with an aspect of human behaviour
under the influence of scarcity, and is not about certain kinds of behaviour
as believed by Marshall.
7. Economics is a science and does not analyse value judgments.
The scarcity of a thing in relation to its demand is the subject matter of eco-
nomics. According to Robbins, an economic problem will arise only when there
is scarcity. The problem arises when wants exceed one’s means with alternative
uses and /or wants, though limited, have different importance.
For example, a student who wishes to score high marks needs to work extra
hours during the day. As there are only 24 hours in a day, he has to forego his
time for entertainment. In other words, he has to make a choice between the
entertainment and his academic scores. Thus, choice between alternatives is the
basic principle underlying all economic activity. In Robbins’ words,
‘To plan is to act with a purpose, to choose, and choice is the essence of
economic activity’.
It may also to be noted that problems may also arise during times of abundance.
For example, air is abundantly available in nature and is free. But, as it is polluted
by high levels of carbon emission during peak hour traffic in cities, the government
has chosen to regulate the emission by strictly enforcing emission standards in

automobiles. Though this has addressed the issue to some extent, the challenge
to protect the abundantly available free air remains.
Merits
1. Robbins’scarcity definition is more analytical than those of his
predecessors.
2. His definition covers almost all activities which come under the realm of
economics.
3. Robbins’ definition makes economics a scientific study.
4. It emphasises scarcity and choice which are two important aspects of life
under all economic, political and business activities.
5. Ethical aspects of economic problems are not taken into account in discus-
sions. In other words, the moral aspects of life are not considered.
Criticism
Missing Human Touch: Robbins’ definition is known for its logical rigor but
it has no human touch. He has defined economics as a science, without any link
between economics and human welfare. Many economists have established that
economics is a social science and its aim should be promotion of human welfare
rather than attaining any scientific stature.
Limits the Scope of Economics: Robbins’ definition is being criticised for
limiting the subject matter of economics merely to resource allocation and price
determination; the scope of economics is much wider. For instance, he has totally
left out the most important macro economic questions concerned with growth,
employment, inflation and business cycles.
Growth Definition of Paul Samuelson

Paul A. Samuelson’s (1915-2009) definition of economics is known as the ‘growth’
definition. His definition is relatively more comprehensive than that of his prede-
cessors. While the earlier definitions by Smith, Marshall and Robbins emphasised
wealth, welfare and scarcity, respectively, Samuelson combined all these aspects
together in his definition, and went on to add one more dimension to his defini-
tion, namely, time element and growth.
According to Samuelson,
‘Economics is a social science concerned chiefly with the way society chooses
to employ its resources, which have alternative uses, to produce goods and
services for present and future consumption’.
According to Samuelson, economics is a social science and it is mainly con-

cerned with the way how society employs its scarce resources for alternative uses
to produce commodities and distribute them among people. This is nothing but a
brief summary view of his predecessors. But, he goes a step further and discusses
‘present and future’ consumption of commodities by ‘various people or groups’.
Some more Definitions of Economics

David Ricardo: Economics studies how the produce of the earth is
distributed.
George Bernhard Shaw: Economy is the art of making the most of life.
Ludwig von Mises: Economics is the logic of rational action.
Robert Solow: Economics becomes the study of the consequences of greed,
rationality and equilibrium.
John M. Keynes: The theory of economics does not furnish a body of settled
conclusions immediately applicable to policy. It is a method rather than a doctrine,
an apparatus of the mind, a technique of thinking, which helps its possessors to
draw correct conclusions.
Duesenberry’s: Economics is all about how people make choices. Sociology is
about why there isn’t any choice to be made.
Jacob Viner: Economics is what economists do.
Thus, the merit of Samuelson’s definition is that it has accommodated the

dynamic changes in the ‘means’ as well as the ‘ends’ over time. Time element is
an important dimension of economic analysis which Samuelson rightly recognised.
This is the precise reason why it is called ‘growth’ definition.
Another interesting point of his definition is that a society may or may not
make use of money; but his definition is applicable equally to both. That is, his
definition is applicable not only to a modern economy with money but also to
a primitive economy without money. The issues of choice and optimisation of
resources are present in a barter economy where money is absent.
As noted earlier, Samuelson’s definition incorporates the views of his prede-
cessors and hence all those criticisms leveled against the earlier definitions are
equally valid for his definition.
NATURE AND SCOPE OF ECONOMICS

Economics plays the most significant role in modern times. In recent decades,
as the movements of finance capital, and commodities between countries have
increased phenomenally, and people are also connected globally (to some extent),
the study of economics has gained more significance.
Economic decisions being made by individuals, governments and business
firms, and such decisions have deeper and wider implications for the wellbeing
of individuals, societies, countries and the world at large.
In the present era, people face two formidable challenges, namely, development
and poverty—we produce millions of goods and services and some people use
most of them while the rest have to go without them. While we have been able
to accelerate our growth at a faster pace, the benefits have failed to reach the
majority of people.
Why does almost two-thirds of the world population go to sleep with an empty
stomach, in spite of the fact that the world GDP has increased manifold? What
are the causes for such grim scenario and how can we mitigate human suffering
of such colossal magnitude? These questions obviously take us to the realm of
economics. The basic structure of an economy needs to be understood thoroughly
to assess and analyse poverty as well as the nature of our growth process.
The roots of many such challenges can be traced to the quality of economic
decisions made at different levels. Thus, economic issues are the major concern
of individuals, society, governments, politics and business.
Nature of Economics
As human beings, we need many goods and services. We like to consume goods
including basic necessities like food, clothes, house, water and luxuries like dia-
monds, cars and huge bungalows. We also need services like education, health
and social security, etc.
All these goods and services are together called commodities; millions of com-
modities are produced and distributed all over the world. Millions of decisions
are being made in the production and distribution of all such commodities.
Commodities satisfy human wants and give pleasure or utility to individuals.
Acquiring the material means (resources) to satisfy all our wants has always been
a challenge in almost all societies.
Economic resources, namely land, labour, capital and entrepreneurship, are used
in producing commodities; these resources are called as factors of production.
Since these resources have limited availability in every society, the capability of
a society to produce the required commodities is also limited. This gives rise to
the problem of making relevant choices and economics is the study of the process
by which scarce resources are allocated to satisfy society’s wants.
BASIC ECONOMIC PROBLEMS

Each society, whether capitalist, socialist or a mixed economy like ours, must
address three basic and independent problems of economic organisation:
1. What to produce and in what quantities? (the what question)
Missiles or hospitals; if so, in what numbers?
Is it more hospitals and less weapons, or vice versa?
2. How shall goods be produced and how to use society’s scarce resources?
(the how question)
Energy consumption by depleting scarce petrol or by generating more
energy from costlier renewable source?
3. For whom shall the goods be produced? ( for whom or distribution
question)
Whether distribution should be based on purchasing power or needs or
some combination of both.
These three are the basic economic problems and they are interdependent.
These are common to all economies. Every society attempts to make its own
choice which depends on its specific economic system. There are three main
alternative economic system namely capitalism, socialism and mixed economic
system. Whatever may be the economic system, the society must make the cor-
rect choice regarding the above three basic economic problems from the various
alternatives available.
Two more questions about these problems are:
1. Why are choices being made?
2. How do we make our choice?
The reason for making choices is scarcity. Choices are made because the
resources (land, labour, capital and time) required to produce all commodities
that a society needs are limited or scarce.
Every society attempts to answer these issues based on the specific choice of
its development perspectives. The nature of a particular choice in a particular
society depends on its specific economic system like capitalism, socialism, and
mixed economy like India.
But the common thread in all systems is that every choice involves a cost,
namely, opportunity cost. The cost of any choice is the alternative option(s) that
a society foregoes. A brief note on these vital concepts of economics may be of
immense help.
Infinite Wants
The starting point of all economic activity in the world is the existence of human
wants. There are many commodities that people like to consume. We want basic
goods like food, clothes, and shelter, and luxuries like big bungalows, luxury cars,
diamond jewellery, swimming pool, etc. We also like to have services like educa-
tion, information, health, reservation, etc. Goods and services together constitute
commodities. Consumption of commodities satisfies a range of human desires.
Hence, the list of commodities we want to consume is very long and may even
be beyond our imagination. We call them infinite or unlimited wants. Obtaining
resources (means) to satisfy our wants has been a perpetual problem.
Finite Resources
If we have unlimited income and/or wealth most of the wants listed above can be
fulfilled. But, in reality, most people do not have sufficient resources to purchase
all the commodities they want. A family of four, with a monthly salary of, say,
Rs. 20,000, can meet only most of its basic needs, and not the luxuries. Similarly,
a rural agricultural labourer’s family with four members and a daily wage of
Rs. 100, that too only during agricultural season may not be able to meet even
its basic needs. If both these families have enough resources like the very rich
people, most of their wants will be fulfilled. But, in the real world, the income
of the people is finite or limited while the wants are infinite or unlimited. Thus,
the means to satisfy our wants are limited.
Scarcity and Choice

Scarcity means that the available finite resource is not enough to satisfy the infi-
nite human wants. Both time and money at our disposal are limited. The factors
of production, namely, land, labour and capital are also limited. Also, modern
economies have grown faster in recent years and have increased our resources
manifold. But our wants have also grown in greater proportion. When we satisfy
some wants, new wants appear. Thus, all our wants cannot be satisfied due to
the limited means at our disposal. Thus, scarcity limits our ability to satisfy our
wants. And it makes choice inevitable, which wants need be chosen and which
may be dropped. Making a choice is precisely an economic problem. Economics
studies choice-making under conditions of scarcity. Thus, economics studies the
process by which scarce resources are allocated for competing ends.
POSITIVE AND NORMATIVE ECONOMICS

Positive economics is about ‘what is’ and normative economics is about ‘what
ought to be’. The distinction between positive economics and normative econom-
ics will be useful for both economic theories, analysis of economic problems and
economic policy designs.
Positive Economics
Positive economics explains what actually happens in the real world. It does so
without the involvement of any personal opinion on the economic aspects being
explained. Positive economics simply deals with the ‘causes and effects’ of eco-
nomic phenomena.
Thus, positive economics describes the economic phenomena in a natural fash-
ion. It simply answers the question ‘what is’ without giving any opinion about the
desirability or otherwise of the particular economic phenomenon.
For instance,
1. What is the level of rural poverty in Tamil Nadu?
2. Why TNEB charges different unit prices for different consumers (house-
holds, business activities, cinema theatres etc.,)?
The answers to these questions will be positive statements because they will
be mere answers to above questions.
1. In Tamil Nadu, 22.2 per cent (76.50 lakh) rural people live below the
poverty line.
2. TNEB adopts discriminated pricing policy and accordingly it charges
different prices for different types of utility/ consumption.
These answers simply describe for the facts without making any moral or value
judgement about the desirability, or otherwise, of either the level of rural poverty
or the discriminated pricing policy of the Electricity Board.
Thus, positive economics is concerned with the question ‘what is’.
Normative Economics
Normative economics is concerned about the valuation of economic phenomena
involving value judgment, opinion or judgement about the desirability or undesir-
ability of a situation of the economic phenomena.
Normative economics answers the question ‘what ought to be’ or how an eco-
nomic problem should be solved. For instance, should Special Economic Zones
(SEZ) be allowed by displacing people from such zones? Your answer may be
‘yes’ or ‘no’. But both the answers, i.e. the acceptance or the rejection of SEZ,
are normative judgements because your answer expresses your judgement (good
or bad) about the people’s displacement, to facilitate economic development that
may not be beneficial to them.
Lionel Robbins was the one who emphasised the distinction between positive
economics and normative economics. Subsequently Milton Friedman said, ‘While
positive economics ‘describes’ what actually happens, normative economics ‘pre-
scribes’ what ought to be’.
A physician who diagnoses the problem of the patient prescribes the medicine
too. If he refuses to do so, the situation is pathetic. Similar will be the situation
if positive an economist refuses to prescribe saying that it is the job of the policy
makers or the elected representatives. The one who has diagnosed the problem is
the right person to prescribe the solution and is more competent to do so without
bothering the scientific stature of the subject.
MICRO AND MACRO ECONOMICS

Economics is studied under various subdivisions. The Journal of Economic
Literature has made a comprehensive and detailed classification and has stan-
dardised it by giving specific codes to 19 major divisions, and each division has
many more branches. The two major subdivisions are micro economics and macro
economics.
Micro Economics
Micro economics, as the name implies, is about the parts of the economy rather
than the whole economy. It deals with the behaviour of individual economic actors
(or agents) in a market economy such as consumers, producers and governments.
For instance, it studies how a consumer (or household) allocates his income among
expenditure on various commodities. Similarly, it is concerned with the firm’s
profit maximising level of production of a commodity.
Micro economics provides various ‘theories of consumer behaviour’ that
explain the behaviour of the consumer under different market structures. Similarly,
a firm’s behaviour is explained by ‘theories of market structure’. The behaviour
of the consumer will aim for maximisation of utility and the firms will aim for
maximisation of profit.
Microeconomics also examines the interactions of these actors in various market
structures, like perfect competition, monopoly and imperfect competition.
The scope of micro economics includes the determination of commodity prices,

factor prices, partial equilibrium analysis, general equilibrium analysis and theo-
ries of welfare economics. In other words, micro economics explains the alloca-
tion of scarce resources for different uses and distribution of commodities among
people.
Macro Economics
Macro economics analyses the behaviour of the economy as a whole in totality. It
is the study of economic aggregates. It explains the broad macro variables of the
economy and their interactions. Thus, macro economics examines the aggregates,
such as total national income, its growth, total (un)employment, inflation or the
general price level in an economy. It is not concerned with individual units and
their problems.
According to Boulding, ‘Macro economics deals with not individual quantities
as such, but with the aggregates of these quantities, not with individual incomes
but with national income, or not with individual prices but with the price level,
not with individual outputs but with the national output’.
The scope of macro economics includes almost all current problems of an
economy. It includes theory of employment and income, theory of general price
level, theory of economic growth and macro theories of income distribution. Macro
economics also deals with growth cycles in the long run, capital accumulation,
capital output ratio, technological change, foreign investments and trade.
The general objectives of macro economic policies include attainment of full
employment, sustained economic growth, stable price levels, and balanced external
sector.
It is to be noted that the boundaries of micro-macro divisions are getting
blurred in modern times due to overlapping of issues. For instance, when the
international crude price races to beyond $140 per barrel, coupled with the falling
supply in recent times, it is purely a micro economic problem; but it affects the
entire macro economic framework of the world, that too with greater repercus-
sion on the developing countries like India. Hence, it is difficult to maintain such
water tight division because of the deepening integration of the world economies
and growing complexity of the economic issues. However, it is still necessary to
introduce such distinction at the introductory level.
Micro and Macro Economics

One of the most valuable results of the criticisms of traditional monetarists and
new- classicists is that macro economists have been forced to examine in great
detail the micro underpinnings of assumed macro economic relations.
—Richard G. Lipsey, An Introduction to Positive Economics
Key Terms and Concepts

Scarcity Wealth
Basic Economic Problems Economic Resources
Economic Growth Factors of Production
Choice Positive Economics
Unlimited Wants Normative Economics
Economic Thoughts Micro Economics
Scarce Resources Macro Economics
Welfare Finite Resources
Chapter Summary
This chapter explains the meaning, nature and scope of economics, positive and
normative economics and micro and macro economics.
• Economics is the science of choice as well as a way of thinking.
• Economic principles and methods have wider applications, ranging
from economy to human emotions. They help to ‘get more’, given the
constraints.
• Economists have defined economics in terms of wealth, welfare, scarcity
and choice.
• The basic problems of any economy are production and distribution.
• Positive economics deals with ‘what is’ and normative economics deals
with ‘what ought to be’.
• Micro economics is about the parts of the economy and macro economics
is about the whole economy. But in the real world both are interrelated.
Questions
A. Very Short Answer Questions
1. Elucidate Adam Smith’s definition of wealth.
2. List the demerits of Adam Smith’s definition.
3. Explain Marshall’s welfare definition of economics.
4. What are the criticisms of welfare definition of economics?
5. Discuss Robbins’ scarcity definition of economics.
6. What is growth definition of economics?

7. Compare wealth definition with welfare definition.
8. What are the main ideas of Robbins’ definition?
9. Compare Marshall’s definition with Robbins’ definition.
B. Short Answer Questions
1. Define economics.
2. Explain welfare definition of economics.
3. What is Marshall’s definition of economics?
4. Explain Robbin’s scarcity definition.
5. What is growth definition of economics?
6. What is the subject matter of economics?
7. Distinguish between positive and normative economics.
8. Distinguish between micro and macro economics.
9. Explain the nature of economics.
10. Make a critical appraisal of Lionel Robinson’s definition of economics?
C. Long Answer Questions
1. Make critical examination of Marshall’s welfare definition of economics.
2. Explain the scarcity definition of economics?
3. Economics is the science of choice. Discuss.
4. Explain the nature and scope of economics?
5. Briefly examine the shift in economic thought in defining economics since
Adam Smith.
6. Examine the role of economics and its significance in modern times.
7. Distinguish the following:
(a) Positive and normative economics
(b) Micro and macro economics
8. What are the basic problems faced by an economy?
Chapter 2
Business Economics:
Definition, Nature, Scope
and Concepts
If you catch too many fish, the best place to store them is in another person’s stomach.
—A proverb
Learning Objectives
The main objective of this chapter is to discuss the meaning, scope and concepts
of business economics. At the end, the students would be able to understand
what is business economics and how economic principles and methods are
applied in the business decision-making process.
• To explain the meaning, definition and scope of business economics
• To know the role of business economists
• To understand some important concepts in economics
• To understand the role of time elements in business economics
INTRODUCTION
Business economics is the application of economic principles and methods to busi-
ness management practices. It deals with the business organisation and decision
making process of the firm. It helps firms in business administration; decision
making and business planning. Decision making involves the process of choosing
the best (optimum) choice(s) or course of action(s) from the many alternatives
available to the decision makers of the firm. Forward planning involves the estab-
lishment of future plans.
Profit is the ultimate aim of almost all business firms. Hence, forward planning
and decision making will generally be targeted towards the maximisation of the
firm’s profit. Some argue that business economics is essentially about the firms
and it deals mainly with the factors which help to influence the firm’s decisions
regarding the process of production and distribution of commodities to satisfy
human wants and needs. The focus is shifted to objectives of the firms other than
profit, like sales, size of firms market share, competition, etc.
Whatsoever may be the short term objective of a firm, the ultimate one could
be nothing but profit. Given such a goal, the nature of most business problems
is basically economic, i.e. getting more from the given resources, and the nature
of competition. The productive resources of the firms are limited in general.
Acquiring more such productive resources, transforming them into goods and
services and selling them for maximum profit involve innumerable plans, deci-
sions and strategies; and the bottom-line of all such issues is getting more from
them. The limited resources have to be used efficiently in such a way as to attain
the ultimate objective of the firm, viz., maximum profit. This is possible only by
making the best (optimum) choice in using the scarce resources of the firms and
by making best decisions about the various aspects of business during the course
of business management.
The firm with several alternatives has to analyse all possible options and
decide the most efficient course of action by using the given resources to attain
maximum profit. Here comes the relevance of economics. The economic theories
and methods help business manager to make efficient choices that give optimum
results in business problems using techniques such as profit maximisation, demand
forecasting, optimum price determination, cost minimisation, revenue forecasting
and revenue maximisation.
DEFINITIONS
As discussed earlier, attempting to define any subject matter concisely and ade-
quately is a bit difficult venture with an associated risk of limiting the boundar-
ies of the subject. Like economics, it is also difficult to have the most accurate
definition of business economics which is concise as well as comprehensive. Many
scholars have attempted to define business or managerial economics by empahsis-
ing its various aspects. However, the focus of this section is to summarise them
to know what business economics is all about rather than deliberating about the
accuracy or otherwise of any one definition.
Business Economics: Deﬁnition, Nature, Scope and Concepts 19
Business economics deals with the application of economic principles and

methods for business and managerial decision making of firms. The following
are some of the attempts to define business or managerial economics.
‘Managerial economics deals with the integration of economic theory with
business practice for the purpose of facilitating decision making and forward
planning by the management’.
—Spencer and Sigelman
‘Managerial economics is concerned with the application of economic principles

and methodologies to the decision making process within the firm or organisa-
tion under conditions of uncertainty. It seeks to establish rules and principles
to facilitate the attainment of the desired economic goals of the management.
These economic goals relate to costs, revenues and profits and are important
within both the business and the non business institutions’.
—Prof. Evans J. Douglas
‘The purpose of managerial economics is to show how economic analysis can

be used in formulating business policies’.
—Joel Dean
‘Managerial economics is concerned with application of economic concepts

and economic analyses to the problems of formulating material managerial
decisions’.
—E. Mansfield
‘Managerial economics deals with the application of economic theory and

methodology to decision making problems faced by public, private and not
for profit institutions. Managerial economics extracts from economic theory
(particularly micro economics) those concepts and techniques that enable the
decision maker to allocate efficiently the resources of the organisation’.
—McGuigan and Moyer
The various definitions listed above are almost same in form and content with
minor shift here and there. These definitions clearly show that economic principles
are useful in decision making, forward planning and to arrive at rational business
and managerial solutions towards efficient outcomes. The essence of these defini-
tions can be summarised as follows.
Business economics may be viewed as the study of economic principles and
methods which are relevant or useful for business and managerial decision
making of firms.
NATURE OF BUSINESS ECONOMICS

In business economics, economic principles are applied to problem solving at the
level of the firm. The problems, of course, relate to choices and application of
resources in the process of production and consumption of commodities which
are basically economic in nature.
Business economics bridges economic theory and economics in practice. It also
uses quantitative techniques, such as correlation, regression, calculus, game theory
and linear programming. The bottom-line that runs through most of business eco-
nomics is the attempt to optimise business decisions, given the firm’s objectives
and given the resource constraints (including time) imposed by the society.
Decision makers of firms are confronted with many issues of decision, having
to choose from among a number of possible alternatives. They must choose a
specific course of action by which the firm’s given resources must efficiently be
used for achieving the ultimate goal, profit. This is, thus, essentially a problem of
choice. Had there been no alternatives available, there would have been no deci-
sion making exercise at all. Managerial economics helps in analysing alternatives
and selecting the one which would achieve the optimal result, within the limited
resources and other constraints. It helps to identify alternative means of achieving
given objectives and then to select the alternative that accomplishes the objectives
efficiently.
For instance, let there are two possible strategies identified, say X and Y, to
meet the growing demand for the product, and X represents an internal expansion
of capacity and Y the purchase of surplus owned by the competitor. Suppose the
objective of the firm is to maximise its profits. The decision rule may be followed,
viz., if profits from strategy X are greater than those from Y, then X be chosen,
and if the profits from strategy Y are greater than those from X, then Y be chosen.
Economic theory assists a manager in choosing an appropriate objective function
and creating decision rules.
Further, there are many forces and institutions that affect the business outcomes
in the real world. They include government structure, policies, climate, socio-and
political issues, NGOs, media, international agreements and trade blocks, etc.
However, economic forces are the most critical among them. Business economics
also studies mostly such forces, both at the micro and macro level, that affect the
business firms and their profit. Thus, business economics is broadly an approach
to decision making about business problems using economics.
SCOPE OF BUSINESS ECONOMICS

The following are some of the key issues that constitute the subject matter of
business economics, at least at the undergraduate level. They are discussed at
length in the remaining chapters.
Fundamentals of Business Economics

• Basic concepts and principles of economics
• Opportunity cost and production possibility curve

• Scarcity and efficiency
The Consumer Markets

• Demand and supply analysis
• Demand function
• Demand schedule and demand curve
• Determinants of demand
• Demand forecasting
• Supply function
• Supply schedule and supply curve
• Equilibrium of supply and demand curve
• Price elasticity of demand
• Elasticity and revenue
The Business Organisation

• Prediction of consumer behaviour
• Determinants of demand curve, like price, income, taste, prices of other
brands, etc.
• How and when consumers react to market signals like price
• Consumer preferences, and business organisation
• Determinants of firms behaviour
• Input cost, output and profit relations
• Price determination in different market structures
• Pricing and sales strategies of firms
ROLE OF BUSINESS ECONOMISTS

Business economics has emerged as a profession only after the Great Depression
of 1930s, when economists took key positions in governments. After the Second
World War, firms began recruiting increasingly business economists. Since then,
the need for business economists has grown rapidly. Now their role is vital in
investment, manufacturing, mining, banking, insurance, transport, communication,
trade and various other business enterprises. They are also playing many vital
role in government departments, public sector enterprises, trade organisations and
public policy making.
Understanding the nature of professionals such as doctors, engineers, lawyers,
teachers and auditors is relatively easies than that of an economist. The role
and responsibilities of an economist, in general, and a business economist, in
particular, are a bit difficult to define. The role of a business economist is vast,
complex and challenging because of the sophisticated nature of the profession.
Economic science is not as exact as the physical sciences. The nature, structure
and functional dynamics of each economy vary based on it’s society and polity
and their interdependence with the global economy at large. Hence, the role played
by business economists also differs from one firm to another, both within and
in different countries. However, the following are some general roles of business
economists.
Collection and Management of Information

Business decision, any decision for that matter, needs to be made on the basis of
accurate, detailed and relevant information. As most information is external, the
firm may neither be aware of nor able to monitor the information. Hence, the col-
lection of all such relevant information about the general business environment, the
actions of the rivals, technological developments, macro economic environment,
inside activities, etc., is the first responsibility of a business economist.
Business Analysis
The focus of business economics is mainly on the application of micro economic
analysis to decision making. Macro economics is also relevant to analyse the
general environment of the business. Hence, a business economist should first be
well versed in the theory and practice of micro as well as macro economics along
with decision making skills in various branches of a business. The public policy
changes at the national and international levels and the business cycles can have
significant impact on the firm’s business prospects. A business economist can
analyse and interpret all such national and global developments, particularly their
impact on sales, prices, costs, competition and other such matters of relevance to
the firm. Business economists are also capable of observing and analysing what
goes on internally in the enterprise.
Business Forecasting
Forecasting future business prospects is one of the principal roles of a business
economist. The business economist provides the baseline macro economic fore-
casts that have crucial bearing on the estimates of sales, revenue, profit and annual
budget estimates. As most future business prospects depend on the performance of
the economy as whole and its various sectors, such forecasts help firms to make
accurate and reliable targets or decisions on inputs, output, revenue, etc.
Business Performance Monitoring

The business economist also plays a key role in the performance evaluation of
business firms. In close relation with forecasting, the performance appraisal of a
firm within the given macro scenario is important for strategic business planning.
For instance, a firm may deviate in either way from the targets already fixed.
The reasons for such divergence need to be thoroughly analysed. Such analysis
can help to identify the causes of both good as well as bad performance. These
understandings can help to correct past mistakes and to focus on the secrets of
success formulas.
Strategic Business Planning

The business economists can make potential contributions to the strategic business
planning process. They can develop more effective planning system for the highly
competitive and complex global business environment. The role of the business
economist grows exponentially when the firm progresses through advanced stages
of strategic planning. The business economist provides vast array of analysis in
areas of industry, economy, competition, regulation, trade and public policies. He
also helps to devise organisational structure and management systems required to
implement the plans successfully.
SOME IMPORTANT CONCEPTS

Before proceeding to discuss the economic principles that are relevant for deci-
sion making and business planning, a brief review of some basic concepts will
be in order.
Further, some concepts used both in economics and in business need clarifica-
tion. For instance, most of the information about the cost of production is sup-
plied by accountants to business decision makers. Some of these concepts may
differ from the conceptualisation of the economist. Hence, these concepts need to
be defined clearly for any effective application. The following are some of such
concepts.
Opportunity Cost
As discussed in Chapter I, economics is the science of making choice. Choices are
being made because our resource endowments are not sufficient (scarce) to pro-
duce all the commodities we need and want. That is, choice emanates from scar-
city. Moreover, every choice that is being made out of scarcity involves cost.
For example, at an individual level you must have chosen among alternatives,
like,
• Whether to watch the latest movie or study an extra hour for the forth-
coming semester examination?.
• Whether to pursue post graduation for two years or take up the job with
monthly salary of Rs.20,000?
• Whether to invest Rs.10,00,000 to start a business or place it in term
deposit for ten years?
For every alternative chosen, the next best alternative must be given up. The
cost of one commodity or choice or decision measured in terms of what must be
given up is called ‘opportunity cost’.
For example, if you choose to watch the latest movie you sacrifice an extra
hour of preparation for the forthcoming semester examination. The cost incurred
in the choice of watching movie is the loss of the next best alterative, that is,
the outcome of an extra hour preparation. Thus, by watching a movie, you have
foregone the opportunity of scoring better marks in that semester.
Likewise, the opportunity cost of giving up the job with salary Rs. 20,000 per
month in order to pursue post graduation is Rs. 4,80,000 (the amount of salary
that would have been earned during the study period).
The opportunity cost of the decision to start a business is the interest for the
term deposit of Rs. 10,00,000 for ten years.
Thus, the opportunity cost is expressed in terms of the next best alterative
foregone. In other words, the best alterative scarified when a choice or deci-
sion is made is the opportunity cost of that decision or choice.
Choices are mostly made based on opportunity cost. The concept of opportunity
cost is useful for valuing different choices and evaluating the actual cost of deci-
sion making. Business and management decisions need to be made by confronting
different alterative possible scenarios. In such context, the concept of opportunity
cost is highly useful.
It is to be noted that choices are made due to scarcity. If there is no scarcity,
there would be no need to choose. Similarity as choice must be made from avail-
able alternatives; it involves comparison of cost and benefit.
Production Possibility Curve

The opportunity cost can also be demonstrated graphically with help of Production
Possibility Curve (PPC). A society has to make choices regarding the three basic
economic problems discussed in Chapter I. For instance, the society has to choose
the commodities to be produced along with their respective quantities with the
limited resources is a simple way to represent the nature of the society’s choice
the production possibility curve. The production possibility curve shows different
combinations of two goods that can be produced with a given amount of resource.
It differentiates between the outcomes that are possible to produce and those which
cannot be produced subject to the available resources.
As can be seen from Table 2.1, if an economy produces only ballistic missiles,
the output will be twelve ballistic missiles. But, if the economy reduces its ballistic
missile production to eleven, it can also construct six public hospitals. Thus, the
opportunity cost of constructing six public hospitals is just one ballistic missile. In
other words, the opportunity cost of one ballistic missile is six public hospitals. The
other combinations in Table 2.1 can also be shown as similar trade-offs between
missiles and hospitals. All the combinations are presented graphically by PPC in
Figure 2.1. Point A in Figure 2.1 corresponds to the first combination in Table
2.1, point B to the second combination, and so on. Thus, PPC is the locus of all
such possible combinations.
There is no ‘ideal’ point on the curve. Any point inside the curve means that
resources are not being utilised efficiently. Similarly, points outside the curve
suggest that they are not attainable with the current level of resources. Figure 2.1
shows the PPC for an economy with a limited amount of productive resources.
The given amount of resources can either be used to produce good X or good Y
or combination of both. The PPC shows the maximum amount of ballistic missiles
and public hospitals that can be produced with the limited amount of available
resources.
Table 2.1 Production Possibility Schedule
Production Possibilities Good X Ballistic Missiles Good Y Public Hospitals

A 12 0
B 11 6
C 10 8
D 8 10
E 6 11
F 0 12
In the Figure 2.1, A and F are the possibilities where the economy either pro-
duces only good X or only good Y. But the production possibility curve as a whole
is the locus of all combinations of good X and good Y. Points B, C, D and E are
such that the economy can produce both commodities in varying combination.
Possibility B shows eleven units of good X and six units of good Y, Possibility D
shows eight units of good X and ten units
of good Y, and so on. The extreme cases A Hospitals
and F show the maximum feasible amount F
of production, if resources are entirely 12 E
used to any one of the commodities. D
10
The specific choice between more
public health and less weapons, or vice C
versa, depends on the given social and
democratic value system of a society
B
and its citizens. For instance, a society
may attach more importance to its public
A
health care and the country may be forced
0 8 12 Missiles
by popular democratic pressure to ban
continental ballistic missiles and choose
Fig. 2.1 Production Possibility Curve
choice A, i.e., no missiles but only public
hospitals.
Accounting Profit and Economic Profit

The meaning of profit in economics is different from its meaning in business
economics.
In general, the term ‘profit’ (P) means the amount by which revenue (R)
exceeds all the costs (C) of doing business. This profit is nothing but ‘accounting
profit’, the difference between revenue and cost.
Profit (P) = R – C
But, in economics, the concept of profit has different meaning. Though the
basic identity, i.e., P = R – C, is the same, the scope of the term ‘cost’ is wider
in economics. In economics, cost includes both explicit cost and implicit cost.
In business accounting, costs are structured according to their causes. Most of
them are only the explicit costs incurred on production and selling activities of
the firms. Such explicit costs include input costs, such as salary, cost of raw mate-
rial, taxes, interest and depreciation. Depreciation is an annual charge arrived at
by accountants to determine the cost of replacing plants and machineries bought
earlier. This charge, to cover the full cost, will be split annually for the entire
productive life span of those assets.
But, economic principle focuses on the efficient allocation of resources among
the alternative uses of inputs at a given point of time. Hence, economists focus on
opportunity cost which is implicit in nature. For instance, the Britannia Industries
Ltd. sold its entire plant located in Padi, Chennai for a very high price to Infosys,
the software giant and moved its production facilities to an alternative location
where the land cost was very low. The opportunity cost of Britannia’s decision
to sell its land in Chennai metro is the sale price he got over and above the land
cost of his new location.
Opportunity cost, a return that could have been earned if the inputs were
employed elsewhere, is also called implicit cost. It is the compensation for not
having used the inputs in alternative opportunities. To compute total cost, oppor-
tunity cost needs to be added along with explicit cost.
Accounting profit is the difference between total revenue and all explicit cost
whereas economic profit is the difference between total revenue and total economic
cost that includes explicit cost and implicit cost (or opportunity cost). Hence, it is
obvious that economic profit will be lesser than the accounting profit as we add
implicit and opportunity cost together. The following identities can help further.
Accounting Profit = Total Revenue – Explicit Cost
Economic Profit = Total Revenue – Explicit Cost
+ Opportunity Cost
Or
Economic Profit = Total Revenue – Total Economic Cost
Where Total Economic Cost = (Explicit cost + Opportunity Cost)
Thus, to compute economic profit, implicit cost has to be added with explicit
cost. Some authors define opportunity cost only with reference to the capital or in
the sense of taking risk. This is erroneous and it should be noted that all factor
inputs, including land and labour, have opportunity cost. To obtain the services
of, say, land or labour, a firm needs to pay at least as much for them as in their
next best alternative use. Hence, it is not just capital or investment alone. All the
factor inputs have opportunity cost as long as they have better alternative uses.
Marginal and Incremental Concepts

Marginal and incremental concepts are well established concepts in economics
and they have critical relevance for sound business decision making.
Marginal Analysis
Marginal analysis deals with a type of decision making in economics. It refers to
the effect of incremental change in production or consumption of a good.
Marginal cost and marginal benefits are the two most important concepts in
economics without which ‘nothing matters in economic decision making’.
A marginal change is a proportionally very small change (positive or negative)
to the total quantity of some variable. Marginalism is the analysis of such changes
in terms of their relationship with the economic variables. Here ‘small’ refers to a
least amount of change in activity level in relation to the total level of activity.
Marginal cost (MC) is the additional cost incurred in producing one more
unit of a product. Marginal utility is the additional benefit derived from marginal
change in an activity. Similarly, marginal revenue (MR) is the additional change
in total revenue (TR) resulted from selling one additional unit of output.
DTC
MC = _____
DQ
Change in total cost
MC = __________________
Change in output
Similarly,
DTR
MR = _____
DQ
Change in total revenue
MR = _____________________
Change in output
Marginal changes can also be quantified by differentiating total magnitudes. For

instance, MR can be expressed as a derivative of the TR with respect to output.
TR = R(Q);
where Q = Quantity produced

d(TR)
MR = ______
dQ
Similarly, MC is the derivative of the TC with respect to quantity of output

produced.
d(TC)
Hence, MC = ______
dQ
Thus, marginal changes measure the rate of change in total magnitudes for a
given unit change in some select variable. Marginal changes can also be shown
graphically.
Incremental change is the change in some variables due to a specific decision
or change in business activity.
For instance, a firm decides to increase its production by 20 per cent, and
may want to know the total effect of this increase on other variables like cost,
revenue and profit. An increase in production may bring in changes in variables
with varying intensities. An increase in production may increase variable cost
(discussed later) proportionately but it may bring down the average fixed cost.
These two together influence the change in total cost. For the given illustration,
incremental cost is the change in total cost associated with 20 per cent change in
production. In simple words, incremental cost is the additional cost of producing
a given increment of production.
Similarly, incremental profit is the change (increase or fall) in total profit
associated with the new decision of the firm. The change could also be in the
quality of product, production technology or use of resources, or in any activity
of the business.
Thus, the concept of incremental change is used to measure the effects of
alternative decisions on cost, revenue and profit. Knowledge about such incremen-
tal changes, their effects and better alternative courses of action are vital for the
decision makers.
Haynes has listed four criteria to choose a profitable decision from the options
available to a firm:
1. It increases revenue more than costs
2. It decreases some costs more than it decreases others
3. It increases some revenue more than it decreases others
4. It reduces costs more than revenue
Thus, a change in business activity will be profitable only when the ultimate dif-
ference between incremental revenue and incremental costs is positive. Incremental
cost analysis is useful only when it is used with incremental revenue and decisions
are based on the ultimate effect, viz, incremental profit. Thus, the contribution
of any decision is equal to the incremental revenue minus the incremental cost
involved; and the decision will be made only if it results in a positive contribution
to profits.
Marginal changes are incremental changes, but they are an extreme case of
incremental changes, with unit-by-unit changes. Marginal change is a limiting
case of incremental change, where the increment is a single additional unit in
addition to the existing total. But, that is not the case in incremental change. The
concept of incremental change is closely related to marginal change with some
difference. An increment may be any amount of change to the total and it need
not be a least or small change; whereas marginal change is the least addition to
the total. In other words, least incremental changes are the marginal changes. But
both concepts are used to measure and analyse the functional relationship between
different variables to make a decision.
EFFICIENCY
Efficiency simply means the absence of waste. It is concerned with the relationship
between resource inputs (cost of inputs, viz., land, labour, capital, etc.) and outputs
whereby efficiency is increased by a gain in units of output per unit of input. This
is possible either by holding the output constant and reducing the inputs or holding
the input constant and increasing the output to the extent possible.
Beyond such physical relation, efficiency analysis helps mainly to determine the
net balance between positive and negative effects of any economic act or event.
The notion of efficiency also refers to cost-benefit analysis.
It is important to understand that efficiency is not an absolute but a relative
term. It is always refered in relation to some criterion. And the criterion for eco-
nomic efficiency is value. Any change that increases value is an efficient change.
Similarly, any change that reduces value is inefficient.
The concept of efficiency is used both at the micro and the macro level of
social and economic analysis. In micro economics, a firm is considered to be
efficient if it attains the maximum profit possible, given the shortest time and
limited resources and other constraints. Similarly, a consumer is considered to be
efficient if he attains the greatest utility by consuming the best mix of commodi-
ties bought at the least price.
In macro economics, an economy is considered to be efficient when all its
resources are used to produce the maximum possible amount of output mix with
the given technology.
The ultimate concern of economists is the efficiency with which society’s
resources are allocated for different uses. At the society’s level, efficiency mea-
sures whether society’s resources are used towards maximum collective welfare
of its citizens or not. Application of the criterion of economic efficiency means
that society makes choices which maximise the public and private goods produced
from the given resources allocated to them. Inefficiency arises when resources
could be reallocated in such a way that would produce more of all or some goods
with the same amount of resources. Similar situations in business organisation are
innumerable, and the concept of efficiency can be used to maximise the outcomes,
given the limited resources.
One of Paul Haynes’ brief but interesting note on efficiency is as follows:
‘To economists, efficiency is a relationship between ends and means. When we

call a situation inefficient, we are claiming that we could achieve the desired
ends with less means, or that the means employed could produce more of the
ends desired. Less and more in this context necessarily refers to less and more
value. Thus, economic efficiency is measured not by the relationship between
physical quantities of ends and means, but by the relationship between the value
of the ends and the value of the means’.
Every concept of efficiency has to employ some measure of value. Economists

normally use monetary measure. Monetary measure of value is broad, useful and
more appropriate. Such measure facilitates comparison of different evaluations
made by different people.
There are positive and normative reasons for the economists’ interest in eco-
nomic efficiency. People as well as business firms mostly search for values. This
is the positive reason. The search for value can be seen in the pursuit of utility
maximisation (by consumers) and profit maximisation (by firms). And, this is the
driving force of most market economies.
The normative reason is the basis to arrive at appropriate policy recommenda-
tions for many economic problems. The criterion of economic efficiency is often
used to evaluate the effectiveness of different policies or situations. For instance, if
an economist wishes to ask whether the recent hike in the petroleum price mostly
affects the poor masses or the rest, he needs a criterion to find an appropriate
answer.
The value maximised in the notion of economic efficiency is the reflection of
goals, like maximum utility or profit, to be pursued respectively by the people
and the business firms.
The concept of efficiency as well as inefficiency can be explained with the
help of PPC, as discussed earlier. An economy is efficient when it uses all its
given resources to produce maximum amount of commodities. This is attained on
any point on the PPC, as discussed earlier. Any combination away from the PPC
indicates either inefficient use of
Hospitals
resources or impossible situations
with available resources.
In Figure 2.2, the points below O
D
the PPC, for instance I, indicate
the production of lesser amount
I
of missiles or hospitals than those
by the points like D on PPC, with
the given resources and technol-
ogy. As more production by com-
binations on PPC means more
value, the points below PPC are 0 Missiles
inefficient. Similarly, the points
Fig. 2.2 Efficient and Inefficient Choices in PPC
above PPC, like O are unattain-
able, given the society’s resources
and technology. Hence, all the points on PPC are efficient because they maximise
output for all the resources available to the society.
TIME ELEMENT
Time element plays an important role both in economics as well as in business
decision making.
Short Run and Long Run

Economists divide time periods into short run and long run. For instance, the flex-
ibility of a firm in adjusting its production to meet the change in demand depends
on the nature of its inputs. There are two types of inputs, namely, fixed inputs
and variable inputs. The fixed input is one whose quantity cannot be adjusted in a
limited time period. Heavy machinery, buildings and capital equipments are such
fixed inputs and they may need more time for installation or replacement.
However, variable inputs, like labour, raw material and electricity, can be
changed quickly to change the supply. Thus, short period for a firm is the time
period during which at least one of the inputs is fixed input and long period is
the time period during which all the inputs are variable inputs. However, specific
duration of short period and long period will vary from firm to firm.
Time in Business
In business decisions making, a firm has to pay its dues over a span of time, i.e.,
weekly, monthly or annually, or any time in the future. It may also have to pay a
series of amounts over a span of time in the future. As the value of money is not
constant over time and keeps changing according to the levels of inflation in the
economy, it is necessary to evaluate the change in value of money and cash flows
over time. That is, time value of money needs to be quantified and incorporated
in business decision making. This is more important, particularly, when the cash
flows are spread over many years in the future.
The perception of time also affects a wide range of business decisions regarding
money, investment, capital and valuation of companies. The concept of discounting
deals with time value of money. Time value of money assumes that a fixed amount
of money available today is more valuable than the same amount in the future.
People value spending now more than future spending due to three reasons:
• There is an inherent risk and uncertainty involved in any future event.
Hence, present spending is preferred.
• Future spending involves sacrifice of current spending. This opportunity
cost could be avoided by spending now.
• Effect of inflation reduces the value or purchasing power of money in the
future. For instance, Rs.1,000 buys ten units of good X today. However,
buying the same ten units of good X after a year may require more than
Rs. 1,000. This means that the value of money or purchasing power has
declined after one year due to inflation.
Time Value of Money and Discounting

All perceptions of time discussed above lead to reduction in the value of money
in the future in comparison with its present value. The concept of ‘discounting’
helps to measure the current costs and benefits in relation to those occurring in
the future.
Discount rate is the rate at which the value of money changes from one year
to the next. In the above illustration, if the discount rate is 0.09 per cent, then
Rs.1,000, an year from now, is worth only Rs.910 or 91 per cent today.
This concept is useful to quantify the time value of money at different points
in the future which, in turn, can help business decisions. The concept of time
discounting in economic evaluation is used to discount not only future costs,
but also future benefits. This concept can also be extended to time valuation
of all economic resources, like investment, capital and valuation of stocks and
companies.
There are algebraic methods to calculate time value of money, capital and value
of companies.
Present value is today’s value of the sum of money to be received in the future.
Present value results when the opportunity cost of having to wait for future con-
sumption is added to amount to be received in the future. Thus, present value
denotes the ‘discounting’ of a sum of money to be received in the future. It can
also be computed by inversing the compound interest as shown in the following
equation.
1
[
Present Value = FVn ______n
(1 + i) ]
Where n = the number of years until payment is received
i = the opportunity rate or discount rate
PV = present value of the future sum of money
FVn = future value of the investment at the end of n years
PVIFi, n = present value interest factor
Compound interest means interest that itself earns interest. For instance, if inter-
est on fixed deposit is added to the principal at the end of year one, the principal
sum for the second year is greater by the amount of interest. The total return
depends on the number of years or the number of times interest is compounded.
Illustration 2.1 Find
(1) the future value of Rs.5 invested after 2 years at 11 per cent per annum
rate of interest, and
(2) the present value of Rs.5 to be received in 2 years at 11 per cent per
annum rate of interest.
Solution 1. The future value of any amount of money is equivalent to the original
sum multiplied by its compound interest.
FVn = PV (1 + i) n
Where n = number of years the interest is compounded
i = annual interest rate or discount rate
= Rs.5 (1 + .11)2
= Rs.5 (1.2321)
= Rs.6.1605
Suppose the compounded period is less than one year, i.e., it is monthly, quar-
terly or half yearly, the formula for future value is
mn
[
1
Future Value = PVn 1 + __
m ]
where m = the number of times interest is compounded during a year. For quar-
terly compounding ‘m’ is 4.
2. The present value of any amount of money is equivalent to the future value
multiplied by its reverse compound interest. The reverse compound interest is
nothing but the discounting rate.
[ 1
Present Value = FVn ______
(1 + i) n ]
[ 1
= Rs.5 ________2
(1 + .11) ]
[ 1
= Rs.5 ______
1.2321 ]
= Rs.5 [.81162243]
The discount rate is .81162243
Hence, Present Value = Rs. 4.058

Opportunity Cost Business Forecasting
Production Possibility Curve Future Value
Accounting Profit Efficiency
Economic Profit Inefficiency
Short Run Time Element
Long Run Total Revenue
Marginal Cost Marginal Revenue
Present Value Discount Rate
Marginal Analysis Incremental Change
Time Value of Money Discounting Rate
Chapter Summary
This chapter has explained the meaning, nature and scope of business economics.
It has also introduced basic concepts of business economics.
• Business economics is the application of economic principles and methods
to business decision making in firms.
• Business economists play many important role in the firms.
• Important concepts like opportunity cost, production possibility curve,

accounting profit and economic profit, marginal and incremental con-
cepts, efficiency and time element have wider applications in business
economics.
Questions
1. What is business economics?
2. State some basic concepts of business economics.
3. Explain accounting profit.
4. What is economic profit?
5. Define the term ‘Production Possibility Curve.’
6. Define opportunity cost.
7. Explain the concepts of time and discounting.
8. Briefly explain the scope of business economics.
9. Define the concept of marginal change.
10. What are the roles of a business economist?
11. Define the concept of efficiency.
1. Define business economics and explain its meaning.
2. Explain the nature of business economics.
3. Explain the scope of business economics.
4. Give the role of a business economist.
5. Distinguish between marginal and incremental change.
6. Distinguish between economic and accounting profit.
7. Explain the concept of time and discounting principle.
8. Explain the concept of efficiency with the help of production possibility
curve.
1. Discuss the nature and scope of business economics.
2. Explain the role and responsibilities of a business economist in a business
firm.
3. Explain the time value of money and the principle of discounting.
4. Explain opportunity cost and production possibility curve.
Chapter 3
Demand: Meaning and
Determinants
‘One difference between a liberal and a pickpocket is that if you demand your money
back from a pickpocket, he won’t question your motives’.
—Anonymous
Learning Objectives
The objective of this chapter is to explain the meaning, determinants and
the law of demand. At the end, the students would be able to understand the
basic concepts of the theory of demand and its important role in business
decisions.
• To introduce the concept of demand
• To understand the determinants of demand and the related concepts
• To know the law of demand and its significance
• To understand individual demand and market demand
INTRODUCTION
Demand and supply are the most basic tools of economic analysis. Both micro
economics and macro economics use them as fundamental tools of analysis. The
tools of demand as well as supply can be used to show how prices and quantities
are determined in a market economy. Diverse economic issues, such as growth,
inflation, unemployment, trade, public finance, etc., are analysed by economists
with the help of these tools.
Demand is one of the most important building blocks of economics. The con-
cept of demand plays a greater role in business economics. The profitability or
success of a firm depends on its ability to minimise its cost. More important than
cost is sales. That is, the demand or willingness of consumers to buy a product
is the most important determinant of a firm’s profitability. Price of a product is
one of the determinants of consumer’s demand for a particular product. The other
factors that influence demand are, such as income and taste of the consumers, style,
reliability, durability, packaging and brand image, availability of close substitutes,
competitor’s sales strategies, etc. Thus, understanding the behaviour of consumers
is the most significant requirement for appropriate pricing and framing best sales
strategies. Demand analysis is an attempt by economists to explain the behaviour
of consumers in a market economy.
Given the pivotal role of demand as a significant determinant of a firm’s profit-
ability, ascertaining the determinants of demand and estimates of expected future
demand will be of great help for business decision makers. Short run business
decisions with regard to cost, revenue, production and profits will be based on
the estimation of current demand. Similarly, long run decisions regarding diver-
sification, expansion, forward planning, etc., will require estimation of future
demand. The estimation of demand and demand forecasting need to be explained
within a larger framework of the theory of consumer behaviour developed by
economists.
DEMAND
Meaning
Demand has a well defined meaning in economics. In ordinary usage, when people
say petrol demand, or kerosene demand, they refer to a mere desire to buy a com-
modity which is also not demand.
In economics, demand for a commodity refers to the willingness to buy it backed
by the ability to pay. In technical terms, demand is a schedule which shows the
various amounts of a product that the consumers are willing and able to purchase
at each price.
Thus, demand refers to a demand curve that traces different quantities of a
product demanded at different prices. Hence, the series of price-quantity combi-
nations (or demand curve) are in the minds of the consumer when he/she enters
the market.
Demand: Meaning and Determinants 37
Demand also implies that consumers can pay for the concerned product, and
that they are also willing to pay the required money. For instance, many may
dream of owning an Audi A4, a luxury car with rain sensing intelligent wipers,
but only a few hundreds in India can convert their desires into demand. This is
because consumers’ choices are subject to one major constraint, viz., their income,
which is limited in relation to their desires. The scarcity of income also makes
the consumer’s choices for different commodities interdependent. That is, people
adjust their purchase of several commodities within their limited income.
Quantity Demanded and Demand

It is important to distinguish between quantity demanded and demand. As they
have different meanings, they need to be used appropriately.
Demand in economics means actions of the consumers. A consumer’s deci-
sion regarding how much of a commodity to be demanded depends on the price
of that commodity, the consumer’s income, taste and preferences, price of other
commodities available, and so on. While quantity demanded depends on a single
factor price, demand depends on all factors, other than price.
Quantity demanded is the number of units of a commodity that a consumer
is willing and able to buy in a given period under a given set of conditions. The
main condition that must be specified would include the price of the commodity,
consumer’s income, taste and all other factors that affect demand. The quantity
demanded—the quantity of the commodity that a consumer wishes and can
purchase—depends on changes in all other factors, such as consumer’s income,
taste, price of other commodities, and so on.
Among the factors that affect demand, price of a commodity plays a key role in
individual markets. Hence, the relationship between price and quantity demanded
is first analysed by using the device of ceteris paribus (Latin phrase for keeping
other things constant).
The distinction between price change that affects the quantity of a commodity
demanded and changes in all other factors, which change the demand or price-
quantity relationship, as a whole is very important. A change in the quantity
demanded is represented by a movement on the demand curve and change in
demand is represented by a shift in the demand curve (discussed below).
Determinants of Demand
As shown above, demand in economics refers to a relationship between price and
the number of units of a commodity that people would want to and can buy. And
demand also depends on many other factors. If it is so, then what are the ultimate
determinants of demand? The answer is that all of them influence demand but
with varying degrees of impact. Demand function is the simple construct that
can be used to explain all the determinants of demand with their varying relative
significance.
For instance, what are the factors that could influence the demand for a single
good, Bajaj Pulsar motorbike (X). The following are some of the factors that affect
its demand:
• Price of the commodity X

• Consumer’s income
• Consumer’s tastes and preferences
• Prices of other brands’ bikes in the market
• Consumer’s wealth
• Expectations about future prices
• Level of advertisement
All these factors (even many more) can be incorporated in the demand function
as:
Dx = f (Px, Y, T, Py, W, S, A, … )
where Dx = demand for commodity X
Px = price of commodity X
Y = consumer’s income
T = consumer’s tastes and preferences
Py = prices of other brands like Honda or Suzuki
W = wealth of consumer
S = future expectations or speculation
A = level of advertisement
The focus of economics is mainly on the relationship between the price of a
product and how much consumers are willing and able to buy. Still, it is important
to examine all determinants of demand for a commodity.
Price of Commodity
Price is one of the most important determinants of demand and the relationship is
explained through law of demand (explained below). Economists have identified
some exceptions to the law of demand; but they are rare cases and not applicable
to all commodities in general. Hence, price is the most significant factor that
determines the demand for a commodity.
Income of Consumer
The income of the consumer is the next significant determinant of demand for
a commodity. There is the positive (direct) relationship between a consumer’s
income and the demand for the commodity. Whatsoever may be the price or other
factors, when income of an individual rises, his demand for the commodity will
certainly expand. Similarly, when income falls, the demand for the commodity
will contract. However, inferior goods are exception to such direct relationship
between income and demand.
Tastes and Preferences of Consumers

Demand for a commodity also depends on the tastes, preferences and latest fash-
ion. Whenever tastes and preferences of the consumer change, his demand also
changes. For example, demand for cut pieces has come down and demand for
ready made garments has gone up due to change in fashion as well as consumer’s
preference.
Price of Other Brands

Some commodities can be substituted for other commodities. For example, the
so called energy drinks, like Horlicks, Boost, Bournvita, are substitutes for each
other. If the price of one brand falls in relation to others, there will be increase
in demand for that particular brand and fall in the demand for others. Thus, the
prices of substitutes and demand for a commodity have an indirect relationship
or they move in opposite directions.
Consumer’s Wealth
Wealth of the consumer or income distribution in the society determine the con-
sumption pattern, and hence the demand for different commodities. The consump-
tion pattern of wealthy people is different from that of poor or middle income
families. The former may demand more luxuries than the latter. Hence, distribution
of rich and poor in a society will determine the demand for different goods.
Level of Advertisement
Advertisement is yet another factor that determines the demand for commodities.
Advertisement can influence consumer’s decision to a considerable extent. Most
of the cosmetic and beverage industries basically depend on advertisement to sell
their products. Hence, the level of advertisement expenditure has a direct relation
with demand.
Future Expectations
An expectation of future price change is another factor that determines the
demand for a product. If consumers believe that the price of petrol will be hiked
next day, they may rush to petrol stations and buy larger quantities than they
normally do.
Other Factors
In the above demand function for a particular product only some known variables
have been listed. These variables may have different degrees influence on the
demand for the product. However, there may also be many unknown variables
that have lesser influence on demand. But the demand analysis has listed the most
significant variables that determine demand, such as:
• Government policy changes
• Number of consumers in the market for a product
• Size of population of a country
• Climate and weather conditions
• State of business or business cycle (boom or recession)
• Consumer innovativeness and new technologies
• Socio-cultural values
LAW OF DEMAND
As noted earlier, for most goods, price of the product is the most significant factor
in determining how much people are willing and able to buy. The law of demand
defines the nature of relationship between price and quantity demanded.
According to the law of demand, there is an inverse relationship between the
price and quantity demanded of a commodity over a period of time, keeping
other things constant.
This fundamental law indicates that as the price of a good decreases, the quan-
tity of the good demanded by the consumer increases (rises) and when the price
increases, the quantity of the good demanded decreases (falls), if other things are
constant at the given time.
Demand Function
The demand function simply specifies the functional relationship between quantity
demanded of a good and all the variables that determine demand. Equations are
the shortest way and the more useful way to represent the law of demand. For
example, if demand for commodity x is ‘qx’, the following equation states that
the quantity demanded of good x. The dependent variable is the function of its
determinants or independent variables, like price ‘Px’ and others.
That is, qx = f(Px, Y, Py, S, A, …,)
Here, ‘Px’ is the independent variable that causes change in ‘qx’. The slash over
all other factors (Y, T, Py, W, S) in the equation indicates that they are constant
for the given period.
The equation shows the functional relationship between the dependent variable,
‘quantity demanded’ of a good, and the independent variables, all determinants
of demand, including the price of the good.
Alfred Marshall defined the law of demand as: ‘The greater the amount sold,
the smaller must be the price at which it is offered, in order that it may find
purchasers; or, in other words, the amount demanded increases with a fall in
price and diminishes with rise in price’.
Thus, the law of demand states that the quantity demanded varies inversely
with price, keeping other things constant.
Assumptions of Law of Demand

The following assumptions are made under the clause ceteris paribus.
1. Consumer’s income remains same
2. Consumer’s tastes and preferences remain same
3. Prices of other goods remain same
4. Prices of substitutes for the goods remain same
5. No change in consumer’s wealth

6. No speculation about future price
7. All factors which can influence demand remain same
Demand Schedule
The demand for a product can also be shown in terms of schedule and curve. These
make it relatively easier to understand the determinants of consumer choice.
As price is the main factor influencing demand, demand schedule shows various
quantities demanded (willing and able to pay) by consumers at different prices.
Table 3.1 Demand Schedule
Price of Good X Quantity Demanded (in units) Points in the Graph

60 5 a
50 7 b
40 10 c
30 15 d
20 20 e
The prices are arbitrarily chosen prices. The demand schedule shows the vari-
ous quantities demanded of a good at different prices. Thus, the schedule explains
the series of combinations of price and quantity of a commodity an individual
consumer is expected to demand. The above schedule shows various quantities
demanded by consumer at five different prices. It is clear from the schedule that
when the price falls from Rs.60 to Rs.50, the quantity demanded expands from
5 to 7.
Demand Curve
Law of demand can also be explained with the help of demand curve. Demand
curve is a simple construct to explain the relationship between price and quantity
demanded. It is a graph depicting the relation-
ship between the price of a commodity and Price
the quantity of it that consumers are willing D
a
and able to buy at the given price. Demand 60
curve is drawn on the assumption that all b
50
other determinants of demand listed earlier c
40
are held constant. d
30
In Figure 3.1, demand curve is drawn to the 20 e
data presented in the demand schedule. The 10
demand curve usually slopes downwards from D¢
left to right reflecting an inverse relationship 0 5 7 10 15 20
between the price and quantity demanded. Quantity demanded
And the downward slope also reflects the ‘law
of demand,’ that is, keeping other things con-
Fig. 3.1 Demand Curve
stant, the quantity demanded of good X will
rise (expand) with every fall in its price and the quantity demanded of good X
will fall (contract) with every rise in its price.’
Any point on the demand curve indicates a particular price-quantity relation.
For instance, point ‘c’ indicates that that when price of good X is Rs. 40, the quan-
tity demanded by the consumer is 10 units. Likewise, joining all the five points
viz. a, b, c, d, and e gives the entire demand curve which shows the complete
functional relationship between price and quantity demanded.
The law of demand was initially based on the law of diminishing marginal
utility. Both laws assumed that utility, a psychological phenomenon, is absolutely
quantifiable, that is, utility is cardinal. But economists have challenged the assump-
tion of cardinal utility. Subsequent approaches argued that though utility can not be
measured in absolute units, it is possible to order or rank. Thus, a consumer can
compare the utility derived from one commodity, say X, against another, say Y. It
is possible to say X gives more satisfaction than Y. Theory of indifference curve
analysis is one such early attempt to place the law of demand on the empirical
and realistic basis. This approach is based on the measurement of utility in ordinal
or relative terms.
Why the demand curve slopes downwards?

Earlier, cardinal utility was the basis of demand analysis. The demand curve slopes
downwards mainly due to the law of diminishing marginal utility. According to the
law of diminishing marginal utility, an additional unit of a commodity gives lesser
satisfaction. The consumer will always try to equate the price of the commodity
with the marginal utility he derives from it. That is, the consumer will try to attain
the following (equilibrium) condition at every point on the demand curve.
MUx = Px
As every additional unit, as per the law of diminishing marginal utility, gives
lesser utility in comparison with the previous units, the consumer is prepared to
pay only a lesser price when he moves down the marginal utility curve, as shown
in Figure 3.2A.
Therefore, the consumer will buy only when his equilibrium condition is ful-
filled. As shown in Figure 3.2A and 3.2B, the demand curve slopes downwards
because the marginal utility curve also slopes downwards and the consumer is at
equilibrium at points where MU1 = P1, MU2 = P2, MU3 = P3, and so on.
Market Demand
The demand curve discussed above is with reference to an individual consumer.
The market demand expresses the quantity demanded of a good in the market as
a whole, i.e., the quantity of a good demanded by all consumers.
The success of a firm basically depends on its sales which, in turn, depend
mainly on setting the right price for a product keeping all consumers in the market.
To know the crucial question of what is the best price for a particular product,
the firm needs to know the total demand of all consumers, or simply the market
demand.
MU P
MU1 P1
MU2 P2
MU3 P3
X1 X2 X3 X1 X2 X3
Quantity demanded Quantity demanded
(a) (b)
Fig. 3.2 (a) Diminishing Marginal Utility Curve, (b) Demand Curve
Table 3.2 Market Demand Schedule
Price per Unit of Good X Quantity of Good X Demanded by
Consumer A Consumer B Market (A+B)

20 6 2 8
18 8 6 14
16 10 12 22
14 12 18 30
12 14 24 38
10 16 30 46
8 18 35 53
Market demand represents the aggregation of individual demands for a firm’s

product. A market demand curve is simply a summation of all individual demands
at various prices. The market demand may be represented by a demand schedule.
The demand schedule can be obtained by summing up all individual demand
schedules, as shown in Table 3.2.
It is assumed that there are only two consumers in the market. To obtain the
market demand (A + B), the quantities demanded by A and B are added at each
price. The market demand curve is the horizontal summation of individual demand
curves, as shown in Figure 3.3.
Market Demand Function

The functional relationship between the quantity demanded of a good in the market
as whole and its determinants can be symbolically expressed as follows.
Qx = f(Px, P1, P2, P3, …. Pn, Y, A)
Price Price Price Market Demand
Quantity demanded Quantity demanded Quantity demanded

(A) (B) (A + B)
Fig. 3.3 Market Demand Curve
where, Qx is the quantity demanded of a good at a given time (or depended

variable) that functionally depends on its determinants (or independent variables)
viz,
Px = price of good X
P1, P2, P3, …. = prices of n other goods
Y = aggregate income all consumers
A = advertisement expenditure
This equation is slightly different from the demand equation of an individual
consumer. It is to be noted that prices charged by all competing brands are
included. With this equation, it is possible to estimate accurately what quantity of
the good would be demanded in the entire market at a given point of time. For
this, the numerical values of all independent variables need to be collected and
used for the estimation of their respective co-efficients that indicate the relative
significance of a each independent variable in determining the market demand.
These estimates are of great use for decision making about the best price for the
product.
Movement along the Demand Curve and Shift in Demand Curve

The relationship between the demand curve and
D
demand function can be explained, respectively,
by movement along the demand curve and shift
in the demand curve. A change in the quantity a
P1
demanded is represented by a movement along
b
the demand curve (up or down, accordingly) keep- P2
ing other factors constant. On the other hand, a
change in other factors or demand is indicated by
a shift in the entire demand curve. D
As discussed earlier, a demand curve shows X1 X2 Q

the relationship between quantity demanded of a
good and price of that good by holding all other Fig. 3.4 Change in Demand
determinants of demand constant.
Given this, any change in price of the good results in changes in the quantity
demanded of a good. This change will be taking place on any points along the
demand curve. Figure 3.4 shows that if the price of good X is at P1, then demand
would be Q1. If, however, the price is reduced to P2, then demand would move
to Q2. As the line DD consists of all such combinations of price and quantity
demanded, any change in price will result in movements along the demand
curve.
So far, it was assumed that other determinants
would be held constant. What would happen if any D1
of those variables in the demand function change?
For example, if income of the consumer increases, D
he may buy more units at each price. This is because
the quantity demanded of a good and consumer’s
income are positively related. Hence, when income
increases, the entire demand curve would shift to
the right indicating that more of the good would be
D D1
bought at higher income.
X1 X2 Q
In Figure 3.5, the entire demand curve shifts
upwards to the right, from DD to D1D1. It is to be
Fig. 3.5 Shift in Demand
noted that more goods are demanded at all prices.
Similarly, a fall in income would push the entire demand curve downwards and
inwards towards the origin. Demand at each price declines as a result of the fall
in consumer’s income.
Hence, similar changes in other determinants in the demand of a good, like
price of substitutes, and so on, would shift the entire demand curve. Such shifts
may be either upward or inward, and it all depends on the nature of the relation-
ship between that particular determinant and quantity demanded of good.

Law of Demand Individual Demand
Market Demand Demand Schedule
Demand Curve Quantity Demanded
Demand Function Determinants of Demand
Downward Slope Diminishing Marginal Utility
Change in Demand Shift in Demand
Chapter Summary
This chapter has introduced the concept of demand and explained the behaviour of
the consumer in a market economy. Along with the law of demand many related
concepts, viz., demand schedule, demand curve and demand function have been
explained.
• Quantity demanded of a good depends on many factors, like price, income,
price of substitutes, taste, etc.
• Among them, price of the good is the most dominant determinant of
demand function.
• According to law of demand, the price and quantity demanded of a good
are inversely related, keeping other things constant.
• Change in demand is due to change in price of the good, whereas shift
in demand curve is due to change in other determinants of demand.
• Market demand is the horizontal summation of individual demand
curves.
Questions
1. Explain the meaning of demand.
2. Give any two features of demand.
3. Give any two determinants of demand.
4. What is the law of demand?
5. State any two assumptions of the law of demand.
6. What is demand schedule?
7. What is demand curve?
8. What is market demand schedule?
9. Explain market demand curve.
10. Why demand curve slopes downwards?
11. What is shift in demand?
12. What is demand function?
1. Explain the factors influencing demand.
2. Distinguish between individual demand and market demand.
3. Explain the law of demand.
4. State the main assumptions of the law of demand.
5. Give a market demand schedule and curve with an illustration.

6. Why does the demand curve slope downward?
7. Discuss the importance of the law of demand.
8. Distinguish between change in demand and shift in demand.
1. What is law of demand? Explain with diagrammatic illustration and
formulae.
2. Explain the demand function and the determinants of demand.
3. Briefly explain the law of demand. Why does demand curve slope
downwards?
4. Distinguish between:
(a) Individual demand and market demand curve
(b) Demand and quantity demanded
(c) Movement along the demand curve and shift in demand curve
Chapter 4
Elasticity of Demand
‘The demand for certainty is one which is natural to man, but is nevertheless an intelleetual
vice’.
—Bertrand Russell
Learning Objectives
This chapter introduces the concept of price elasticity of demand. At the end, the
students would be able to understand the concepts of elasticity of demand, types
of elasticity, determinants of elasticity and its role in business decision making.
• To explain the meaning and types of elasticity of demand
• To discuss the ranges of elasticity along the demand curve
• To understand the different methods of measuring elasticity
• To know the determinants of elasticity of demand
• To learn the importance of elasticity in economic analysis
INTRODUCTION
As per the law of demand, the quantity demanded of a good that a consumer would
buy increases when the price of the good falls and it would decrease with a price rise.
Thus, the law of demand gives only the direction of change in price and quantity
demanded of a good; it does not show the degree of responsiveness, that is, the rate
at which the quantity demanded of a good changes for a marginal change in price or
any other determinant of demand.
For instance, you can see the different degrees of responsiveness in the quantity
demanded for two commodities, viz., rice and carrot, as a result of a uniform change
in their respective prices (Figure 4.1 and Figure 4.2).
Price D Price
R
DC
DC
DR
Q Q¢ Quality Q Q¢ Q ¢¢ Quantity
Fig. 4.1 Price Elasticity of Rice Fig. 4.2 Price Elasticity of Carrot
The difference in the rate of change in demand for the same amount of change in
price is due to different price elasticities of demand for these two goods. That is, for
the same amount of change in price from P to P’ change in the quantity demanded
is higher for carrot than for rice. Such differences in the sensitivity of quantity
demanded to changes in price of a good can precisely be measured by the concept of
elasticity.
It has wider application in tax policies of the government and pricing policies of
the firms. Business decision makers need to know how consumers would react to a
change in price.
The concept of elasticity is useful not only for revenue purpose but also for plan-
ning and efficient use of resources. Knowledge of the demand curve and related
elasticities are very useful for business decisions regarding changing prices as well
as quantum of production. A company may change the price of its good as an experi-
ment and may want to know the precise impact of such price changes on demand and
revenue.
Alfred Marshal introduced the concept of elasticity. The clear formulation of the
concept of elasticity was another significant contribution of Alfred Marshall to demand
theory. Marshall’s discussion of elasticity was not limited to demand but extended to
supply. It has also been extended into cross-price and income elasticities.
ELASTICITY OF DEMAND
Meaning
Elasticity, in general, means the sensitivity or responsiveness of one variable to any
change in another related variable. Price elasticity of demand is a measure of respon-
siveness of the quantity demanded to changes in price. It is expressed as the ratio of
the percentage change in quantity demanded to the percentage change in price. This
ratio captures the extent to which quantity demanded would respond to a change in
price.
Thus, price elasticity of demand, or supply elasticity of demand, is equivalent to
the absolute value of the percentage change in quantity demanded divided by the
percentage change in price of the same commodity.
Types of Elasticity of Demand

The concept of elasticity of demand can be classified with respect to a change in
its determinants, like own price, prices of substitutes or complementary commodi-
ties and income of the consumer. Accordingly, there are three types of elasticity of
demand;
• Price elasticity of demand
• Income elasticity of demand
• Cross elasticity of demand
Price Elasticity of Demand

Price elasticity of demand (PED) is the degree of responsiveness of quantity
demanded to a change in price. It can be defined as the percentage change in quantity
demanded in response to a 1 per cent change in price.
Percentage Change in Quantity Demanded
Price Elasticity of Demand = ___________________________________
Percentage Change in Price
% DQ
Or Price Elasticity of Demand = ______
% DP
Symbolically,
DQ/Q
= ______
DP/P
DQ P
= ___ × __
DP Q
Where P = Price, Q = Quantity and D = Change
Range of Elasticity Along a Linear Demand Curve

Elasticity changes over at cutting point along the demand curve. This is so even when
the slope of the demand curve is linear. That is, the values of elasticity can differ
significantly even along a straight line demand curve.
Price
Ae=a
e=>1
e= 1
P
B
e=<1
e=0
O
q C Quantity
Fig. 4.3 Range of Price Elasticity Values
For instance, consider the linear demand curve in Figure 4.3; it can be divided into
different segments, each with a range of elasticity.
The upper portion PA of the demand curve AC is termed as elastic range because
price elasticity of demand is greater than one in this portion. The lower portion OP of
the demand curve AC is termed as inelastic range because price elasticity of demand
is less than one in this portion. And elasticity at the mid-point of the demand curve at
B is termed as unitary because price elasticity of demand is equal to one.
Table 4.1 provides a summary view of the different range values of price elasticity of
demand, their description and interpretation.
Table 4.1 Price Elasticity of Demand its Range of Values
Elasticity Values Description Interpretation
0 Demand is perfectly the quantity demanded does not change for a

inelastic given change in price
<1 Demand is inelastic the change in quantity demanded is less than
the change in price
=1 Unitary elasticity the change in quantity demanded is same as
the change in price
>1 Demand is elastic the change in quantity demanded is greater
than the change in price
a Demand is perfectly the change in quantity demanded is infinity
elastic for a given change in price
Figure 4.4 presents a graphical version of the various range of values of price
elasticity of demand.
Income Elasticity of Demand

As discussed in Chapter 3, income is the major determinant of demand next to the
commodity’s price. Hence, income elasticity of demand is the degree of responsive-
ness of demand to the change in the income of the consumer.
P P D
p D p
p¢ p¢
D¢
D¢
Q¢ Q Q ¢ Q ¢¢ Q
PED = 0 PED = < 1
Perfectly Inelastic Relatively Inelastic
(a) (b)
P D P
p
p¢
D
D¢ D¢
Q Q¢ Q Q Q¢
PED = 1 PED = > 1
Unitary Elasticity Relatively Elastic
(c) (d)
P
D D¢
Q
PED = a
Perfectly elastic
(e)
Fig. 4.4 Ranges of Price Elasticity of Demand
Percentage Change in Quantity Demanded

Income Elasticity of Demand = ___________________________________
Percentage Change in Consumer’s Income
Symbolically,
DQ/Q
= ______
DY/Y
DQ Y
= ___ × __
DY Q
Where P = Price, Y = Income and D = Change
Cross-elasticity of Demand
Prices of related goods will also affect the demand for a particular good. For
instance, the change in the price of desktop computers will affect the demand for its
substitute – the laptop; the change in the price of petrol will affect the demand for its
complimentary commodity – the car.
The cross-elasticity of demand measures the rate of change in the demand of one
good to changes in price of another related good. Thus, it is the responsiveness of
demand for one good x (say Desktop PCs) to the change in the price of another good
y (say Laptop PCs).
Percentage Change in Quantity Demanded of X
Cross-elasticity of Demand = ________________________________________
Percentage Change in Price of Substitute Good Y
Symbolically,
DQx/Q
= _______
DPy/Py
DQx Py
= ____ × ___
DPy Qx
Where Px = Price of good x, Py = Price of Substitute, Q = Quantity and
D = Change
Price, Revenue and Elasticity of Demand

It is important for a business firm to know not only the magnitude of the quantity
change as result of a price change, but also its impact on total revenue and marginal
revenue.
Revenue: Total, Marginal and Average

The total revenue of a firm is the total earnings from the sale of its product. If
the price change for all consumers is same, then total revenue is price multiplied
by quantity sold.
Total Revenue (TR) = Price (P) × Quantity (Q)
TR = P × Q
In Figure 4.5, TR is bell-shaped. It increases along with sales up to Q1, and
then starts declining.
Marginal revenue is the addition to total revenue from selling the last unit of
output. It represents nothing but the rate of change of total revenue. As shown
in the figure, MR lies below the demand curve. The demand curve is also the
average revenue (AR) curve. Average revenue is simply total revenue (TR) divided
by quantity sold (Q). Average revenue will be identical to price. That is, the price
of the product is the average revenue earned per unit of sales.
Total Revenue
Average Revenue (AR) = ____________
Total Output
TR
AR = ___
Qy
TR Py ◊Q
AR = ___ = _____ = P
Qy Qy
MRnn = TRnn – TRn–1n
The relationship between price, revenue and elasticity of demand is the prime
concern for pricing analysis of a firm. Normally, when the price is very high, sales
will be low because only a few will buy at high price; and, as a result, revenue will
also be low. On the other extreme, if price is zero, sales may be massive but without
any revenue. That is, when price is raised from zero onwards, total revenue will start
increasing. But the total revenue increase will continue only up to a peak, and after
reaching that peak, it will start declining. The reverse will continue until the total
revenue reaches zero level.
Price, MR
e=a
A
e = >1
e=1
P1 = 9
e = <1
e=0
0 Quantity
Q1 MR
TR B
TR
TR
O Quantity
Q1
Fig. 4.5 Elasticity, Total Revenue and Marginal Revenue

Figure 4.5 presents the graphical version of the relationship between demand,
marginal revenue and total revenue (See Box for meaning of these concepts).
Further, it can also help to obtain total revenue. If 18 units of a product are sold at
the price of Rs.9 per unit, the total revenue will be Rs.162 (Rs.9 × 18). In Figure 4.5,
total revenue can be found simply by multiplying the height of the rectangle (or price
P1) with its width (quantity, Q1).
Marginal revenue is the additional revenue from the sale of an extra unit of the
product. Marginal revenue varies with change in price elasticity of demand.
(a) When price elasticity of demand is unitary (PED = 1), change in marginal
revenue will be zero.
(b) When price elasticity of demand is more than one (PED >1), change in
marginal revenue will be positive.
(c) When price elasticity of demand is less than one (PED < 1), change in
marginal revenue will be negative.
For instance, case (c) can be illustrated with Figure 4.5. As per Figure 4.5, the firm
cannot sell more than 18 units at the rate of Rs.9 per unit. To increase sales more than
18 units, price must be brought down. For instance, to sell the 19th unit, price must
drop to Rs.8 and the total revenue will fall from Rs.162 to Rs.152 (19 × Rs.8 = 152).
The marginal revenue has declined to the extent of Rs.10 by the sale of an extra unit.
This is because of the inelastic demand for the product.
Similarly, if the firm increases its price to Rs.12, sales will come down from 18
to 12 units but total revenue will be Rs.144. As demand is elastic in this region (see
Figure 4.5), marginal revenue will be increasing. The lower segment of the mar-
ginal revenue curve is increasing corresponding to the elastic segment of the demand
curve. Whereas, after the peak, the marginal revenue is decreasing as it falls in the
inelastic region.
Thus, the above discussion, shows that firms can always maximise profit by charg-
ing prices where demand is either unitary elastic or elastic.
Table 4.2 gives a summary view of the relationship between elasticity, marginal
revenue and total revenue.
Table 4.2 Price Elasticity of Demand and Revenue
Effect on Total Revenue

Elasticity Values Marginal Revenue For Fall in Price For Rise in Price
Unitary (PED = 1) 0 0 0
Elastic (PED > 1) Positive Increase Decrease
Inelastic (PED < 1) Negative Decrease Increase
Given this scenario, firms need to make sensible decisions about price to be
charged to maximise revenue. Price elasticity of demand will be useful not only to
mark the revenue maximising price but also to make forecasts.
ELASTICITY OF DEMAND: MEASUREMENT

The slope of the demand curve, as shown in Figures 4.1 and 4.2, provides a rough
measure of differing elasticities for the two demand curves; but it cannot provide
an accurate picture. Price elasticity of demand has been defined as the ratio of the
percentage change in quantity demanded to the percentage change in price. Hence,
such percentage changes need to be calculated to arrive at an accurate measure of
elasticity. There are different methods for making such calculations of price elasticity
of demand, as listed below.
(1) Percentage method
(2) Arc Elasticity method
(3) Point method or slope method
Percentage Method
Under this method, elasticity is measured as the relative change in demand divided
by relative change in price, or, percentage change in demand divided by percentage
change in price.
For instance, in Figure 4.6, if the price of milk falls from Rs.8 to Rs.6, the quan-
tity demanded changes from 40 litres to 50 litres, the PED can be computed with the
following formula.
%Dq
PED = _____
%Dp
In terms of percentage, the price fall from Rs.8 to Rs.6 is 25% and rise in demand
from 20 litres to 30 litres is 50%.
p
12
D
10
A
8
B
6
2
D¢
0
10 20 30 40 50 60 q
Fig. 4.6 Measure of Elasticity

%Dq
As PED = _____
%Dp
25
= ___ = 0.5
50
This means that for every one unit fall in price, there is a 0.5 unit increase in
demand.
It is important to note that price elasticity of demand is a pure number and does
not depend on the units in which price and quantity demanded are measured. In the
above illustration, unit of price is measured in rupee and quantity in litres.
The percentage method, however, is an approximate one, and is not accurate
enough to measure the elasticities in non-linear demand curves.
Arc Elasticity Method

If the demand curve is a non-linear curve, percentage change cannot be applied
DQ DQ
because the ratio ___ will not be a constant. The ratio ___ will continuously vary
DP DP
over the gradient of a non-linear demand curve.
In such cases, the alternative measures of price elasticity of demand, namely arc
elasticity and point elasticity, are used. Arc elasticity is a measure of average elastic-
ity. The segment of a demand curve between two points is called as ‘arc’. Arc elastic-
ity measures the average elasticity between two points on a demand curve.
Instead of using only the initial value (as in the case of percentage method), the
arc elasticity method uses the average of both the initial and final values of an arc.
That is, arc elasticity examines an average relationship over a range in the demand
curve. The formula to measure price elasticity of demand by arc method is
DQ
_________ × 100 Price
(Q + Q1)\2
_______________
Arc Elasticity = A
DP
_________ × 100 a
(P + P1)/2 p
The alternative formula is
p¢
DQ
___ b
Q1 p≤
Arc Elasticity = ____ B
DP
___
P1 q q¢ q≤ Quantity
DQ P + P1
Or = ___ × ______ Fig. 4.7 Arc Elasticity of Demand
DP Q + Q1
Point Method or Slope Method

Point method is a relatively better method to measure price elasticity of demand. This
method is particularly useful when the demand curve is not a straight line. By this
method, the price elasticity of demand can be measured at a single point, that is, at a
single price – quantity combination on a given demand curve.
This method uses differentiation to find the effect of an infinitesimally small (mar-
ginal) price change on quantity demanded.
The formula to measure price elasticity of demand by point method is:
dQ
___
Q dQ P
PED = ____ = ___ × __
___ dP Q
dP
P
dQ
where ___ represents the differentiation of Q (quantity demanded) with respect to P
dP
dQ
(price). Differentiation ___ finds the slope of the demand curve at a point.
dP
That is, point elasticity of demand (e) is
P
e = slope of the demand curve × __
Q
FACTORS DETERMINING ELASTICITY OF DEMAND

The elasticity of demand depends on the shape of the demand curve; Some of the
important factors are affecting price elasticity of demand listed below.
1. Availability of substitution commodities
2. Income effect
3. Time element
4. Nature of the commodity
5. Number of uses for the commodity
6. Consumer’s taste
Availability of Substitution Commodities

The substitution effect (discussed elaborately in subsequent chapters) depends on the
availability of substitute commodities. If there are close substitutes available, demand
for a commodity will be more elastic. Otherwise, the reverse will be the case.
Income Effect
The income effect of a fall in the price of a commodity depends on the proportion of
income spent on that particular commodity. The higher the income spent on a given
commodity, the more elastic the demand, keeping other things constant.
Time Element
Time element is another important factor that determines the value of elasticity.
Demand tends to be more elastic in the long run. This is because consumers may
normally take time to adjust their consumption behaviour. Similarly, the demand is
inelastic in the short run because it is difficult for consumers to cut down their con-
sumption suddenly.
Nature of a Commodity
The specific nature of a commodity is yet another important determinant of its price
elasticity. The degree of substitutability of a good will vary from one consumer to
another. It depends on the particular nature of the need that is being satisfied by the
good. A sophisticated camera is a ‘necessity’ for a professional photographer; but it
may be a ‘luxury’ for a common man.
Number of Uses for a Commodity

If the number of uses for a commodity are several, then, the demand will obviously
be more elastic. And the demand will be less elastic if the product has only a few
uses.
Consumer’s Taste
Consumer’s tastes will change continuously; and such changes in tastes towards a
particular commodity will obviously affect the elasticity of demand.
IMPORTANCE OF ELASTICITY
The concept of elasticity of demand is widely used in the decision making of both
private business firms and government. The importance of the tool emanates from its
wider application in such diverse areas. The following are some such areas where the
concept of elasticity is being applied.
Business decision making: The concept of elasticity is of great importance in
the various decision making processes of the business firm. It enables planning
and efficient use of resources. It helps in determining prices as well as quantum of
production. A company may also ascertain the impact of price changes on demand
and revenue.
Price Discrimination: In a monopolistic market condition, the seller can charge
different prices form different consumers in order to eliminating consumer surplus.
Such discrimination can be easily effected with the help of the elasticity of demand.
Taxation: Elasticity of demand is also highly useful in the taxation policy of the
government. It helps the finance minister to fix a particular rate of tax on a commod-
ity based on its demand and elasticity.
Wage Fixation: Elasticity of demand can also be applied in the price determina-
tion of factor market. For instance, wages are normally fixed on the basis of elasticity
of demand for labour.
International Trade: Governments fix the terms of foreign trade like tariff, terms
of trade etc. by using the concept of elasticity. The concept of elasticity is also used
in determining the rate of exchange

Elasticity of Demand Price Discrimination
Price Elasticity Income Elasticity
Cross-elasticity Percentage Method
Point Method Arc Method
Range of Elasticity Income Effect
Slope Method Consumer’s Surplus
Chapter Summary
Elasticity of demand is an important tool in economics as well as in business. This
chapter has introduced the concept of elasticity of demand and its various types,
methods of measurement, determinants and importance.
• Elasticity is a measure of responsiveness in quantity demanded due to
changes in the determinants of demand.
• The three types of elasticity are price elasticity, income elasticity and
cross-elasticity of demand.
• The range of elasticity varies over the demand curve from zero to
infinity.
• The relationship between price, revenue and elasticity is important for
business decisions.
• The three methods to measure price elasticity of demand are percentage
method, point method and arc method.
• Consumer’s income, prices of substitutes, taste and time element are some
of the major determinants of elasticity.
• The concept of elasticity is important for business decision making in
many ways.
Questions
1. What is price elasticity of demand?
2. Briefly state different types of elasticity.
3. Give any two determinants of price elasticity of demand.
4. Define perfectly inelastic demand.
5. Define cross-elasticity of demand.
6. What is unitary elasticity?

7. What is income elasticity of demand?
8. State different methods of measuring elasticity of demand.
9. Explain point method of measuring elasticity.
10. State the percentage method of measuring elasticity of demand.
1. Explain the various types of elasticity of demand.
2. Explain the ranges of elasticity along the demand curve.
3. Explain the various factors influencing elasticity.
4. Distinguish between point and arc methods of measuring elasticity.
5. Explain the relation between price, revenue and elasticity.
6. Explain the various methods of measuring elasticity of demand.
7. Distinguish between percentage and point methods of measuring
elasticity.
8. Explain the importance of the concept of elasticity.
1. Define price elasticity of demand and explain its various values with
suitable illustrations.
2. Explain the following:
1. Price elasticity of demand and its types
2. Income elasticity of demand and its types
3. Cross-elasticity of demand and its types
3. Explain the concept of elasticity and different methods of its measure-
ment.
4. Define price elasticity and explain the determinants of price elasticity.
5. Explain the relationship between elasticity, price, total revenue and
marginal revenue.
6. Explain the factors determining elasticity and its application in decision
making in business and government sectors.
Chapter 5
Demand Forecasting
An economic forecaster is like a cross-eyed javelin thrower; they don’t win many accuracy
contests, but they keep the crowd’s attention
— Anonymous
Learning Objectives
This chapter aims to discuss the role and use of demand forecasting in predicting
consumer behaviour. At the end, the students would be able to understand the
concepts, objectives, and various methods of demand forecasting.
• To introduce the concept of demand forecasting
• To discuss the short-term and long-term objectives of demand forecasting
• To understand the various methods of forecasting demand
• To learn the trend and regression method with illustrations
• To understand the qualities of best forecasting methods
Demand Forecasting 63
INTRODUCTION
The two preceding chapters have discussed several useful concepts in demand analy-
sis; and it was assumed that the demand function for a product was known. However,
in practice, the actual demand function needs to be estimated by using actual data on
demand and its key determinants, like price, income, taste, etc. Such estimation of
demand function or demand forecasting is the subject matter of this chapter.
Demand forecasting is necessary to make use of the demand relationship in busi-
ness decision making. The firm must know what will be the demand for its product
at various time periods, say today, tomorrow, or a month or a year later. Such infor-
mation is essential for the firm to adjust either price, or production, or both in such a
way as to achieve its ultimate goal of profit maximisation.
However, it is not so easy to forecast demand on the basis of the current data.
But, once the demand function is estimated, the firm can acquire substantial benefits.
It can provide accurate insights into the key factors that determine sales. This, in
turn, can help the firm to make good decisions. Further, the knowledge of demand
function and the key determinants of future demand will also help firms in planning
production capacity and in the choice of goods to be produced.
Further, forecasting demand is also equally essential for public sector in various
areas. For instance, the Planning Commission of India may want to estimate the
demand for final housing, primary schools, energy, etc., for the next Five Year Plan.
OBJECTIVES OF DEMAND FORECASTING

The estimation of demand function and demand forecasting have several objectives.
The objectives of demand forecasting may be classified into short-term and long-
term objectives.
Short-Term Objectives
Raw material management: Demand forecasting will be useful to attain effi-
ciency in raw material use and management. Owing to demand estimate, only the
required quantity of raw material would need to be stocked. This also reduces inven-
tory cost.
Short-Term Capital Efficiency: Demand forecasting helps to manage short-
term capital efficiently. The working capital requirement for daily expenses can be
arranged as per the specific requirements of demand forecasting.
Regulation of Sales: Fixing accurate sales target and incentive level for sales as
per demand forecast is yet another useful objective. Selling activities and selling
expenses can also be regulated as per the demand forecast.
Price Policy: Reliable sales forecast will be useful to prepare relevant pricing
polices. If the demand is high as per the forecast, prices can be increased margin-
ally; similarly, when the forecast shows lower demand, a higher price may dip the
sales further. Hence, demand forecast can help to formulate relevant price policies to
maximise profit.
Planning: Given accurate demand forecasting, appropriate production plan and

policies can be formulated in tune with the demand forecast. Such planning can help
to avert either over-production or under-production.
Objectives of Demand Forecasting (Long-Term)

1. Demand forecasting is essential for the firm to ascertain future demand in
the long run. Such long run forecast will be of use to plan for the expan-
sion of the existing plants, new plants or new product launches.
2. Demand forecasting for the long run will be useful to plan for labour
requirements. According to the long-term manpower needs, relevant train-
ing programme may be launched to acquire skilled and trained labour
force.
3. Assessment of long-term demand forecast enables the firm to plan, mobi-
lise and manage adequate capital and financing.
4. Long-term demand forecast can help firms to identify profitable avenues
of investments on the lines of economic growth cycles.
METHODS OF DEMAND FORECASTING

There are different methods to estimate and forecast demand function. The follow-
ing are the three important methods. Each has some merits as well as demerits.
1. Consumer survey or interview
2. Market experimentation
3. Statistical methods
a. Trend projection
b. Regression analysis
Among these three methods, the first two are direct methods, and are used widely
by specialised market research agencies or firms. The statistical method is an indirect
one but is one of the best and is more accurate. It is the single most important method
used in business economics. The two main statistical methods are trend projection
and regression analysis.
Consumer Survey
Consumer survey, or market survey, is the direct method. Firms can obtain informa-
tion about their product by directly asking actual or potential consumers through
survey or interview.
The consumer may simply be asked about the quantity they would buy at various
prices, or their future buying intentions. They may also be asked about their reac-
tion to new products to be launched, or to changes in established products. All these
information can be used to determine the relationship between demand for the firm’s
product and its determinants, like price, income, taste, etc.
Interview or survey can provide quick but excellent information about the prevail-
ing market conditions which may be used to estimate the demand relationship.
The consumer survey can be detailed, or can be quick on-the-street interviews.

Market research agencies widely use pre-tested questionnaires and interviews on
behalf of firms. The results are then aggregated to estimate the demand function,
using which the firms can make more accurate decisions.
One of the major advantages of the consumer survey is that it is very useful when
the existing information is limited. It gives latest information about the current mar-
ket conditions and much useful and supplementary information, like the effect of
advertisement, product characteristics, consumer awareness about relative products,
their prices, etc. It is simple and can provide quick information.
Though the consumer survey technique is simple, quick and useful, its quantity is
limited. The validity of the result is doubtful. The reliability of the result depends on
how accountably the survey is conducted; it is subject to sample bias. For instance,
the respondents may not be actual consumers.
Market Experimentation
Market experiment is yet another direct method of demand forecasting. In this
method, the consumer behaviour is examined in a controlled environment, or in a
segmented market, instead of examining it in a whole market. The demand for the
product at various prices is explored in a relatively small geographical area (like
select cities or shops), or with reference to a specific consumer group. This is also
called test marketing.
Test marketing is quite useful for exploring consumer relation to different prices
or other determinants of demand for the given product. In this method, the actual
spending behaviour of the consumers is observed instead of asking them about their
behaviour.
This method can also be used for investigating other important aspects, such as
regional variations in sales, advertisements, consumer behaviour, etc. It can also
identify problems, if any, in any city or region.
Like the consumer survey method, this direct market method also has some seri-
ous drawbacks.
First, the regions or cities are normally heterogeneous and may not be compa-
rable. The response obtained in one city may not be similar to that of another city.
As the sample is very limited, the results are doubtful.
It is costly and more risky. Controlled variations in the price or product may
adversely affect sales prospects. This method can be used only for a short period.
This method is not useful for identifying long-term trend.
Statistical Methods
Statistical method is an indirect method of demand forecasting but it is the most
effective one. While the above two methods may provide data about demand, they
may not be able to draw accurate inferences about the demand function. Estimation
of demand function requires detailed information about both the dependent variable
(quantity demanded) and independent variables (price, income, price of substitutes,
taste, etc).
The most effective means of estimating the demand function relationship are the
statistical methods, particularly by regression analysis. The cost of demand estima-
tion is also relatively low by regression technique. This method has also gained
wider popularity because of the easy availability of fast computers loaded with pow-
erful statistical software packages like SPSS, SAS, Strata, etc. The demand function
can also be estimated using the trend analysis. Trends can be estimated by various
methods including the regression technique.
Trend Method
Trend method is based on the assumption that past demand patterns can be used to
predict future demand. Economic performance, in general, follows some pattern and
the past pattern can be used to predict future trend.
In the trend method, or time series analysis, past information recorded over time
is used to draw a graph or a line of best fit. This line is called trend line, and it can
then be extended to forecast the future trend.
Time series simply means observations recorded over a period of time. The obser-
vations are normally related to profits, sales, revenues, costs and related variables of
a firm. Time series analysis is used to understand, interpret and estimate many types
of variations in economic variables over time.
Time series has four components, namely
1. Secular trend (T)
2. Seasonal variations (S)
3. Cyclical variations (C)
4. Irregular variations (I)
All above variations are used for forecasting the future cause of events. This chap-
ter is confined to the discussion of only the trend, which can be completed with the
following methods.
1. Free-hand method
2. Semi-average method
3. Moving average method
4. Method of least square
Free-Hand Method
Free-hand method is the simplest method of measuring trend. Time and the con-
cerned variables are plotted, respectively, on the X-axis and Y-axis of a graph. Then
the plotted points are joined together by a free-hand smooth curve to draw a trend
line. It is the easiest method to fit a trend line. It can also be done with the help of
MS-Excel in personal computer.
Though it is the easiest method, the accuracy of the line is limited. And there is
some subjectivity involved in drawing the trend line by the free-hand method.
Figure 5.1 shows the trend line of sales over a period of ten years drawn by free-
hand method.
45
40
35
Sales 30
25
20
15
10
5
0
1 2 3 4 5 6 7 8 9 10
Time Period
Fig. 5.1 Trend Line by Free-Hand Method
Semi-Average Method
This is another simple way of measuring trend. The given data would be divided into
two equal parts. For instance, in case of ten years data on sales, from 1998 to 2007,
the two equal parts will be
First five years (1998-2002), and
Second five years (2003-2007)
In case of odd number of years, say 11, the middle year will be omitted. The aver-
age sales for the two segments will be calculated and plotted against the mid-point of
each part as shown in Table 5.1. Then these two points would be plotted on a graph.
The required trend line is drawn by joining the two plotted points.
Illustration 5.1: The sales figures of a firm over the last ten years are given below.
Fit a trend line by the method of semi-average method.
Year Sales in
00000 units
1998 290
1999 408 Sum of sales in five years (1998-2002) = 2450/5 = 490
2000 525
2001 643
2002 584
2003 707
2004 704
2005 766
2006 807 Sum of sales in five years (2003-2007) = 3840/5 = 768
2007 856
Solution: Semi-average of the first half is 490. It is plotted against the middle year
of that half, i.e., year 2000. Similarly, the semi-average of 768 is plotted against year
2005. The trend line is arrived at by connecting these two points in a graph.
Moving Average Method

This is yet another simple method of fitting trend line. The moving averages are
simply the consecutive arithmetic means of successive data of a series. The moving
averages help to smoothen time series observations. The moving averages can be
calculated for three years, five years, or months, weeks or even days. The following
illustration will explain the procedure.
The data used in Illustration 5.1 can be used to compute three yearly and four
yearly moving averages. Three yearly moving averages of a time series are defined
as follows:
Year Sales in, 00,000 Units 3 Yearly Moving Total 3 Yearly Moving Average
1998 290 - -
1999 408 1223 407.66
2000 525 1576 525.33
2001 643 1752 584
2002 584 1934 644.33
2003 707 1995 665
2004 704 2177 725.66
2005 766 2277 759
2006 807 2429 809.66
2007 856 - -
If the consecutive observation are a, b, c, d…………………, then

a+b+c
MA1 = ________
3
b+c+d
________
MA2 =
3
+d+e
c________
MA3 =
3
In the case of four yearly moving averages, or any even number of years, like 6
or 8, the moving total does not correspond to the middle year. Hence, another mov-
ing total, called as centered moving total is calculated to plot the averages against
the particular mid-year.
The computed values have to be plotted against each mid-point of the three years
to draw the trend line in a graph. For instance, 407.66 should be plotted against the
year 1999, 525.33 against 2000, and so on.
Method of Least Square
The method of least square is a widely used technique to select a single line of best
fit for any time series trend. The trend in demand or sales can formally be estimated
for projection using the method of least square.
The basic aim of the method of least square is to algebraically fit a trend line
whose equation is of the form of the three yearly averages
Y=a+bX
Where, Y = dependent variable (effect)

X = independent variable (cause)
b = slope
a = constant or intercept
On a priori basis, X and Y are related, and in the above case Y depends on X. That
is, the dependent variable Y responds to changes in the independent variable X. And
b, the slope of the line, means the change in the dependent variable Y due to unit
change in independent variable X.
To find the trend line with least deviation of the actual data from its average val-
ues, slope b and constant a need to be computed from the given pair of observations
X and Y. The constant a and slope b can be computed by solving the following two
normal equations.
Straight Line Y = a + bX
Normal equations
SY = na + bS X
SXY = aSX + bSX2
The following illustration can help to understand the method further.
Illustration 5.2: The sales figures of a firm over a period of seven years are given
below. (1) Fit a trend line by the method of least square (2) Based on the trend, proj-
ect the probable sales for the year 2010.
Year 2001 2002 2003 2004 2005 2006 2007
Sales
in million units 5 6 6 7 9 7 10
Solution: The equation for the straight line to be fitted is

Y = a + bX
Where, Y = sales, X = Years, b = slope, a = constant
The normal equations are
SY = na + bSX ...(1)
2
SXY = aSX + bSX ...(2)
To solve the two normal equations the following are needed to be computed from
the given data.
SY, SX, SXY, SX2 and n
Year Sales (million units) Year 2004 Trend Line

=Y =X X2 XY YC = 7.14 + .71X
2001 5 –3 9 –15 5
2002 6 –2 4 –12 5.71
2003 6 –1 1 –6 6.42
2004 7 0 0 0 7.14
2005 9 1 1 9 7.91
Table Contd.
Table Contd.
2006 7 2 4 14 8.62
2007 10 3 9 30 9.33
SY = 50 SX = 0 SX 2 = 28 SXY = 20
By substituting the numerical values in equations (1) and (2), we get

35 = 7a + b(0) ...(3)
20 = a(0) + 28b ...(4)
That is, 35 = 7a
35
a = ___ = 7.14
7
and 20 = 28b
20
b = ___ = .714
28
The computed straight line trend is
YC = 7.14 + .71 X
The trend values YC for each year are computed by substituting their respective X
values in the above equation. For instance, the trend value for the year 2001 is
Y2001 = 7.14 + .71 (–3)
= 7.14 + .71 (–3)
= 7.14 – 2.14 = 5
Similarly, Y2002 = 7.14 + .71 (–2)
= 5.71
The trend values for all years are shown in the last column and it may be noted that
YC changes each year at the
rate of .71 which is the com- Sales
puted co-efficient of X. Thus, 10
sales increase every year by 9
.71 million units.
8
In Figure 5.2, year is mea-
sured on X axis and sales fig- 7
Y = 7.14 | .71X
ures are measured on Y axis. 6
The dots are the actual pairs of
5
values. If all YC values are plot-
ted in the graph it will form a 4
perfect straight line trend. 3
Based on this trend, the
probable sale for the year 2010 2001 2002 2003 2004 2005 2006 2007
Year
can be computed. The value of
X for the 2010 will be 6. By Fig. 5.2 Trend Line fit by Method of Least Squares
substituting this in YC, we get
YC = 7.14 + .71 X
Y2010 = 7.14 + .71 ...(6)
= 11.42.
That is, if the same current trend continues, sales of the firm in the year 2010 will
be 11.42 million units.
Regression Method
Regression method assumes a causal relationship between the independent vari-
able and the dependent variables. In demand function, while changes in quantity
demanded is the dependent variable, the determinants of demand, viz., price, income,
taste, etc., are independent variables. The independent variables are the ‘cause for
any effect’ in the dependent variable.
When the relationship is between one independent variable and one dependent
variable, it is called simple regression; whereas the relationship between one depen-
dent variable and many independent variables is called multiple regressions.
Regression analysis involves a number of stages as listed below:
1. Model Specification
2. Data Collection
3. Specifying regression equation
4. Estimation and interpretation
Specification of Variable or Model Specification: The first step to carry out
regression analysis is to specify the range of variables which may affect demand for
the given product. It is also necessary to specify the specific form of the relationship,
like linear or non-linear.
The demand function provides an a priori basis for this. That is, the relation-
ship between quantity demanded and its determinants is already known. Such known
or theoretically established relation is called deterministic relationship.
Where the relation is unknown or the specification of the form of function is
uncertain, it is called as statistical relationship. In the case of statistical relationship,
the regression co-efficient may be computed with alternative assumptions regarding
the form of the function. The particular specification that explains the maximum
variation is chosen.
In the case of demand function, the relationship is deterministic (or a priori). The
own price of a good is expected to be the main determinant of quantity demanded for
most products.
Q = f(p) ...(5.1)
If the firm wants to know the effect of the price of a substitute good the function
becomes
Q = f(p, y) ...(5.2)
Where ‘Q’ represents sales, ‘p’ represents price and ‘y’ represents income of the
consumer. The question of whether there are any substitute goods, or past prices of
the own good, or consumer’s taste affecting sales could be considered for inclusion.
Similarly, any other factors which affect sales could also be identified.
But, given the limitations of economic theory, non-availability of data on some
variables and difficulties of quantification, it is impossible to identify and include
all relevant variables on the right side of equation 5.2. To account for the omitted
variables in the model, a residual (or error) term needs to be added. Hence, the linear
demand function will be
Q = f(p, y, u) ...(5.3)
where ‘u’ is the error term
Data Co1llection: After identifying all the relevant variables affecting sales, the
data needs to be collected for analysis. The range of information regarding price,
advertisement and rival products can be obtained by observing retail sales. Some of
them may also be available in public domains. Data on consumer’s income, taste,
demographic changes, taxes, etc., can be collected from government sources like
CSO NCAER, Census, etc.
Estimation of Regression: Ordinary least square method is a widely used tech-
nique to estimate both linear and non-linear forms of regression equation. In simple
regression, two variables are used.
The variation in the dependent variable is explained by the independent variables,
by examining the tendency of the former to respond to the movements of the later.
This tendency of the dependent variable to vary must be consistent and systematic
for a regression model to have meaning. Regression analysis aims to determine the
exact and precise form of such tendency.
In the OLS method, ‘least square’ means estimating the ‘line that minimises the
sum of squares of the differences between the observed values of the dependent vari-
able and the fitted values from the line. The following illustration will explain the
relationship between two variables.
Illustration 5.3: Find the regression equation for the following data keeping X as
the independent variable and Y as the dependent variable.
X 8 10 10 14 13 13 16
Y 2 4 6 8 10 12 14
Solution: The regression line of Y on X is

Y = a + bX ...(1)
The most simple formula given by Wonnacoat (1977) to calculate the least squares
slope or regression co-efficient b is
__ __
S(X – X) S(Y – Y)
_______________
b= __
S(X – X)2
__ __
The deviations S(X – X) and S (Y – Y) can be abbreviated further as follows.
__
S(X – X) = x
__
S(Y – Y) = y
Sxy
Now b = ____2
Sx
The computed value of b can be substituted in the regression line to find the value
of the constant a.
__ __
X Y x = S(X – X) y = S(Y – Y) x2 xy
8 2 –4 –6 16 24
10 4 –2 –4 4 8
10 6 –2 –2 4 4
14 8 2 0 4 0
13 10 1 2 1 2
13 12 1 4 1 4
16 14 4 6 16 24
SX = 84 SY= 56 Sx = 0 Sy = 0 SX 2 = 44 SXY = 66
__ 84
SX ___
X = ___
n = 7 = 12
__ SY ___56
Y = ___
n = 7 =8
Sxy
b = ____2
Sx
66
b = ___ = 1.5
44
The value of constant a can be calculated by substituting the value of b in another
simple formula
__ __
a = Y – bX
a = 8 – 1.5(12)
a = 8 – 18 = – 10
Substituting these values of a and b in equation (1), we get the estimated trend
line
YC = –10 + 1.5 X
Or YC = 1.5 X –10
Multiple Regression
In the above illustration, there is only one independent variable that causes changes
in the dependent variable. But the real world is not so simple. An economic vari-
able may change due to many factors. The variables that are possible to identify and
are amenable for quantification need to be included as independent variables in the
regression equation. This will give more accurate estimation and prediction.
For instance, the demand function given below (discussed in Chapter 3) depends
on factors like own price, prices of substitutes, income, taste, climate, tax policy,
etc.
Dx = f(Px, Y, T, Py, W, S, A, ....)
where Dx = demand for commodity X

Px = price of commodity X
Y = consumer’s income
T = consumer’s tastes and preferences
Py = prices of other brands like Honda or Suzuki
W = wealth of consumer
S = future expectations or speculation
A = level of advertisement
Here, quantity demanded has to be estimated and predicted by using multiple
regression analysis. The variables affecting quantity demanded (dependent variable)
will be included as independent variables.
SELECTING BEST FORECASTING METHOD (OR)

QUALITIES OF BEST FORECASTING
As there are many methods to forecast demand with different levels of strength and
weaknesses, firms need to select the most appropriate technique to meet their spe-
cific requirement. To select the appropriate method of forecasting, managers must
ascertain the time and resources involved and the level of accuracy needed.
The following are some of the criteria for selecting the most suitable forecasting
method.
1. Data availability
2. Availability and simplicity
3. Accuracy
4. Reliability
5. Flexibility
6. Durability
7. Time and cost
8. Role of judgement
Data Availability: Availability of adequate past data is the basic requirement to
make any reasonable forecast about the future. Different methods require different
types of data, like time series, cross-section and panel data. Further, the sources may
either be primary or secondary. Therefore, the selection of a particular forecasting
technique depends on the availability of required data for the method.
Accuracy: Level of accuracy is one of the important factors to select the relevant
method of forecasting. Accuracy normally depends on precision with which the inde-
pendent variable can be predicted. As accuracy of different methods of forecasting
varies considerably; the manager has to choose the method according to the required
level of accuracy.
Time and Cost: Some forecasting methods may be effective in the short run while
others may be effective only in the long run. For instance, survey method may be
quick and trend projection involves a longer time horizon. Similarly, cost of using
different methods also varies. Hence, a firm should also consider the time and cost
involved while selecting a particular method of forecasting.
Availability and Simplicity: The data required for forecasting should be simple
and readily available for use. Certain secondary sources of data, like census, is pre-
pared once in ten years. But the National Council of Applied Economic Research
(NCEAR) surveys on consumer spending are available annually. There are also
monthly and weekly statistics, like inflation data. The firm should choose a simple
method that uses immediately available sources of data.
Reliability: Reliability of the results is yet another important criterion in choosing
a specific method of forecasting. Time and resources involved may be considered
but not at the cost of reliability of the predictions. Hence, reliability of the chosen
method’s forecasting capability should be ascertained.
Flexibility: Economic and business conditions are always dynamic. The moment
the required data is collected, many new and sudden developments may take place. A
new policy may be announced, or new entry in the industry may take place bearing
significant effect on sales. Hence, the model should be flexible enough to include
such new variables or conditions.
Durability: Though the model needs to be flexible, the results should be durable.
For instance, the functional relationship of a demand function should be stable and
the forecast should be valid for a reasonable time-span.
Role of Judgement: The role of judgement is the last important factor in choosing
a particular method of forecasting. For instance, application of all the above criteria
may pose challenges because no single method may satisfy all of them. Under such
conditions, the manager should judge effectively to make the best trade-off to choose
a method to suit the resources and requirement.
Formulae
Trend Line by the Method of Least Squares
Straight Line Y = a + bX
Normal equations
SY = na + bSX ...(1)
2
SXY = a SX + bSX ...(2)
Where, Y - dependent variable (effect)
X - independent variable (cause)
b - slope
a - constant or intercept
Regression Line of Y on X
The regression line of Y on X is
Y = a + bX ...(1)
The most simple formula to calculate the least squares slope or regression co-
efficient ‘b’ is
__ __
S(X – X) S(X – Y)
b = _______________
__
S(X – X)2
Sxy
Or = ____2
Sx
The value of constant a can be calculated by substituting the value of b in another
simple formula
__ __
a = Y – bX

Demand Forecasting Objectives of Forecasting
Long-term Objectives Short-Term Objectives
Consumer Survey Market Experiments
Statistical Methods Trend
Free Hand Method Semi-Average Method
Moving Average Method Method of Least Square
Regression Method Model Specification
Multiple Regression Qualities of Best Forecasting
Chapter Summary
Demand forecasting is of the most practical use in economics as well as in business.
This chapter has introduced the concept of demand forecasting and its objectives in
the short and long run. The various methods of demand forecasting with suitable
illustrations and their relative strengths and weaknesses have been explained. The
factors to be considered in selecting the best method of forecasting have also been
discussed.
• Demand forecasting plays a critical role in business decision making.
• It provides an accurate insight about the key determinants of sales and
future demand; it also helps firms for planning production capacity and
the choice of goods to be produced.
• There are many specific objectives in the short-term as well as long-term
for demand forecasting.
• There are mainly three methods to forecast demand, viz., consumer survey
or interview, market experimentation and statistical methods.
• Trend projection and regression analysis are the main techniques of statisti-
cal method.
• Each method has some strengths and weaknesses and choosing the right
method depends on many factors like data availability, accuracy of results,
time and cost involved.
Questions
1. What is demand forecasting?
2. What are the objectives of demand forecasting?
3. What is trend?
4. What is survey method of demand forecasting?
5. What is market experimentation?
6. Explain statistical method of demand forecasting.
7. What is regression method?
8. What is method of least squares?
9. State the qualities of good demand forecasting.
1. What is demand forecasting? Explain its objectives.
2. Discuss the various methods of demand forecasting.
3. Explain the method of least squares to forecast demand.
4. Discuss the various objectives of demand forecasting.
5. Describe the best qualities of good demand forecasting.
6. Compute the trend by the method of three yearly moving average from
the given data.
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008
Sales in, 000 units 110 30 120 140 150 145 155 160 157

1. Explain the various methods of demand forecasting.
2. Explain the various factors to be considered to select an appropriate
method of forecasting.
3. Explain the following:
(a) Free-hand method of trend
(b) Moving average method
(c) Regression method
(d) Least square method
4. Compute the trend line from the given data by the method of least
squares.
Year 2001 2002 2003 2004 2005 2006 2007 2008

Sales in, 000 units 15 16 16 19 18 22 23 25
5. Find the regression line of y = a + bx from the following data.
x 6 5 9 8 2 6
y 7 8 6 5 4 6
Chapter 6
Supply: Law, Determinants
and Market Equilibrium
‘One difference between a liberal and a pickpocket is that if you demand your money back
from a pickpocket, he won’t question your motives’.
—Anonymous
Learning Objectives
This chapter aims to introduce the concept of supply and market equilibrium. It
describes how demand and supply determine market price. At the end, the stu-
dents would be able to understand, the law of supply, its determinants, and how
market attains equilibrium.
• To introduce the concept of supply
• To discuss the law of supply, supply curve and supply function
• To understand the elasticity of supply and its types
• To introduce the concept of backward bending supply curve of labour
• To examine the various determinants of supply
• To understand how demand and supply interact with each other to
determine the equilibrium price and quantity of a commodity in a
market
INTRODUCTION
Along with demand, economic theory deals also with the concept of supply. Supply
and demand together determine the market clearing or equilibrium price and
quantity.
Supply means the quantum of goods offered for sale at alternative prices during
a specific period of time. Business firms supply commodities in output markets and
demand factors of production in input markets. The concept of supply deals with the
behaviour of firms in the output market.
Firms engage in business mainly for profit. A firm can make profit when rev-
enue exceeds costs. Given this scenario, supply decision of a firm normally depends
on profit levels. That is, supply is likely to react to changes in revenue and cost of
production.
The revenue of the firm mainly depends on the price of the product and the num-
ber of units sold. Cost depends mainly on the input prices and technology. As input
prices and technology may remain same in the short run, profit depends on revenue
maximisation, which, in turn, depends on price and sales. The law of supply explains
the relationship between supply and price of the product, given the input prices, tech-
nology and other determinants of supply.
SUPPLY: MEANING AND DEFINITION

Quantity supplied is the amount of a good that a firm would be willing and able to
offer for sale at a given price during a particular time period; other things that affect
supply, like prices of inputs, resources, technology, etc., are assumed to be constant.
Some definitions of supply are given in the Box.
Definitions of Supply
Anotol Murad: Supply refers to the quantity of a commodity offered for sale at
a given price, in a given market, at a given time.
McConnel: Supply may be defined as a schedule which shows the various
amounts of a product which a particular seller is willing and able to produce
and make available for sale in the market at each specific price in a set of pos-
sible prices during a given period.
LAW OF SUPPLY
Law of supply establishes a direct relationship between quantity of a good supplied
and its price. That is, law of supply can be summed up as: other things remaining the
same, an increase in market price would lead to an increase in quantity supplied and
a decrease in market price would lead to a decrease in quantity supplied.
According to this law, price is the major determinant of supply. Generally the
marginal cost of production increases with increase in outout, hence, the rising price
acts as an incentive for firms to supply more.
Supply: Law, Determinants and Market Equilibrium 81
Supply Schedule
The law of supply can be illustrated with the help of supply schedule, supply curve
and supply function. Supply schedule shows how much of a good would be sold at
different prices. Table 6.1 shows the various quantities of a good supplied at different
prices.
Table 6.1 Supply Schedule
Price Quantity Supplied

(Rs. per Kg) (1000 kg per Week)
7 10
9 20
12 30
16 45
20 45
That is, supply Schedule 6.1 simply lists different amounts of the good that
the seller would put up for sale at the alternative prices. For instance, as shown in
Schedule 6.1, the firm sells 10 units (10,000 kg) when the price is Rs.7 per kg. If the
price rises to Rs.9 per kg, it offers 20 units. The firm continues to increase its offer
quantity as price rises. But when the price rises from Rs.16 to Rs.20, quantity sup-
plied no longer increases. This is because the firm’s ability to respond to an increase
in price is limited by its total capacity for production in the short run. Hence, in the
above illustration, the firm’s maximum capacity is 45 units (45,000 kg) at which the
supply stays constant.
Supply Curve
The positive relationship between the quantity of a good supplied and its price can be
graphically presented through a supply curve. Supply curve slopes upward indicating
the direct relationship between price and supply.
The supply curve may be linear
or non-linear. When the supply Price
Supply Curve S
schedule is plotted on a two dimen- 20
sional graph, with price of the good
measured on the Y-axis and the 15
quantity supplied on the X-axis, the
10
outcome is a linear supply curve.
The upward sloping supply curve 5
implies that as price rises, the quan-
tity supplied tends to increase. That 0
is, the producer would supply more 10 20 30 40 50
when the price is higher. Note that Quantity supplied
the positive slope of the supply Fig. 6.1 Needs to be redrawn to measurement
curve becomes vertically steeper
after reaching its full capacity of
45,000 kg.
The supply curve may, alternatively, represent the minimum price that the firm
would want to charge for supplying each quantity.
Supply Function
The question of how much of a product will be supplied will depend on many factors.
The price of a good is one of the most important factors. Other than price, the cost
of production, the technology used, prices of related products, etc., are some of the
determinants of the quantity supplied. The supply function captures the relationship
between the quantity supplied and the determinants of quantity supplied.
Qs = f(Px, C, T, I, Py)
Where
Px = Price of the good
T = Technological know-how,
I = Input prices,
Py = Prices of other substitute.
P P S¢
S
S S ¢¢
P¢
P
S¢
S S ¢¢
O Q Q¢ Q Q¢ Q Q ¢¢ Q
(a) Change in supply (b) Shift in supply
Fig. 6.2
Change and Shift in Supply

Just like demand, price is the major determinant of supply and the other determinants
are related to the conditions of supply. While the price determines slope of the supply
curve, other determinants cause the shift in the supply curve. As shown in Figure 6.2
(a), higher the price, more would be the supply of good, and lower the price, lower
would be the supply.
But both these changes in supply in response to price changes take place on the
supply curve. Thus, any price changes from P to P,¢ or from P¢ to P, bring movement
on the supply curve.
However, change in condition of supply or change in the other determinants of
supply may shift the entire supply curve. For instance, during summer, the ice-cream
supply may increase at the existing price itself, whereas, during winter, it may fall
again. These changes in the condition of supply may shift the supply curve either to
the right (summer) or to the left (winter) as shown in Figure 6.2 (b).
Market Supply Curve

Like demand, the ‘market supply schedule’ is the supply schedule of all firms in
a given industry. The market supply schedule
simply shows the quantity supplied of a partic- S
ular product that sellers are prepared to sell at P ¢¢
different prices in the market in a given period
of time. The market supply function presents
P
this relationship between quantity supplied and
its price and other determinants.
P¢
The relationship between quantity supplied
and its price need to be plotted on the graph to
obtain the supply curve. Thus, market supply
curve represents the total quantity supplied at Total quantity supplied
each price, keeping other things constant. The
market supply curve can be arrived at in the Fig. 6.3 Market Supply Curve
same way as the market demand curve. The
market supply curve can be arrived at by a horizontal summation of individual supply
curve of all firms in the industry. Figure 6.3 shows one such market supply curve.
ELASTICITY OF SUPPLY: MEANING

Elasticity of supply measures the response of a good supplied to a change in the price
of that good. While the law of supply explains the direction of change in supply to
a price change, elasticity of supply explains the rate of change in supply in response
to a price change.
Elasticity of supply can be defined as the ratio between percentage change in
quantity supplied to percentage change in price of the good.
Percentage change in quantity supplied
That is, Elasticity of supply = ________________________________
percentage change in price
Figure 6.4 shows the varying responses in quantity supplied for a uniform price
change. There are two supply curves S and S¢ with different elasticity. For a price
change from P to P¢, supply extends from Q to Q¢ with S. But for the same price
change from P to P¢, supply extends from Q to Q¢¢ with S¢. At price P, therefore, S¢ is
said to be more elastic than S.
Backward Bending Supply Curve

Elasticity of supply, in general, is likely to be positive in output markets as higher
price encourages more supply from firms. However, some interesting problems arise
in the input market, more particularly in the labour market. Consider the case of a
labour supply curve, which shows the quantity of labour supplied at different wage
rates.
P
Wage
S c
S¢
P¢ W* b
P
Q Units of labour
Q Q¢ Q ¢¢
Fig. 6.5 Backward Bending
Fig. 6.4 Elasticity of Supply Supply Curve
Figure 6.5 shows the labour supply curve which is backward bending. The shape
of the labour supply curve explains the response of the households to changes in
wage rate. When there is an increase in wage level, the households get more income.
But they may not increase the supply of labour in response to a hike in wage beyond
certain level because they also value leisure.
Since there are only 24 hours in a day, the individuals face a trade-off between
wages (or goods and services that can be bought by the wage) on one hand, and lei-
sure on the other. The individuals therefore attempt to maximise their total utility by
distributing their 24 hours between labour and leisure.
Initially, when the wage rate increases from the lowest level to higher level, the
individuals increase the supply of their labour to get more income. Hence, below W¢,
the supply curve is upward sloping.
But, when the wage rate increases beyond W¢, the supply of labour starts declining.
This is because when wage rate is sufficiently high to buy the required goods and
services, the individual prefers more leisure to work.
Types of Elasticity of Supply

There are three main types of elasticity of supply which are of economic signifi-
cance. They are:
1. Perfectly Elastic Supply
2. Perfectly Inelastic Supply
3. Unitary Elastic Supply
Perfectly Elastic Supply

In the case of perfectly elastic supply, the co-efficient of elasticity will be infinite (a).
It indicates that when a single firm demands a very small proportion of, say, labour, it
can obtain an infinite amount of supply. Figure 6.6 (a) shows that at a given price of
P, the supply curve is horizontal, which means availability of infinite labour supply.
This is the case of perfect competition in factor market where production takes place
at constant cost.
P P
S
P S
O Q O Q Q
Elasticity of supply = a Elasticity of supply = 0
(a) (c)
Fig. 6.6 (a) Perfectly Elastic Supply (b) Perfectly Inelastic Supply
Perfectly Inelastic Supply

In the case of perfectly inelastic supply, the supply of a good is fixed for any change
in price. The co-efficient of elasticity is equal to zero indicating no change in supply
for any change in price.
Figure 6.6 (b) illustrates the perfectly inelastic supply curve as a vertical line. As
quantity Q is fixed, no change will take place. Perfectly inelastic supply is possible
in the case of rare artifacts, paintings or coins which are limited in supply forever.
Also,
Unitary Elastic Supply P
In the case of unitary elastic supply, the sup- S
ply of a good changes in the same proportion
as the given price change. The co-efficient of
P
elasticity of supply is 1.
Figure 6.7 shows the unitary elastic supply
curve that passes through the origin. P¢
The unitary elastic supply curve has lim-
ited significance in economics as compared
to the unitary elastic demand curve because Q Q¢ Q
the former describes a condition where sup-
Elasticity = 1
ply changes are always in equal proportion to
a given price change. And this may be a rare Fig. 6.7 Unitary Elasticity of Supply
situation.
DETERMINANTS OF SUPPLY
As discussed in the supply function, quantity supplied depends on many factors,
including price. The following are some determinants of supply.
Own Price: As shown earlier, price is the most significant factor affecting the quan-
tity supplied by a firm. As profit is the difference between revenue and cost, higher
price will yield higher revenue as well as profit. Hence, it is obvious that firms would
be willing to supply more at higher price.
Technological Knowledge: An improvement in production techniques is an other
factor that determines the level of supply. If the improved technique reduces cost of
production, supply curve will shift to the right indicating higher supply.
Input Prices: A change in input costs affects the supply curve of a firm. When the
cost of inputs rises, supply tends to fall, and vice versa. An increase in the input price
would increase the cost of the product. As a result, only lesser amount of goods can
be supplied at the old price. A fall in input costs would have an opposite effect.
Invisible Hand
‘Every individual is continually exerting himself to find out the most advanta-
geous employment for whatever capital [income] he can command. It is his own
advantage, indeed, and not that of the society which he has in view. But the
study of his own advantage naturally, or rather necessarily, leads him to prefer
that employment which is most advantageous to society. . . . He intends only his
own gain, and he is in this, as in many other cases, led by an invisible hand to
promote an end which was not part of his intention.’
—Adam Smith, The Wealth of Nations (1776)
Prices of Substitutes: Changes in the prices of the other goods, particularly sub-
stitutes, also affect supply. If the price of a substitute commodity increases, it may
attract more resources for its production. Such shift in production will obviously
reduce the supply of the original product.
Expectations: If the price of a particular product is expected to rise, stocks will be
retained for future sale. That is supply, will fall when there is an expectation for price
increase. Similarly, if the price is expected to fall, stocks will be depleted fast.
Taxes and Subsidies: Government policies of taxation and subsidies affect sup-
ply. A tax that the government imposes on the sale of a good would result in fall in
the quantity supplied for sale at the old price. That is, tax increases the price and
moves the supply curve to the left. A subsidy, on the other hand, cuts the cost and
moves the supply curve to the right indicating higher supply at the old price.
Entry of New Firms: Entry of new firms also affects the supply of existing firms;
when a new firm enters the market and captures a considerable market share, it pro-
portionately reduces the share of other firms. But this is possible only in the long
run.
Non-Economic Factors: Supply can be influenced by many non-economic factors

both in the short run as well as in the long run. For instance, the possible depletion of
non-renewable energy sources or invention of new raw materials may affect the sup-
ply of some goods. Natural disasters, war, changing political climate, etc., are some
of the other non-economic factors.
MARKET EQUILIBRIUM OR PRICE DETERMINATION

Demand and supply are the two most important concepts used to explain the market
mechanism or the behaviour of the market economy. We have discussed how price
determines both demand and supply. In the market equilibrium framework, demand
and supply together determine market price. In a free market economy, demand and
supply alone are expected to determine price and quantity, both in the goods market
and the factor market.
The discussion on demand has highlighted that the demand curve shows the quan-
tities of the commodity consumers would buy at various prices. Similarly, supply
curve shows the quantities that firms would be willing to sell at various prices. But
there is only one price at which the buyer and the seller transact. That price is called
the equilibrium price or the market clearing price. Equilibrium simply means a
balance or a state of rest with no tendency to change.
In a free market economy, economic activities are mostly organised through the
system of market. Buyers and sellers pursue their respective objectives by interact-
ing in the market.
While buyers’ preferences are governed by the utility maximising behaviour, sell-
ers’ preferences are governed by the profit maximising behaviour. Utility maximi-
sation is possible by a price cut whereas profit maximisation is possible by a price
hike.
Equilibrium price or market clearing price is determined by the interaction of these
two opposing interests. As demand and supply curves have the same axes, viz., price
and quantity, both can be combined Price
in a single diagram (Figure 6.8). The
demand curve exhibits the consumer’s S
D S>D
preference, that is, more will be bought Excess Supply
at lower price. The supply curve, on
P¢
the contrary, shows that less will be
supplied at lower price. Given these
diverging preferences, the two curves P* E D=S
have diametrically opposed slopes, and
they also intersect with each other at P ¢¢
price P* and quantity Q*. The point of D>S
intersection, E is called an equilibrium Excess Demand
point where demand is equal to supply
(D = S), and P* is the market clear-
ing price and Q* is the equilibrium Q* Quantity Demanded
quantity.
Fig. 6.8 Equilibrium Price
Given the opposing interest, thus, the consumers are willing to buy Q* quantity at
the price of P*, and the seller is also willing to sell the same quantity at the price of
P*. As quantity demanded by buyers is equivalent to quantity supplied by the sellers
at P*, the equilibrium price is called as market clearing price.
Equilibrium refers to state of rest or balance, and even if there is a deviation, the
original equilibrium would be restored by the market forces, i.e., by the interaction of
supply and demand. Deviation from equilibrium price exhibit either excess demand
or excess supply.
Excess Demand or Shortage in Supply

Excess demand occurs when some buyers are unable to fulfill their demand, or there
is shortage of goods. When goods are in short supply, consumers compete to buy the
goods by bidding higher prices. Auctions are the typical case where prices are raised
by consumers.
When every buyer tries to bid a higher price to buy the desired quantity of goods,
such competition raises the price until it reaches the equilibrium level. This upward
tendency in price is shown by an upward arrow mark in the Figure 6.8.
Excess Supply or Shortage in Demand

Similarly, when there is excess supply, the sellers may find it difficult to sell their
stocks at the current market price. Hence, they may offer special discounts, and when
every seller does so the competition pushes the price downwards until it reaches the
equilibrium price where supply and demand are equal. For instance, during season,
the plantain prices will go down. Clearance sales at discounted prices are also the
case of excess supply.
Such downward tendency in the price due to excess supply is shown by a down-
ward arrow in Figure 6.8. Thus, price acts as a signal to consumers and firms to
restore equilibrium by adjusting the demand or supply.
Demand–Supply Applications
The tools of demand and supply determine price and quantity in a free market econ-
omy. Price, in a competitive market, is expected to equalise the demand and supply
to bring equilibrium price and quantity. This is also called as price system. There are
many applications in our day-to-day life where this price system functions.
The price of vegetables shoots up if there are floods in Karnataka or a strike by
truckers. This is the case of price increase due to shortage in supply.
The price of vegetables also shoots up during festival season. This is the case of
price increase due to excess demand.
Sometimes, when market determined price is beyond the access of poor people, the
state intervenes to protect them through rationing (or public distribution system).
The functioning of the price system can be seen by students on the website of
the National Stock Exchange of India (www.nse-india.com). During trading hours,
one can witness how buy orders and sell orders change in seconds and determine the
price of each share.
Static and Dynamic Equilibrium

In economics, economic equilibrium normally means equilibrium in a market where
the price of a certain commodity has attained a point where the amount supplied of
the product equals the quantity demanded. Thus, the supply and demand balance is
an economic equilibrium.
The equilibrium in the market discussed above is static. However, economic equi-
librium in reality is dynamic in nature. For instance, the equilibrium price of a share
is a case of dynamic equilibrium as it changes continuously. As economic conditions
are ever changing and reality is always dynamic, the static equilibrium discussed
above may not persist. But the concept of equilibrium needs to be considered as an
ideal to be pursued forever.
Partial and General Equilibrium

What has been discussed above is just partial equilibrium with reference to one good
or one sector. But equilibrium may be multi-sectoral where all sectors of an economy
are examined. Such equilibrium is called as general equilibrium.

Equilibrium Law of Supply
Static Equilibrium Dynamic Equilibrium
Partial Equilibrium General Equilibrium
Determinants of Supply Elasticity of Supply
Supply Curve Excess Supply
Supply Function Supply Schedule
Excess Demand Market Mechanism or Price System
Change in Supply Shift in Supply
Quantity Supplied Market Supply Curve
Price Determination Backward Bending Supply Curve
Chapter Summary
Like demand supply is an another dimension of a market economy. Demand and sup-
ply together determine the equilibrium price in a typical market economy. Business
firms should know how the market system functions. This chapter has introduced the
concept of supply, its elasticity and determinants, and how it establishes equilibrium
price along with demand.
• Quantity supplied by a firm mainly depends on price.
• The other determinants are cost of inputs, technology, prices of close
substitutes, etc.
• Change in supply is due to change in the price of the good; whereas shift
in supply is due to change in the other determinants of supply, or supply
conditions.
• Equilibrium price for a product, or for a factor, is determined by the
interaction of supply and demand in a market economy.
• Any deviation from equilibrium will either result in excess supply or ex-
cess demand. In both conditions, the market forces (demand and supply)
will interact to re-establish the balance.
Questions
1. What is supply?
2. Briefly state the law of supply.
3. Define elasticity of supply.
4. Define supply function.
5. Define market supply.
6. Define backward bending supply curve for labour.
7. What are the different types of elasticity of supply?
8. Define market equilibrium.
1. Explain the law of supply.
2. Briefly explain the different types of elasticity of supply?
3. Explain the concepts of supply function, supply schedule and supply curve
with illustrations.
4. Explain market supply.
5. Distinguish between change in supply and shift in supply.
6. What is backward bending supply curve for labour?
7. Explain price determination in a market economy.
8. What are the major determinants of supply?
1. Explain the law of supply and its determinants.
2. Explain the different types of elasticity of supply.
3. Explain backward bending supply curve for labour.
4. Explain how equilibrium price is determined in a market economy.
5. Discuss the various determinants of supply.
6. Briefly discuss the following concepts.
• Supply function
• Excess demand
• Excess supply
• Market equilibrium
• Change and shift in supply
Chapter 7
Theory of Consumer
Behaviour: Demand,
Diminishing Marginal Utility
and Equi-Marginal Utility
‘The laws of economics are to be compared with the laws of the tide, rather than with the
simple and exact laws of gravitation’.
—Alfred Marshal
Learning Objectives
This chapter aims to introduce the most fundamental concepts in economics, viz.,
utility, demand and the cardinal utility theories. The cardinal utility theories (law
of demand and law of diminishing marginal utility) assume that utility is quantifi-
able and explain the behaviour of the consumer.
• To introduce the concept of utility, demand, marginal utility and total
utility
• To explain the law of diminishing marginal utility
• To explain the law of equi-marginal utility
• To understand the concepts of cardinal utility and ordinal utility
INTRODUCTION
The law of demand explains the relationship between price and quantity demanded.
The downward sloping demand curve indicates the manner in which price influences
consumer’s choice. A consumer buys more at lower prices. Why does consumer buy
more when price falls? Or, what is the rationale behind such behaviour of the con-
sumer? Or, simply, why does the demand curve slope downwards? Or, how do people
make choices?
To answer all these questions, one should understand the economist’s construction
of the simple theory of consumer choice. The rationale behind consumer’s choice is
explained first by the marginal utility theory. The basic assumption of these theories
is that consumers will allocate their income between different goods with an ultimate
aim of maximising their utility.
UTILITY
Utility simply means satisfaction gained from the consumption of a product. The
term utility in economics means that a good has the power to satisfy a want. The
satisfaction that a consumer derives from consuming a good is called ‘utility’. Utility,
being a psychological phenomenon, is not amenable to management. Utility cannot
be measured objectively as it is purely subjective in nature, like love, beauty, etc.
Utility is also a relative concept. For instance, an alcoholic may get utility from
alcohol whereas a teetotaller person may not get the same utility.
Paradox of Value
The issue of relative price determination of goods leads to the ‘paradox of
value’. This can be explained with two goods, water and diamond. Water is
a necessity, but its price is low in comparison with diamond, a luxury. Water,
being a necessity, gives more utility than diamond, which has no such usage,
yet water is cheaper and diamond is costlier. So the price of a commodity does
not reflect its use value.
This paradox is explained in terms of relative scarcity, supply and demand. It
is not luxury or necessity that determine value but supply and demand. Supply
and demand determine the relative value, and hence its price. Water, though
a necessity, is available in plenty in relation to demand. But, the supply of dia-
mond in relation to the demand is very less.
Utility is also value neutral between good and bad. Drinking alcohol may dam-
age the individual’s health. But alcohol has utility as it is wanted (or needed) by that
particular individual.
And utility, being a psychological feeling, cannot be explained or demonstrated to
others. It can only be felt by the consumer of the given product.
Measurement of Utility
Utility, being a subjective concept, is different from one individual to another. Even
the same individual may get different levels of satisfaction from the same product at
Theory of Consumer Behaviour: Demand, Diminishing Marginal Utility... 93
different times. For instance, the first cup of coffee in the morning may give more
satisfaction than at noon. Hence, it is very difficult to quantify utility.
Economists like Hicks and Samuelson argued that utility cannot be measured.
However, their predecessor, Alfred Marshall, argued that utility can be measured
indirectly. To get one more unit of a good, how much the consumer is willing to
sacrifice needs to be found. The price of their product is the extent of sacrifice the
consumer would be willing to make to attain the satisfaction or utility of the good.
Hence, price is an indirect way of measuring utility. If the utility is higher the con-
sumer may be willing to pay a higher price, and vice versa. Therefore, price acts as a
measure of utility.
Marginal Utility and Total Utility

The aim of all consumers is maximisation of total utility. But they make their deci-
sions only on the basis of marginal utility. Thus, consumers decide their consumption
at the margin in order to maximise their total utility.
Marginal Utility
Each addition to a given quantity is called marginal change. Utility represents ‘value’
or satisfaction. Marginal utility represents the change in utility from consuming an
additional unit of the product. It is defined as the addition to total utility due to
consumption of an extra unit of the product. Thus, marginal utility is the change in
total utility gained or lost from the consuming or little more of a product.
Total Utility
Total utility represents the summation of utility gained from consuming some amount
of a product. It can be defined as the sum of utilities gained from the each unit of a
good consumed.
For instance, if five units of a good are consumed, total utility is the sum of the
satisfaction derived from consuming in each of the five units of the good. Given the
income, the objective of the consumer is to obtain the greatest possible level of total
utility. The assumption of ‘consumer’s aims to maximise their total utility’ is the
basic formulation of neo-classical economics.
However, the most important idea to be noted is that the utility maximising con-
sumer makes decisions considering only marginal utility and not total utility.
Table 7.1 Utility Schedule
Goods Consumed Total Utility Marginal Utility

Unit Unit
1 9 10
2 14 8
3 17 5
4 18 2
5 18 0
6 16 –2
In economics, decisions are mostly made at the margin. Table 7.1 shows the vari-
ous levels of marginal and total utility from consuming different quantities of a good.
It clearly shows that total utility rises till the consumption of the fourth unit, becomes
zero for the next, and starts falling from the sixth unit.
Figure 7.1 depicts the above schedule in the form of a graph showing the total
utility curve and the marginal utility curve.
Total and marginal utility can be represented symbolically as:
TUn = U1 + U2 + ... Un –1, Un
U1 = Utility from first unit
U2 = Utility from second unit
Un = Utility from nth unit
MUn = TUn – TUn–1
Where MUn = Marginal utility of nth unit
TUn = Total utility from nth unit
TUn–1 = Total utility from n–1th unit
LAW OF DIMINISHING MARGINAL UTILITY

Law of diminishing marginal utility is one
TU
of the early as well as simple theories of
consumer behaviour. It simply states that
‘as additional units of a good are con- TU Curve
sumed, each additional (or marginal) unit
gives less and less utility’. Hence, mar-
ginal utility added to total utility will be
diminishing.
Alfred Marshall’s definition of the law
is as follows:
Quantity of goods consumed Q
‘The additional benefit, which a per-
son derives from a given increase of MU
his stock of a thing, diminishes with
every increase in the stock he already
has.’ MU Curve
Thus, the law states that as the con-

sumer increases consumption of a given
good at a point of time, the marginal util-
ity gained goes on diminishing.
For instance, consumption of a cup of
coffee gives 10 units of satisfaction. If two Quantity of goods consumed Q
cups are consumed at a point of time, the
Fig. 7.1 Total and Marginal Utility Curves
marginal utility will not be 20 units but
less, say, 18 units. Similarly, 3 cups give 23 units and 4 cups give 25 units of satisfac-
tion. Thus, marginal utility decreases as more and more cups of coffee are consumed.
If the consumer gains 18 units of satisfaction from two cups of coffee, utility gained
from the first cup is 10 and the second is 8. Any further increase in consumption of
the same product will eventually reduce the satisfaction gained from each additional
unit.
In Table 7.1, note that consumption of one cup gives 10 units of satisfaction. Two
cups give 18 units of satisfaction. The satisfaction derived from the second cup can
be computed simply by deducting the 10 units of satisfaction from the first cup.
Likewise, the marginal utility from every additional unit can be arrived at.
Why the marginal utility should decline with increase in total consumption? Any
want is fully satisfied. For example, you are thirsty, and you could endlessly drink
water. Off course, the first sip of water should give you high level of satisfaction,
but thereafter, for every additional sip the level of satisfaction should decline and at
some points of time you will stop drinking further, that is, at that time, the marginal
utility of the last sip should be zero. Hence, the marginal utility from highest level in
the first sip, should have declined to zero marginal utility in the last sip. This is the
rationale for diminishing marginal utility.
Marginal Utility and Demand Curve

As noted earlier, consumers aim to maximise their total utility but make decisions at
the ‘margin’, or by considering the marginal utility.
Consumers allocate their given income among different commodities in such a
way as to maximise their total utility. But, with regard to one commodity, they decide
on the basis of marginal utility. Maximisation of total utility occurs at a point when
the consumer cannot increase total utility by any reallocation of his spending. Such
equilibrium takes place when the following condition is fulfilled.
MU1/P1 = MU2/P2 = ..... MUn/Pn
In case of a single good, consumer try to maximise utility by equating his ‘Marginal
Utility’ to the price of that good. For instance, in Figure 7.2, when MU of the first
unit is very high, at ten, the consumer is willing to pay a higher price, P. But when
the second cup gives lesser utility of eight units, the consumer prefers to give a lesser
price, P1, and so on. Thus, over the downward slope of the MU curve, the consumer
is willing to pay prices according to the level of the MU i.e., when MU is high, he is
prepared to pay a higher price, and when it is less he wants to pay a lesser price. This
is the reason why the demand curve is sloping downwards.
Assumptions
The law of diminishing marginal utility is based on certain basic assumptions which
are as follows:
Homogeneous Goods
The units of the goods being consumed must have some similar standards. They
should be identical or homogeneous, like cups of coffee, or pairs of shoes, or glasses
of drink, from the utility point of view.
MU of X Price of X
MU ¢ P¢
P ¢¢
MU ¢¢
MU ¢¢¢ P ¢¢¢
X¢ X¢¢ X¢¢¢ Quantity of X X¢ X¢¢ X¢¢¢ Quantity of X

MU
Fig. 7.2 Marginal Utility and Price
Static Condition
The law is operational only under a static condition, that is, all units of the good are
consumed at a given time. There is no time interval between the successive units of
consumption. This static condition is the most important basis of the law.
Rationality
The consumer is assumed to be rational. This is the basic assumption of neo-classical
economics as a whole. According to this assumption, a consumer will try to maxi-
mise his total utility. He will do so by satisfying his wants in the order of preference
and by allocating his limited income for the consumption of different commodities.
Constant Taste
The taste, habits, customs and preferences of the consumer are assumed to remain
constant in the short run. Any change in any one of them may affect the operation-
alisation of the law.
Cardinal Utility
The law assumes that utility is cardinal, that is, utility can be measured in numerical
units. A hypothetical measuring scale, utils, is being used to quantify the level of
utility.
Exceptions to the Law of Diminishing Marginal Utility

The law of diminishing marginal utility may not be universally applicable. There are
exceptions to this law. Some such exceptional cases where the law would not hold
good are given:
Liquor: Marginal utility may not diminish in the case of alcohol. A drunkard,
though drinking continuously, may not have diminishing marginal utility.
Money: It is also noticed that diminishing marginal utility does not apply to money.
The human greed drives people to earn more and more money, and they do not see
any diminishing marginal utility.
Hobbies: Some types of hobbies, viz., collection of stamps and coins (specially
old stamps and coins) offer more satisfaction to a person instead of diminishing
satisfaction with increasing collection.
Importance of the Law of Diminishing Marginal Utility

Some points highlighting the importance of the law are given below:
1. The law of diminishing marginal utility provides the basic framework for
the cardinal utility theory of consumer behaviour.
2. The law of diminishing marginal utility provides the foundation for the
theory of taxation.
3. Based on this law, business firms can change the design, packing and style
of their goods.
Limitations of the Law of Diminishing Marginal Utility

The law of diminishing marginal utility, though important in many respects, suffers
from many limitations. Some of them are given below:
1. The assumption of cardinal utility is unrealistic, and it has been severely
criticised by the proponents of ordinal utility theories.
2. There are many exceptions to this law, like drunkards and drug addicts,
collectors of rare coins and artefacts, etc. This law would not operate in
such cases.
3. Consumers would consume many goods as against the assumption of
single good consumption.
4. The assumption of constant utility of money is another unrealistic
assumption.
5. Consumers are not always rational. Their choices are sometimes governed
by emotions or, demonstration effects.
LAW OF EQUI-MARGINAL UTILITY

While the law of diminishing marginal utility explains the behaviour of the consumer
with reference to one good, the law of equi-marginal utility explains the consumer
behaviour when he consumes two or more commodities. This law is also known as
the principle of proportionality between prices and marginal utility or the law of
substitution or the law of maximum satisfaction.
Consumers do not normally make choices with reference to one single good, they
choose from among many goods at a time. They also substitute one good for another.
As wants are unlimited, the limited income of the consumer needs to be allocated
optimally among many goods.
The law of equi-marginal utility explains how consumers distribute their limited
income among various commodities to attain maximum possible satisfaction.
Assumptions
The law of equi-marginal utility is based on the following assumptions.
1. Utility of a commodity is cardinal, i.e., quantifiable or measurable.
2. The consumer is rational and always prefers more to less.
3. Marginal utility of money is assumed to be constant.
4. The price of the commodity and income of the consumer are fixed.
5. It is operative only in the case of two or more goods.
Definition and Meaning

Alfred Marshall, who advanced this law, defined it as follows:
‘If a person has a thing which can be put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all’.
According to the law of equi-marginal utility, the limited income of the consumer
is spent on more than one good in such a way that the marginal utility derived from
the spending on each good is equal.
In other words, consumer income will be spent on buying many goods in such a
way that the marginal utility derived from each rupee spent on all the goods will be
equal. This way, the consumer will be aiming to get the maximum utility from his
given income.
Consumer’s Equilibrium
Assume that the consumer wants to spend his given income on two goods, namely,
A and B. As the consumer is assumed to be rational, his aim is getting more satisfac-
tion from his limited income. Towards that, he is expected to allocate his limited
income to buy goods A and B in such a way that he maximises his total utility or
satisfaction.
The point of equilibrium is the one where he gets maximum utility from his total
expenditure incurred on the two goods, A and B. In other words, the consumer will
be in equilibrium at the point where the satisfaction gained from the last rupee spent
on both goods (A and B) is equal.
In terms of an equation, the consumer will be in equilibrium at a point where the
ratio of marginal utility derived from good A to price of A is equal to the similar ratio
for good B.
Thus,
MUA MUB
MUM = _____ = _____
PA PB
Where,
MUA = Marginal utility of good A
MUB = Marginal utility of good B
PA = Price of good A
PB = Price of good B
MUM = Marginal utility of money
Table 7.2 Marginal Utilities of Two Goods
Units MUx (Units) MUy (Units)

1 10 12
2 8 9
3 6 6
4 4 3
5 2 0
6 0 –3
7 –2 –6
MUA MUB
The marginal utilities of money expenditure are the ratios _____ and _____. These
PA PB
two ratios refer to the marginal utility of each rupee spent on the each good.
The law of equi-marginal utility can also be presented with the help of the follow-
ing tables and curve.
If the price of good A is Rs.2 and B is Rs.3, the marginal utility of money expen-
diture on goods A and B can be calculated by dividing the marginal utilities by their
respective prices.
Table 7.3 Marginal Utility of Money Expenditure
MUA
____ MUB
____
Units in Utils in Utils
PA PB
1 5 4
2 4 3
3 3 2
4 2 1
5 1 0
6 0 –1
7 –1 –2
Table 7.3 shows the marginal utility derived from each rupee spent, respectively,
on good A and good B. They are declining due to the operation of diminishing mar-
ginal utility. The marginal utility derived from each rupee spent on good A becomes
negative after the sixth unit. In the case of good B, the marginal utility turns out to be
negative after the fifth unit itself.
According to the law of equi-marginal utility, the consumer would buy either two
units of A and one unit of B, or three units of A and two units of B, or five units of
A and four units of B. The pair of consumer choice depends on his level of income.
But, whatever may be the income, the consumer would allocate his income in such
MUA MUB
a way that the ratios _____ and _____ are equal. He would continue to buy upto five
PA PB
units of A and four units of B because, after this the respective marginal utilities
would become zero. And the consumer would not choose either two units of A and B
or three units of A and B because, in such cases, the marginal utilities are not equal.
Thus, the important point to be noted is that the consumer would equate marginal
utility of each rupee spent on the two goods.
Figure 7.3 illustrates the law of equi-marginal utility with the help of equi-mar-
ginal utility curves. Curves AA and BB are the marginal utility curves of good A and
good B. Both curves have been drawn by plotting the marginal utility of money spent
MUA MUB
on the two goods. Thus, the values of the two ratios _____ and _____ are plotted on
PA PB
the Y-axis and the quantity of the two goods are measured on the X-axis. Both the
curves slope downwards indicating the operation of the law of diminishing marginal
utility.
Marginal utility of Money Expanditure
MU of A
A
P of A
(Units per rupee)
B
MU of B
P of B
MU of
E money
O b a B A Quantity
Fig. 7.3 Equi-Marginal Utility Curves
Having assumed marginal utility of money as constant, the expenditure level mea-
sured on the Y-axis depends on the income of the consumer. Suppose if the income is
at OE, a horizontal line drawn from point OE will intersect AA and BB. A vertical line
from the point of intersections will fix the quantity of good A at point Oa and quan-
tity of good B at point Ob on the quantity axis. At these levels the marginal utility
of money spent on both the goods are equal. Thus, the consumer has distributed his
income between two goods with the help of the downward sloping marginal utility
curves in such a way that the marginal utility of each rupee spent on the two goods is
MUA MUB
equal. Hence, this is the equilibrium point where MUM = _____ = _____.
PA PB
Any change in income may bring a shift on the Y-axis but the above equality will
hold intact at each level because of the two parallel downward sloping marginal util-
ity curves.
Limitations of Law of Equi-Marginal Utility

The following are some of the limitations of the law of equi-marginal utility.
1. The assumption of cardinal utility is unrealistic.

2. Indivisibility of many goods poses serious difficulty in applying this
law.
3. Money is like any other good and its marginal utility is not constant.
4. Utilities of various goods are interdependent; but the law assumes that
they are independent.
CARDINAL AND ORDINAL UTILITY THEORIES AND THEORIES

OF RISK AND UNCERTAINTY
The theories of consumer behaviour can be divided under three major categories:
1. Cardinal utility theories
2. Ordinal utility theories
3. Theories of risk and uncertainty
Cardinal Utility Theory

The Cardinal Utility theories assume that utility is quantifiable. Utility can be
measured by hypothetical measure, namely ‘utils’. Many economists, like Alfred
Marshall, Carl Menger and J. Benthem, have made use of this assumption to build
their theories. Law of Diminishing Marginal Utility, Law of Equi-Marginal Utility
and Law of Demand have been constructed with this assumption as the basis.
Ordinal Utility Theory

The ordinal utility theories argue that utility is a psychological phenomenon, like
happiness, satisfaction or feelings. Most of them are highly subjective in nature and
they may vary from one individual to the other. Hence, they cannot be quantified
in precise numerical terms. However, they may be ranked or ordered like beauty or
other qualitative variables. Thus, utility can be ordered in relative terms like ‘less
than’ or ‘greater than’.
Economists like J.R. Hicks, Paul Samuelson and R.G.D Allen have contributed a
great deal in the formulation of ordinal utility theories. Indifference Curve Analysis
and Revealed Preference Axiom are some of the major ordinal theories of consumer
behaviour.
Theories of Risk and Uncertainty

Both the cardinal and ordinal theories of consumer behaviour assume certainty in
conditions. More particularly, they assume that the choices of consumers and their
outcomes are certain. For instance, the consumer pays a certain price for a good
because he is certain about the outcome or utility he would gain from the good.
But, in real life, there are many situations with uncertain outcomes or elements
of risk. How a consumer will make choices when the outcomes are uncertain or
involves risks? Economists like John von Neumann, Oskar Morgenstern, Friedman
and Saveage have developed theories that explain the behaviour of the consumer
under risk and uncertain conditions.

Utility Cardinal Utility
Marginal Utility Ordinal Utility
Total Utility Diminishing Marginal Utility
Equi–Marginal Utility Consumer Behaviour
Homogeneous Goods Consumer’s Equilibrium
Risk and Uncertainty Money Expenditure
Utility Maximisation Rationality
Chapter Summary
The behaviour of the consumer in the market has been explained in this chapter. For
this purpose, we analysed
• The relationship between total utility and marginal utility
• The demand curve is derived from marginal utility curve
• Consumer maximises his utility at the point of equilibrium
• Importance of Diminishing Marginal Utility in the real world
• Equi-Marginal Utility explains the consumer behaviour with regard to two
goods.
Questions
1. What is utility?
2. What is marginal utility?
3. Differentiate between marginal and total utility.
4. What is meant by consumer’s equilibrium?
5. What is meant by cardinal utility?
1. Distinguish between the concept of marginal utility and total utility.
2. Explain the derivation of demand curve from diminishing marginal utility
curve.
3. State the assumptions of the law of diminishing marginal utility.
4. State the importance of the law of diminishing marginal utility.
5. Explain the law of diminishing marginal utility.
6. What are the exceptions to the law of diminishing marginal utility?

7. What are the limitations of law of diminishing marginal utility?
8. State the assumptions of the law of equi–marginal utility.
C. Long-Answer Questions
1. Explain the meaning and importance of the law of diminishing marginal
utility.
2. Explain the behaviour of the consumer through the law of diminishing
marginal utility.
3. Explain consumer’s equilibrium in the law of equi–marginal utility.
4. Discuss the important cardinal utility theories of consumer behaviour.
Chapter 8
Theory of Consumer
Behaviour: Indifference
Curve Approach
‘Contentment is natural wealth; luxury is artificial poverty’.
—Socrates
Learning Objectives
This chapter aims to introduce an important approach for consumer behaviour
that is, ordinal utility theory, viz., indifference curve approach. The indifference
curve approach argues that utility, being a psychological phenomenon, cannot be
measured in numerical units; but it is possible for a consumer to rank or order
commodities based on the level of utility derived from each one.
• To introduce the concept of ordinal utility
• To explain the behaviour of the consumer by indifference curve
approach
• To explain the concepts of price effect, income effect, and substitution
effect through indifference curve approach
• To derive demand curve using indifference curve analysis
Theory of Consumer Behaviour: Indifference Curve Approach 105
INTRODUCTION
Business firms produce commodities to make profit. They produce with the
expectation that the consumers would buy their products. Thus, it is necessary to
understand the preferences of the consumers, or their behaviour. Such understand-
ing can also help firms to modify their products in order to meet the expectations
or changing consumer tastes. Some multi-national corporations (MNC) have the
practice of modifying their products continuously and introducing different brands
mainly to discourage competition or new entry.
Consumers are assumed to behave in a rational manner. Like profit maximising
firms, consumers aim to maximise their satisfaction or utility at minimum cost.
The theory of consumer behaviour, discussed in the earlier chapter, is based on the
assumption of cardinal utility. The cardinal utility theory also treats that utility is
susceptible to cardinal measurement.
The Marshalian approach has been criticised for its restrictive and unrealistic
assumption of measuring utility by hypothetical cardinal units. Economists have
challenged its scientific validity. In 1934, J.R. Hicks and R.G.D. Allen argued that
the law of demand could be derived based on the principle of rational choice without
the assumption of cardinal utility. They developed the indifference curve approach
as an alternative to explain the behaviour of the consumer. But Johnson and Slutsky
had independently developed the same approach as early as in 1913 and 1915.
INDIFFERENCE CURVE APPROACH

Indifference curve approach is based on the ordinal measurement of utility. This
approach begins with the premise that each consumer is able to consistently rank
his preferences for various commodities based on the level of utility he/she derives
from each commodity. Hence, this approach is also called ‘preference approach’. It
also helps to analyse the effects of price and income changes on the preference of
the consumer.
Indifference Curve: Meaning

Indifference curve represents consumer’s choice set and preferences. ‘Indifference’
simply means ‘no difference’.
An indifference curve is the locus of points, each representing a combination of
some amount of good X and some amount of good Y, that yield the same amount of
satisfaction to the consumer.
Definition
Indifference curve is the locus of points representing parts of quantities between
which the individual is indifferent, and so it is termed as an indifference
curve’
—J.K. Hicks
Assume there are two goods fruits and vegetables. A consumer has to choose
between three combination A (3 fruits + 1 vegetable), B (2 fruits + 2 vegetables) and
C (1 fruit + 4 vegetables). All these three combinations give the same level of sat-
isfaction. Obviously, the consumer will be indifferent between three combinations.
Why these combinations should give the same level of satisfaction? Suppose com-
bination A gives a particular level of satisfaction. When the consumer moves from
combination A to combination B. He/She losses 1 fruit but gain 1 vegetable, thus the
loss in fruit is compensated by the gain in vegetables. Therefore the satisfaction from
A should be equal to satisfaction from B and the consumer is indifferent between A
and B. Similarly as the consumer moves from B to C, he/she losses 1 fruit but gains
2 vegetables. Once again, the
loss in fruit is compensated by Fruits (Y )
gain in vegetables, therefore the
consumer is indifferent between
B and C. The indifference curve
A
(IC) in Figure 8.1 represents a
level of utility that a consumer
can obtain from buying various
combinations of X and Y on the B
indifference curve. The points A,
B and C represent three differ-
C
ent combinations of good X and IC
good Y. But all the three com-
binations provide the same level O
of satisfaction to the consumer. Fish (X )
Hence, the consumer is indiffer-
Fig. 8.1 Indifference Curve
ent between any combinations
on the indifference curve.
Assumptions of Indifference Curve Approach

The indifference curve approach is based on the following assumptions.
Rationality: The consumer is assumed to be rational. This is a general assumption
being followed in most of neo-classical economics. It means that a consumer always
wants to maximise his satisfaction. In simple terms, ‘more is better’ for any consumer
because ‘more’ is expected to make him better-off.
Ordinal Utility: Utility is assumed to be amenable only for ordinal ranking. Utility
cannot be quantified in numerical units as assumed by the cardinal utility theory. But
the levels of satisfaction can be ranked in order of consumer preferences.
Diminishing Marginal Rate of Substitution (DMRSXY): It is assumed that the
marginal rate at which the consumer is willing to substitute one good for another
will be diminishing in such a way as to keep the same total utility on the indifference
curve. This is mainly due to the law of diminishing marginal utility (detailed expla-
nation is given below).
Transitivity: The indifference curve approach also assumes that consumers are
capable of choosing among the various combinations of goods. While choosing, their
choice is assumed to be transitive, that is, if the consumer prefers A over B, and B
over C, then he must prefer A over C.
Consistency: Consumer’s choice is also assumed to be consistent. If a consumer
prefers A to B, then he should not prefer B to A, that is, the consumer will always be
consistent in his choice.
Diminishing Marginal Rate of Substitution (DMRSXY)

Diminishing marginal rate of substitution (DMRSXY) between two goods (X and Y)
is the fundamental assumption of the indifference curve approach. According to this
assumption, the rate at which one good is substituted for another will be diminish-
ing so that the total utility from the two goods remains the same on all combinations
of the indifference curve. The convex shape of the indifference curve is due to the
operation of DMRSXY.
The DMRSXY emanates from the law of diminishing marginal utility. The concept
of DMRSXY can be illustrated with help of a diagram.
In Figure 8.2, a comparison of two segments a-a¢ and b-b¢ can help to the under-
stand the law of diminishing marginal utility and DMRSXY. Moving from point a to
a¢, the consumer is prepared to sacrifice a larger amount of good Y (i.e. Y-Y’) to gain a
small amount of good X (i.e. X-X¢). But at the lower segment of the same indifference
curve, the rate of trade-off between X and Y gets reversed. Moving from point b to b¢,
the consumer is willing to trade-off only a smaller amount of Y (i.e., Y¢¢-Y¢¢¢ ) to gain
a substantial amount of X (i.e., X¢¢-X¢¢¢ ).
Good Y
Y a
Y¢ a¢
b
Y≤ b¢
Y¢≤ IC
O
X X¢ X≤ X¢≤ Good X
Fig. 8.2 Diminishing Marginal Rate of Substitution Between X and Y

Such changing trade-off is due to the law of diminishing marginal utility. Between
the segment a-a¢ the marginal utility of good Y must be very low because the con-
sumer is already consuming a large amount of good Y. But the marginal utility of
good X in this segment (a-a¢) is very high because the consumer is consuming a small
amount of good X. The consumer, by moving from a to a¢, however, continues to gain
the same level of total utility because the utility lost by giving up more of Y is com-
pensated by the gain of same utility from a smaller quantity of X. Because of such
differing marginal utility, the consumer is willing to give up more of Y for smaller
quantity of X in the segment a-a¢.
On the contrary, in the segment b-b’ in the indifference curve, the consumer is
willing to sacrifice only a small amount of good Y to gain a larger amount of good X.
This is because the consumption of good Y has come down, as a result, its marginal
utility has increased; whereas the increased consumption of good X has reduced its
marginal utility. Therefore, the consumer has reduced the rate at which good Y would
be given up for good X.
The marginal rate of substitution between good X and good Y is equivalent to the
ratio of the marginal utilities of the two goods.
MUX
Thus, MRSXY = _____
MUY
The ratio is also the slope of the indifference curve at a given point. Hence,
MUX
Slope of Indifference Curve = MRSXY = _____
MUY
The slope or the ratio would fall while moving downward from left to right on
the indifference curve that is MRSxy diminishes. Such falling rate of substitution is
called the Diminishing Marginal Rate of Substitution (DMRSXY).
Properties of the Indifference Curve

Based on the assumptions discussed above, the following properties can be attributed
to the indifference curve.
Negative Slope
Indifference curve always has a negative or downward slope. Negative slope means
as Y declines X increases. Any other shape like flat or upward slope would not satisfy
the assumption of rationality.
We have already seen, if the consumer should get the same level of satisfaction,
then decline in Y should be compensated by increase in X. Thus, the indifference
curve has to be necessarily downward slopping.
Hicks on Negative Slope

‘So long as each commodity has a positive marginal utility, the indifference
curve must slope downward to the right’ —J.R. Hicks
Indifference Curves are Convex to the Origin

Each indifference curve must be convex to the origin. Convexity of the indiffer-
ence curve implies the diminishing MRSXY operates. We have already explained why
there is diminishing MRSXY.
Higher Indifference Curve Means Greater Utility

Higher indifference curves yield higher levels of satisfaction. For every point on the
X-Y quadrant, an indifference curve can be drawn. This way an indifference map
can be constructed; and, within that map, higher indifference curves indicate higher
levels of satisfaction because they consist of larger quantity of at least one or both the
goods. Larger quantities of goods on a higher indifference curve yield greater satis-
faction than lesser quantities on lower indifference curves (See Figure 8.4).
Indifference Curves Never Intersect

Indifference curves never intersect with each other and they cannot be tangent to one
another. This is an important property of indifference curves. Violations of this prop-
erty will go against the definition of the
indifference curve itself. Good Y
Suppose, in Figure 8.3, IC1 is
greater than IC2 points b and a are in
IC1 giving greater satisfaction than c
points on IC2. Similarly, points C and b
a are on IC2 giving lesser satisfaction
a
than points on IC1. Now it is paradoxi-
cal for point a to give two different lev-
els of satisfaction, hence indifference IC1
curves cannot intersect each other. IC2
O
Good X
Indifference Map
Fig. 8.3 Indifference Curve won’t intersect
An indifference curve is drawn by join-
ing various combinations of goods
X and Y that provide the same level Good Y
of satisfaction. Similar indifference
curves with varying levels of satis-
faction can be drawn within the same
quadrant. Such indifference curves
are called indifference map. Figure
8.4 shows a typical indifference map.
For each point in the X-Y quadrant,
an indifference curve can be drawn. IC4
IC3
Hence, within two indifference curves, IC2
say IC1 and IC2, innumerable indiffer- IC1
O
ence curves can be drawn. Good X
Thus, an indifference map consists Fig. 8.4 Indifference Map
of infinite number of indifference
curves. The basic question, however, is, the given such vast number of indifference
curves, which one would the consumer choose? The concept of budget line would be
used to understand this issue.
Budget Line or Price Line

Let us assume the concept of budget line simply defines the set of possible choices
available to the consumer, given the price of the good and the income of the
consumer.
Suppose, if the given money Good Y
income ‘M’ has to be spent on M /Py
two goods, viz., X and Y, then the
A
budget line may take the form as
in Figure 8.5. The budget line A
indicates that, given the prices of
good X and good Y, the maximum
amount the consumer can buy. OA
is the maximum quantity of good Y M /Px
that can be purchased if all income
is spent on good Y. Similarly, if all O B Good X
income is spent on X, OB is the
maximum quantity of good X the Fig. 8.5 Budget Line or Price Line
consumer can buy.
The consumer is able to buy any combinations on or within the budget line. A con-
sumer can buy any combination of X and Y that lie between these two points, A and
B, on the budget line. He can substitute good X for good Y, or vice versa. Any point
on the budget line exhausts the given income of the consumer. Combinations above
the budget line are not reachable because such combinations cost the consumer more
than the given. Similarly, the combinations below the budget line are available to the
consumer but he may not prefer them because he cannot spend all his income. As a
rational consumer, he is expected to buy more of good X as well as good Y within his
income. Any point on the budge line exhausts the given income of the consumer. The
Budget line can be defined, as a locus of all points that show different combinations
of X and Y that have a total expenditure equal to the given income (or) the budget line
shows different combinations of X and Y, spending all the given income, at the given
prices of X and Y.
AB = Y = Px X + Py Y
Where, Y = income of the consumer, AB is the budget line
Px = Price of good X
Py = Price of good Y
X, Y = quantities of good X and Y respectively.
The budget line is determined by the fixed income (M) and known prices, Px and
Py. Maximum quantity of a commodity that can be bought can be arrived at by divid-
ing the income by the respective prices. The intercepts of the budget line on the Y and
X axes also indicate the maximum of each good that can be bought.
M
Maximum quantity of X = ___ = B
PX
M
Maximum quantity of Y = ___ = A
PY
The slope of the budget line is the price ratio the two goods.
PX
Slope of budget line = ___
PY
Any changes in the parameters, namely, income or price of goods, can change
the budget line. For instance, an increase in the income of the consumer can shifts
the entire budget line. In Figure 8.6 the shifts are parallel indicating that given the
increase in income, the consumer can buy more quantities of both X and Y. Similarly,
a fall in income brings a downward shift in the budget line.
Good Y Good Y
A≤
A
A¢
A
B B¢ B≤ Good X B B¢ Good X
Fig. 8.6 Change in Income Fig. 8.7 Change in Price
Changes in the price of good(s) can also shift the budget line. For instance, assume
that there is a cut in the price of good X. This will shift the budget line as shown in
Figure 8.7. The budget line shifts along X-axis, because lower price of X, the con-
sumer can buy more of X.
Consumer’s Equilibrium or Choice of Consumer

The consumer choice can be explained with the help of the indifference map and the
budget line. A indifference curve indicates the indifference of a consumer between
different combinations of X and Y that give the same level of satisfaction. The
indifference map represents the availability of similar curves in large numbers. But,
as the income and the prices of the goods are fixed, the budget line shows the choices
available to the consumer. The consumer choice is the challenge of choosing the
most preferred combinations of X and Y that give maximum satisfaction within the
given income.
As discussed earlier, the combinations above the budget line are not reachable due
to limited income. The combinations on and within the budget line are available to
the consumer. But a rational consumer will choose, the highest indifference curve that
can be achieved within the budget constraint. Thus, he attains equilibrium wherever
he maximises his satisfaction. As point E provides the highest level of satisfaction,
the consumer chooses this combination. At point E, IC2 is tangent to the budget line.
It is the highest indifference curve available to the consumer, and is the maximum
satisfaction level the consumer can reach with his income. Hence, E is called equilib-
rium point and X* and Y* are the equilibrium quantities of goods X and Y.
Good Y
M /Py B
Y* E
IC3
C
D
IC2
IC1
X* M /Px Good X
Fig. 8.8 Consumer’s Equilibrium
EQUILIBRIUM CONDITIONS
The following two conditions should be satisfied for consumer’s equilibrium:
1. The slope of the indifference curve must be equal to the slope of the
budget line. The slope of the Indifference Curve is the marginal rate of
substitution between X and Y (MRSxy). The slope of the budget line is the
ratio of the price of X and Y (i.e., Px /Py). Hence,
Slope of Indifference Curve = Slope of Budget Line
MUX PX
i.e., MRSXY = _____ = ___
MUY PY
At the point of tangency, there is no scope to reach any other higher
indifference curve.
2. The second condition requires that, at the point of tangency, indifference
curve must be convex to the origin. If it has other shapes, equilibrium
cannot be attained and it may lead to corner solutions. Consider the
implications of concave indifference curve as shown in Figure 8.9. Among
the two points A and C, a ra- Good Y

tional consumer will end up
buying only one good at point A
A. Hence, the condition of
convexity must be met to at-
tain consumer equilibrium in
indifference curve approach.
C
Income Effect, Price Effect and
Substitution Effect
Any changes in the price of the good or
the income of the consumer will change O
B Good X
the equilibrium conditions. This can be
understood through the following:
Fig. 8.9 Corner Solution of Concave
1. Income Effect Indifference Curve
2. Price Effect and
3. Substitution Effect
Indifference curve approach helps to understand these three effects and their rela-
tions in a better way than the cardinal theory.
Income Effect
Keeping all other things, including the prices of goods constant, any changes in the
income of the consumer would shift the budget line. Such shift would be parallel
to the original budget line because change in income (increase or decrease) would
equally affect the consumption of both goods measured on X- and Y-axes.
Figure 8.10 shows the parallel
shift in budget line due to increase Good Y
in income. Budget line AB moves A¢≤
upwards to A’B’ due to an increase
in consumer’s income. The equilib- A≤
rium point also moves upward to a A¢ ICC
higher indifference curve. Further A
increase in income will shift the
budget line upwards. The equilib-
rium is also shifted from the initial
level to a new point of tangency in
A¢¢B¢¢, A¢¢¢B¢¢¢ and so on. Connecting
all those points of equilibrium, we
get the income consumption curve O
B B ¢ B ≤ B ¢≤
(ICC), which shows when income Good X
increases, demand for any one or
Fig. 8.10 Income Consumption Curve (ICC)
both the commodities will increase.
Price Effect
Price effect simply means the change in consumer demand due to changes in price.
For instance, if price increases, the consequent fall in quantity demanded is the price
effect. Such continuous changes can be used to construct the price consumption
curve.
In Figure 8.11, a fall in the price of good X shifts the budget line from AB to AB¢,
indicating increased purchasing power. Thus, the budget line moves only on the X
axis indicating that the consumer would buy more good X due to fall in price.
Good Y
PCC
O
B B¢ B≤ Good X
Fig. 8.11 Price Consumption Curve (PCC)
The points of tangency between new budget line takes place with a higher
indifference curve. Any further in price of good X will shift the budget line to AB¢¢
and a new equilibrium takes place at a higher indifference curve. The line joining
the points of tangency between each budget line and each indifference curve form
the price consumption curve (PCC). It may be noted that if the price of good Y falls,
more of good Y would be bought and the budget line would move along the Y axis.
Substitution Effect
Price effect is the combination of two effects, viz., income and substitution effects.
Any fall in price of a good would encourage the consumer not only to buy more of
that good, but also to substitute for the goods whose price remains unchanged. Thus,
consumers have a tendency to replace costly goods with more of cheaper goods.
Such substitution is the optimising behaviour of the consumer.
The cardinal utility theory treats the consumer’s decision to buy a commodity is
based on its price and never considered the substitution effect.
Price effect has two components, namely, income and substitution effects. The
cardinal utility theory could not split these two components of price effect. Instead,
all changes in the quantity demanded were attributed to price. But the indifference
curve approach can split the income and substitution effects separately.
Derivation of Demand Curve through Indifference Curve

Indifference curve can also derive the law of demand without any of the restrictive
assumptions of the cardinal utility theory. Figure 8.12 shows that the budget line
moves from AB to AB¢ and AB¢¢ due to fall price of good X from P to P¢ and P¢¢. The
equilibrium point also shifts from (a) to (b), and then to (c), that at higher indifference
curves. The movement of the equilibrium point is towards the right indicating that
more of good X is bought as price falls.
In the lower segment of the figure, the price is measured on the Y-axis along with
the quantity of good X on the X-axis. It clearly shows that the quantity of good X is
bought more when the price falls. When price is P, quantity X is bought. When price
is P¢¢, quantity bought increases to X¢¢. If all parallel equilibrium points on the lower
segment, a¢, b¢ and c¢, are connected, it forms the downward sloping demand curve,
indicating the inverse relation between price and quantity demanded. Note that the
indifference curve could establish the demand curve without any restrictive assump-
tion of the cardinal utility theory.
Good Y
IC
A
IC¢
a IC≤
b PCC
c
B
X X¢ B¢ X≤ B≤ Good X
Price of X
a¢
P
P¢ b¢
P≤ c¢
Demand curve
X X¢ X≤ Good X
Fig. 8.12 Derivation of Demand Curve Through Indifference Curve

Importance of Indifference Curve Approach

The indifference curve approach is a significant advancement in the field of con-
sumer behaviour analysis, and is useful for many practical applications in welfare
economics and policy making. The following are some of its applications.
1. Indifference curve approach is less stringent in its assumptions than the
cardinal utility theory.
2. It provides a sound basis to measure consumer’s surplus
3. It establishes a better criterion to classify substitutes and complimentary
goods
4. It helps to decompose price effect into income and substitution effects
5. It is useful in designing various government policies
Limitations of Indifference Curve Approach

The indifference curve approach is considered to be superior to cardinal utility
approach in explaining consumer behaviour. But it also has some limitations. Some
are listed below:
1. The assumption about the existence of convex indifference curve is
weak
2. All consumers are not as rational as this approach assumes
3. This approach retains the assumption of constant utility of money
4. Consumer’s ability to order and choose among such vast alternatives is
doubtful
5. Consumers can commit mistake in choosing their options
6. Consumer choice may change due to other factors, like emotions, adver-
tisements, etc.

Indifference Curve Indifference Map
Diminishing Marginal Utility Budget or Price Line
Marginal Rate of Substitutions (MRS) Price Effect
Slope of Indifference Curve Diminishing MRS
Income Effect Properties of Indifference Curve
Substitution Effect Consumer’s Equilibrium
Chapter Summary
Consumer behaviour is explained through indifference curve approach without many
the unrealistic assumptions of cardinal utility theory. Indifference curve is simple in
its assumptions and is able to derive the demand curve.
• Indifference curve approach assumes utility can be measured by ordinal

ranks.
• Indifference curve is convex to the origin and has downward slope. The
curves do not intersect with each other.
• The marginal rate of substitution between two goods diminishes due to
operation of the law of diminishing marginal utility.
• Within a given income and prices, a consumer reaches equilibrium when
the slope of the budget line is tangent to the highest indifference curve.
• Indifference curve analysis can be used to derive the demand curve without
assuming utility as cardinal.
Questions
1. Define indifference curve.
2. What is cardinal measurement of utility?
3. State any two assumptions of the indifference curve.
4. State consumer’s equilibrium condition with indifference curve.
5. What is marginal rate of substitution (MRS)?
6. What do you mean by ordinal utility?
7. Explain diminishing marginal rate of substitution.
8. What is meant by rational consumer?
9. Why does indifference curve slope from left to right?
10. What is indifference map?
11. What is price line?
1. What are the properties of an indifference curve?
2. State the assumptions of indifference curve.
3. Explain the concept of indifference map and budget line.
4. Explain the diminishing marginal rate of substitution between two goods
in the indifference curve analysis.
5. Explain consumer’s equilibrium in indifference curve analysis.
6. Explain the concepts of price, income and substitution effects.
1. Explain the assumptions and properties of indifference curve analysis.
2. Explain the equilibrium of consumer with the indifference curve
approach.
3. Explain the following concepts using diagrams:
(a) Marginal rate of substitution (MRS)

(b) Indifference map
(c) Shift in budget line
4. Explain the price effect, income effect and substitution effect in the indif-
ference curve approach with the help of graphical illustrations.
Chapter 9
Laws of Production
‘Until the laws of thermodynamics are repealed, I shall continue to relate outputs to
inputs, i.e., to believe in production function’.
—Paul A. Samuelson
Learning Objectives
This chapter aims to introduce the basic concepts of the theory of production. It
explains two of the most important laws of production, viz., law of variable propor-
tion and law of returns to scale. It also explain the equilibrium of the consumer.
• To introduce the concept of production, both in short and long run
• To explain the law of variable proportion
• To explain the law of returns to scale
• To explain producer’s equilibrium
INTRODUCTION
A market system has two participants, buyers and sellers. The theory of consumer
behaviour discussed earlier has explained consumer choice and decisions behind
demand and supply curves. Firms need to consider consumer preferences in order to
increase revenue, and profit.
Firms should also consider their own activities and environment. Thus, behaviour
of a firm explains the supply side of the market and a major determinant of a firm’s
profit, as well as of the overall efficiency of the market economy.
A firm purchases inputs from the factor market, converts them into output through
the process of production and sells them in the goods market. Thus, a business firm
demands factor inputs in factor markets and supplies outputs (like cellphones, motor-
bikes, ice-cream, etc.) in output markets.
Production function is useful to specify the technical relationship between inputs
and outputs. This chapter discusses the economic aspects of the production process,
the central economic issue of production is how a firm should use its inputs to pro-
duce goods at the least cost.
PRODUCTION
In economics, production means the process of combining factor inputs and trans-
forming them into outputs. The factor inputs are land, labour, capital, organisation
and natural endowments. They are also called factors of production. The outputs are
those goods and services which provide utilities or have exchange value. Thus, pro-
duction is the process of creation of commodities which have utilities or exchange
value.
Business firms engage in production with the ultimate aim of earning maximum
profit. For instance, a firm decides about quantity of output to be produced, technol-
ogy to be applied, quantum of probable sale, etc. All such production decisions of the
firm depend on its cost and revenue. And the difference between cost of production
and revenue from sales determines profit.
Importance of Production
Production, consumption and distribution are the three major divisions of economics.
Among them, production is the basis for the other two divisions. There are several
reasons for this.
1. Production creates value by applying labour on land and capital.
2. According to the neo-classical economists, production also helps to im-
prove welfare because more commodities mean more utility, and hence
more welfare.
3. By utilising factor inputs production generates employment and income
which keep the economy on the development track.
Laws of Production 121
4. The theory of production forms the basis to understand the relation be-
tween cost and output.
5. Ownership pattern of factors of production also helps to understand the
macro theories of distribution.
Production Function
Production function simply relates factor inputs to outputs. The functional relation-
ship between factor inputs and outputs is called production function.
Production function expresses quantities of total output as a function of quantities
of inputs. This relation between factor inputs and outputs depends on the available
technology. Given the nature of the available technology, the production function
denotes the relationship between maximum attainable output and a given amount of
inputs.
Thus, production function is the relationship between technically efficient combi-
nation of factor inputs and outputs.
‘Production function is the name given to the relationship between the rate of
input of the productive services and the rate of output of the products. It is the
economists’ summary of technical knowledge’
—G. J. Stigler
Production function can be expressed in equation form as follows.
Q = f (L, N, K, O)
Where, Q = quantity of output
L = land
N = labour
K = capital
O = organisation
However, the general form of production function is Q = f (N, K). All the three
variables (Q, N, and K) are flow variables.
N and K can be combined in many ways. Each way represents a particular produc-
tion method. Production function consists of all such technically possible combina-
tions, but all of them need not be efficient. However, it is possible to identify the
efficient input combination that provides the maximum amount of possible output.
That is, an efficient input combination is the one that produces the maximum output
from a given amount of inputs. Production function helps to identify such efficient
input–output combinations.
Cobb Douglas production functions is one of the widely used production func-
tions in economics. It can be written as follows.
Q = A La Cb
where, constants (or parameters) a and b indicate the relative distributive share of
inputs L and C in total output Q and A is a positive constant defining the scale of
production.
Importance of Production Function

Production function has several uses. some of the most important uses are listed
below.
1. It helps to determine the level of production of a firm, an industry or an
entire economy.
2. It identifies the maximum output that can be attained with a given amount
of inputs.
3. It identifies the minimum inputs with which a given amount of output can
be attained.
4. Production function provides innumerable possibilities for substituting one
input for another, and helps to identify the input combination with least
cost.
5. It helps to solve the managerial problem of technical efficiency.
Production Decision
To understand the laws of production, it is necessary to discuss some of the basic
issues of production decisions. The input-output decision of a firm includes the fol-
lowing three issues:
1. How much to produce?
2. How to produce?
3. How much input to be used?
These issues need to be decided in such a way as to either to minimise the cost of
production of a given output or attain technical efficiency in employing the inputs to
maximise output. Technical efficiency refers to the effectiveness with which a speci-
fied input combination is used to produce the maximum possible output. Technical
efficiency is also known as X-efficiency.
SHORT RUN AND LONG RUN

Time element plays a significant role in all the above decisions. For instance, the
decision to expand a firm’s output twice or thrice may need significant time to mobi-
lise capital for building new plants, to buying machinery and to recruiting additional
workforce. Any small increment in output within the existing plant capacity may not
require such a long time.
Such differences in time period between major expansion and marginal increase
in output is mainly due to the nature of the input change involved. In other words,
the ability of a firm to change its production depends on the nature of the relevant
inputs.
There are two types of factor inputs, fixed and variable. A variable input is one
in which the firm can change as and when required. A fixed input is the one which
the firm cannot change within a given time period. For instance the exhaust tower in
a Ariyalure cement factory is a fixed input which cannot be changed immediately,
whereas the main raw material, gypsum, can be adjusted to meet any small increase
in production. This provides the basis for the two time periods for decision making,
namely short run and long run.
Short Run
In the short run period, it is difficult for any firm to change all its inputs. There may
be one or two inputs whose quantity determines the capacity of the entire plant. Such
factors are called fixed factors and they remain fixed. Any change in such inputs
needs adequate time. Hence, a short run period is one during which at least one of
the firm’s inputs remain fixed. Limited flexibility in production can be attained by
altering only the variable inputs.
Long Run
In the long run, all factor inputs will change. Any major expansion, like doubling the
inputs or manifold increase in output, requires expansion of all inputs. This requires
along period of time. Hence, a long run period is the one during which all the inputs
undergo changes and there are no fixed inputs.
Period of short run changes from firm to firm. A day may be a short run for a tea
shop, but even one year may be a short run for a can manufacturer. Therefore, short
run cannot be defined in terms of years, or months, or days. Therefore, short run and
long run periods can only be defined by the time taken to change all inputs.
TOTAL, AVERAGE AND MARGINAL PRODUCTS

Total products
A firm has many options. It can increase its output by increasing one variable input
or all the inputs (variable as well as fixed). Suppose, only one input is variable, the
quantities of all other inputs remain fixed. Then the output depends on that single
variable input.
L
Symbolically, Q = f (L, K) TP
Thus, output from the PF depends on the Q = f (L, K)
level of one single input, L, keeping other input
(K) fixed. This relationship between the output
and one variable input, keeping the other inputs
fixed, is referred to as the total product of the
variable input. It is also known as total return
from the variable input. O
Q
This can be plotted in the form of a graph.
The total product curve in Figure 9.1 shows the Fig. 9.1 Total Product Curve
relationship between output (Q) and variable
input (L), keeping the other input (c) as fixed.
Total product curve depicts how many units of good X can be produced with dif-
ferent quantities of labour (L). TP increases up to certain level and then it starts
diminishing.
Average Product
Average product refers to the quantity of output per unit of available input. It can be
arrived simply by dividing total product by the units of variable input.
Thus,
Total Product
Average Product of Labour = ________________
Quantity of Labour
TP
APL = ___
L
Where, APL = average product of labour
TP = total product
L = corresponding quantity of labour
Marginal Product
Marginal product of an input is the output gained from per unit change in input,
keeping other inputs as constant. When capital is assumed to be constant in the short
run, marginal product of labour is the change in output divided by change in quantity
of labour.
Output
d
MP
AP
Labour
Fig. 9.2 Marginal Product and Average Product Curves
Change in Output
Marginal Product of Labour = _______________
Change in Labour
DQ
MPL = ___
DL
Where, Q = Output,
L = Input,
= Change.
Marginal product increases at the initial level and after reaching the maximum of
3 units it starts declining (Table 9.1). Plotting these figures would form the reverse
‘U’ shaped marginal cost curve as in Figure 9.2. The reasons are explained below.
Laws of Production
The laws of production mainly deal with two types of input-output relations or pro-
duction functions. Accordingly, there are two fundamental laws of production,
1. Law of Variable Proportion (Short Run Analysis)
2. Law of Return to Scale (Long Run Analysis)
The production function is first used to study the implications on output due to
one variable input, while all other inputs are held constant. This type of input-output
relation is dealt within the law of variable proportion. This is mostly a short-term
concern.
The production function then deals with the implication on output as a result of
change in all inputs. This is the long-term concern and forms the subject matter of
law of return to scale.
Law of Variable Proportion (Short Run Analysis)

To understand the law of variable proportion it is first necessary to state the law of
diminishing marginal productivity.
The law of diminishing marginal productivity states that, keeping at least one
input fixed, if we increase the variable input by equal quantities, then its marginal
product would eventually diminish. Thus, increasing the variable input would dimin-
ish its marginal product.
Table 9.1 Total Product, Marginal Product and Average Product
Labour (units) Total Product (TP) Marginal Product (MP) Average Product (AP)
(1) (2) (3) (4)
0 0 0 0
1 1 1 1
2 3 2 1.5
3 6 3 2
4 8 2 2
5 9 1 1.8
6 7 –2 1.1
The law of variable proportion is closely related to the law of diminishing mar-
ginal productivity. The law of variable proportion is also known as the law of vari-
able factor proportion. The law of variable proportion states that when equal units
of a variable input are increased, a point is reached beyond which any addition of
variable input would lead to diminishing rate of return and marginal product would
decline. Diminishing returns refer to reduction in output with every additional unit
of input. Figure 9.2 shows how marginal product of an input initially rises with its
employment level until it reaches a maximum at point ‘d’ and starts declining.
‘Diminishing marginal productivity of labour, when it is used in connection with

a fixed amount of capital, is a universal phenomenon. This fact shows itself in
any economy, primitive or social’
—Clark, 1899
The inverse ‘U’ of the marginal product curve in Figure 9.2 can also be found in
Table 9.1. The marginal product in column (3) starts increasing from the first unit up
to the third unit, and then it starts declining.
The reasons for such shape and movement of the marginal product are:
1. Increasing variable inputs use fixed inputs intensively during the initial
phase
2. Factor proportion reaches an optimal point
3. Variable input, for instance, labour, gains efficiency when production
increases
4. Beyond such optimum level (point d in Figure 9.2,), inputs combination
becomes unfavourable as variable inputs gets crowded.
Law of Returns to Scale (Long Run Analysis)

The law of variable proportion has examined the implications of change in vari-
able input (s) when at least one input is fixed. As at least one input is fixed, this is
mostly a short run phenomenon. However, as discussed earlier, all inputs are vari-
able in the long run. The law of returns to scale examines what happens to output
when all inputs are changed simultaneously. Thus, the law of returns to scale deals
with the proportionate increase in all inputs and their effect on output; whereas the
law of variable proportion describes what happens when at least one input remains
unchanged. Whereas other inputs are changed.
If all inputs vary in same proportion, what would be the effect on output? Law
of returns to scale discusses the following three possible effects on output when all
inputs are changed in same percentage.
1. Constant returns to scale
2. Increasing returns to scale
3. Decreasing returns to scale
Constant Returns to Scale: If all inputs vary in the same proportion, output
may also change in exactly the same proportion. That is, if inputs are doubled,
output would also increase by two-fold. Such proportional increase in output due
to change in input is called constant returns to scale.
Increasing Returns to Scale: If a proportionate increase in all the inputs leads to
an increase in output by more than that proportion, it is called increasing returns
to scale. That is, if the inputs are doubled, output would increase by more than
two-fold.
Decreasing Returns to Scale: If a proportionate increase in all inputs leads to
an increase in output by less than that proportion, it is called decreasing returns
to scale. That is, if the inputs are doubled, output would increase by less than
two-fold.
Returns to Scale and Economies of Scale

Returns to scale and economies of scale are closely related terms but with different
meaning with respect to production analysis. Both simply describe what happens
when the scale of production increases.
Returns to scale indicates changes in output due to proportional rate of change
in all inputs. Economies of scale refers to the cost advantage for a firm as a result of
expansion. When scale of production is expanded, per unit cost would get reduced.
Such cost advantage occurs in the long run. It is further discussed in Chapter 10.
PRODUCER’S EQUILIBRIUM
Production function is a highly useful tool in choosing the optimum combination
of factors of production to produce the given output. Such optimum combination of
factor inputs is also called point of producer’s equilibrium. Producer’s equilibrium
can be explained with the help of tools, namely, isoquant curves and isocost line.
Isoquant curve is similar to indifference curve and isocost line is similar to budget
line. Before discussing these tools, it is necessary to list the assumptions under which
producer’s equilibrium can be attained.
Assumptions:
1. Profit maximisation is the ultimate goal of firms
2. The producer is assumed to be rational
3. The prices of the factor inputs are given
4. The price of the output is also fixed
Isoquant: Meaning
An Isoquant or equal product curve represents producer’s choice set and preferences.
It is used as a tool to describe the production function.
An Isoquant is the locus of points, each representing a combination of some
amount of input L (labour) and some amount of input K (Capital), that can produce
an equal amount of the product.
As all the points of the two input combinations produce the same amount of out-
put, the producer is indifferent in his choice among them. Hence, Isoquant is also
called product indifference curve.
Table 9.2 shows various combinations of labour and capital that can be used to
produce 100 units of good X.
Table 9.2 Equal Production with Two Inputs
Combinations Capital (K) (Units) Labour (L) (Units) Output (Good X) (Units)
A 1 5 100
B 1.5 3 100
C 2 2 100
D 3 1.5 100
E 5 1 100
For instance, combination A shows that 1 unit of capital and 5 units of labour can
be combined to produce 100 units of output X. Similarly, the same amount of X can
be produced with Combination, C i.e., 2 units of capital and 2 units of labour, or
combination E, i.e., 5 units of capital and 1 unit of labour.
The locus of points of all possible com- Labour

binations of capital and labour that can
be used to produce 100 units of good X is
called the equal product curve of 100 units
of X.
Thus, an isoquant (Fig. 9.3) represents
a level of production that the producer can
obtain from using various combinations of L
and C on the indifference curve. The points
A, B, C, D and E represents five different Q = 100
combinations of the two inputs. As all the O
Capital
five combinations provide the same level of
output, the producer is indifferent between Fig. 9.3 Isoquant or Equal Product
Curve
the combinations on the isoquant curve.
Properties of Isoquant
Isoquant has following properties which are analogous to those of the indifference
curve.
Negative Slope: Isoquant always has a negative or downward slope. Isoquant is
downward sloping from left to right, because as one input is increased the other input
should be increased to keep the quantum of output constant.
Isoquants are convex to the origin: Each isoquant curve must be convex to the
origin. Hence, he would substitute one for the other. The slope of the isoquant,
i.e., MRTSLK, indicates the rate at which one input is substituted for the other. As
MRTSLK is diminishing, isoquant is convex to the origin.
Higher Isoquant Means Higher Output: Higher isoquant yields higher level of
output. It is because higher isoquant consists of larger quantity of at least one or
both inputs. And larger quantities of inputs obviously yield higher production.
Isoquants will Never Intersect: Isoquants will never intersect each other and
they cannot be tangent to one another. This is similar to the property that in-
difference curves can never cut each other. If two isoquants cut each other, then
it would give a parodoxical situation of one combination of inputs producing two
different levels of output.
Slope of Isoquant
The slope of the isoquant is equal to the ratio of the marginal productivity of the
two inputs. This ratio is equal to the marginal rate of technical substitution between
the two inputs. That is, the marginal rate of technical substitution MRTSCL between
labour (L) and capital (K) is the slope of their isoquant.
Symbolically,
MPK
Slope of Isoquant = _____ = MRTSKL
MPL
Isoquant Map
An isoquant is drawn by joining various combinations of inputs L and K that yield
equal production. Similar isoquants with varying levels of production can be drawn
within the same quadrant. For instance, isoquant Q1 represents units of output, iso-
quant Q2 will produce 200 units and isoquant Q3 represents 300 units. Isoquants with
varying levels of production within a quadrant is called isoquant map.
Figure 9.4 shows an isoquant map. Isoquant Q1 represents production of 100 units
of output by employing any input combination on Q1. Similarly, Q2 can produce 200
units, Q3 can produce 300 units, and so on. Thus, an isoquant map consists of infinite
number of isoquants. The basic question, however, is which isoquant the producer
would choose, for which, the concept of isocost line needs to be introduced.
Labour
Q4 = 400
Q3 = 300
Q2 = 200
Q1 = 100
Capital
Fig. 9.4 Isoquant Map
Isocost or Budget line

Let us assume that the total outlay of a firm is fixed, and that the prices of two factors
namely labour and capital are fixed in the market.
The isocost line represents all equally costly input combinations for a producer.
Isocost line shows all the combinations of capital and labour for a given total cost.
The isocost line can be defined as
TO = L (w) + C (r)
Where, w = wage rate and r = rate of interest. The slope of the isocost line is the
ratio of the input prices.
Symbolically,
Wage Rate
Slope of Isocost line = ___________
Interest Rate
r
= __
w
Labour
Labour
A¢ TC
w
A A
TC
r
B B¢ Capital B Capital
Fig. 9.5 Isocost Map Fig. 9.6 Isocost Line or Budget Line
Just like the isoquant map, there are infinite number of the isocost lines, or the
isocost map (Figure 9.5), for various levels of total cost.
The higher isocost line indicates higher cost and the lower one indicates lower
cost of inputs. The higher isocost line includes more units of inputs than the lower
one. But for a given budget and input prices, there can be only one budget line, as
shown in Figure 9.6. Under such condition, maximisation of output is the only option
left for the producer.
Producer’s Equilibrium
The producer is in equilibrium when he maximises his profits. Profit is the difference
between cost of production and revenue earned from the sales of the production.
Thus, profit can be defined as
P=R–C
The producer’s ultimate aim is maximisation of P, which is possible in two ways.
One is maximisation of revenue and the other is minimisation of cost. Revenue
depends on the price of the good, which is assumed to be constant. As input prices
are also fixed in the short run, the producer can maximise profit (P) only by produc-
ing maximum possible output of a given total cost.
Thus, producer’s equilibrium is attained at a point where outputs maximise for a
given cost of outlay. To identify such equilibrium point, the isoquant map and isocost
lines need to be superimposed upon each other. The equilibrium point can be defined
at the maximum output that can be produced for the given budget line. The highest
possible isoquant tangent to the budget line at point E determines the equilibrium
point where slope of isocost line is also equal to slope of isoquant at point E.
r
Slope of the Isocost Line = __w
MPK
Slope of Isoquant = _____ = MRTSKL
MPL
MPK r Labour
At point E, _____ = MRTSKL = __
w
MPL K
w
A
In Figure 9.7, profit maximising output
at equilibrium point is 200 units on ‘q’ for B
the given cost outlay. And L*, and C* con- E
stitute optimum input combination to pro- L*
duce the maximum output of 200 units. q = 200
Let us take any other combination on the q = 100 K
isocost line, say B, it produces 100 units of r
output, hence E is preferable to any other K* B Capital
point on the isocost line.
Fig. 9.7 Isocost Line or Budget Line

Production Production Function
Total Production Returns to Scale
Variable Proportion Average Product
Isoquant Isocost Line
Marginal Productivity Factor inputs
Output DMRTSLK
Short Run Long Run
Constant Returns to scale Increasing Returns to scale
Isoquant Map MRTSLK
Chapter Summary
The laws of production, the short run and the long run, are explained. Producer’s
equilibrium is discussed with the tools of isoquant and isocost line.
• Production is the process of converting inputs into outputs.
• Production function relates output to inputs and summarises the process
of converting inputs into output.
• The law of variable proportion examines the effect of a change in vari-
able input(s) on output when at least one input is fixed. It is a short run
analysis.
• Law of returns to scale examines what happens to output when all inputs
are changed simultaneously in the long run.
• Producer’s equilibrium occurs when maximum output is attained with the

least cost of input combination, within a given budget.
Questions
1. What is production?
2. Define production function.
3. What is meant by short run?
4. What do you mean by long run?
5. Define marginal product.
6. What do you mean by average product?
7. What is meant by fixed input?
8. What is meant by variable input?
9. Define Isoquant line.
10. What are the conditions for producer’s equilibrium?
11. What is the law of variable proportion?
1. Distinguish between short run and long run periods.
2. Distinguish between fixed and variable inputs.
3. What is the importance of production?
4. What is production function. Explain its importance.
5. Explain the concept of total, average and marginal products.
6. Distinguish between law of variable proportion and laws of returns.
7. What are the reasons for the shape of the marginal product curve?
8. Explain the conditions of producer’s equilibrium.
1. Explain the meaning and significance of production and production
function.
2. Explain the shape and movements of marginal product curve, average
product curve and total product curve.
3. Explain producer’s equilibrium with the help of isoquant and isocost
line.
4. Distinguish between law of variable proportion and laws of returns.
5. Explain various returns to scale of production.
6. Explain the law of variable proportion.
7. Explain the relationship between total product curve and marginal product
curve in short run.
8. Explain the following
(a) Decreasing return to scale
(b) Slope of isoquant curve
(c) Diminishing marginal rate of technical substitution
Chapter 10
Cost and Break-Even
Analysis
‘Economies are supposed to serve human ends, not the other way round. We forget at our peril
that markets make a good servant, a bad master and a worse religion’.
—Amory Lovins
Learning Objectives
This chapter aims to introduce the concepts of cost, revenue and profit. The theo-
ries of cost are discussed in terms of short run and long run periods. The shape and
movement of the long run cost curve is explained with different returns to scale
due to economies and diseconomies of scale. The relation between cost, revenue
and profit is discussed in terms of break-even analysis.
• To introduce the various concepts of cost
• To discuss the theories of cost in the short run and the long run
• To understand the relation between short run and long run cost curves
• To discuss the sources of various economies and diseconomies of
scale
• To understand the concept of break-even and its merits and demerits
Cost and Break-Even Analysis 135
INTRODUCTION
The production function, discussed earlier, describes the physical relationship
between input and output. The theory of cost expresses a similar relationship in terms
of monetary terms; that is, the relation between output and cost of corresponding
inputs.
Production function is also used to identify the most efficient input combinations
to produce any amount of output. But there are other issues to be decided upon by a
business firm. Given the different techniques of production, say, labour intensive and
capital intensive techniques, which one should the firm choose? In other words, it is
a challenge to choose the optimum input combination. The optimum input combina-
tion purely depends on the cost of inputs because profit, the ultimate goal of firms,
depends on cost incurred and the revenue earned.
COST
Cost: Meaning
Cost of production, or cost, refers to the expenses incurred in the production of any
amount of a good.
The money spent is mostly payment for services of factor inputs employed for
production. Thus, cost of production depends on the quantity of output, the relevant
inputs combination and the cost of inputs.
Cost, in economics, basically refers to opportunity cost. It is used to discuss the
efficient allocation of society’s resources. A business firm also needs to address the
issue of allocating its limited resources for the best possible uses. There are also other
cost concepts, like opportunity cost and explicit and implicit costs. They have already
been discussed in Chapter 2.
Cost Function
The cost function is the functional relationship between output and cost, given a tech-
nology and prices of inputs. Symbolically, cost function can be written as
C = f(Q)
where C = Cost
Q = Quantity of output
SHORT RUN COST AND LONG RUN COST

The cost function or the functional relationship between cost and output can be dis-
cussed by two fundamental concepts, viz., short run cost and long run cost. The
distinction between short run cost and long run cost is similar to the one described
in production analysis.
Long Run Cost

In the long run, all factor inputs are variable. Nothing remains constant because
increasing production in the long run requires expansion of plant capacity or creation
of a new or additional plant. As all factors undergo changes, firms have complete
flexibility in expanding the level of production.
Short Run Costs: Variable Cost and Fixed Cost

The short run is the period during which at least one factor input is held constant. It
is the operating period during which the firms have limited flexibility in changing the
level of output. For example, if plant size is fixed, the firms cannot change the output
level beyond the existing plant capacity. The change in the variable inputs is also
limited as the factory does not have huge production facility in terms of machinery.
Thus, the change in output is due to change in variable inputs.
Hence a distinction can be made between variable cost and fixed cost. The dis-
tinction between variable cost and fixed cost is fundamental, and they are used with
reference to only short run production. The variable cost and fixed cost together
constitute total cost in short run.
Total Variable Costs

The variable cost ‘varies’ with production within the limits imposed by the fixed
plant capacity.
The following are some variable costs:
• Cost of raw materials
• Cost on wages and salaries of temporary labour
• Cost of depreciation on machines, buildings and such other capital
goods
• Cost of running any fixed capital, like fuel, electricity, maintenance, etc.
Total Fixed Cost

Fixed costs are also called overhead. A firm has to spend for land, some machinery
of permanent nature, an effluent treatment plant, etc. All such expenses have to be
incurred irrespective of the output level, and they are called total fixed cost.
The fixed costs do not change with changes in output; they are independent of
output. As these costs must be incurred by a firm in the short run even if there is no
production, they are called as fixed cost.
The following are some fixed costs:
• Cost of salaries to regular staff
• Cost of land, buildings, machinery, and capital of fixed nature
• Cost incurred on insurance premium
• Cost incurred for any other purpose of permanent nature
Total Cost
The total cost (TC) refers the total cost of production at any level of production. The
total cost is summation of total variable cost (TVC) and total fixed cost (TFC).
Table 10.1 Total Fixed Cost, Total Variable Cost and Total Cost
(In Rupees)
Quantity (units) TFC TVC TC = TFC + TVC

(1) (2) (3) (4)
0 20 0 20
1 20 18 38
2 20 24 44
3 20 29 49
4 20 36 56
5 20 48 68
6 20 68 88
7 20 98 118
Thus, the sum of total fixed cost and total variable cost is the total cost.
i.e., TC = TFC + TVC
Where, TVC = Total variable cost
TFC = Total fixed cost
TC = Total cost
Table 10.1 and Figure 10.1 show total variable cost, total fixed cost and total cost
curves and their relationship. Column (2) in the Table shows 20 as the TFC of a firm
over the entire range of output. Note that the total fixed cost curve is a flat line in
Figure 10.1. It starts at zero units on the X-axis reflecting the fact that it has to be
incurred even in the absence of production.
Cost Cost Cost
TC
TVC TVC
TFC TFC
O O O
Output Output Output
TFC + TVC = TC
Fig. 10.1 Total Cost, Total Variable Cost and Total Fixed Cost
The total variable cost, however, changes with the number of units produced.
Higher the output, larger will be the total variable cost. But the rate of change in total
variable cost varies over the levels of production. The production cost will increase
slowly during the initial level of production. Thus, cost will increase at a decreasing
rate at the early levels of production. When production is increased further, the total
variable cost will continue to increase but at a ‘increasing rate’.
Total cost curve has the same shape as of total variable cost. It is because the
TVC is higher by an amount of TFC since it is added to TFC. Thus, as shown in
Figure 10.1, total cost is simply the vertical summation of total fixed cost and total
variable cost.
Average Fixed Cost

Average cost is the per unit output cost. It can be arrived at by simply dividing total
cost by the quantity of output. The average fixed cost (AFC) is total fixed cost divided
by the quantity of output. Thus, AFC simply is the fixed cost per unit of output. It
would obviously decline as output increases because a fixed amount is being shared
(or divided) by the increasing output.
TFC
Thus, AFC = ____
Q
Where AFC = Average fixed cost
TFC = Total fixed cost
Table 10.2 Average Fixed Cost, Average Variable Cost and Average Cost
(In Rupees)
TFC TVC
Quantity (Units) TFC AFC = ____ TVC AVC = ____ TC SAC = AFC + AVC
Q Q
(1) (2) (3) (4) (5) (6) (7)
0 20 20 0 0 20 20
1 20 20 18 18 38 38
2 20 10 24 12 44 22
3 20 6.6 29 9.6 49 16.2
4 20 5 36 9 56 14
5 20 4 48 9.6 68 13.6
6 20 3.3 68 11.3 88 14.6
7 20 2.8 98 14 118 16.8
In Table 10.2, the total fixed cost of 20 is being divided by increasing amount of
output. As a result, average fixed cost declines steadily with increasing output.
The graphical presentation in Figure 10.2 shows that average fixed cost curve is
a rectangular hyperbola. Under rectangular hyperbola, any combinations of cost and
output will have same area or magnitude. Note that AFC for the combination ‘a’ is 20
(a2 = 1 × 20); and for the combination ‘b’ is also 20 (b2 = 4 × 5).
Average Variable Cost

Average variable cost (AVC) is obtained by dividing total variable cost by the quan-
tity of output. It is the variable cost per unit of corresponding output.
TVC
AVC = ____
Q
Cost Cost
20 a TFC
AFC =
Quantity of output
2
a
20 TFC
b
4 2
AFC
b
O O
Output 1 2 3 4 5 6 7 Output
Fig. 10.2 Total Fixed Cost and Average Fixed Cost
Where, AVC = Average variable cost

TVC = Total variable cost
In Table 10.2, AVC is computed by dividing TVC by output. The short run average
variable cost is zero when output is zero. For the first unit produced, the AVC is 18,
and it starts declining and reaches 9. After reaching the lowest cost 9 for the 4th unit,
AVC starts increasing and reaches 14 for the 7th unit. Thus, AVC declines initially due
to increased productivity of the variable
Cost
factors and reaches minimum when the
input (fixed and variable) combination
SAVC
become optimum (or the plant reaches
its optimum capacity). Beyond this it
starts ‘declining’. Plotting this entire
trend in a graph will yield a ‘U’ shaped
AVC curve, as in Figure 10.3.
As output increases, AVC will fall till
production reaches efficient capacity
output due to the operation of increas- O
ing returns. But beyond the efficient Output
capacity output, the AVC will rise due
Fig. 10.3 Short Rum Average Variable Cost
to the operation of diminishing returns. Curve
Average Total Cost

Average total cost is also known as average cost. It is the average cost per unit of out-
put produced. Adding average total fixed cost to average total variable cost will give
average total cost (ATC). It can also be arrived by dividing total cost by the quantity
of the corresponding output.
Thus, ATC = AFC + AVC

TC
or, ATC = ___
Q
Where AC = Average cost
TC = Total cost
Marginal Cost
Marginal cost, in the short run, is the cost of producing the last unit of output. It can
be computed by dividing the change in total cost by change in output. Thus, it is the
addition to total cost as a result of one more unit of output.
DTC
Thus, SMC = ____
DQ
Where
SMC = Short run marginal cost
TC = Total cost
D = Change
Marginal cost essentially reflects changes in total variable cost. Note that as fixed
cost is assumed to be constant in the short run, and any change in output is reflected
only in variable cost. That is, the change in total cost caused by change in output
must be due to change in variable cost. Thus, any increase in output in the short run
would reflect only in variable cost. It is clearly shown in Table 10.3. MC is simply
the increment in TVC for each unit of output. And marginal cost is the change in total
variable cost due to the production of the last unit of output.
MC can also be computed in a simple way:
MCn = TCn – TCn – 1
Where, MCn = Marginal cost
TCn = Total cost of producing n units
TCn–1 = Total cost of producing n–1 units
Marginal cost is also ‘U’ shaped (Figure 10.4). It is the mirror image of marginal
product curve discussed in the previous chapter. The ‘U’ shape is due the operation
of the law of variable proportion.
Table 10.3 Marginal Cost (In Rupees)

DTC
Quantity (units) TVC TC MC = ____
DQ
(1) (2) (3) (4)
0 0 20 -
1 18 38 18
2 24 44 6
3 29 49 5
4 36 56 7
5 48 68 12
6 68 88 20
7 98 118 30
As marginal product of variable input rises initially, marginal cost declines.

The reasons behind the law of variable proportion, viz., optimum factor propor-
tion, intense use of fixed factors and
Cost
improving efficiency of variable
input, equally hold good for the ‘U’ SAC
shaped MC curve. Due to the above
SMC
factors, increasing factor returns, set
in during the initial level of produc-
tion, and marginal cost starts falling.
The marginal cost curve starts rising
due to the operation of diminishing
return. The reasons are that the factor
proportion changes to unfavourable O
level and the production process gets Q* Output
crowded with more variable inputs
Fig. 10.4 Short Run Marginal Cost and Average
when production is increased beyond Cost Curves
a certain level.
Relationship between Marginal Cost and Average Cost

Marginal cost curve intersects average cost curve at its lowest point. When MC is
below AC, AC falls towards MC. After the intersection, MC is above AC, and, from
this point, AC starts increasing away from MC (Figure 10.4)
Short Run Cost Curves

Figure 10.5 gives a summary view
Cost
of all short run cost curves. Alfred
Marshal focused mostly on the ‘U’ AC
MC
shaped marginal cost curve. The shape
AVC
and movement of average variable cost
and average cost curves, and even total
cost curves, are solely determined by
the shape and movement of marginal
cost curve, which in, turn, is due to the
operation of increasing and diminishing
returns to variable factors. AFC
From Figure 10.5, we can conclude: O
Output
• Cost of production would be
lowest at the point of intersec- Fig. 10.5 Short Run Cost Curves
tion of the MC and AC.
• The shut down point of production is determined by the AVC.

• AFC starts from a height and slides gently and monotonically as produc-
tion increases
Long Run Average Cost Curve (LAC)

If a firm wants to expand its output to meet its growing demand, it needs to expand its
production capacity by altering all its inputs, like land, plant, machinery, wages, etc.
Thus, in contrast to the short run (where at least one input remain fixed), in the long-
run all inputs are variable. In the long run, as there are no fixed factors, we have no
distinction between fixed and variable costs. Hence, the focus would be on marginal
and average costs.
The long run average cost (LAC) is
TC Total Cost
LAC = ___ = _________
Q Output
The long run marginal cost (LMC) is the cost of producing an extra unit of output.
The long run marginal cost is
LMC = TCn – TCn – 1
Where, TCn – Total production cost of nth unit of output

TCn – 1 – Total production cost of n –1th unit of output
Relationship between LAC and SAC

LAC is derived from the envelope of an infinite of number of short run average cost
curves (SAC), as shown in Figure 10.6. Each SAC represents a particular plant size.
This means that the firm has a series of plants of different sizes to choose from, in
order to expand production. This is the reason why the LAC is also called ‘planning
curve’.
Cost
LAC
SAC7
SAC1
LMC SAC6
SAC2
SAC5
SAC3
SAC4
LAC*
b
Q* Output
Fig. 10.6 Long Run Average Cost Curve
Each SAC is ‘U’ shaped, and by joining the outer points (like a, b, c and d in
Figure 10.7), the long run average cost curve is derived. This is the reason why the
Cost
LAC SMC≤
SMC SAC≤
SAC
d¢ LMC
a c
d SMC¢
SAC¢
Q Q¢ Q ≤ Output
Fig. 10.7 SAC and LAC
LAC is also called as ‘envelope curve’. Each SAC touches the LAC only at a single
point of tangency.
How the firm chooses its plant size or moves over the LAC can be illustrated
with the selection of three potential plant sizes represented by SAC, SAC’ and SAC’’
(Figure 10.7). These three SACs represent small, medium and large plant sizes.
For instance, if the firm wants to produce OQ output it will be on SAC at point
a, it has to accept the excess capacity. If the firm wants to increase its output level
gradually to meet the demand it need not move on the same SAC to reach the low-
est cost at point d; instead, the firm can shift to the falling segment of another SAC
(tangent to LAC at d) which lies below the lowest point of the previous SAC. This
way, the firm can keep moving on the LAC. The continuum of SACs provides smooth
LAC.
But the optimum plant size, or the lowest long run average cost, is attained at point
b where LMC cuts LAC at its lowest point. At point b in Figure 10.7, even SMC cuts
SAC at its lowest. LAC, LMC, SAC and SMC are all equal at this point. A firm may
not prefer to move beyond this point because then the cost would rise. Hence, the ‘U’
shaped LAC could also be reduced to only ‘L’ shape.
The shape and movement of the long run marginal cost curve (LMC) is similar to
that of the average cost curve. LMC cuts LAC at the lowest point. Both are same for
the first unit of output; then LMC lies below LAC as long as LAC falls. But, when
LAC starts rising, after the intersection at point b, it lies below LMC.
Why LAC is ‘U’ Shaped?

The shape and movement of the long run average cost (LAC) curve is determined
by the scale of production and the corresponding returns to scale due to various
economies of scale of production. As discussed in the earlier chapter, there are three
possible returns to scale on cost when scale of production is increased. Each one is
due to economies or diseconomies of scale.
1. Increasing returns to scale (or Economies of scale)

2. Constant returns to scale (or Constant cost)
3. Decreasing returns to scale (or Diseconomies of scale)
Increasing Returns to Scale (or Economies of Scale): If expansion of a firm’s
scale of production reduces the production cost, as shown in Figure 10.8 (a), it is
called increasing returns to scale The reduction of cost or increasing returns is due
to economies of scale (discussed below in detail).
Constant Returns to Scale (or Constant Cost): When cost of production remains
constant for expansion in the scale of production, as shown in Figure 10.8 (b), the
it is called constant returns to scale. That is, to increase output thrice, inputs need
to be increased thrice. There is no reduction in cost or economies of scale does not
take place.
Decreasing Returns to Scale (Diseconomies of Scale): If an expansion in the
scale of production increases the cost of production (due to the requirement of more
than proportionate input), it is called decreasing returns to scale; and the shape of
the AC curve would decline, as shown in Figure 10.8. (c). Increasing cost is due to
diseconomies of scale.
Cost Cost Cost
LAC
LAC LAC
O O O
Output Output Output
(a) (b) (c)
Fig. 10.8 (a) Economies of Scale or Increasing Returns (b) Constant Cost or Constant
Returns (c) Diseconomies of Scale or Decreasing Returns
Cost
LAC
Output
Fig. 10.9 Long Run Average Cost Curve (LAC)

The three segments of Figure 10.8 together constitute the ‘U’ shaped long run
average cost curve. If there is a constant return to scale between increasing returns
to scale and decreasing returns to scale then the LAC would be saucer shape with a
flat base, as in Figure 10.9. It depicts the functional relationship between output and
average cost of production in the long run. To produce a given level of output, LAC
indicates the lowest average cost among infinite plant sizes.
ECONOMIES OF SCALE
Economies of scale mean the cost advantage of large scale production. They occur
mostly in the long run when increasingly larger plants yield lower cost of production.
Thus, it is related to the size of the plant.
Economies of scale arise when a business firm expands its scale of production,
the unit cost of production decreases. If the unit cost increases while expanding the
scale of production, it is called diseconomies of scale. If cost remains same for plant
expansion, there are no economies of scale. These three possibilities determine the
shape of the long run cost curves. At the initial level of production, the firm has
increasing returns due to economies of scale and the average cost falls. The operation
of diseconomies causes decreasing returns to scale and it increases the average cost.
Constant return operates when cost remains same.
Types of Economies of Scale

Economies of scale can be classified under two broad categories, viz., internal econo-
mies of scale and external economies of scale.
Internal Economies of Scale

Internal economies of scale involve cost reduction within the firm. They are exclu-
sive to a particular firm. For instance, a firm may develop a new technology with
patent to cut costs. This is an internal advantage enjoyed only by the concerned firm.
The following are some of the sources of internal economies.
• Labour economies
• Technical economies
• Managerial economies
• Marketing economies
• Financial economies
• Risk bearing economies
Labour Economies: Division of labour is a major source of cost reduction. Large
scale production needs division of labour. It improves the skills, professional capa-
bilities and specialisation of work force. This saves time, improves productivity and
cuts costs.
Technical Economies: The sources of technical economies are indivisibilities and
specialisation of the machinery. Very large scale production requires heavy machinery
and sophisticated equipments which are indivisible and need huge investment. But,
in the long run, they become more profitable at appropriate scale of production.
Managerial Economies: The main source of managerial economies is specialisa-

tion and division of labour. It can be achieved by delegating the decision making to
right persons and ensuring supervision. The departments can be divided in terms of
broad areas, like production, sales, finance, accounting, material, research, etc. This
helps in supervision and in fixing responsibility to each department.
Marketing Economies: Marketing economies are associated with selling products
and buying raw materials and inputs. A large firm can enjoy economies in expendi-
ture on advertisement, selling and product promotion activities. Increasing produc-
tion leads to lower unit cost on all such expenditures. Similarly, as the size of pro-
curement is large, the firm gets a better bargaining power to reduce its input prices.
Financial Economies: A large firm has the advantage of mobilising required
finance relatively at a cost than that of a smaller firm. A large firm can easily raise
share capital and loans from public, issue debentures and borrow from banks at lower
interest rate. In the globalised era, it can raise resources even from abroad at lower
interest rate.
Risk Bearing Economies: A large firm can spread its risks through appropriate
diversification of production and marketing. For instance, in the current phase of
recession, many CEOs have announced cost cutting strategies in order to absorb the
losses incurred on sales. They may also shift risk from one product to another as they
have many products with different brand names. Such maneuvering is possible only
for a large firm.
External Economies of Scale

External economies are those which occur externally. They are enjoyed by all firms.
When costs are reduced by external factors, like improved infrastructure, they are
called external economies. They may occur from the following sources:
Economies of Concentration: A large number of firms are concentrated in spe-
cial export zones or industrial estates. The benefits of various infrastructures in such
areas accrue to all firms to reduce their cost of production.
Economies of Information: Firms of a particular industry could share common
portals of information, like own journal, web sites, news bulletins, or an information
centre to provide and share basic information, like raw materials, technology devel-
opment, etc. Such information sharing would help to reduce the average unit cost of
production.
Economies of Disintegration: Each big industrial production can be sub-divided
into several processes. Growth of subsidiary and ancillary industries in and around
industrial estates would help large firms to cut their unit cost of production by disin-
tegrating the production process.
DISECONOMIES OF SCALE
The diseconomies of scale mean increase in average cost when a firm expands its
scale of production. Firms continue their production until they reach the lowest point
in the long run average cost curve. When the scale of production continues to grow
and expand beyond this optimum level, the firm faces decreasing returns or disec-
onomies of scale due to increasing unit cost. The sources of diseconomies of scale
are many. Some one listed below.
1. It is difficult to manage the firm when it grows beyond certain optimum
level.
2. Controlling top level managers and supervision of the large work force
are difficult.
3. Bureaucratic inefficiency, poor coordination and wastages increase the cost
of production.
4. The input combination is optimum at the lowest point of LAC, moving
further leads to suboptimal outcomes.
5. Division of labour slips from the point of efficiency to overcrowding.
6. A very large firm faces strong trade union bargaining for just pay, bonus
and improved working conditions.
But it should be noted that business firms may stop expanding their scale of pro-
duction at their lowest point of LAC. As profit is the ultimate goal, firms may not
move beyond such optimum level. This is one of the reasons why the shape of LAC
is also considered to be ‘L’ instead of ‘U’. Thus, firms may continue with constant
returns to scale after completing the phase of increasing returns.
BREAK-EVEN ANALYSIS
The relationship between cost, revenue and profit is most important for a firm to
exercise its options in deciding optimum output levels. The ultimate objective of a
firm is maximisation of total profit. This depends on the total revenue earned through
sales (demand side) and total cost of production (supply side). Thus, total profit is
equal to total revenue minus total cost (P = TR-TC). Break-even analysis is a useful
method to analyse the relationship between cost, revenue and profit. It aims to deter-
mine the level of output at which a firm attains the break-even point.
Meaning of Break-Even Point

Break-even point simply means a no-profit-no-loss situation. The firm breaks it
even at an output level where total revenue equals total cost. Thus, Break-even point
TR = TC.
Cost, Revenue and Profit

The relationship between cost, revenue and profit may lead to three possibilities:
(1) The firm earns profit when revenue exceeds cost
(2) The firm suffers loss when cost exceeds revenue
(3) The firm breaks even when revenue equals cost
It should also be noted that when the firm is breaking even, it earns normal rate of
return which is already factored in the total cost.
As discussed earlier, total cost comprises of fixed cost and variable cost. The
total cost function may be linear or non-linear. The total cost function is linear when
variable cost remains same over a period; otherwise it is non-linear. Total revenue is
the amount of money a firm receives by the sale of its output in the market. Profit (P)
is total revenue minus total cost.
Profit = Total Revenue – Total Cost
P = TR-TC = (P × Q) – TC
Symbolically, break-even point or no-profit-no-loss level is
Break-even Point = TR = TC
P × Q = TFC + TVC
P × Q = TFC + AVC × Q
Q (P – AVC) = TFC
TFC
Q = _______
P – AVC
Illustration: If total fixed cost (TFC) is Rs.1000, price is Rs.60 and average vari-
able cost (AVC) is Rs.10 per unit, what is the break-even level of output?
TFC
Solution: Break-Even = ________
P – AVC
1000
= _______
60 – 10
1000
= _____
50
= 20 units
Graphical Representation: To maximise profit, the difference between TR and TC
needs to be maximised. Towards this, the firm must find the price and quantity that
maximise the difference between TR and TC.
Figure 10.10 shows the break-even point through linear cost (TC) and revenue
functions (TR). The TR is passing through the origin indicating that the price is con-
stant in the perfectly competitive market. And
the total cost curve starts from the level of fixed TR
Profit
cost and increases as variable cost increase for

Cost, revenue and profit
different levels of output. The firm is breaking Profit

Break-even point
even at the level of output Q* where the TR is
Fixed cost Variable cost
TC
equal to TC. To the left of Q* the firm faces
losses and to the right of Q* it has profit, as
TR exceeds total cost. At the point of break-
even, TR is exactly equal to TC. At the initial
Loss
level of production, the loss (shaded area in
Figure 10.10) is greater. It can be minimised
only by increasing production. Similarly, from O Output
Q*
the break-even point, profit can be maximised
by increasing production. Fig. 10.10 Break-Even Point
Figure 10.11 exhibits break-even TC
TR and TC
points through non-linear functions. The B¢
total cost function is non-linear reflecting a
TR
the law of variable proportion. The firm
maximises its profit at only one output Max P
level, Q*, where the vertical distance B
between total cost and total revenue is a¢
maximum. Below and above the output
level Q* the firm earns profit, but it is O Q Q* Q ¢ Output
lesser than at the Q* level. At output lev-
Total profit
els below Q and above Q¢, the firm suf-
fers losses because, in both cases, TC is
more than TR. Hence, points B and B¢ are
called break-even points because the firm
makes neither profit nor loss at B and B¢.
Importance of Break-Even O
Q Q* Q ¢ Output
Analysis Total profit
Break-even analysis has many applica-
Fig. 10.11 Break-Even Points
tions and plays a significant role in busi-
ness decision making. Some of them are:
1. Break-even analysis helps to make decisions about the optimum level of
price and output.
2. It helps to adjust the level of output to maximise profit, or at least to
minimise loss.
3. It helps to plan for the purchase of raw materials and other inputs in
adequate quantity at appropriate time.
4. It also helps to choose the appropriate technology.
5. It is useful in planning cost cutting strategies in advance.
6. It also helps to plan and adjust selling expenditure.
Limitations of Break-Even Analysis

Though break-even analysis is important for various decision making processes, it
suffers from many limitations. Some are listed below.
1. Price and output decisions depend on many other determinants, like com-
petition, business cycles, etc. Hence, break-even analysis may go wrong.
2. Break-even analysis is static in nature. The real business environment is
more dynamic and profits depend on various other factors in addition to
cost and revenue.
3. Application of break-even analysis is difficult when a firm engages in the
production of different products.
4. Estimation of cost function is difficult in the long run.
5. Splitting total cost into fixed and variable components is also difficult.

Cost Cost Function
Short Run Cost Long Run Cost
Fixed Cost Variable Cost
Average Cost Marginal Cost
Total Cost Economies of Scale
Diseconomies of Scale Constant Cost
‘U’ Shaped Cost Curve ‘L’ Shaped Cost Curve
Envelope Curve Planning Curve
Break-Even Point Maximum Profit
Internal Economies External Economies
Diseconomies
Chapter Summary
The concepts of cost and cost function are discussed in the short run and in the long
run. The shape of the long run cost curve and its relation with the short run cost are
explained. The various economies of scale accruing to the firm in the long run are
also explained. Finally, the concept of break-even point is discussed.
• Cost function relates cost to output and provides various options to decide
the profit maximising output level.
• Cost is determined mainly by the level of output and input prices along
with other determinants.
• Short run is the period where at least one input is fixed, and in the long
run all inputs are variable.
• The long run average cost is ‘U’ shaped due to economies and disecono-
mies of scale at various levels of output.
• Break-even is attained when revenue from the sale of a product equals
the cost of producing that output.
Questions
1. Define cost function.
2. Define short run cost.
3. Define long run cost.
4. What are fixed and variable costs?

5. What is marginal cost?
6. What is average cost?
7. What is planning curve?
8. What is break-even point?
9. What is an envelope curve?
10. Distinguish between short run and long run.
1. What is the relationship between marginal cost and average cost?
2. Explain the shape of the long run average cost curve.
3. Explain the short run cost curves.
4. Explain SAC and LAC and their relationship.
5. Explain various costs incurred by the firm.
6. Explain the break-even point.
7. Explain the various economies of scale.
8. Why is the long run average cost curve ‘U’ shaped?
1. Explain the various cost curves in the short run.
2. What is the relationship between fixed and variable costs?
3. Explain the shape and movements of the long run average cost curve.
4. Explain the SAC and LAC and their relationship.
5. Explain total, average and marginal cost curves in the short run.
6. Explain the break-even point with a suitable diagram.
7. Explain the sources of economies and diseconomies of scale.
8. Explain the reason for the ‘U’ shape of LAC.
.
Chapter 11
Market Structure
‘The market came with the dawn of civilization and it is not an invention of capitalism.
If it leads to improving the well-being of the people there is no contradiction with socialism.’
—Mikhail Gorbachev
Learning Objectives
This chapter aims to discuss the price and output determination by firms under
different market structures. Market structure deals with the behaviour of firms
in making decisions regarding supply and price. Different markets have various
degrees of control and competition. At the end, the students would be able to
understand the concepts, objectives and equilibrium conditions of firms under
different market structures.
• To introduce the concept and classification of market
• To understand the price and output decisions of firm under different
market structures
• To understand the different degrees of competition among firms and their
relative control over the market
• To learn about the behaviour of firms in a market economy
INTRODUCTION
The theory of market structure, is central to both economics and business. The mar-
ket consists of buyers and sellers. It has already been discussed in Chapter 6 how
the buyers and sellers together determine price in a simple market framework. The
behaviour of these two needs to be understood further to understand how price of a
good is determined. Understanding the market mechanism would also help in under-
standing whether society’s resources would be allocated efficiently and income
would be distributed equally. The theory of consumer behaviour has already been
discussed in detail in previous chapters. Similarly, behaviour of the producer (or
firm) in determining supply needs detailed understanding to know about the market
system. How firms behave in response to demand, competition and other market
conditions.
MARKET STRUCTURE
The term ‘market’, in ordinary language, refers to a particular place or locality where
goods are sold and purchased. The term ‘market’ in economics connotes a different
meaning. The existence of contract between the sellers and buyers for purchase of
a commodity, at an agreed price, means an existence of the market. The buyers and
sellers may be present in a small locality, or may spread over a region, or a town, or
a country. The essential feature of a market is communication between sellers and
buyers, which may be direct or indirect, through exchange of letters, telegrams, tele-
phone, e-mail, short message services (sms), etc. This exchange of communication
results in transaction of commodities at an agreed price.
Definition of Market
The market consists of buyers and sellers. The following definitions provide the vari-
ous aspects of market.
Cournot: ‘Economists understand by the term ‘market’, not any particular market
place in which things are bought and sold but the whole of any region in which buy-
ers and sellers are in such free intercourse with one another that the price of the some
goods tends to equality easily and quickly.’
Ely: ‘Market means the general field within which the force determining the price
of a particular product operates.’
Benham: ‘Market is any area over which buyers and sellers are in close touch with
one another, either directly or through dealers, that the price obtainable in one part of
the market affects the prices paid in other parts.’
Stonier and Hague: ‘Any organisation whereby buyers and sellers of a good are
kept in close touch with each other …. ‘There is no need for a market to be in a single
building…. The only essential for a market is that all buyers and sellers should be
in constant touch with each other, either because they are in the same building or
because they are able to talk to each other by telephone at a moment’s notice.’
Thus, it is evident that market means the sellers for a product come in contact with
each other in order to buy or sell the commodity for an agreed price.
Components or Essentials of a Market

The essentials for a market are listed below.
1. A commodity should be offered for sale
2. Existence of buyers and sellers
3. A place which may be a region, a country or the entire world
4. Contact between buyers and sellers which results in fixation of price for
the commodity
Meaning of Market Structure

Market structure refers to the manner in which markets are organised or structured.
They are structured on the basis of the number of firms, their relative strength, the
degree of competition and collusion among them, the extent of product differentia-
tion and the ease of the firm’s entry into, and exit from, the market.
Classification of Market Structure

Markets may be classified into different types on the basis of area, time and nature
of transactions, volume of business, status of sellers, regulation and competition.
Among the various classifications, the most important one is based on competition.
This is based on three crucial elements. They are the number of firms producing a
commodity, the nature of the product produced by the firms, that is, whether it is
homogenous or differentiated, and the restrictions or easiness with which the new
firms enter the industry.
Classification on the Basis of Area

The markets, based on area, are classified into local, regional, national and interna-
tional markets. If the commodity is sold only in a particular area, it is called local
market. If the commodity is sold in a region, for example, in a few states in India it
is known as regional market. If the commodity is sold throughout the country then
it is said to have national market. If a commodity is sold outside the country, then it
is known as international market. According to the nature of the commodity, taste
and preferences of the buyers, availability of storage, method of business, political
stability and portability of the commodity, it becomes saleable in local, or regional,
national or international markets.
Classification on the Basis of Time

Marshall classifies market on the basis of time into very short period or market
period, short period and long period. Very short period market refers to the market in
which commodities are fixed in supply in the given time period. In this time period
supply is fixed and changes in demand bring changes in price. Short period is the
period in which changes in supply can be made to a limited extent in response to
changes in demand. In short period, variable factors are increased or decreased in
order to increase or reduce supply in response to changes in demand. In this period,
it is impossible to increase fixed factors. Long period is the period in which all fac-
tors, i.e., fixed factors and variable factors, can be varied for bringing about changes
in supply in response to changes in demand.
Classification on the Basis of Transactions

Markets are classified as spot market and futures market on the basis of transac-
tions. When goods are transacted on the spot, the market is called spot market. When
people enter into agreements to buy or sell goods at a future date, then it is called
futures market.
Classification on the Basis of Volume of Business

When goods are transacted in large quantities the market is known as wholesale
market. In retail market, the volume of transactions of a particular commodity is
less. Wholesale market is a link between the producer and the retailer, whereas retail
market creates a link between the wholesaler and the consumer.
Classification on the Basis of Regulation

Markets are classified into regulated and unregulated market. In the regulated market
the Government regulates sale and purchase of certain commodities. The market
forces are not allowed to operate freely. In an unregulated market sale and purchase
of goods are left to the operation of market forces.
Classification on the Basis of Competition

Markets are classified into perfect competition and imperfect competition. Market
conditions vary between industries. The degree of competition faced by firms in an
industry varies from industry to industry.
The Market Structure Continuum

The market structure continuum shown in the box gives an overview of the four basic
market structures. The right extreme of the line indicates total market is controlled
by a firm, whereas the left extreme indicates zero level market control by the firms.
While moving from left to right, the firms gradually dilute the competition and gain
higher degrees of market control. Market control depends on the number of sellers
and the degree of competition. On the left, with infinite number of sellers and no
market control, is the perfect competition. At the other extreme, with no competitor
and a firm exercises complete control over the market, is monopoly. In between these
two extremes, there are different market structures–for instance, imperfect competi-
tion refers to a market with many firms, but each enjoying some amount of monopoly
power and at the same time facing competition from other firms. An oligopoly mar-
ket is one, where there are a few firms, which may be either in collusion or in fierce
competition with each other.
PERFECT COMPETITION
Perfect competition is an extreme form of market structure. The market forces of
demand and supply work freely. The operations of demand and supply determine
The Market Structure Continuum
Perfect Monopolistic
Oligopoly Monopoly
competition competition
- Very large number - Relatively large - A few large sellers - Single seller
of sellers and number of sellers - Differentiated or - Price maker
buyers and buyers homogeneous
products - No substitutes
- Homogeneous - Differentiated
products products - Interdependence - Control over market
- Firms are price takers - Collusion - Blocked entry
- Free entry and exit - Easy entry and exit - Entry barriers - No competition
- Competition is total - Mutual control over
price
the allocation for resources among different commodities and distribution of income
among factors. Perfect competition is a non-existent situation. According to Leftwich,
the study of perfect competition ‘furnishes us with a simple and logical starting point
for economic analysis’. It is a kind of market structure where there is no rivalry
among firms since all the firms producing identical products will be able to sell the
quantity produced by them at the prevailing market price.
Assumptions
The perfect competitive market can also be characterised by its own assumptions.
They are:
Large Number of Buyers and Sellers: The existence of large number of buyers
and sellers in the market is an essential feature of perfect competition. The buyers
and sellers are numerous and, hence, each buyer buys so little and each seller sells so
little that none of them is in a position to influence the price in the market. The price
of the product in the market is influenced by market demand and market supply. The
firm is a ‘price taker’. Once the price is determined by the market forces of demand
and supply each firm has to adjust its output according to the market price.
Homogeneous Product: The products sold by the firms are identical in all respects.
The technical characteristic and services provided by the firms are identical, and
hence the products produced by competitive firms are considered perfect substitutes
by consumers. Due to homogeneity of the products of the competitors, the sellers
cannot charge price slightly more than the ruling market price. If a higher price is
charged by the firm, it would lose all its customers.
Absence of Regulations: There are no restrictions on the demand, supply and
prices of goods and factors of production in the market. There are no restrictions
or regulations on the supply of goods and factors, either by the government or by
any cartel system among producers. There is no rationing of the product by the
government.
Free Entry and Exit: The firms in perfect competition have the freedom to enter
or exit the industry. If the firms earn abnormal profits, new firms would enter the
industry. The excess profit would be taken away due to entry of new firms. Similarly,
if firms incur losses then they will leave the industry.
Perfect Knowledge of Market Conditions: The buyers have knowledge about the
product, hence, there is no need for the firms to advertise their products. Similarly,
the sellers have knowledge of the market conditions. This implies that both the buy-
ers and the sellers have full knowledge of the price at which the market demand and
market supply are equal. Absence of information regarding market conditions inhib-
its the functioning of competition.
Perfect Mobility of Factors of Production: The factors of production can freely
move between industries. There is no monopoly in supply of raw materials. There is
no labour union which prevents free functioning of market forces.
Non-Existence of Transport Costs: The existence of a single price for the prod-
uct is an essential condition in perfect competition. If there is transport cost, there can
not be a uniform price. Perfect competition assumes that firms are present so close to
each other and to that there are no transport costs.
Distinction between Pure Competition and Perfect Competition

The term ‘pure competition’ was first used by E.H. Chamberlin. The existence of
a large number of buyers and sellers, existence of homogenous product, absence of
artificial restrictions, and condition of free entry and free exit for firms are enough
for competition to be termed pure competition. These conditions ensure absence of
monopoly conditions in the market. Hence, all firms are price takers. Pure com-
petition is a part and parcel of prefect competition. In addition to the above four
conditions of pure competition, the other three conditions, namely, perfect knowl-
edge on the part of buyers and sellers, perfect mobility of factors of production and
non-existence of transport costs, should be present for the market to be classified as
perfect competition. To summarise, it could be stated that there should be a single
uniform price in the market and the price should be determined by the market forces
of demand and supply, i.e., the combined action of all the buyers and sellers in the
market determine the price.
Firm and Industry

These two concepts need `to be defined. A firm is a business organisation for trans-
forming factors of production into outputs or commodities. A firm produces a prod-
uct. For instance, Tata Steel produces steel. The concept of industry includes all the
firms producing a particular product. For instance, all steel makers in India, like
SAIL, Tata Steel, JSW, etc., constitute ‘steel industry’. Thus, a large number of firms
producing similar products are included under the concept of industry.
In perfect competition, the industry (all sellers), or market supply along with
market demand (all buyers) determine the market price, as shown in Figure 11.1. The
firm is called price taker because any individual firm has to sell only at the market
determined price.
D S
P* D = MR = AR
O O
Quantity in billions Quantity in hundreds
The Market The Firm
Fig. 11.1 Market Determined Price for The Firm in Perfect Competition
Short Run Equilibrium of a Firm

To determine the equilibrium point or the profit maximising level of output, a firm
must know its cost and revenue. We have already discussed various concepts of
costs. The relevant concepts of revenue are marginal revenue and average revenue.
Marginal revenue (MR) of a firm is the change in total revenue due to the sale of
an extra unit of the good. Thus, it is the addition to total revenue from selling an
additional unit of the good. The marginal revenue curve in perfect competition is just
the horizontal price line, because price of the good is an addition to total revenue by
selling an extra unit.
Average revenue is the per unit revenue. It is arrived by dividing total revenue by
the units of goods sold.
TR PxQ
Hence, AR = ___ = ____
Q Q
AR = P
That is, price is the average revenue earned per unit of sales and, therefore, it
is also the demand curve for the product. Thus, the demand curve that a firm faces
under perfect competition is the horizontal line where P = MR = AR.
A firm could earn maximum profit (P) by maximising the difference between
its total revenue (TR) and total cost of production (TC). Thus, P = TR-TC in perfect
competition. The price is determined by the market forces (demand and supply), as
shown in Figure: 11.1. In other words, price is determined by the industry and the
firm is a price taker. The perfectly competitive firm, being a price taker, can maxi-
mise profit only by minimising the cost. Given this, a firm could be in equilibrium in
the short run under the following conditions:
Equilibrium Conditions: A firm can earn maximum profit when its cost of pro-
ducing an extra unit is equal to the revenue earned from the sale of that unit.
Thus, firm can earn maximum profit when,
1. MR = MC
2. The MC curve cuts the MR curve from below
Slope of MC > Slope of MR CR

The first condition means market price
should be able to cover the marginal cost of L
producing the output. The second condition can
be explained with Fig. 11.2. In Figure 11.2, the A B
P MR
MC = MR at two points A and B. Till the pro-
duction reaches Q1, the MC is above MR, there-
after for every unit the firm must be incurring M
loss and only at Q1 unit, it attains break-even.
Therefore, it has accumulated loss represented O
Q1 Q2
by the area PAL. As production increases from
Q1 to Q2, for every unit MC is less than MR, so
Fig. 11.2 Equilibrium of a firm
the firms accounted profit from Q1 to Q2 is the
shaded area AMB. Therefore, the firm attain
maximum profit only at OQ2 level of output,
and at Q2, the MC = MR and MC curve cuts MR curve from below. Any increase in
production beyond Q2 will increases loss for the firm. Hence, “MC curve cuts MR
curve from below” is an essential second condition for equilibrium of a firm.
Figure 11.3 shows the three different cases of a firm, with abnormal profit, loss
and normal profit (or break-even). Figure 11.3 (a) shows the profit maximising out-
put of X which is determined by drawing a vertical line from point E, where MC is
equal to MR. At this point, MC also cuts MR from below.
Price & Cost
SMC SMC
SAC SATC
SMC SAC L¢
E L E* AR = MR
P P E P
G AR = MR AR = MR SAVC
G¢ S
P¢
AFC
X Output X≤ Output X¢ X* Output
Profit = Shaded area Loss = Shaded area Break point = E *
Shut down point = S
(a) (b) (c)
Fig. 11.3 (a) Short Run Profit (b) Short Run Loss (c) Short Run Equilibrium
Figure 11.3 (b) shows the short run loss of the firm. The profit maximising output
of X is determined by drawing a vertical line from point E, where MC is equal to MR.
At this point, MC also cuts MR from below. But, note that the firm is incurring a loss
because the short run average cost (SAC) is above the short run average revenue, or
price of the good. The extent of loss per unit is equal to AC – AR. The area LPEL’ is
quantum of loss to the firm.
Thus, even if MC equals MR, the short run profit or loss depends on whether the
average revenue earned, or the price of the good, is more than the average cost. Note
that in Figure 11.3 (a), AR or price P is greater than SAC and the difference between
them determines the quantum of profit.
Shut Down Point: If price falls further in Figure 11.3 (b), the loss would increase
as the distance between SAC and AR gets widened. But how long can a firm con-
tinue its production with loss? The firm would continue its production as long it
can meet the average variable cost from the price, or AR. Thus, if price falls below
AVC, the firm would shut down production in order to minimise its loss. Point S in
Figure 11.3 (c) shows the point where the firm would close down its operation to be
better-off.
Break-Even: Normal profit or break-even is attained when the short run average
total cost is equal to price or short run average revenue. Thus, when price and SAC
are equal, the firm attains break-even. Point E* is also the short run equilibrium with
normal profit. The equilibrium output level of the firm is X* where price is equal to
SATC. Hence, firm can get normal profit. At normal profit of the perfectly competi-
tive firm, SAC = SMC = MR = AR = P.
Supply Curve of the Firm

Supply curve of the firm refers to the direct (or positive) relationship between the
price and the output level of the firm. The supply curve shows how much output the
firm would supply. The firm would supply when the market price increases, and
would cut its supply when the market price declines. The point of intersection of firm
demand curve with its MC curve determines the supply level of the firm.
Figure 11.4 exhibits the derivation of supply curve of the firm. This indicates
that quantity supplied by the firm increases when price increases. When price is P1
the firm would supply X1, and it would increase its supply to X3 when market price
increases to P3.
P P S
MC
P3 P3
Satc
P2 P2
Savc
P1 P1
O X1 X2 X3 X O X1 X2 X3 X
Fig. 11.4 Firm’s Supply Curve
Supply curve of the industry is derived by horizontal summation of the supply

curves of all the firms in the market. Suppose there are only two firms in the market.
The derivation of industry’s supply curve is shown in Figure 11.5. Given the market
price, firms A and B produce 1,000 and 2,000 units, respectively. As a result,
Firm A Firm B Industry

S = S1 + S 2
S1 S2 Industry supply
curve
P* P* P*
O O O
1000 Q 2000 Q (1000 + 2000) 3000 Q
Fig. 11.5 Industry’s Supply curve
market supply is 3,000 units, which is the total product of all firms (A and B) in the
industry.
Long Run Equilibrium of a Firm and Industry

A competitive firm can earn abnormal profit or loss in short run, as shown in Figure
11.2 (a) and (b). But, it is impossible in the long run due to free entry and exit in the
market. If a firm earns abnormal profit in the short run, it would attract new entry till
the entry pushes the price (demand curve of each firm) downwards such that excess
profit disappears.
Likewise, if a firm incurs loss, it would also disappear in the long run, as a result
of exit of loss-making firms. Hence, every firm can just equate its AR to AC and
make only normal profit. Equilibrium situation of the firm and industry is shown in
the Figure 11.6.
Price & cost
Price & cost
D S
SMC LMC
SAC
LAC
P*
P = MR = D
X* Output X* Output
Fig. 11.6 Long Rum Equilibrium of Firm in Perfect Competition
In the long run, there is no fixed cost because all costs are variable. As a result,
long run total cost is also equal to long run variable cost. Hence, the equilibrium
condition for the firm is P = LMC = LAC. Given this condition, the firm would
adjust its plant size in such a way as to reach the lowest point of LAC with the above
condition.
Thus, the firm would be in equilibrium at the level of output at X*, where its short
run marginal cost is also equal to its long run marginal cost, and the short run average
cost is also equal to its long run average cost. Thus, the long run equilibrium of the
firm under perfect competition exists at the output level, where
SMC = LMC = SAC = LAC = P = MR
The industry’s demand and supply curve determines the market price P*. Given
this, the firms can earn profit only by cutting their cost of production. Any change in
demand and supply would change the price and move the demand curve of each firm,
resulting in loss or profit. And consequent entry or exit are expected to bring back the
equilibrium where each firm is expected to earn just normal profit.
Competition: Thus, such market mechanism in perfect competition is expected to
achieve least cost of production, lowest price possible for the goods sold and optimal
allocation of society’s resources. Share market, vegetable markets and markets for
perishables are some of the markets where perfect competition can be witnessed.
MONOPOLY
Monopoly is an extreme market structure where a single producer controls the entire
supply of a unique commodity which has no substitutes. Monopoly is present only
when there are strong barriers which prevent the entry of other firms into the indus-
try. In monopoly, firm and industry are one and the same. The barriers which prevent
new firms from entering the industry may be economic, institutional or artificial.
Having total control over the market, the single firm is the ‘price maker’ for the
industry.
Whether monopoly is a boon or bane is a controversial issue. Normally, it
depends on whether monopoly is in the private or public sector? For instance, Indian
Railways, being a public sector monopoly, aims to facilitate economic growth and
serve people.
Meaning of Monopoly
The term monopoly has two syllables—mono and poly. Mono means single and
poly means seller. Hence, monopoly implies the presence of a single seller for a
commodity which has no close substitutes, and there are barriers to entry and
absence of competition in the market. This situation is called pure, or absolute,
or perfect monopoly. This type of pure or perfect monopoly is usually not pres-
ent in the economy. In reality, only imperfect monopoly is present. An imperfect
monopoly is a situation wherein there is only a single seller for a product for which
there are no close substitutes. In other words, it implies that substitutes are avail-
able but they are not close substitutes. Imperfect monopolist is not as strong as a
perfect monopolist. Hence, in an imperfect monopoly, the cross elasticity of demand
between the monopolist product and that of the distant competitor is small and above
zero. According to Joel Dean, ‘A product of lasting distinctiveness’ is termed as
monopolised product. Its distinctiveness lasts for several years.
Assumptions of Monopoly
The monopoly model is based on some basic assumptions. They are:
1. There is a single producer/seller for the product
2. There are no close substitutes for the product
3. The presence of barriers prevents new firms from entering the industry
4. The monopolist uses his monopoly power to maximise his revenue
Basic Causes for Monopoly

Monopolies emerge due to several reasons. The following are some of them.
1. Government Permission: Monopoly may be protected from competition
by public policies. By restricting entry into an industry, the govern-
ment can create a monopoly for reasons like public utility or national
security.
2. Ownership of Resource: Monopoly may emerge due to ownership of raw
material and production techniques in the hand of a single producer.
3. Economies of Scale: If a firm has downward sloping average cost curve,
it poses monopoly power. When it increases its output, cost of production
decreases.
4. Natural Monopoly: In the case of power, telephone and railways, the
sheer size of investment creates natural monopolies, due to huge capital
cost and long gestation period.
5. Pricing Policy: Sometimes artificial barriers are created by an existing
firm at the market, by imposing price limit, to prevent other firms from
entering into the market.
6. Patterns: If an individual or a firm owns a copyright or pattern for a
product or a superior technology, it would create a monopoly.
Demand and Revenue Curves

The monopoly firm, being a single seller in the industry, faces normal downward
sloping demand curve. Thus, the firm’s demand curve is also the industry’s demand
curve. In contrast, the price line or demand curve of a firm in perfect competition
is flat because the firm is the price taker. But the monopolist is a price maker in
the market. The demand curve is also the average revenue curve (AR), which is
equal to price and demand. The relationship between price and AR is explained in
Table 11.1.
Table 11.1 Price and Revenue of a Monopolist
Output (Q) Price (P) TR AR MR

1 5 5 5 5
2 4 8 4 3
3 3 9 3 1
4 2 8 2 –1
5 1 5 1 –3
We know, TR = P × Q
TR
AR = ___
Q
DTR
MR = ____
DQ
Due to the downward sloping demand curve, price and output are inversely related.
At higher price, output would be lower. But when price decreases more output can be
sold. The total revenue (TR) is determined by the price and quantity of output. Both
AR and MR are sloping downwards. But the slope of MR is twice that of AR curve.
However, both curves start at the same point. AR and MR are graphically depicted in
Figure 11.7.
P D
e=a
e>1
e=1
e<1
D = AR = P
e 0
O
MR X
Fig. 11.7 AR and MR Curves of Monopoly
Price Elasticity of Demand and MR Curve

It is known that elasticity of demand varies along the demand curve. The relationship
between MR and elasticity of demand is indicated in Figure 11.6. In general, price
elasticity of demand decreases as we move downwards from top. It is infinitive at the
top and zero at the intersection point of demand curve and the quantity demanded.
But, elasticity is unitary at the mid-point of the demand curve.
MR is positive in the elastic area of the demand curve and becomes negative in
the inelastic area. MR is zero while elasticity is equal to one. Being a monopolist
with the aim of profit maximisation, the firm would prefer the elastic portion of the
demand curve. It will never come forward to produce in the inelastic area because
MR is either zero or less than one in that portion.
Short Run Equilibrium of Monopoly Firm

The monopoly firm is in equilibrium when it attains maximum profit. The two basic
conditions for the equilibrium of a monopoly are:
1. MC = MR
2. MC curve cuts the MR curve from below.
In figure 11.8, at the point L, MC is equal to MR; this equality indicates the equi-
librium level of output at X1 and corresponding price at P1. The monopoly firm
always earns abnormal profit due to its control over the market. The shaded area
exhibits its abnormal profit. Further, the monopoly power indicates that the firm can
set maximum price or minimum quantity for the industry. But the downward sloping
demand curve indicates that the monopoly can fix either price and accept the cor-
responding quantity, or fix the quantity, and accept the relevant price. Thus, it cannot
decide both the price and the quantity at the same time.
SMC
M
P2 SAC
P1
D = AR
O X1 X
MR
Fig. 11.8 Equilibrium of Monopoly
Price Discrimination
A monopolist sells his product in different markets at different prices. This is called
price discrimination. In order to maximise profit, the monopoly firm sets different
prices for different customers. However, it faces same cost function and produces
similar goods.
The following are some examples where price discrimination is being applied.
1. A doctor charges different price for different patients (lower charges for
poor people and higher charges for rich people)
2. Different electricity charges for different users ( zero price for agriculture
use and higher prices for commercial use)
Basic Conditions for Price Discrimination

Discriminated price can be charged effectively only under the following three
conditions.
Different Demand Elasticity: The markets needs to be subdivided according to
the price elasticity of demand for different consumers. The producer charges higher
price in the market where demand elasticity is lesser as compared to the other market
in which lower price is charged.
Separate Markets: There should not be any connection between the sub-divided
markets. That is, a consumer should not be able to resell the product with a higher
price in another market.
Monopoly Power: The firm must have monopoly power to charge the discrimi-
nated price.
Price discrimination is also discussed in detail in the next chapter as a pricing
technique.
MONOPOLISTIC COMPETITION
Pure competition and monopoly models of producer behaviour were popular up to
the early part of the 20th century. These two classical theories, being the two extreme
cases of market structure, have failed to explain the situations in the real world; espe-
cially pure competitive market has several unrealistic assumptions. This has resulted
in emergence of new theories of market structure which describe the markets that
in-between these two extreme cases. Piero Srafa was the first one to point out the
downward sloping demand curve. E.H. Chamberlin (monopolistic competition) and
Joan Robinson (imperfect competition) independently developed a similar model but
with different terms. In monopolistic competition, many sellers sell differentiated
product. The large number of sellers or producers is called ‘group’ in monopolistic
competition in contrast to ‘industry’ in the pure competition market.
Monopolistic competition tries to explain how markets have been structured in
the real world and what determines producer behaviour.
Characteristics
The following are some of the characteristics of a monopolistic competitive market.
1. There are large number of producers (sellers) and consumers (buyers) in
the market.
2. Products are close substitutes (not fully substitute), but are differentiated
from others products by various means.
3. Free entry and free exit of sellers and buyers are allowed.
4. Prices of factors of production and technology remain same.
Product Differentiation
In this model, many sellers sell differentiated products. Products of firms in monopo-
listic competition are substitutes but differentiated from each other. For example,
different brands of fans, soaps, toothpastes, blades, radios, mobile phones, cars, tea
packets, etc.
Methods of Product Differentiation

It is to be noted that different toilet soaps are substitutable for one another; but one
brand is highly differentiated from the other to the extent that the consumer may
feel they are different. For instance, Hamam is differentiated from Lux in innumer-
able ways, like colour, pack, shape, price and claims of advertisement, etc. Further,
monopolistic competitive firm uses strategies to differentiate its products in order to
increase its sales at the market, such as offering discount, transport services, some
other good with its product, prizes etc.
Demand Curve for Monopolistic Competition Firm

A few firm under monopolistic competition
P
can decide its price or the amount of its prod- D
uct. If it increases its price, demand will go
down, and vice versa. Hence, demand curve
P1
always slopes downward. Thus, price is neg-
atively related with the quantity demanded. P2
It is indicated in Figure 11.9. In general its
demand curve is a little more elastic than that D
of monopoly, due to the number of sellers in
the group.
Short Run Equilibrium of Firm in

Monopolistic Competition O
Q1 Q2 X
According to the Chamberlin’s model of
Fig. 11.9 Firm’s Demand Curve in
monopolistic competition, to reach equilib- Monopolistic Competition
rium, the firm equates its cost and revenue
like a monopoly firm. Hence, the firm would be able to earn abnormal profit in short
run through its market control, gained by product differentiation and selling activi-
ties. But it is impossible in the long run because the abnormal profit would attract the
entry of new firms.
As products are differentiated but are close substitutes to one another, all firms in
this market face same demand and cost function. With this assumption, Chamberlin
has explained long run equilibrium under the following three models.
1. New Entry and Equilibrium
2. Price Competition and Equilibrium
3. Price Competition and Free Entry and Equilibrium
Equilibrium of Firm with Free Entry

There is no price competition among firms except free entry in this model. All firms
try to maximise their profit. This model explains that a firm can earn abnormal profit
in short run but it would disappear in the long run due to the entry of new firms into
the industry. Hence, every firm in long run gets only normal profit. This is shown in
Figure 11.10.
P&C
D
LMC
D1
L
P1
E
P2 LAC
M
P3
A
B
D
D1
MR1 MR2 X
Fig. 11.10 Equilibrium of Firm in Monopolistic Competition
At the beginning, equilibrium point in the short run is at A where MR2 = MC. At
this equilibrium, the firm gets abnormal profit to the extent of the area P1LMP3. But
this situation is impossible in the long run because of free new entry. The abnormal
profit attracts new firms into the industry. Thus, demand curve shifts downward,
from DD to D1D1. Hence, new equilibrium point is now B, and the firm earns only
normal profit at the price of P2.
Equilibrium of Firm with Price Competition

In the second case (equilibrium with price competition), the entry and exit are
assumed to be absent because profit in the long run would be normal. Hence, firms
would compete with each other by cutting their price. This would push the demand
curve downward until it is tangent to the long run average cost.
Equilibrium of Firm with Price Competition and Free Entry

In the third case (equilibrium with price competition and free entry), the entry and
exit equilibrium is achieved both by price competition and new entry. This would
push both the price and demand curve downward, even below the LAC. This would
send out the financially weak firms who cannot withstand the loss. And such exit
would move the demand curve of the existing firms upward until it is tangent to the
long run average cost. At that point, the long run equilibrium would be established
with the existing firms sharing the market demand.
DUOPOLY
Duopoly is a market situation where there are two sellers for the product. In other
words, two monopolists share their monopoly power. Duopoly is of two types. First
is Duopoly with product differentiation and the second is Duopoly without product
differentiation.
In the case of product differentiation duopoly, each producer would have his own
loyal customers, and there would be absence of price war between them.
In duopoly where there is no product differentiation, products would be identical.
The duopolists may have an agreement regarding prices or divide the market. If there
is no agreement on price, then there would be a constant price in the market, and
there would be only normal profits. In the case of differentiated cost in production,
the firm with the least cost would push the other firm out of the market, which would
result in monopoly. In the case of an agreement between the duopolists, monopoly
price would be fixed and the market and profits would be divided.
OLIGOPOLY
Oligopoly is derived from two Greek words – ‘Oligos’ and ‘Poly’. Oligos means ‘a
few’ and poly means ‘sell’. Oligopoly is a situation where there is presence of a few
large firms that compete with each other. An element of interdependence between
them with regard to policy decisions would be present. A policy change by one firm
would lead to reaction from other competitors. In oligopoly, the products may be
either homogeneous or differentiated.
Classification of Oligopoly
Pure or Perfect Oligopoly and Imperfect Oligopoly: If the products produced by
the firms are identical then they are called pure oligopoly. If the competing firms
produce differentiated products, which are close but not perfect substitutes, then they
are termed as imperfect oligopoly.
Open and Closed Oligopoly: This classification is based on the freedom to enter
the industry. If new firms can enter the industry then they are termed as open oli-
gopoly. If the conditions are such that there are barriers to the entry of new firms,
then they are termed as closed oligopoly.
Collusive and Non-Collusive Oligopoly: In a collusive oligopoly, the firms, instead
of competing with each other, combine together to fix the prices and output in the
industry. Collusion between the firms can be explicit or tacit. In explicit oligopoly,
the oligopolists collude to fix the price in a legal manner, whereas in tacit oligopoly
the collusion is secretive in nature, and it is without any written agreement.
Partial and Full Oligopoly: In partial oligopoly, there is presence of a market
leader who fixes the price, and other firms in the market just follow the price leader.
The market leader is one whose share in the market for that product is huge. Full
oligopoly implies the absence of price leadership.

Market Market Structure
Market Structure Continuum Monopoly
Imperfect Competition Firm
Monopolistic Competition Oligopoly
Duopoly Industry
Price Taker Price Setter
Price Discrimination Product Differentiation
Selling Activities Perfect Competition
Chapter Summary
Market structure analysis is central to economics and business. This chapter has dis-
cussed the various market structures to explain producer behaviour, and to show how
price is determined.
• Market structure deals with the behaviour of firms in making decisions
regarding supply and price.
• Different markets have various degrees of control and competition.
• Perfectly competitive market structure is organised with large number of
sellers selling homogeneous product.
• In monopoly there is only one seller selling a product or service.
• In monopolistic competition, the market is organised with both the ele-
ments of competition and monopoly.
Questions
1. Define market.
2. Define firm.
3. What is an industry?
4. What is perfect competition?
5. Who is a price taker and why?
6. Who is a price setter and why?
7. Define monopoly.
8. What is market supply curve?
9. Define oligopoly.
10. What is monopolistic competitive market?
1. What are the assumptions of perfect competition?
2. Distinguish between perfect and imperfect competition.
3. Explain the shape of the demand curve of a firm in perfect competition.
4. Explain the equilibrium conditions of a firm in perfect competition.
5. Explain the features of monopoly.
6. Explain the reasons for the emergence of monopoly.
7. What are the different kinds of markets?
8. Explain the break-even point and shut down point for a firm under perfect
competition.
9. Explain the equilibrium of a firm with price competition in monopolistic
competition.
1. Explain the classification of markets.
2. Explain the equilibrium of firm under perfect competition in the short and
long run.
3. Explain the feature and equilibrium of a monopoly firm.
4. Explain the feature and equilibrium of firm in monopolistic competition.
5. Explain the price discriminating monopoly and the required conditions.
Chapter 12
Pricing Techniques
‘A cynic is a man who knows the price of everything but the value of nothing.’
—Oscar Wilde
Learning Objectives
The aim of this chapter is to introduce the major pricing techniques that are being
used by firms in the market. Firms use different pricing techniques depending
upon the competitive conditions and the type of product.

• To explain the meaning of major pricing techniques
• To explain the conditions that are suitable for practising different pricing
techniques
• To explain the drawbacks of the different pricing techniques
Pricing Techniques 173
INTRODUCTION
In earlier chapters we have seen that a firm charges a price per unit of its product so
that its profit is maximised. Usually, under perfect competition, the firm is a price
taker, that is, it accepts the price determined in the market. Having accepted this
price, it produces a quantity of its product, so that its marginal cost equals marginal
revenue. But, in reality, a firm is under imperfect competition, that is, it has some
authority to decide the price of its product. While deciding the price of its product,
the firm should try not only to keep the extent of consumer’s surplus to the minimum,
but also dissuade its competitors from capturing its consumers. In other words, the
pricing techniques should allow the firm to charge a price high enough to reap con-
sumer’s surplus, and also low enough to keep its competitors at bay. Depending upon
the market conditions, the firm has to choose from a range of pricing techniques. Let
us discuss some of the major pricing techniques in this chapter.
PRICE DISCRIMINATION
In a market where a firm has a larger monopoly power, it can practise price
discrimination.
Price discrimination means a firm charging different prices for the same product
from different consumers. This sort of price discrimination is possible only if differ-
ent consumers have different demand functions and they cannot easily exchange the
products among themselves.
We have already stated that a firm would try to fix a price for its product that
keeps consumer’s surplus at the minimum. If every consumer has identical demand
function, then the firm can reap the aggregate consumer’s surplus of all consumers
by a single price. If every consumer has a distinct demand function, then the firm
has to charge every consumer a distinct price. While fixing the prices, the firm also
should take care that such prices are not too high for the consumers to reduce their
demand.
Degrees of Price Discrimination

Price discrimination is classified into three categories depending upon the range of
prices that a firm charges from its customers, namely, first- degree price discrimina-
tion, second-degree price discrimination and third- degree price discrimination.
First-Degree Price Discrimination

First-degree price discrimination refers to a set-up wherein a firm fixes a different
price for every unit that a consumer buys. The first-degree price discrimination is a
hypothetical situation which helps us to comment on the other types of price dis-
crimination. The first-degree price discrimination enables a firm to completely wipe
out the surplus that a consumer may otherwise reap.
Suppose a consumer wants to buy three units of a commodity. Let us also assume
he gets Rs 15, Rs 14, and Rs 13 worth of marginal utility from the three units, that is,
the total utility from three units is Rs 42. If the same price is charged, say Rs 13 per
unit, for all the three units, then the consumer pays Rs 39 to get Rs 42 worth of utility
and the consumer’s surplus is Rs 3. If first-degree price discrimination is practised by
the firm, it would charge Rs.15 for the first unit, Rs.14 for the second unit and Rs.13
for the third unit, thus completely wiping out consumer’s surplus. That is, the price
paid is Rs.42 and total utility is Rs 42 for the three units.
One can easily understand that this is totally hypothetical. The consumer must
always be a truth teller. He should say that he derives Rs15 worth of utility from first
unit, so that the firm may charge him Rs.15. Then he should say that he derives Rs 14
and Rs 13 worth of utility from second and third units respectively. This sort of the
transaction, wherein the consumer transacts one unit after another of a commodity,
and reveals his marginal utility for every unit is quite unlikely to happen.
Second-Degree Price Discrimination

Second-degree price discrimination refers to a situation wherein the firm charges
different unit prices for different quantities of a product. Usually, a firm sells higher
quantities of a product at lower unit price than the unit price for a lower quantity of
the same product. For example, one dozen cakes would be sold for Rs. 9 (unit price
Rs 0.75), whereas one cake separately would be sold for Rs.1. Thus, firms charge
lower unit price if the product is sold in bundles. There are three types of second-
degree price discrimination, namely, block pricing two-part pricing, and commodity
bundling.
Price
Block Pricing
Block pricing refers to the practice of a firm sell- D
ing the product in blocks, and not as individual
units, at some price per block. In this strategy of Block Pricing
pricing, the firm tries to take away entire con-
sumer’s surplus and thus maximises its profit.
Consider a consumer’s demand curve, DD,
for product X as given in Figure 12.1. If the 2 MC
marginal cost of producing X is Rs.2, then the D
market equilibrium price should be Rs. 2, and 0 4 Quantity
equilibrium quantity would be 4 units.
Fig. 12.1 Block Pricing
If the firm sells at Rs.2 per unit then the con-
sumer would buy 4 units and also gain a con-
sumer’s surplus of Rs.16, which is given as the shaded area below DD and above MC.
Since the firm has monopoly power to fix the price, it would decide to sell 4 units of
X as a single package. The price of the 4 units package is determined as the sum of
(i) MC times number of units, and (ii) the value of consumer’s surplus. That is, Rs.16
plus Rs.8, equal to Rs.24.
The firm sells the package of 4 units of X at Rs. 24 per package. What is the profit
to the firm?
Profit = TR – TC
TR =16 + 8 = 24
TC = 2*4 = 8
Profit = 24 – 8 = Rs.16
Thus, the firm takes the entire consumer’s surplus as its profits.
Similar to block pricing is another type of pricing used for near-public goods, like
an amusement park or a golf-course. This is called ‘two-part pricing’. Block pricing,
consists of two parts (i) consumer’s surplus, (ii) per unit price. Similarly, two-part
pricing also has two parts. There is an entry fee for the amusement park or the golf-
course along with a charge, for each ride in the roller-coaster or each round of golf.
Thus, the two-part pricing also tries to take away consumer’s surplus through an
entry fee and collect marginal cost of providing services through price per unit times
the quantum of services availed.
Commodity bundling is another form of second-degree price discrimination. We
often come across instances where two or more products are bundled as one pack-
aged unit and given to us. A familiar example is we also get complimentary morning
breakfast when we take a room in a hotel. An airline gives to-and-fro air ticket along
with stay for two nights in a hotel in a foreign country. Let us take the first example.
If there are two customers who value every product differently, then it would not
charge same price for each product from each of them. Rather, it would bundle the
two products and sell them at the same price, but each customer may think he is pay-
ing in accordance to his own valuation of the items in the bundle. In Table 12.1 given
below, the values of the two products made by the two customers are given:
Table 12.1 Valuation of two products by two customers
Customer Room (Rs) Breakfast (Rs) Total (Rs)

A 1,200 300 1,500
B 1,000 500 1,500
If the firm tries to maximise the return for each product, it would charge Rs 1,200
for room and Rs 500 for breakfast. But, it would get only one customer for each prod-
uct and total revenue would only be Rs 1,700. By charging Rs 1,500 per bundle, the
total revenue increases to Rs 3,000. If the marginal cost of the bundle is Rs1,000, it
would get still a marginal revenue Rs 300 from the second bundle. Thus, commodity
bundling is one of the important pricing practices.
Third-Degree Price Discrimination

Third-degree price discrimination refers to a situation when a firm is able to distin-
guish its customers into groups with distinct demand functions, and is then able to
charge different prices from different groups. Three conditions should be met for
exercising third-degree price discrimination.
(i) The firm is able to identify the distinct price elasticity of demand for each
consumer group
(ii) The firm is able to identify each consumer group in terms of age, economic
status, geographical location or any other characteristics
(iii) The consumers from each group are unable to buy the product from other
groups
The rationale for the third-degree P, R D 1 MC

price discrimination is that when D2
different groups have different
demand functions, the equilibrium
between MC and MR for each group
P2
would be at different quantities of
the product, and naturally the price P 1
MR 2
would also differ across groups. MR 1
For instance, let us consider two
groups, 1 and 2. The demand func- 0 Q1 Q2 Q
tion for 1 is more elastic than for 2 as
given in Figure 12.2. You may notice Fig. 12.2 Third-Degree Price Discrimination
that the corresponding MR curves
are different for the two groups; therefore, the equilibrium quantity and price differ
for the two groups.
COST PLUS OR MARK-UP PRICING

In case of price discrimination, the firm has substantial market power to fix a higher
price based on the marginal utility or revenue curve. The firm, being a monopoly,
aims at maximising its profits by minimising the consumer’s surplus. In this pricing
strategy, the firm should know the consumer’s demand function. Often firms do not
have this information. Moreover, if the firms operate in a competitive market, they
have to work out a pricing strategy that ensures a return equivalent to their cost, and
also be competitive. The pricing strategy based on cost of production is called cost
plus or mark-up on cost or mark-up on price strategy.
Mark-up is the difference between price and cost of a product, that is,
Mark-up = Price – Cost
Usually mark-up is expressed as a percentage of cost.
Then, Mark-up = {(Price – Cost)/Cost}*100.
Then, price = cost (1 = Markup on cost).
In the conventional approach, average variable cost is calculated and then a per-
centage mark-up or profit margin is added.
Sometimes the mark-up is determined as a percentage of price.
Therefore, Mark-up on Price = [(Price – Cost)/Price] × 100
The mark-up on price takes into consideration a wrong notion of cost, that is,
price.
One of the basic criticisms of cost plus pricing is the unrealistic assumption that
historical cost truly reflects future cost. The firm only knows the cost incurred for
production of commodities till date. It fixes a price based on past production cost for
all its future production. This pricing strategy may be sub-optimal because the cost
of production may increase instantaneously. Then cost plus price based on historical
cost would be inadequate to accrue maximum profit.
The cost plus pricing is usually used by firms in the competitive market, yet, the
fact remains that the price in this strategy does not take into account the demand con-
ditions prevailing in the market. Thus, the cost plus pricing would not help in fixing
an optimal price for a product.
PEAK-LOAD PRICING
Peak-load pricing is a strategy to fix different prices for a product at different time
periods because demand varies with time. There is higher demand for
1. Public transport during office hours
2. Electricity in summer after noon
3. Hotel rooms in resorts during weekends
In other periods, the demand for these commodities would be lower. In Figure
12.3, DD1 represents higher demand for electricity during afternoons and DD2 rep-
resents its lower demand in the morning. Correspondingly, marginal revenue curves
differ for the two time periods. Therefore, we find that MR = MC at lower price and
quantity in the morning and MR = MC at higher price and quantity during afternoons
for electricity.
The afternoon price for electricity is called peak load price.
Sometimes, the firm may produce with full-capacity, then any further increase in
output would lead to increase in all factors of production. There would be some other
periods, when the firm would produce at less than full-capacity, and any increase
in output would only be achieved by increasing the variable factors of production.
For example, for telephone services, 9 a.m. to 5 p.m. would be the peak period. The
off-peak period is between 5 p.m and 9 a.m. The firm usually keeps a mark up on full
cost for the services during the peak period and gives a discount on full-cost prices
for services during the off-peak period.
P&R MC
Peak load
price
DD1
Off-peak
price MR1
DD2
MR 2
0 Q1 Q2 Q
Fig. 12.3 Peak Load and Off-Peak Pricing

TRANSFER PRICING
With technological development, companies are vertically integrated. That is, a pro-
duction process is divided into many sub-processes, each sub-process is taken as one
unit, and a company consists of many units, and each unit takes a sub-process. As
such, the output of one unit is the input for another. Moreover, for each unit to func-
tion efficiently, each unit is allowed to make profit from supplying its output as input
to another unit in the company.
Let us explain this vertical integration with an example. Let X be a textiles com-
pany producing ready-made shirts. There are three units in the company. The first
unit spins cotton thread. The second unit weaves cotton cloth. The third unit stitches
ready-made shirt. Now, the first unit sells cotton thread to the second unit, the sec-
ond unit sells cotton cloth to the third unit and the third unit sells cotton shirts in the
market.
The problem in this set-up is that every unit fixes a price for its output and sell it
to the next unit. The price so fixed is the profit maximising price for that unit. If every
unit fixes a price equivalent to its MC, then the aggregate of MCs of three the units
is equivalent to the price of ultimate product. But, in practice, if every unit fixes a
mark-up on cost, then the aggregate MC of the three units is be greater than the MC
of the third unit.
This is called the problem of double marginalisation. Suppose MC of unit one is
Rs. A. It fixes a mark-up of 10% on MC. Then, input cost for B would be Rs. 110%
of A. Therefore, the MC for unit two would include the mark-up added by unit one.
Now, unit two fixes a price with 10% mark-up on its MC. Thus, there is mark-up on
mark-up, and the result is higher input price for unit three. Since unit three faces a
higher price, it would not demand optimal quantity of cotton cloth from unit two. In
turn, unit two would not demand optimal quantity of cotton thread from unit one. On
the whole, the company produces at less than optimal level because there is mark-up
on mark-up, otherwise called double marginalisation.
Double marginalisation is the basic problem of transfer pricing. Transfer price
is the price of a commodity sold by one unit to another unit within a company. The
problem of transfer pricing can be analysed under three conditions, namely, (i) trans-
fer pricing for products without external markets, (ii) transfer pricing for products
with perfectly competitive external markets, and (iii) transfer pricing for products
with imperfect external markets.
Transfer Pricing for Products without External Markets

In our example, let us assume there are no external markets for cotton thread and
cotton cloth. Now, unit one and unit two are monopolies as far as supplies of cotton
thread and cotton cloth are concerned. Therefore, these units would fix very high
prices, higher than the MC, and the problem of double marginalisation would arise.
Though units one and two make abnormal profits, unit three faces a competitive
market. As unit three buys cotton cloth at a very high price, its output, namely cotton
shirts, should also be sold at a higher price, and thus, it loses the market. This would
reduce the overall profitability of the company.
Transfer Pricing for Products with Perfectly Competitive External

Markets
In our example, let us assume there are perfectly competitive markets for cotton
thread and cotton cloth. Now, unit one and unit two would sell thread and cloth at
the prices fixed in the competitive markets. We know that in a perfectly competitive
market, the price of a product is equal to its MC of production. Therefore, if every
unit sells its output to the next unit at MC, then the last unit would have a MC that is
equal to the aggregate MC of all units. As such, every unit would place an optimal
demand for the output of the preceding unit, and the overall profitability of the com-
pany would also be optimal.
Transfer Pricing for Products with Imperfect External Markets

In our example, when there are imperfect markets for cotton thread and cotton cloth,
then every unit would fix the price and quantity of its output when MC = MR. There
are two possibilities with regard to supply of a unit’s output to the next unit, (i) at this
price, the entire output of a unit would not be bought by the next unit. In this case, the
first unit may sell excess output in the market. (ii) A unit may fix the price subject to
the condition of MC = MR, but its production may be inadequate to meet the demand
of the next unit. Under these circumstances, the demanding unit may source the extra
input from the open market. In either of these cases, every unit supplies and demands
optimal quantities and the overall profitability of the company is also optimal.
SKIMMING PRICE
Skimming price is one of the strategies used by a firm when it introduces a new prod-
uct in the market. In this strategy, the firm charges a very high price for the product
and, later, gradually reduces the price. The reason for using this strategy is that the
firm has incurred a substantial cost on development of the new product, and, before
the competitors enter the market, the firm wants to take back the development cost.
Once competition picks up in the market, the firm gradually reduces price. Though
the sale volume would be low when skimming price is charged, the profit margin
being high, the firm would be able to recoup its development cost.
Conditions for Using Skimming Price

Essentially, a firm should introduce a high prestige new product, which is likely to be
bought by consumers who do not decide the purchase on the basis of price. In other
words, the demand for the product should be highly inelastic. Usually, for any new
high value product, the price elasticity would be low in the short run, whereas the
long run demand curve would be elastic. Hence, the firm would reduce the price in
the long run.
As the firm is introduces a new product, the market is also new. Therefore, it is
easier for the firm to initially charge a price much higher than the cost of production,
as it does not face any competition.
Limitations of Skimming Price

When the price is very high, the retail traders keep very low volume of inventory.
This reduces the profitability of the company and its ability to expand the market for
the product.
Skimming price is fixed basically for the higher profit margin the firm wants in
order to recoup its development cost. This higher margin would attract competitors
quickly into the market. So the firm should keep a vigil on the entry of competitors
and reduce its price at an appropriate time to retain its market share.
Since the price is high, there is need for heavy spending for promotion of the
product. This adds to the selling cost and reduces the profit margin.
PENETRATION PRICE
Penetration price is used by a firm which introduces its product in a highly competi-
tive market. The firm, in order to capture a substantial market share, would charge a
price that is the lowest in the market. This lowest price would attract more custom-
ers to the product. The higher sale volume would result in better return, though the
profit margin per unit is low. The penetration price strategy would work provided the
customers of other brands shift to the new brand because of the attractive low price.
The penetration price would help in better diffusion and adoption of the product in
the market.
Conditions for Using Penetration Price

The penetration price strategy can be effectively used under the following
conditions:
1. The product has very high price elasticity, so when a new product with
lower price enters the market there is substantial shift of customers from
existing firms to the new firm.
2. The existing market should be large enough such that there are already
enough customers to buy the new product at lower price.
3. When the price is low, there is expansion of demand. The firm should be
able to derive benefits of economies of scale by increasing production.
4. When competition is stiff in the market, and a firm enters the market with
the lowest price, it is sure to make an appreciable impact in the market.
5. When the existing market does not have a standardised product, a low-
priced product would be a better substitute for the existing products.
Limitations of Penetration Price

The following are some limitations of the Penetration Price strategy.
• The ability to fix a low penetration price by a firm depends on its cost of
production. If the new firm’s cost of production is high as compared to its
cost of production of the competitors, then its ability to fix a penetration
price is low.
• Sometimes, the firm may experience diseconomies of scale with expan-

sion in production, then penetration price would not enable it to expand
its market share.

Price Discrimination Mark-Up
Peak-Load Pricing Cost Plus
Skimming Price Transfer Pricing
First-Degree Price Discrimination Penetration Pricing
Second-Degree Price Discrimination Block Pricing
Third-Degree Price Discrimination Cost Plus Pricing
Commodity Bundling Double Marginalisation
Chapter Summary
This chapter explains pricing techniques like price discrimination, cost plus pricing,
peak-load pricing, transfer pricing, skimming price, and penetration price.
• Price discrimination means a firm charges different prices for the same
product from the different consumers.
• First-degree price discrimination refers to a set-up wherein a firm fixes a
different price for every unit a consumer buys.
• Second-degree price discrimination refers to a situation wherein the firm
charges different unit prices for different quantities of a product.
• Block pricing refers to a practice of a firm selling the product in blocks,
and not as individual units, at some price per block.
• Commodity bundling is yet another form of second-degree price discrimi-
nation where two or more products are bundled as one packaged unit, and
are given to us.
• Third-degree price discrimination refers to a situation in which a firm is
able to distinguish its customers into groups with distinct demand func-
tions, and it charges different prices from different groups.
• The pricing strategy based on cost of production is called cost plus, or
mark-up on cost, or mark-up on price strategy.
• Peak-load pricing is a strategy to fix different prices for a product at dif-
ferent time periods, because the demand varies with time.
• Transfer price is the price of a commodity sold by one unit to another
unit within a company.
• Skimming price is one of the strategies of a firm to introduce a new prod-

uct in the market, where it first charges a very high price for the product
and, later, gradually reduces the price.
• Penetration price is used by a firm which introduces its product in a highly
competitive market with an aim to capture a substantial market share.
Questions
1. What is price discrimination?
2. What are the different types of price discrimination?
3. What is cost plus pricing?
4. Define peak-load pricing?
5. What is skimming price?
6. What is penetration price?
7. What are the conditions for using penetration pricing?
8. What is double marginalisation?
1. Explain the different types of second-degree price discrimination.
2. Explain the process of fixing cost plus price for a product.
3. Explain the peak-load price determination with a graph.
4. Explain double marginalisation.
5. How does transfer pricing under perfect competition remove double
marginalisation?
6. What is the skimming price strategy?
7. Why and how is the penetration pricing strategy used in mass consumption
goods?
Long Answer Questions
1. Explain the various pricing techniques.
2. Explain the concept of price discrimination and its different types.
3. Explain in detail the three forms of price discrimination.
4. Explain in detail transfer pricing under different market conditions.
5. Explain the technique of cost plus pricing.
6. Explain peak-load and off-peak price determination.
7. Explain transfer pricing under perfect competition.
8. Explain the skimming price strategy.
9. Explain the penetration price strategy.
Chapter 13
Managerial Theories
of Firm
‘We get paid for bringing value to the market place.’
—Jim Rohn, American businessman, author, speaker, philosopher
Learning Objectives
The chapter aims to provide an overview of various theoretical viewpoints with
regard to the objectives of a firm.
• To introduce classical and neo-classical concepts regarding the objectives
of a firm
• To explain the behavioural theories of a firm, notably those by Baumol,
Williamson, Marris and Cyert and March
INTRODUCTION
There are basically three types of firms – proprietorship, partnership and public lim-
ited company. In a proprietorship company, there is only one owner, and the owner
is both investor and manager of the firm. The profit or loss entirely goes to the single
owner of the firm. In a partnership company, the firm is jointly owned by several per-
sons, and all of them are jointly and individually liable to the debts and agreements
made by the company. The profit and loss of the partnership company are divided
in accordance with the amount of money invested by each one. In a public limited
company, the owners of the company are different from those who manage the firm.
The owners of a public limited company are called share holders; the liability of a
shareholder is limited to the value of the shares he/she owns. The management is
responsible for the agreements made by the public limited company. In this chapter,
we will study various theories that explain the behaviour of a firm.
CLASSICAL THEORY OF PROFIT MAXIMISATION

Classical theory of a firm is dominated by the ideas of the economist, John Bates
Clark. Hence, it is called the Clark Model. This theory is generally applicable to pro-
prietorship or partnership companies, which aim at profit maximisation. The theory
has certain assumptions, (i) given technology, that is, technology does not change,
(ii) labour is a homogenous factor of production, (iii) land and capital are combined
as one homogenous factor of production, and (iv) a firm produces only one homog-
enous output. Thus, the model postulates that a firm, using two homogenous factors
of production, namely, labour and capital, produces one homogenous commodity
with a given technology. The quantum of output is dependent on the quantum of
inputs used. With this, we add two more assumptions, namely, (v) wage rate is given,
and (vi) the price of output is also given. Why do we make these assumptions? In the
classical theory, we always think a firm functions in the perfectly competitive factor
and product markets. Therefore, the wage rate is fixed in the labour market and the
firm cannot determine the wage rate. Similarly, the price of the product is fixed in the
product market and the firm, as a price-taker, accepts this price as given.
Given these assumptions, the firm has to make a decision, that is, for a given out-
put, what should be the minimum amount of labour to be used, or, for a given labour
time, what should be maximum amount of the output to be produced. This was
extended by the neo-classical economists. They proclaimed that profit maximising
level of output occurs when MC = MR and MC curve cuts MR curve from below.
According to the classical theory, the behaviour of a firm is controlled by its
objective of maximising profit. But this is criticised by economists on the ground
that if investors and managers are two different sets of people, then profit maximisa-
tion is not the only objective of the firm, and that there are many other objectives that
the managers would like to pursue in their own self interest. These other theories of
firm’s behaviour explain particularly the behaviour of the public limited companies,
where the shareholders and managers have two distinct objectives.
Managerial Theories of Firm 185
TRANSACTION COST THEORY OF A FIRM

Ronald Coase, a noble laureate, raised an important question in the path-breaking
article ‘Nature of the Firm’ published in 1937 about the size of a firm. Coase’s
description of firm is compatible with the broader neo-classical theory, and extends
our understanding of the size of the firm and its determinants. He proved that a firm
would grow till the marginal transaction cost in the market was equal to the marginal
cost of internal transaction.
Transaction costs include (i) search and information costs, (ii) bargaining and
decision costs, and (iii) policing and enforcements costs. These components of trans-
action costs exist in both market and internal transactions.
In the market, the transaction costs depend upon (i) identification of the seller,
(ii) negotiation for bargain and finding the right price, (iii) creation of contract, (iv)
inspection to make sure that the contract is honoured, and so on. The transaction
costs are higher if the contract is for a long term, and the associated uncertainties
compel it to be re-negotiated time and again.
Compared to this, an entrepreneur would settle for expanding the internal contract,
which is more stable and less costly. For instance, his contract with the labourers is
for a longer time, and for a previously agreed salary in return for the labour time
used. Thus, a firm would extend its size as long as the internal cost of transaction is
not higher than the external market transaction cost. In other words, the entrepreneur
is substituting the complicated market based transaction with entrepreneur coordi-
nated and directed production.
BAUMOL’S THEORY OF SALES MAXIMISATION

Baumol’s contention is that, in a public limited company, the management aims at
maximising the sales revenue subject to attaining some minimum profit to satisfy
the shareholders. Why is the management interested in maximising the sales revenue
and not the profit? Profit maximisation would only increase the dividends to the
shareholders and in no way help the management. Whereas sales revenue maximisa-
tion would give the management (i) a sense of pride for managing a firm with a large
market share, (ii) power for the firm to compete effectively in the market, (iii) abil-
ity to increase the remuneration for the management, as it is mostly linked to sales
volume, and (iv) the capacity to increase the number of employees. Moreover, banks
are ready to lend to a firm that has a large sales volume. However, the shareholders
should also get larger profit otherwise they would sell their shares and the company’s
share price would come down. This would allow others to take over the company
and change its management. Therefore, the management is interested in maximising
the sales revenue subject to attaining larger profit. Sometimes, even the shareholders
accept this goal, because sales maximisation is a better short-term goal to pursue, and
it is quite likely to increase the long-term profit for the company.
Baumol gives two models of sales maximisation, namely, static model and
dynamic model. In the static model, there are two basic assumptions: (i) there is a
single period in which the management tries to maximise profits subject to a profit
constraint, and (ii) the level of profit is fixed exogenously by the shareholders. In
C, R, P
TC
TR
N Min profit
O Q
P
Q1 Q2 Q3
Fig. 13.1 Baumol’s Sales Maxmisation Model
Figure 13.1, the TR and TC curves represent total revenue and total cost, respectively.
Profit is the difference between TR and TC. Curve P is an inverted ‘U’, and represents
that profit increases until production reaches Q1, and declines thereafter. A profit
maximising firm would produce at Q1. Whereas, if the manager of the firm wants to
maximise sales revenue, then the output would be Q3, at which the TR is maximum.
This substantially reduces the profit level. So, let us assume that the shareholders
fix the minimum profit to be earned as N. Accordingly, the sales maximising output
would be Q2.
Baumol brings in the role of advertising expenditure in determining the sales
maximising output. He assumes that marginal revenue due to advertising is always
positive, and that advertising cost does not lead to increase in the price of the com-
modity, because advertising expenditure increases demand. Of course, many have
criticised these assumptions as unrealistic, because advertising cost would lead to
change in the price of the commodity, and advertising’s positive influence on demand
would taper off at some point.
Baumol also gives a dynamic model. The major criticism of the static model is
that profit is exogenously determined by the shareholders. In the dynamic model,
the profit is endogenously determined. The assumptions of the dynamic model are,
(i) the firm attempts to maximise the rate of growth of sales over its lifetime, (ii)
profit supplies the finances to attain higher sales volume, so profit is endogenously
determined, and (iii) sales growth may be financed through external sources, such as
market borrowing, but profit is the surest way to do it, so profit is endogenously deter-
mined. Through this dynamic model, Baumol shows that the sales volume increases
as profit increases. This satisfies both the management and the shareholders.
WILLIAMSON’S MANAGERIAL UTILITY FUNCTION

Like Baumol, Oliver E. Williamson also argues that there is a disjunction in the inter-
ests between the shareholders and the management. Williamson argues that the man-
agers have discretion to pursue their self-interests rather than to work to maximise
profit, which is the self-interest of the shareholders. Nevertheless, the managers are
constrained by minimum profit, which is essential for the shareholders to own the
company to provide job security to the managers.
Subject to the minimum profit constraint, the managers maximise their utility
functions, which include salary, security of job, power to spend, status and prestige
and professional excellence. The managers use their discretion in spending to attain
the maximum point of their utility function.
Managers’ powers to appoint personnel, and to disburse salary give them satisfac-
tion. Power to spend reflects power, status and prestige, and professional achievement
in the company. Hence, it is one of the important variables in their utility function.
Suppose, the minimum profit expected by the shareholders is Pm. Let the actual
profit that the firm can attain is Pd. That is, the managers have the discretion to
increase the profit to Pd. In other words, Pd-Pm could be named as discretionary
profit. According to Williamson, the managers would report a profit that is net of
discretionary expenditure (De) carried out by them, that is, Pd+Pm-De.
MARRIS GROWTH MAXIMISATION MODEL

Unlike Williamson, Marris tries to show where the managers and shareholders agree
and have common interest. Accepting that the managers have a utility function which
is different from that of the shareholders, it is certain that both would like to maximise
the size of the firm, as it gives power to the managers and also ensures maximum
profit in the long term to the shareholders. Further, Marris emphasises that managers
would like to maximise the rate of growth of the firm rather than the absolute size of
the firm. As the firm expands, it enhances the opportunities for the managers to attain
greater heights in their career.
Let the manager’s utility function be U = f (Gm, S),
Where, Gm = rate of growth of demand for the products of the company
S = a measure of job security
Let the shareholders’ utility function be U = f(Gc),
Where, Gc = rate of growth of capital of the firm
S is measured as a weighted average of three ratios, namely, liquidity ratio, lever-
age ratio and profit-retention ratio.
Liquid Assets
Liquidity Ratio = ____________
Total Assets
Value of Debt
Leverage Ratio = ____________
Total Assets
Retained Profits
Profit – Retention Ratio = ______________
Total Profits
The liquidity ratio emphasises that the company should have enough liquid assets
to manage its day-to-day expenses. Further, if its liquidity position is very weak,
it may not be able to service its debts, and leading to bankruptcy or takeover by
others. A high leverage ratio would create debt-servicing problems and reduce the
profit-retention ratio. The profit-retention ratio should be high enough to motivate
the shareholders to keep their investments in the company; else, they would shift
their investments to other companies. Too high a retention ratio would also be prob-
lematic, as it would reduce the capacity of the management to finance growth of the
company.
Both Gm and S have components which are similar to the ones for Gc. The growth
of capital base of the company is addressed if the three ratios explained above are
kept at optimal level.
CYERT AND MARCH BEHAVIOURAL THEORY OF A FIRM

Cyert and March consider the firm as a coalition of several groups, and each group
pursues distinct but conflicting goals. For example, a firm has shareholders, manag-
ers, workers, customers and financiers, or bankers. Each group wants the firm to
perform in such a way that maximises its distinct utility function. If the shareholders
want to maximise profit, the managers would like to maximise sales, the workers
would like to maximise wage rate, the customers would like to minimise price and
the bankers would like to maximise revenue so that debt servicing is easy for the
company.
The differences caused by these conflicting goals have to be resolved. Every divi-
sion competes to get larger allocation from the company in order to achieve its goal.
The bargaining power of each division is determined by its past performance. But,
at the same time, there is uncertainty in the environment because the reactions of the
market and the competitors can never be gauged. So, there is no consensus on the
goals of the firm. Every group faces the constraint from the other group, and they
indulge in bargaining to minimise the constraints. The firm strives to create an inter-
nal organisation process to control and stabilise, and to facilitate the growth of the
company. The commonly agreed set of goals is called the satisfying goals.
Though there are several goals for the several groups in a firm, the satisfying goals
are set by the top management. Cyert and March identify the following as the areas
where the satisfying goals are determined.
Production Goal: The production division would aim at smooth production func-
tioning, so they may aim at continuous increase in output even when sales have
declined.
Inventory Goal: The inventory division’s goal would be to maintain the optimal
stocks of products and inputs; but, the finance department would object to mainte-
nance of large idle stocks.
Sales goal: The sales division would like to achieve higher growth rate of sales
volume, this may be achieved by reducing the price, and thus reduce the profit per
unit.
Market Share Goal: The marketing division would like to increase the market
share of the company’s product through large scale promotion activities.
Profit Goal: Share holders and financiers would be happy in setting a goal to attain
satisfying profit.
The conflict resolution within the firm is carried through payment of money, or
through other policy commitments to groups, so that they accept the goals set by the
top management.

Profit Maximisation Transaction Cost
Sales Revenue Manager’s Utility Function
Discretionary Expenditure Liquidity Ratio
Leverage Ratio Profit-Retention Ratio
Goals of a Firm Shareholders’ aim
Chapter Summary
• The conventional and the generally accepted view about the objectives of a
firm is that a firm always aims at maximizing profit. Though this still the
most relevant objective of a firm, yet with changes in the organisational
structure of the firm, its objectives also undergo changes.
• The classical and neo-classical theories emphasised that a firm always
aims at maximising profit.
• Ronald Coase established that the size of a firm was determined by the
difference in the costs between internal and external transactions.
• Baumol’s theory explains the divergence in the interest between share-
holders and managers in a public limited company, and analysed how
the manager usually tried to maximise sales revenue subject to minimum
profit.
• Williamson showed that the managers always tried to maximise their
discretionary expenditure, which was considered an indicator of their
managerial power.
• Marris explained that both shareholders and managers agreed to aim for
maximising the growth rate of the firm.
• Cyert and March emphasised that different groups in a firm had differ-
ent objectives and the top management resolved them to bring about
consensus.
Questions
• What does classical theory of profit maximisation emphasise as the objec-
tive of a firm?
• Why do the objectives between managers and shareholders of a company
differ?
• What is the rationale for keeping sales revenue maximisation an objective
of a firm?
• What are the conflicting goals of a firm?
• Explain the classical theory of profit maximisation.
• Explain how Coase determines the size of a firm.
• How does Williams theory differs from Baumol’s theory of firm.
• Explain Baumol’s theory of sales maximisation.
• Explain how Williamson’s managerial utility function differ from Marris
Growth Maximisation model.
• Explain Cyert and March behavioural theory of a firm.
.
Madras University
(Semester Examination) Business Economics, April 2007
Part A (10 × 3 = 30 Marks)

1. State Marshal’s definition of economics.
2. Distinguish between accounting profit and economic profit.
3. State the law of demand.
5. Explain the determinants of supply.
6. What are the properties of indifference curve?
7. What is price discrimination?
8. What are the conditions of price discrimination?
9. Define monopoly.
10. What is meant by variable cost?
11. What is monopolistic competition?
12. Indicate the scope of economics.
Part B (5 × 6 = 30 Marks)
13. Explain Robinson’s scarcity definition of economics.
14. Why does the demand curve slope downward from left to right?
15. Point out the features of perfect competition.
16. Differentiate oligopoly from monopoly.
17. Explain the Law of Returns.
18. What is equilibrium? Explain the equilibrium of a firm?
19. Explain the relationship between average cost and marginal cost.
20. Discuss the factors determining elasticity of supply. Distinguish between
change in supply and elasticity of supply.
Part C (2 × 20 = 40 Marks)
21. Describe consumer’s equilibrium with the help of the indifference
curves.
22. Explain how price is determined under monopoly.
23. Examine the break-even principle.
24. Describe the nature and scope of managerial economics.
Madras University
(Semester Examination) Managerial Economics, April 2007
Part A (10 × 3 = 30 Marks)

1. Define managerial economics.
2. List out the important concepts of economics.
3. Identify the micro economic concept’ and models which are used in
managerial economics.
4. State the law of demand.
5. What do you mean by demand forecasting?
6. Define marginal utility.
7. What is meant by ‘isoquant curve’?
8. Explain fixed and variable costs.
9. Define price discrimination.
10. What is penetration pricing?
11. Define oligopoly.
12. What is perfect competition?
13. Briefly explain the various objectives of a modern business firm.
14. Define indifference curve and discuss its characteristics.
15. Explain the various types of price elasticity of demand.
16. Discuss the classification of economics of scale.
17. Explain the relationship between average revenue and marginal revenue
curve and perfect competition and imperfect competition.
18. Discuss the role of the government in pricing in India.
19. Analyse the general considerations of pricing.
20. Examine the main features of monopolistic competition.
Part C (2 × 20 = 40 Marks)
21. Analyse the factors affecting price elasticity of demand.
22. Explain the law of return to scale.
23. Discuss any five pricing methods or strategies.
24. Describe the nature and scope of managerial economics. Also bring out
its significance.
Question Papers 193
Madras University
(Semester Examination) Business Economics, April 2007
Part A (10 × 3 = 30 Marks)

1. Indicate the scope of the subject managerial economics.
2. Is managerial economics positive or normative?
3. What do you mean by change in demand?
4. Explain the term income elasticity of demand?
5. What is semi-variable cost?
6. What is learning curve?
7. What do you mean by customary pricing?
8. What is meant by equilibrium?
9. Define perfect competition.
10. What is monopoly?
11. State the essential conditions for price discrimination.
12. State any two differences between short run costs and long run costs.
13. Discuss the significance of managerial economics.
14. Explain the importance of indifference curve technique.
15. Explain the law of demand.
16. Explain the factors associated with demand forecasting.
17. Explain the law of variable proportions.
18. Explain the factors affecting pricing policy.
19. Discuss the features of monopoly.
20. Describe the consumer psychology in pricing.
Part C (2 × 20 = 40 Marks)
21. Distinguish between macro economics and micro economics.
22. Discuss critically the different methods of forecasting demand and point
out their limitations.
23. Explain the economics of large scale production.
24. Explain the pricing policy in public utility services.
Madras University
(Semester Examination) Business Economics, Nov 2006
Part A (10 × 3 = 30 Marks)

1. Explain the Marshall’s definition of economics.
2. What is economic profit?
3. Define demand.
4. What is consumer’s surplus?
5. Explain the term ‘demand forecasting’.
6. What do you mean by production function?
8. What is autonomous demand?
9. What is production function?
10. List out the purpose of short-term demand forecasting.
11. What is supply schedule?
12. What are the factors of production?
1. Distinguish between micro economics and macro economics.
2. Explain various types of price elasticity of demand.
3. What are the social responsibilities of business?
4. Explain the law of demand with illustrations.
5. What are the factors involved in demand forecasting?
7. What are the characteristics of capital?
8. Explain the law of diminishing returns with an example.
9. Describe the various methods of demand forecasting.
Part C (2 × 20 = 40 Marks)
1. Explain the three stages of law of return to scale.
2. Discuss the law of equi-marginal utility and its importance.
3. Discuss why profit maximisation is not always the aim of a business
firm.
4. Discuss the factors determining labour productivity.
Question Papers 195
Madras University
Part A (10 × 3 = 30 Marks)

1. Give the welfare definition of economics.
2. What are the objectives of a business firm?
3. What are the important determinants of demand?
4. Explain derived demand.
5. Distinguish the demand for durable goods and non-durable goods.
6. What is elasticity of demand?
7. What is capital formation?
8. What is cross elasticity of demand?
9. What is consumer’s equilibrium?
10. What is indifference curve analysis?
11. Distinguish between marginal utility and total utility.
12. Explain the law of constant returns.
13. Explain optimum theory of population.
15. What are the objectives of business firms?
16. Critically examine the Malthusian theory of population.
17. Explain the importance of division of labour.
18. Explain various types of demand.
19. Explain the law of diminishing returns.
20. Discuss the factors determining elasticity of supply.
Part C (4 × 10 = 40 Marks)
21. Explain the characteristics of indifference curve.
22. Explain the different types of elasticity of demand.
23. Discuss the significance of factors of production.
24. Explain the production function through iso-quant curve.
25. Describe the social responsibilities of a business firm.
26. Explain consumer’s equilibrium with the help of indifference curve
analysis.
Madras University
Part A (10 × 3 = 30 Marks)

1. Give the welfare definition of economics.
2. What are the objectives of a business firm?
3. What are the important determinants of demand?
4. Explain derived demand.
5. Distinguish between the demand for durable goods and non-durable
goods.
6. What is elasticity of demand?
8. What is autonomous demand?
9. What is production function?
10. List out the purposes of short-term demand forecasting.
11. What is supply schedule?
12. What are the factors of production?
14. Explain various types of price elasticity of demand.
15. What are the social responsibilities of business?
16. Explain the law of demand with illustrations.
17. What are the factors involved in demand?
19. What are the characteristics of capital?
Part C (4 × 10 = 40 Marks)
20. Explain the law of diminishing returns with an example.
21. Describe the various methods of demand forecasting.
22. Explain the three stages of law of return to scale.
23. Discuss the law of equi-marginal utility.
24. Discuss why profit maximisation is not always the aim of a firm.
25. Discuss the factors determining labour productivity.
Question Papers 197
Madras University
(Semester Examination) Managerial Economics, Nov 2005
Part A (10 × 3 = 30 Marks)

1. Define managerial economics.
2. Is there any relevance between managerial economics and macro
economics?
3. What is demand?
4. Explain the concept of price elasticity of demand.
5. Write a short note on Isoquant
6. Write a short note on opportunity cost vs. outlay cost.
7. What is skimming prices?
8. What is full-cost pricing?
9. What is a market according to the economic theory?
10. What is oligopoly?
11. Define monopoly.
12. What is duopoly?
13. Describe the main characteristic of managerial economics.
14. Why do firms, in general, aim at reasonable profit?
15. Describe the determinants of demand.
16. What are the factors influencing elasticity of demand.
17. What is meant by returns to scale? Illustrate your answer.
18. Analyse the relationship between AFC, AVC and ATC.
19. What are the general conditions affecting the size of the market.
20. Explain the features of monopoly.
Part C (2 × 20 = 40 Marks)
21. (a) Indicate the scope of managerial economics. Or
(b) Explain different types of elasticity of demand.
22. (a) What are the important types of market situations.
(b) Explain the equilibrium of a firm under simple monopoly.
Madras University
(Semester Examination) Managerial Economics, Nov 2004
Section A (10 × 3 = 30 Marks)

1. Explain Adam Smith’s definition of economics.
2. Explain the difference between the law of demand and elasticity of
demand.
3. Explain law of supply.
4. Enumerate the factors that determine the efficiency of labour.
5. What are the features of land?
6. What is capital formation?
7. What is cross elasticity of demand?
8. What is consumer’s equilibrium?
9. What is indifference curve?
10. Distinguish between marginal utility and total utility.
11. Explain the concept of constant returns.
12. Explain optimum theory of population.
14. What are the objectives of business firms?
15. Critically examine the Malthusian theory of population.
16. Explain the importance of division of labour.
17. Explain the various types of demand.
18. Explain the law of diminishing returns.
19. Discuss the factors determining elasticity of supply.
20. Explain the characteristics of indifference curve.
Part C (4 × 10 = 40 Marks)
21. Explain the different types of elasticity of demand.
22. Discuss the significance of factors of production.
23. Explain the production function through isoquant curve.
24. Describe the social responsibility of a business firm.
25. Explain consumer’s equilibrium with the help of indifference curve.
26. Discuss the features of monopolistic competition.
Question Papers 199
Madras University
(Semester Examination) Managerial Economics, April 2002

1. (a) What is the difference between profit maximisation and wealth
maximisation?
(b) What is demand schedule?
(c) What is zero elasticity of demand?
(d) What is BEP?
(e) What is marginal cost?
(f) Distinguish between fixed cost and variable cost.
(g) What do you mean by price leadership?
(h) What is price discrimination?
(i) What is privatisation?
(j) What is per capita income?
Section B (5 × 6 = 30 Marks)
1. Give the exceptions to the law of demand with examples.
2. Distinguish between consumer goods demand and industrial goods
demand.
3. Explain the difference between escapable cost and unavoidable cost.
4. Explain break even analysis with the help of a diagram.
5. Discuss the features of oligopoly.
6. Describe the situations when and where price discrimination is justified.
7. Explain the disadvantages in calculating national income by using income
approach.
Section C (2 × 20 = 40 Marks)
9. (a) Discuss the factors which influence price elasticity of demand.
Or
(b) Why is the short-run average cost curve ‘U’ shaped?
10. (a) Give a detailed account on the social responsibility of business.
Or
(b) Bring out of the contributions of Nobel Price winners to Economics.
Madras University
Business Economics, May 1999

1. (a) State the exceptions to the law of demand.
(b) What is an Isoquant curve?
(c) Point out any five objectives of business.
(d) What do you mean by least cost combination?
(e) What is ATC?
(f) What is BEP?
(g) What do you understand by price leadership?
(h) List any five objectives of pricing.
(i) What is wealth maximisation?
(j) What do you mean by mixed economy?
2. What is income elasticity of demand?
3. State the difference between average cost and marginal cost with
diagrams.
4. How is the demand for new products estimated.
5. What are the main features of oligopoly?
6. Distinguish between risk and uncertainty.
7. What is the utility of the cost plus pricing for public sector units?
8. What is discrimination?
9. (a) Define price elasticity of demand and distinguish its various types.
Or
(b) Explain the advantages of large scale production.
10. (a) State the salient features of LAC curve.
Or
(b) Explain how price and output decisions are taken under conditions of
oligopoly.
Question Papers 201
Madras University
Business Economics, May 1999

1. (a) What is demand curve?
(b) List the factors which influence price elasticity of demand.
(c) State the difference between AFC and AVC.
(d) What do you mean by production function?
(e) What is profit maximisation?
(f) What is replacement cost?
(g) What is kinked demand curve?
(h) Name the characteristics of perfect competition.
(i) What is the meaning of least cost combination?
(j) What do you mean by business ethics?
2. What is penetration price strategy?
3. Discuss the features of oligopoly.
4. Explain demand distinctions.
5. Why is short run average cost curve U shaped?
6. Profit is the reward of risk-taking. Discuss.
7. Write a note on pricing in public utilities.
8. What are the limitations of break–even analysis?
9. (a) Describe the nature and scope of business economics.
Or
(b) Define price elasticity of demand and distinguish its various types.
10. (a) What is meant by price discrimination ? What are its objectives?
Or
(b) Write a note on industrial policy.

Sivagnanam PDF

Uploaded by

Copyright:

Available Formats

Sivagnanam PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Sivagnanam PDF

Uploaded by

Copyright:

Available Formats

Business Economics

About the Authors

Tata McGraw Hill Education Private Limited

The McGraw-Hill Companies

8. Theory of Consumer Behaviour: Indifference Curve Approach 104

12. Pricing Techniques 172

ECONOMICS: MEANING AND DEFINITIONS

Wealth Definition of Adam Smith

But wealth definition, by its exclusive stress on ‘material wealth’, neglected

Welfare Definition of Alfred Marshall

Judged by the existing standards of present day theory, Marshall’s Principles is

Scarcity Definition of Lionel Robbins

The following are the fundamental aspects of Robbins’ scarcity definition.

has chosen to regulate the emission by strictly enforcing emission standards in

Growth Definition of Paul Samuelson

According to Samuelson, economics is a social science and it is mainly con-

Some more Definitions of Economics

Thus, the merit of Samuelson’s definition is that it has accommodated the

NATURE AND SCOPE OF ECONOMICS

BASIC ECONOMIC PROBLEMS

Scarcity and Choice

POSITIVE AND NORMATIVE ECONOMICS

MICRO AND MACRO ECONOMICS

The scope of micro economics includes the determination of commodity prices,

Micro and Macro Economics

Key Terms and Concepts

6. What is growth definition of economics?

Business economics deals with the application of economic principles and

‘Managerial economics is concerned with the application of economic principles

‘The purpose of managerial economics is to show how economic analysis can

‘Managerial economics is concerned with application of economic concepts

‘Managerial economics deals with the application of economic theory and

NATURE OF BUSINESS ECONOMICS

SCOPE OF BUSINESS ECONOMICS

Fundamentals of Business Economics

• Opportunity cost and production possibility curve

The Consumer Markets

The Business Organisation

ROLE OF BUSINESS ECONOMISTS

Collection and Management of Information

Business Performance Monitoring

Strategic Business Planning

SOME IMPORTANT CONCEPTS

Production Possibility Curve

Table 2.1 Production Possibility Schedule

Production Possibilities Good X Ballistic Missiles Good Y Public Hospitals

Accounting Profit and Economic Profit

Marginal and Incremental Concepts

Marginal changes can also be quantified by differentiating total magnitudes. For

where Q = Quantity produced

Similarly, MC is the derivative of the TC with respect to quantity of output

‘To economists, efficiency is a relationship between ends and means. When we

Every concept of efficiency has to employ some measure of value. Economists

Short Run and Long Run

Time Value of Money and Discounting

Key Terms and Concepts

• Important concepts like opportunity cost, production possibility curve,

Quantity Demanded and Demand

• Price of the commodity X