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Course code: 106 Microeconomics

Part-1: Price theories of micro economics


Unit-I Nature and Methodology of economics.
Chapter: 1- Nature of Economics : Definitions
Chapter: 2- Nature of Economics : Scope and Method

1. Definition of economics.
Answer: Economics comes from the ancient Greek word “oikonomia”
Or “oikonomikos.” Oikonomikos translates to “the task of managing a household.”
French mercantilists used “economy politique” or political economy as a term for
matters related to public administration.
Definition: Economics is a social science discussing how goods and services are
produced using scarce resources, and distributed for consumption.
Top 3 definitions of economics by different authors:
Adam Smith’s definition of Economics:
Adam Smith was a Scottish philosopher, widely considered as the first
Modern economist. Smith defined economics as “an inquiry into the nature and
causes of the wealth of nations.”
Criticism of Smith’s definition
1. The wealth-centric definition of economics limited its scope as a subject and
was seen as narrow and inaccurate. Smith’s definition forced the subject to ignore
all non-wealth aspects of humane existence.
2. The Smithian definition over-emphasized the material aspects of well- being.
3. The Smithian prevents the subject from exploring the concept of resource
scarcity. The allocation and use of scarce resources are seen as a central topic of
analysis in modern economics.
Alfred Marshal’s definition of economics:
British economist Alfred Marshal defined economics as the study of man in the
ordinary business of life. Marshal argued that the subject was both the study of
wealth and mankind. He believed it was not a natural science such as physics or
chemistry, but rather a social science.
Criticism of Marshal’s definition
1. The Marshallian definition, like the Smithian definition, ignored the problem of
scarce resources, which possess unlimited potential uses.
2. Marshal’s definition restricted economics as a subject to only analyze the
material aspects of human welfare. Non-material aspects of welfare were ignored.
Critics of the Marshallian definition asserted that it was difficult to separate
material and non-material aspects of welfare.
3. The Marshallian definition does not provide a clear link between the acquisition
of wealth and welfare. Marshall’s critics claimed that it left the subject in a state of
perpetual confusion.
Lionel Robin’s definition of economics:
Lionel Robin, another British economist, defined economics as the subject that
studies the allocation of scarce resources with countless possible uses. In this 1932
text, “An Essay on the Nature and Significance of Economic Science,” Robbins
said the following about the subject: “Economics is the science which studies
human behaviour as a relationship between ends and scarce means which have
alternative uses.”
Criticism of Robbins definition
1. Robbin’s definition of economics transformed the subject from a normative
social science into a positive science with an undue emphasis on individual choice.
His definition prevented the subject from analyzing topics such as social choice
and social interaction theory, which are important topics within the modern
microeconomic theory.
2. Robbin’s definition prevented it from analyzing macroeconomic concepts such
as national income and aggregate supply and demand. Instead, economics was
merely used to analyze the action of individuals, using stylized mathematical
models.
Modern Definition of Economics
The modern definition, attributed to the 20th-century economist, Paul Samuelson,
builds upon the definitions of the past and defines the subject as social science.
According to Samuelson, “Economics is the study of how people and society
choose, with or without the use of money, to employ scarce productive resources
which could have alternative uses, to produce various commodities over time and
distribute them for consumption now and in the future among various persons and
groups of society.
Conclusion: Economics studies how individuals, businesses, governments, and
nations make choices about how to allocate resources. Economics focuses on the
actions of human beings, based on assumptions that humans act with rational
behavior, seeking the most optimal level of benefit or utility.

02. What types of fundamental problems facing an economy?


Answer: The following points highlight the five basic problems of an economy.
The problems are:
1. What to Produce and in What Quantities?
2. How to Produce these Goods?
3. For whom is the Goods Produced?
4. How efficiently are the Resources being utilized?
5. Is the Economy Growing?

Problem # 1. What to Produce and in What Quantities?


The first central problem of an economy is to decide what goods and services are
to be produced and in what quantities. This involves the allocation of scarce
resources in relation to the composition of total output in the economy. Since
resources are scarce, the society has to decide about the goods to be produced:
wheat, cloth, roads, television, power, buildings, and so on. Once the nature of
goods to be produced is decided, then their quantities are to be decided. How many
tons of wheat, how many televisions, how many buildings, etc. Since the resources
of the economy are scarce, the problem of the nature of goods and their quantities
has to be decided based on priorities or preferences of the society. If society gives
priority to the production of more consumer goods now, it will have less in the
future. A higher priority on capital goods implies fewer consumer goods now and
more in the future. But since resources are scarce, if some goods are produced in
larger quantities, some other goods will have to be produced in smaller quantities.
This problem can also be explained with the help of the production possibility
curve as shown in Figure 1.Suppose the economy produces capital goods and
consumer goods. In deciding the total output of the economy, the society has to
choose that combination of capital goods and consumer goods which is in keeping
with its resources. It cannot choose the combination R which is inside the
production possibility curve PP1 because it reflects economic inefficiency of the
system in the form of unemployment of resources. Nor can it choose the
combination R which is outside the current production possibilities of the society.
Society lacks the resources to produce this combination of capital goods and
consumer goods. It will, therefore, have to choose among the combinations В, E,
or D which give the highest level of satisfaction. If the society decides to have
more capital goods, it will choose combination B; and if it wants more consumer
goods, it will choose combination D.
Problem # 2. How to Produce these Goods?
The next basic problem of an economy is to decide about the techniques or
methods to be used to produce the required goods. This problem is primarily
dependent upon the availability of resources within the economy. If the land is
available in abundance, it may have extensive cultivation. If the land is scarce,
intensive methods of cultivation may be used. If labor is in abundance, it may use
labor-intensive techniques; while in the case of labor shortage, capital-intensive
techniques may be used. The technique to being used also depends upon the type
and quantity of goods to be produced. For producing capital goods and large
outputs, complicated and expensive machines and techniques are required. On the
other hand, simple consumer goods and small outputs require small and less
expensive machines and comparatively simple techniques. Further, it has to be
decided what goods and services are to be produced in the public sector and what
goods and services in the private sector. But in choosing between different
methods of production, those methods should be adopted which bring about an
efficient allocation of resources and increase the overall productivity in the
economy. Suppose the economy is producing certain quantities of consumer and
capital goods at point A on the PP curve in
Figure 2. У adopting new techniques of production, given the supplies of factors,
the productive efficiency of the economy increases. As a result, the PP0 curve
shifts outwards to P1P1.
It leads to the production of more quantities of consumer and capital goods from
point A on PP0 curve to point С of PP with be the new production possibility curve
and the economy will move from point A to В where more of both the goods are
produced.
Problem # 3. For whom are the Goods Produced?
The third basic problem to be decided is the allocation of goods among the
members of
The society. The allocation of basic consumer goods or necessities and luxuries
comforts and among the household takes place on the basis of the distribution of
national income. Whosoever possesses the means to buy the goods may have then.
A rich person may have a large share of the luxury goods, and a poor person may
have more quantities of the basic consumer goods he needs. This problem is
illustrated in Figure 3 where the production possibility curve PP shows the
combinations of luxuries and necessaries. At point В on the PP curve, the economy
is producing more of luxuries ОС for the rich and less of necessaries ОС for the at
whereas at point D more of necessaries OH are being produced for the poor and
less of luxuries OF for the rich.

Problem # 4. How efficiently are the Resources being utilized?


This is one of the important basic problems of an economy because having made
the three earlier decisions, the society has to see whether the resources it owns are
being utilized fully or not. In case the resources of the economy are lying idle, it
has to find out ways and means to utilize them fully. If the idleness of resources
says manpower, land or capital, is due to their male allocation, the society will
have to adopt such monetary, fiscal, or physical measures whereby this is
corrected. This is illustrated in Figure 4 where the production possibility curve PP
reflects idle resources within the economy at point A, while the production
possibility curve P1P1 reflects the full utilization of the resources at point В or C.
It is for the society to decide whether to produce more capital goods at point В or
more consumer goods at point C or both at point D at the level of full employment
represented by the In an economy where the available resources are being fully
utilized, it is characterized by technical efficiency or full employment. To maintain
it at this level, the economy must always be increasing the output of some goods
and services by giving up something of others.

Problem # 5. Is the Economy Growing?


The last and the most important problem is to find out whether the economy is
growing through time or is it stagnant. If the economy is stagnant at any point
inside the production possibility curve, says in Figure 5, it has to be moved on to
the production possibility curve PP whereby the economy now produces larger
quantities of consumer goods and capital goods. Economic growth takes place
through a higher rate of capital formation which consists of replacing existing
capital goods with new and more productive ones by adopting more efficient
production techniques or through innovations. This leads to the outward shifting of
the production possibility curve from PP to P1P1; (in Figure 5). The economy
moves, say after 5 years, from point A to В or С or D on the P1P1 curve. Point С
represents the situation where larger quantities of both consumer and capital goods
are produced in the economy. Economic growth enables the economy to have more
of both goods.
All these central problems of an economy are interrelated and interdependent.
They arise from the fundamental economic problems of scarcity of means and
multiplicity of ends which lead to the problem of choice or economizing of
resources.

Question-3: Define the concept of micro economics.


Answer: Economics is the science of resources."
- Adam smith.
 "Economics is a subject that deals with the day-to-day life of the people."
-Professor Alfred Marshall
In 1933, Ragner Frisch, a professor at the University of Osla, Sweden, divided
economics into two parts, macroeconomics and macroeconomics. 

#Micro Economics: 

Microeconomics (from Greek prefix mikro- meaning "small" + economics) is a


branch of economics that studies the behavior of individuals and firms in making
decisions regarding the allocation of scarce resources and the interactions among
these individuals and firms.

#Concept of micro economics:

1. Microeconomics analyzes the market mechanisms that enable buyers and sellers
to establish relative prices among goods and services. 

2. One goal of microeconomics is to analyze the market mechanisms that establish


relative prices among goods and services and allocate limited resources among
alternative uses.

3. Microeconomics shows conditions under which free markets lead to desirable


allocations. It also analyzes market failure, where markets fail to produce efficient
results.

4. Microeconomics focuses on firms and individuals. Microeconomics also deals


with the effects of economic policies (such as changing taxation levels) on
microeconomic behavior and thus on the aforementioned aspects of the economy.

5. Microeconomic theory typically begins with the study of a single rational and
utility maximizing individual. To economists, rationality means an individual
possesses stable preferences that are both complete and transitive.
The technical assumption that preference relations are continuous is needed to
ensure the existence of a utility function. Although microeconomic theory can
continue without this assumption, it would make comparative statics impossible
since there is no guarantee that the resulting utility function would be
differentiable.

6. Microeconomic theory progresses by defining a competitive budget set which is


a subset of the consumption set. It is at this point that economists make the
technical assumption that preferences are locally non-satiated. Without the
assumption of LNS (local non-satiation) there is no 100% guarantee but there
would be a rational rise in individual utility. With the necessary tools and
assumptions in place the utility maximization problem (UMP) is developed.

7. The utility maximization problem is the heart of consumer theory. The utility
maximization problem attempts to explain the action axiom by imposing
rationality axioms on consumer preferences and then mathematically modeling and
analyzing the consequences. The utility maximization problem serves not only as
the mathematical foundation of consumer theory but as a metaphysical explanation
of it as well. That is, the utility maximization problem is used by economists to not
only explain what or how individuals make choices but why individuals make
choices as well.

8. Microeconomic theory progresses by defining a competitive budget set which is


a subset of the consumption set. It is at this point that economists make the
technical assumption that preferences are locally non-satiated. Without the
assumption of LNS (local non-satiation) there is no 100% guarantee but there
would be a rational rise in individual utility. With the necessary tools and
assumptions in place the utility maximization problem (UMP) is developed

4. Explain the importance of micro-economics.


Answer: Micro-economics is a branch of economics that studies the aspect of
individuals and firms in making decisions regarding the allocation of scarce
resources and interaction among these individuals and firms. As a branch of
economics, it occupies a very important place in the study of economic theory. It
has both theoretical and practical importance. By studying micro-economics we
come to know
● How a free enterprise economy functions
● How millions of consumers and producers make decisions about the allocation
of productive resources among millions of goods and services in an economy.
● How goods and services produced in the community are distributed through the
market mechanism.
● About the determination of the relative prices of the various products and
productive services.
● About the conditions of efficiency in consumption and production and departure
from the optimum.
So, it can undoubtedly be said that micro-economics has great theoretical
importance.
Practical importance: From the practical point of view, micro- economics helps in
the formulation of economic policies calculated to promote efficiency in
production and the welfare of the masses. All in all, the study of micro-economics
teaches us about how the economy operates. It also teaches us how the economy
should be operated and how general welfare can be promoted through it.

5. Discuss the limitation of Micro-Economic.


Answer: The word micro means a very small portion. From this point of view,
micro economics is the study of specific economic units of the whole
economy. Under this, a commodity, a consumer, a firm or an industry is
studied individually. Microeconomics is the most important branch of economics.
It is also known as the foundation for whole economic analysis. It describes the
individual behavior of society and firm. According to William Flenar,
”Micro economics is related to the individual decision-making units.” It tells us
how the price and output level of any commodity is determined? How cost
of production is determined? What do we mean by market and its types?
How wage rate and payment for capital is defined? How the government
policy affects all such activities? Etc. Besides such important aspects
of microeconomics, it has some imitations as given below
1) Individual analysis
Microeconomics explains only small individual units of economic activity. 
This is a partial and incomplete analysis. For the national economic analysis,
aggregate income and output, aggregate production and expenditure show the
economic level of a country. All those subjects are not considered by
microeconomics. So it is regarded as an incomplete matter.
2) Impractical assumption
Most theories and models of microeconomics are derived based upon some
assumptions for example: other things remaining the same, full employment,
concept of rationality etc. In real life, it’s near impossible to be fulfilled those
assumptions. In our daily activities, there are many variable factors along with
time. Those changes in variables bring the change in individual behavior that
affects microeconomic activity. Same way, it is impossible to be full employed in
the economy. 
3) Wrong concept of laissez faire economy
Microeconomics believes in the concept of laissez faire economy that means there
should be no interference in the market economy by the government. It has been
explained in market life that government should interfere with its smooth activities.
An event of great depression- 1930 had made failure to the concept of laissez faire.
4) Micro economics ignores the macro-level activity
The real economic mirror of a country is employment, income, output, foreign
trade, price level, impact of policy (monetary and fiscal) implementation etc. 
But microeconomics does not analyze all those subjects. Limitations of Micro-
Economics: Micro-economic analysis suffers from certain limitations: It does not
give an idea of the functioning of the economy as a whole.  It fails to analyze the
aggregate employment level of the economy, aggregate demand, inflation, gross
domestic product, etc. Microeconomics is the study of individuals, households and
firms’ behavior in decision making and allocation of resources. It generally applies
to markets of goods and services and deals with individual and economic issues.
Here are some examples of microeconomics: How a local business decides
to allocate its funds. How a city decides to spend a government surplus.
The housing market of a particular city/neighborhood. Production of a local
business. Every individual behaves in a logical or sensible manner. Valid
information about supply, demand, price, and other market conditions are freely
available. Efforts of goods and labor are divisible. There is always full
employment in the market.
6. Need for Integrating Macro and Micro economics.
Answer: In our economy to take any decision or make any analysis we need to use
macro and micro economics both. Microeconomics is the study of individuals and
business decisions, while macroeconomics looks at the decision of countries and
governments. Though these two branches of economics appear different, they are
actually interdependent and complement one another. Many overlapping issues
exist between the two fields. The main key role of microeconomics is to examine
how a company could maximize its production and capacity so that it could lower
prices and better compete in its industry. It plays a vital role to make financial
statements. The important key factors of microeconomics are:
o Labor Economics
o Production theory
o Costs of production
o Demand Supply and Equilibrium
In macroeconomics we normally clarify the survey how the nation’s total
manufacture and the degree of employment are associated with features like:
o Cost prices
o Profit
o Wage rates
o Rate of interests
It does not only discuss issues with which the economy goes through but also helps
in resolving them, thereby enabling it to function efficiently. It can give different
results if we don’t use it properly. In single-use it can be true but together this same
thing can be false or rejected. Without using this, economic growth can be raised
or property can happen but it will be uncontrolled. To take any decision we need to
think about the whole situation. Some macroeconomics problems are caused by
micro economics, the same thing happened with micro economics. It totally works
as a compliment. It is therefore only proper to marry the two approaches both in
analyzing the economic problems and in prescribing policy measures for tackling
them. Ignoring one and exclusively concentrating attention on the other may often
lead not only to inadequate or wrong explanations but also to inappropriate or even
disastrous remedial measures. Microeconomics focuses on the actions of individual
agents within the economy like households, workers and businesses. But the
macroeconomics looks at the economy as a whole, board issues like growth,
unemployment. Trade balance. Inflation. These two branches of economics appear
different, they are actually independent and complement one another. Many
overlapping issues exist between the two fields. Macro and micro economics both
are needed to use in any proper decision. For example in economics the micro
decisions of individual businesses are influenced by whether the macroeconomic y
is healthy for example firms will be more likely to hire workers if the overall
economy is growing. In turn the performance of the macroeconomic ultimately
depends on the microeconomic decisions made by individual households and
businesses.  To understand their need for integrating, think of an export company.
The owner noticed that he can easily export some products from foreign countries
which have so many demands in our country. For this profitable idea, he will use
microeconomics, but this product tax by our government is high which will be
considered as macroeconomic. If the owner wants to launch his products he will
have to use macro and micro economics.
7. Discuss the method of economic.
Answer: An economic theory derives laws or generalizations through two
methods.
(1)Deductive Method and (2) Inductive Method.
These two ways of deriving economic generalizations are now explain in brief.
1. Deductive Method of Economic Analysis:
The deductive method is also named the analytical, abstract or prior method. The
deductive method consists of deriving conclusions from general truths, takes few
general principles and applies them draw conclusions. For instance, if we accept
the general proposition that man is entirely motivated by self-interest. In applying
the deductive method of economic analysis we proceed from general to particular.
Steps of Deductive Method:
The main steps involved in deductive logic asunder.
(i) Perception of the problem to be inquired into: In the process of deriving
economic generalizations, the analyst must have a clear and precise idea
of the problem to be inquired into.
(ii)Defining of terms: The next step in this direction is to define clearly the
technical terms used analysis. Further assumptions made for a theory should also
be precise.
(iii)Deducing hypothesis from the assumption: The third step in deriving
generalization is deducing the hypothesis from the assumption taken.
(iv)Testing of hypothesis: Before establishing law or organization, the hypothesis
is should be verified through direct observation of events in the real world and
through satirical methods.
Merit so Deductive Method: The main merits of deductive method are as under.
(i) This method is near to reality. It is less time consuming and less
expensive.
(ii) The use of Mathematical techniques in deducing theories of economics
brings exactness and clarity in economic analysis.
(iii) There being limited scope of experimentation, the method helps in
deriving economic theories.
(iv) The method is simple because it is analytical.
Demerits of deductive method:
(i) The deductive method is simple and precise only
If the underlying assumptions or valid. More often
Truths or have no relation to reality. The conclusions drawn from such assumption
will therefore, be misleading.
(ii) Professor learner describes the deductive method as 'armchair' analysis.
According to him, the premises from which inference are drawn may not.
(iii) The deductive method is highly abstract it requires, a great deal of care to
avoid bad logic or faulty economic reasoning. As the deductive method
employed by classical and neo-classical economists led to many facile
Due to reliance on imperfect and incorrect assumptions, therefore under the
German historical school of Economist, a sharp reaction began against this method.

(2) Inductive Method of Economic Analysis:


The inductive method which also called the empirical method was adopted by the
"Historical school of Economic". It involves the process of reasoning from
particular facts to a general principle. This method derives economic generalization
on basis of (1) Experimentations (2) Observation and (3) statistical methods.
In this method, data is collected about a certain economic phenomenon. These are
systematically arranged and the general conclusion is drawn from them.
Steps of inductive method:
The main steps involved in the application of the inductive method are:
(1) Observation (2) Formation of hypothesis (3) generalization (4) verification.
Merits of Inductive Method:
(i) It is based on facts as such the method is realistic.
(ii) In order to test the economic principles method makes statistical
techniques. The inductive method is therefore, more reliable.
(iii) The inductive method is dynamic. The changing economic phenomenon
is analyzed and on the basis of collected data, conclusions and solutions
are drawn from them.
(iv) The induction method also helps in future investigations.
Demerits of Inductive Method:
The main weakness of this method area sunder.
(i) If conclusions are drawn from insufficient data, the generalizations
obtained may be faulty.
(ii) The collection of data itself is not an easy task.

The sources and methods employed in the collection of data differ from
investigation to investigation. The result therefore, may differ even with the same
problem.
(iii) The inductive method is time-consuming and expensive.
The above analysis reveals that both methods have weaknesses. We cannot rely
exclusively on any one of them. Modern economists are of the view that both these
Methods are complimentary. The partner sand not rivals. Alfred Marshall has
rightly remarked. Inductive and Deductive methods are both needed for scientific
thought as the right and left foot is both needed for walking.

8. Is economic positive or normative?


Answer: In this article, we will explain whether economics is a positive or
normative science or both.

A positive science only explains what is and normative science tells us what ought
to be, right or wrong of a thing positive science describes, while the normative
science evaluates. When we say, for instance, that the businessmen, while making
decisions, use profit maximization as the criterion, it is positive economics, but
when we ask "ought they use this criterion, " we enter the field of normative
economics.
Definition of positive economic:
Positive economics is concerned with the development and testing of positive
statements about the world that are objective and verifiable. Positive statements
can be tested, at least in theory, if not always in practice. For example: If the price
of fish were higher, people will buy less. Or, as the money supply increases, the
price level will rise.
Definition of normative economic:
Normative economics derives from an opinion or a point of view. Thus the words
'should', 'ought to ', or ' it is better to ' frequently occur. The validity of normative
statements can never be tested. For example: people who earn large incomes ought
to pay more income tax than people who earn a low income.
Description of positive or normative economics:
* Positive economics is the study of economic issues subject to verification. It
deals with economic issues related to the past, present and future. The statements
in positive economics represent ' what was', what is ' and 'what would be '. Here,
facts and figures are used to verify the truth.
* Normative economics refers to the study of economic issues which involve a
value judgment. It deals with the opinions of economists related to solutions for
economic issues or problems. The statements in normative economics represent
'what ought to be '. It involves value judgment and opinions by economists.
Whether or not raising farm prices in developing countries is a good thing is
another question. To say that 'raising farm Prices in developing countries is a good
thing ' is a normative statement. On the other hand, the assertion that 'raising farm
prices in developing countries will improve rural incomes in those countries ' is a
positive statement. Why?  Because, again, it could, in theory, be tested. It does not
say that rural incomes in developing countries ought to be raised, just that higher
farm prices will have that effect.
We will notice that positive statements can often be broken down into a cause and
an effect. Whether the effect is described or not is a normative question that will
depend upon the subjective opinion of those affected.  Economists practicing
positive economics can help analyze the effects in greater detail by breaking them
down into positive and testable statements in the way we have done above. They
can advise policymakers in government, business and other organizations both on
the effects of specific policies and on the specific policies that need to be
implemented in order to achieve desired effects. However, it is ultimately
politicians and managers, and the people that empower them, that decide - on the
basis of normative judgments - what is ’desirable ' or what is not.
It is important to realize that economists practicing positive economics do,
however, make value judgments. Any analysis involves an element of subjectivity.
Economic decisions have many different effects and it is rarely possible to
examine them all in detail.
Indeed, whether to economic a problem from an economic perspective at all, or
whether to focus instead on alternative perspectives, such as those provided by the
disciplines of sociology, biology or political science, depends in large part on
normative/subjective views of the world.
9. Discuss about opportunity cost.
Answer:  Opportunity cost is the next best alternative foregone.
● Opportunity cost is the forgone benefit that would have been derived by an
option not chosen.
● To properly evaluate opportunity costs, the costs and benefits of every
option available must be considered and weighed against the others.
● Considering the value of opportunity costs can guide individuals and
organizations to more profitable decision-making.
For example: 
If we spend that 20$ on a textbook, the opportunity cost is the restaurant meal we
cannot afford to pay.
If you decide to spend two hours studying on a Friday night. The opportunity cost
is that you cannot have those two hours for leisure.
Opportunity Cost Formula and Calculation:
 
Opportunity Cost=FO−CO
Where: 

FO=Return on best foregone option
 CO=Return on chosen option

The formula for calculating an opportunity cost is simply the difference between
the expected returns of each option. 
Say that you have option A: to invest in the stock market hoping to generate capital
gain returns. Option B, on the other hand is: to reinvest your money back into the
business, expecting that newer equipment will increase production efficiency,
leading to lower operational expenses and a higher profit margin.
Assume the expected return on investment in the stock market is 12 percent over
the next year, and your company expects the equipment update to generate a 10
percent return over the same period. 
The opportunity cost of choosing the equipment over the stock market is (12% -
10%), which equals two percentage points. In other words, by investing in the
business, you would forgo the opportunity to earn a higher return.
The concept of opportunity cost does not always work, since it can be too difficult
to make a quantitative comparison of two alternatives. It works best when there is a
common unit of measure, such as money spent or time used.

Opportunity cost and a free good:


The concept of opportunity cost does not always work, since it can be too difficult
to make a quantitative comparison of two alternatives. It works best when there is a
common unit of measure, such as money spent or time used. If there were
decisions to be made that require no sacrifice then these would cost-free decisions
with zero opportunity cost.

      

10. Is Economy Science or Arts?

Answer: There is a great controversy among economists regarding the nature of


economics, whether the subject ‘economics’ is considered as science or an art. 

Economics is the study of the general methods by which men cooperate to meet
their material needs. According to the French economist J.B.Says, Economics is
the science which treats wealth. There is a great controversy among economists
regarding the nature of economics, whether it is science or arts. It is however,
necessary to understand the true nature of economics
Economics as a Science:
If we have a clear concept about science, we can easily decide whether economics
is a science or not.
Basically, science is a systematic study of knowledge and fact which develops the
correlation-ship between cause and effect.
There are the following characteristics of any science subject, such as;
1) It is based on a systematic study of knowledge or facts;
2) It develops correlation-ship between cause and effect;
3) All the laws are universally accepted;
4) It can make a future prediction;
5) It has a scale of measurement;
According to some economists, ‘Economics’ has also several characteristics
similar to other science subjects.
1) Economics is also a systematic study of knowledge and facts. All the theories
and facts related to both micro and macroeconomics are systematically collected,
classified and analyzed.
2) Economics deals with the correlation-ship between cause and effect.
3) All the laws of economics are also universally accepted, like, the law of
demand, the law of supply, the law of diminishing marginal utility etc.
4) Theories and laws of economics are based on experiments, like, the mixed
economy too is an experimental outcome between capitalist and socialist
economics
5) Economics has a scale of measurement. Such as money is used to measure rod
in economics.
The human development index (HDI) is used to measure the economic
development of a country.
All these lead us to the conclusion that economics is a part of science.
Economics as an Arts:
Economics is also considered an art. Science gives us principles of any discipline
however, arts turn all these principles into reality. It is a science in its methodology
and an art in its application. It has a theoretical aspect and is also an applied
science in its practical aspects. According to T.K.Mehta,
`Knowledge is science, the action is arts.’ Therefore, considering the activities in
economics, it can be claimed as art also, because it gives guidance to the solutions
of all the economic problems. Therefore, from all the above discussions we can
conclude that economics is neither a science nor an arts only. However, it is a
golden combination of both. Hence, economics is considered as both a science as
well as art.

—◑—
Unit:2 Theory of Demand
Chapter: 5- Utility Analysis of Demand

1. Law of diminishing marginal utility and it's limitation of the law

When a consumer consume a particular commodity continuously then the derives


from each successive unit goes on diminishing.

UNITS
UTILITY
CONSUMED
POINT DERIVED (PACKETS OF

(UTILS)
CHOCOLATES)

A 1st Packet 100


B 2nd Packet 75

C 3rd Packet 50

D 4th Packet 25
UNITS
UTILITY
CONSUMED
POINT DERIVED (PACKETS OF

(UTILS)
CHOCOLATES)

E 5th Packet 0

(Point

of

Satiety)

F 6th Packet

She ate the first one being delighted and was extremely satisfied with consuming
it. She then grabbed the second one, but her satisfaction level from this packet
was slightly low.

Then, with each consecutive packet of chocolate, the satisfaction level of X


goes on decreasing and reaches a point of satiety (at point E). At this point,
she was not deriving any satisfaction from her consumption.
At point F, we can see that the marginal utility becomes negative, indicating that
X is getting a negative satisfaction from her consumption.

Limitations of the law:


i. Unrealistic assumptions:
Include homogeneity, continuity, and constancy conditions. All these assumptions
are impossible to find at once.

ii. Inapplicability to certain goods:


Implies that the law of diminishing marginal utility cannot be applied to goods,
such as television and refrigerator. This is because the consumption of these
goods is not continuous in nature

iii. Constant marginal utility of money:


Assumes that MU of money remains constant, which is unrealistic. There is
also a gradual decline in the MU of money.

iv. Change in other people’s stock:


Implies that the utility of consumers is also dependent on what other people have
in their stock. Thus, the utility depends on social needs.
2. Marginal utility
Marginal utility can be defined as the change in the total utility resulting from a
one-unit change in the consumption of a commodity per unit of time. When a man
is purchasing a commodity, he is consciously or unconsciously weighing in his
mind the price he has to pay and the utility of each unit that he buys. He will
continue purchasing till the marginal utility equals the price. Here is a fundamental
proposition of the theory of consumer demand: "A consumer will exchange money
for units of any commodity A, up to the point where the last (marginal) unit of A
which he buys has for him a marginal significance in terms of money just equal to
its money price."
(1) Units (Toast) (2) Total Utility (Units of (3) Marginal Utility
satisfaction) (Units of satisfaction)
1 20 20
2 38 18
3 53 15
4 64 11
5 70 6
6 70 0
7 62 -8
8 46 -16

Refer to the table. Where will our consumer stop? It depends upon the price. If the
price is 6 Paise per toast, then he will stop at the 5th, for there the marginal utility
is equal to the price (marginal utility being represented in Paise units). If the price
is 11 Paise per toast, he will stop at the 4th, and, if they are free, then he will go on
consuming till the additional utility comes down to zero (i.e., up to the 6th unit).
He will not go beyond this point because disutility will be the result. The consumer
stops at a point where the price and the marginal utility are just equal. This is
called the marginal purchase and the extra utility at this point is called the marginal
utility. It is a point where we consider just worthwhile to purchase, for here the
pain of parting with the money and the benefit derived from the purchase of the
commodity just balance.
Marginal utility has also been defined as the addition made to the total utility by
the consumption of the last unit considered just worthwhile. In other words, it may
be defined as the change in total utility resulting from a unit change in the quantity
of the commodity consumed. Thus, if we buy 5 toasts, the 5th is the marginal toast.
But marginal utility is not the utility of the 5th toast, because all the toasts are
supposed to be alike. It only refers to the addition made to the previous total by the
consumption of this particular toast. Marginal utility is the increase in total utility
resulting from the consumption of the marginal unit. The following formula may
be used to measure it.

Marginal Utility (MU)=Change in total utility/Change in the quantity consumed

It thus measures the ratio of change in the two variables.

The margin is not something rigid or fixed. It shifts forward and backward
according to changes in price. If the price fails, it will become worthwhile to
purchase more of the commodity and the margin will descend and vice-versa.

3. Law of Equi-Marginal Utility and Its Limitations

The law of equi-marginal utility explains the behaviour of a consumer when he


consumes more than one commodity. Wants are unlimited but the income which is
available to the consumer to satisfy all his wants is limited. This law explains how
the consumer spends his limited income on various commodities to get maximum
satisfaction.
Suppose there are two goods, X and Y on which a consumer has to spend a given
income. The consumer being rational, he will try to spend his limited income on
goods X and Y to maximize his total utility or satisfaction. According to the law of
equi-marginal utility, the consumer will be in equilibrium at the point where the
utility per Taka of both the goods are equal in symbolic terms and the consumer
has spent all of his money income.
Let us illustrate the law with the help of the following table:

Schedule:
Money Income 60 Tk.
Price of Good ‘X’ 10 Tk.
Price of Good ‘Y’ 5 Tk.

Units MUx MUy MUx/Px MUy/Py

1 100 35 10 7

2 90 30 9 6

3 80 25 8 5

4 70 20 7 4
5 60 15 6 3

6 50 10 5 2

So we can see that our ‘Marginal Utility of Money’ of both goods has been
matched in 3 places(Highlighted).

Now let us find out where the consumer will be most satisfied with the help of the
consumer’s Money Income.

Suppose the marginal utility of money is constant at 7 units, the consumer will buy
4 units of commodity ‘X’ and 1 unit of commodity ‘Y’.
His total expenditure will be,
(Tk 10 × 4) + (Tk 5 × 1) = 45 Tk.

Here we can see that the whole income which is 60 Tk. Has not fully spent. So the
consumer will not get full satisfaction. And he will not be in equilibrium.

Again suppose the marginal utility of money is constant at 5 units, the consumer
will buy 6 units of commodity ‘X’ and 3 unit of commodity ‘Y’.
His total expenditure will be,
(Tk 10 × 6) + (Tk 5 × 3) = 75 Tk.

Here the consumer will not be able to afford it because his money income is Tk.
60. So he will not get any satisfaction. As a result, he will not be in equilibrium.
Lastly suppose the marginal utility of money is constant at 6 units, the consumer
will buy 5 units of commodity ‘X’ and 2 unit of commodity ‘Y’.
His total expenditure will be,
(Tk 10 × 5) + (Tk 5 × 2) = 60 Tk.

At this expenditure his satisfaction is maximized because he has spent all of his
money income and he will be in equilibrium.

Limitations of the Law

1. Indivisibility of Goods:
The theory is weakened by the fact that many commodities like a car, houses etc.
are indivisible. In the case of indivisible goods, the law is not applicable.

2. The Marginal Utility of Money is Not Constant:

The theory is based on the assumption that the marginal utility of money is
constant. But that is not really so.

3. The Measurement of Utility is not possible:

Marshall States that the price a consumer is willing to pay for a commodity is
equal to its marginal utility. But modern economists argue that, if two persons are
paying an equal price for given commodity, it does not mean that both are getting
the same level of utility. Thus utility is a subjective concept, which cannot be
measured, in quantitative terms.

4. Utilities are Interdependent:

This law assumes that commodities are independent and therefore their marginal
utilities are also independent. But in real life commodities are either substitutes or
complements. Their utilities are therefore interdependent.

4. Definition of Demand by Utsha Paul


It is necessary to distinguish between demand and desire or need. A sickly child
needs a tonic; a peon desires to have a car. But such needs and desires do not
constitute demand. When the person desiring is willing and able to pay for what he
desires, the desire is changed into demand.
Demand is an economic principle referring to a consumer's desire to purchase
goods and services and willingness to pay a price for a specific good or service.
Holding all other factors constant, an increase in the price of a good or service will
decrease the quantity demanded, and vice versa. Market demand is the total
quantity demanded across all consumers in a market for a given good. Aggregate
demand is the total demand for all goods and services in an economy.
Multiple stocking strategies are often required to handle demand. Also the demand
is always per unit of time-per day, per week, per month or year.
It is also closely related to supply. While consumers try to pay the lowest prices
they can for goods and services, suppliers try to maximize profits. If suppliers
charge too much, the quantity demanded drops and suppliers do not sell enough
products to earn sufficient profits. If suppliers charge too little, the quantity
demanded increases but lower prices may not cover suppliers’ costs or allow for
profits. Some factors affecting demand include the appeal of a good or service, the
availability of competing goods, the availability of financing, and the perceived
availability of a good or service.

5. Types of Demands
=Three kinds of demands may be distinguished:
1. Price demand
2. Income demand and
3. Cross demand
Price Demand: When demand changes due to change in price by keeping it stable
in other conditions, it is called price demand. The demand for a commodity
depends on its price, that is, if the price goes up, the demand goes down and if the
price goes down the demand goes up. If we form the price demand line in the
figure we get the downward demand line which is shown in the figure below.
Income Demand: When the demand of the consumer changes due to the change in
income while remaining stable in other conditions, it is called price demand. The
relationship between income and demand is positive. That is, the more a person's
income increases, the more his demand will increase. However, it is not applicable
to inferior products. Because there is a negative relationship between income and
the demand for inferior goods. The inferior product is the product that the customer
wants to give up when the income increases. In other words, when income
increases, the demand for inferior goods decreases.
The income demand line for common goods and inferior goods is shown below.
In the case of common goods, the demand line goes up from left to the right and in
the case of inferior goods; the demand line goes up from right to the left.
Cross Demand : If the price of one commodity increases or decreases and it
affects the demand for another commodity then it is called cross demand. In this
case, it can be said that the demand for coffee has increased due to the increase in
the price of tea or a drop in demand for coffee due to rising sugar price. Here sugar
and coffee are complementary goods and tea and coffee are substitutes goods.
Complementary Goods : If the price of one commodity increases then the
demand for another decreases then it is called complementary goods.
Substitute Goods : In the case of substitute goods , if the price of one product
increases, the demand for another product increases. That is, there is a positive
relationship between the price of one commodity and the demand for another
commodity.
The cross demand line for complementary goods and substitute goods is shown
below.

The demand for coffee has decreased due to the increase in the price of sugar and
the cross demand line of complementary goods goes up from the right to the left.
The demand for coffee has increased due to the increase in the price of tea and the
cross demand line of substitute goods goes up from the left to the right.

6. The law of demand by


The law of demand is one of the most fundamental concepts in economics. The law
of demand means, others things remaining the same, the higher prices of
commodity the smaller the quantity demanded and the any price of a commodity,
the higher the quantity demanded
Others things remaining the same, as the price of goods increases (↑), quantity
demanded will decrease (↓); conversely, as the price of a goods decreases (↓),
quantity demanded will increase (↑)". The only factor which influences the
quantity demanded is the price. The law of demand is the inverse relationship
between demand and price. It also “works with the law of supply to explain how
market economies allocate resources and determine the prices of goods and
services that we observe in everyday transactions” The law of demand describes an
inverse relationship between price and quantity demanded of goods.
The law can also be stated thus, “A rise in the price of commodity or service is
followed by a reduction in demand, and a fall in price is followed by an increase in
demand, if conditions of demand remain constant.”
In Marshall Words, the greater the amount to be 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 increase with a fall in price and diminishes with a rise in price.
Obviously the law of demand is based on the law of diminishing marginal utility.
In other words, it is the law of diminishing marginal utility which explain the law
of demand.
The law of demand with fictional schedule
Prices (taka) Quantity
10 30
20 20
30 10

According to the schedule, when the price of the product is 10 taka, then the
demand is 30 units.  When the price of a commodity increases from 10 to 20 taka
and 30 taka respectively, the quantity of demand decreases 30 to 20 and 10 units.
This has been the general human behavior on relationship between the price of the
commodity and the quantity demanded. The factors held constant refer to other
determinants of demand, such as the prices of other goods and the consumer's
income. There are, however, some possible exceptions to the law of demand, such
as Geffen goods and Veblen goods.
So we can say that demand is inversely related to the price of goods.  And this is
the law of demand.

7. Limitations of the law of demand


Law of demand indicates the inverse relationship between price and quantity
demanded of a commodity/ goods. It is generally valid in most of the situation .
But there are some situations under which there may be direct rrelationship
between price and quantity demanded of a commodity/ good. These exceptions are
known as limitations of the law of demand.
(1)Change in taste or fashion: According to the law of demand, when price falls,
demand is expected to increase. But if in the meantime consumer tastes have
undergone a change or if the commodity has gone out of fashion, more may not be
demanded even if the price falls.
(2)Change in income: Sometimes the demand of a product may change according
to the change in income. If a consumer’s income increases, he may purchase more
products irrespective of the increase in their price, thereby increasing the demand
of the product.
(3)Discovery of substitutes: Acting on the law of demand, Bangladesh may lower
the price of jute by reducing export duty to boost her sales of jute. But the
discovery of cheap substitutes like synthetic bags may nullify our efforts and jute
may not be demanded even if the price of jute falls.
(4)Necessary goods and service: The commodity/goods that is essential in daily
life, no matter how much it’s price goes up, the demand does not decrease, it
remains stable. For example Salt, Medicine etc.
(5)Veblen or luxurious goods:Veblen goods are named after American economist
Torstein Veblenn.A Veblenn goods is a goods for which demand increases because
of its exclusive nature and appeal as a status symbol. For example:
Diamond,Car,Gold.
(6)Griffen/Inferior goods:Sir Robert Griffens research has shown that a slight
increase in the price of some inferior goods not reduce the demand but increases
it.For example:Rice.
(7)Anticipatory changes in price:Anticipatory changes in prices may also can upset
the law of demand.It is often seen that there is stockpiling of goods and larger
purchase even though the price are rising.
(8)Others exception: Poor communication system,decrease of consumers
purchasing capability etc.The above are a few exceptions to the law of demand.
8. Demand Curve
Ans: Demand curve, in economics, a graphic representation of the relationship
between product price and the quantity of the product demanded.Such conditions
include the number of consumers in the market, consumer tastes or preferences,
prices of substitute goods, consumer price expectations, and personal income.
We give here a demand curve of an imaginary consumer. The demand curve
simply shows how the quantity purchased varies with the variation in price. Alone
OX are represent the quantities of the good purchased and alone OY the prices. We
can see on the OY line that when the price of the product is 50 each, the demand

for the product is 100 units. As the price of the product decreased slightly to 40,
the demand for the product was 200 units. Again we can see in the picture that if
the price of the product is 30 then the demand is 300 units, if the price is 20 then
the demand is 400 and if the last price is 10 then the maximum demand is 500
units. And finally adding DD line gives Demand Curve. The demand curve is also
known as the Average Revenue Curve.

9. Cause of change in demand


We spell out below some of the causes which bring about changes in demand and
also explain how demand will be affected by the following factors.
Change in real income: A distinction is made between money income, i.e., the
amount of money which a man may earn, and real income which means the
quantity of goods and services which he can buy with that amount of money. In
times of technical progress, there is a large output of cheap goods. The purchasing
power of money increases or, as it may be said, real income increases. Less money
will be needed to purchase the same quantity of goods, and the saving so made will
find outlet in the purchase of some other commodities. The demand schedules will
have to be recast. Some goods may be eliminated from consumption and instead
entirely new goods purchased; demand for some goods will decrease and that for
others increase.
Change in the level and distribution of income: Through the instrument of
public finance, e.g., by taxing the rich and spending the funds so obtained on the
poor, wealth is redistributed. There is a transfer of spending power. This is bound
to affect demand. Demands for those goods will increase which are purchased by a
class whose spending power has increased, and vice versa. The larger is the
average household income; greater is the demand for the commodities they
consume.
Changes in tastes, preferences and fashion: We see that increasing habit of
taking tea has decreased the demand for milk. Change in the mode of dress means
a change in the demand for the dress materials. The fashion among ladies to keep
hair long or short brings about changes in demand for hair-pins, hair-nets, etc.
Climate or weather changes: It is obvious that demand for a commodity must
change with the change in season. In winter, there is a greater demand for warm
clothing, for certain types of tonics and for coal or fuel. In summer, there is a great
demand for electric fans, room coolers and cooling drinks, ice, etc.
Changes in the size and composition of population: If, for instance, the
Commonwealth countries and America allow a free entry to Indians, we can expect
emigration from India. If Indians stick to their own mode of living in food and
dress in their new homes, demand for such things will be created there.
It is not merely a change in the size of the consuming population but change in the
composition of the population, too, which affects demand for certain commodities
and services. In a country of increasing population, like India, where lakhs of
children are born every day, there will naturally be demand for toys, feeding
bottles and nipples, perambulators, etc.
Changes in money supply: Where there is inflation, the additional money will add
to the purchasing power of the community, and the prices will rise. But the rise of
prices will not be uniform in the case of all goods. People will have to readjust
their expenditure; demand for certain things will be reduced and for others
stimulated. For example, shortage of sugar in India increased demand for gur and
shakker, and restrictions on the supply of electricity have reacted a demand for
kerosene lamps, and so on.
Change in the price of the commodity: Obviously, demand is decisively affected
by the change in the price of the commodity concerned. There is inverse relation
between price and the quantity demanded. Lower the price, the greater is the
demand, and vice-versa.
Change in savings: Demand for goods is affected by a change in consumer's
propensity to save. Large saving means less money available for the purchase of
goods. The demand will therefore decrease.
Change in asset preferences: It is quite obvious that if a consumer develops
marked liquidity preference, his demand for goods will decrease, because he
prefers to keep with him ready cash instead of buying things.
Conditions of trade: Demand for everything is greater in a boom even though the
prices are rising. On the other hand, in times of depression, there is a general
slackening of the demand.
Expectations or Anticipations: Expectations also bring about a change in
demand. If prices are expected to rise in future, the demand for goods will increase
now in the present. Similarly, expectations of rising incomes will restrain current
purchases and- postpone purchases to a future favorable situation.
Prices of Related goods: In case of substitutes, e.g., tea and coffee, increase in the
consumption of one will lead to a decrease in the demand for the other. When a
decline in the price of one good results in a decline in the demand for another, they
are substitutes. Or, two goods are substitutes if the demand for one is directly
related to the price of the other.
In the case of complements, e.g., horse and carriage, increased demand for one
will augment that for the other. Two goods are complements if the price of one and
the demand for the other are inversely related. For instance, if the price of the
carriages falls, the demand for horses rises. Other examples of complementary
goods are pipes and tobacco, tennis rackets and tennis balls, etc.
In the case of joint supply, e.g., wheat and straw, the increased demand for one
will lead to the late its demand too, after some time.
When there is a case of joint demand, the increase in the demand for the ultimate
object, e.g., the house will increase the demand for everything needed in building a
house.
In the case of composite supply, e.g., light obtained from electricity, gas or
kerosene, cheapening of any one of them will reduce the demand for the others.
In the case of composite demand, e.g., water required for drinking, washing
bathing, etc., any extension or contraction of its uses will correspondingly change
the demand.
Thus, the demand for a commodity does not depend only on its own price but the
prices of other goods too.
The limited supply of money that a consumer has is to be allocated among
numerous goods that he has to purchase. Hence, the demands and prices of all
goods are inter-related. A big price hike in certain commodities is bound to affect
the demand for other goods that a consumer has to purchase.
These are some of the factors which bring about changes in demand.

10. Short Coming of Utility Analysis by Mahir Shahriar Sawmik


(i) Unsound Psychology: It is urged that market demand is an objective
phenomenon. But the utility theorists try to explain it in terms of desire,
motivation, etc. As such, the utility theory is individualistic and hedonistic (or
utilitarian). To attribute motive to the consumer is unrealistic. When the theory
says that with successive increases in the quantity consumed, the marginal utility
diminishes, it is too naive a description of human nature. It must, however, be said
that the utility analysis given by Marshall is free from hedonistic or utilitarian
interpretation. The modern economists regard the diminishing marginal utility as a
familiar and fundamental tendency of human nature. It is true that the principle is
based on introspection, but it has been supported by observed human behavior.
(ii) Cardinal Measurement Not Possible: The utility analysis assumes that utility
is measurable cardinally, i.e., it can be assigned definite numbers. But the fact is
that cardinal measurement of utility is not possible. Instead, we can only have an
ordinal measure, i.e., we can only compare the two situations and say whether the
satisfaction is more or less. As Hicks observes, it is possible to establish
elementary parts of the demand theory with the help of cardinal numbers, but in
advanced theory, it becomes a nuisance. He says: "It might be, more convenient
as a sort of scaffolding useful in erecting the building, but to be taken down
when the building has been completed," Thus, the utility analysis breaks down on
the ground of measurability of utility and economists. Like J.R. Hicks want the
cardinal measurability of utility to be given up as being unrealistic.
(ii) Wrong Assumption of Independent Utilities: The utility analysis further
assumes that utilities are independent. On this assumption, the utility of a
commodity to a consumer varies with the quantity of that commodity, and of that
commodity alone. This means that the satisfaction that a consumer obtains form
the consumption of a particular good is not affected in any manner by the
consumption of another goods. This is not correct. The utility of a pen is certainly
enhanced if a good quality paper is made available. It, therefore, follows from this
assumption that the total utility of all the goods consumed is merely a sum of their
separate utilities. That is, the utility function is additive. Actually this is not so. All
the goods consumed by a person form one system and as such the satisfaction
derived from the consumption or the commodity is influenced by that from the
other, the Commodities are interlinked. This makes the marginal utilities
interdependent and not independent.
Hence, the marginal utility of a commodity depends not merely on its own
consumption but also on the consumption of some other commodity or
commodities. This IS so because the commodities may be complements or
substitutes of one another. Thus the assumption that utilities are independent is not
a valid assumption to base the utility analysis on as, for example, Marshall did it.
This is a weakness of Marshallian utility analysis.
(iv) Income Effect and substitution Effect Not Brought Out: Besides, the utility
analysis does not bring out fully the income effect and substitution effect of a
change in price. We know, for instance, that when the price of a commodity falls,
the consumer feels as if his income has increased and he is able to purchase more.
This is the income effect. Also, the consumer substitutes the cheaper commodity
for some other rival commodities. This is the substitution effect in a price change.
It is unable to explain how much of the increased demand is due to the income
effect and how much to the substitution effect. As Hicks says, "The distinction
between direct and indirect effects of a price change is accordingly left by the
cardinal theory as an empty box which is crying out to be filled,"
(v) Does Not Explain Giffen Paradox: It is Owing to the assumption of constant
marginal utility of money and ignoring the income effect that Marshallian utility
analysis failed to explain the ‘Giffen Paradox'.
(vi) Assumption of Constant Marginal Utility of Money Wrong: Further, the
utility analysis is based on the assumption that the marginal utility of money
remains constant even when a consumer is proceeding with his purchases and is
parting with money at every step. Constancy of marginal utility of money is
necessary in the marginal utility analysis because, according to Marshal, utility is
measured in terms of money and the measure, therefore, must not change.
Obviously, the reduction in the quantity of money with the purchaser must raise its
marginal utility. But these facts conveniently brushed aside in the utility analysis.
(vii) Applies to One-Commodity World: The Marshallian law of demand cannot
be genuinely S n derived from the utility analysis on the assumption of constant
marginal utility of money except in one- commodity world. The assumption of
constant marginal utility is not compatible with the law of demand in a situation
where a consumer has more than one commodity to spend his income on. In a
multi-commodity model, the margınal utility of money does not remain the same.
When a consumer has to spend his income on a number of goods, there must occur
a change in the marginal utility of money with every change in the price does not
remain the same, utility ceases to be measurable and the marginal utility analysis
breaks down.
(vii) Assumes Too Much and Explains Too Little: The marginal utility analysıs
is based on too many assumptions like measurability of marginal utility and
constancy of marginal utility of money. But it is restrictive in scope. For example,
it does not split the price effect into its two components, the income effect and
substitution. It does not explain the Giffen' paradox. On the other hand, Hicks-
Allen indifference curve technique steers clear of these assumptions and is still
able to deduce a more general theorem of demand which covers the Giffen Paradox
too.
Conclusion
We have examined above at some length the various shortcomings of the utility
analysis. In conclusion, we may draw attention of the student once again to some
basic weakness of this analysis also known as the cardinalist approach.
(i) The satisfaction derived from the various commodities cannot be measured
objectively: Hence the assumption of cardinal utility is extremely doubtful. No
doubt Walras has attempted to use subjective units (utils) for measuring utility but
it is not a satisfactory solution.
(ii) The assumption of constant utility of money is also unrealistic: The
marginal utility of money changes with changes in income. Hence money fails as a
measuring rod because its own utility changes.
(ii) The law of diminishing marginal utility has been derived from
introspection: It is only a psychological law which must be taken for granted. In
view of its various shortcomings, the utility analysis has now been replaced, by and
large, by the modern indifference curve analysis or the ordinal approach.
—◑—

Chapter: 11- Elasticity of Demand

Question No 1 :- Meaning of Elasticity and Elasticity of Demand


Answer :
Meaning of Elasticity :We have studied the law of demand and we have seen
that there is an inverse relation between demand and price.
Elasticity is the measurement of the responsiveness of an economic variable in
response to a change in another economic variable.
Elasticity is a central concept in economics, and is applied in many situations.
Basic demand and supply analysis explains that economic variables, such as price,
income and demand, are causally related. Elasticity can provide important
information about the strength or weakness of such relationships.
The term expresses the degree of correlation between demand and price.It is the
rate at which the quantity demanded varies with a change in price.

Elasticity of Demand :Elasticity of demand is the measure of the responsiveness


of demand to Changing Prices.
The elasticity of demand is defined as the rate of Chang in quantity demanded for
a given change in price.It is primirily related to extension or contraction of demand
for a fall or rise in price.
Another precise definition is by Mrs.joan Robinson thus: the elasticity of demand
(at any price or at any output) is the proportional change of amount purchased in
response to a small change in price, divided by the proportional change of price.
Other things are assumed to remain constant, e.g, other prices, consumers income.
It may be carefully noted that elasticity depends primarily on proportional and
percentage changes and not on absolute changes in prices and quantity demanded.

Question No-2: Elastic and inelastic demand

Answer :
Elastic demand: A change in demand is not always proportionate to the change in
price.A small change in price may lead a great change in demand.In that case,we
shall say that the demand is elastic or sensitive or responsive. If a product is elastic
a small change in the price will have a big impact on the supply or demand of the
product. If a client can easily replace the product with a substitute, then the product
will be elastic. For example, if people like both coffee and tea and the price of tea
goes up, people will have no problem switching over to coffee. The demand for tea
will thus fall, and the demand for coffee will increase the products are substitutes
for each other. 
If a purchase is optional, there is a bigger chance that a rise in the price will ensure
a fall in quantity demanded. If you are considering buying a new laptop because
your old laptop is slow, but the price goes up just before you buy the computer,
there is a good chance that you will not purchase the computer and instead stick it
out with your old laptop until it breaks.

Elastic Demand Conclusion :


 Perfect elastic demand is when the demand for the product is entirely
dependent on the price of the product.
 The elasticity of demand is when a change occurs in the price, there will be a
change in the demand.
 Examples of elastic goods include gas and luxury cars
 Factors that affect elasticity is substitutes, time and necessity.

Inelastic Demand: A big change in price is followed only by a small change in


demand it is said to be a case of inelastic demand.If a product is inelastic a small
change in the price will have not a big impact on the supply or demand of the
product.The price of a product will go up, and the consumers will still buy the
same number of products, this is the exact same with if the price of the product
decreases. Let’s take, for example, the gas in your vehicle. You need gas to drive
your car to and from work, it doesn’t matter what the price of gas is you will still
fill up your tank.

Inelastic Demand Conclusion


 Perfectly inelastic is where a small increase or decrease in the price of a
product will have no effect on the quantity that is demanded or supplied of
that product.
 If a 1% change in the price of a product, there will be less than 1% change in
the quantity demanded or supplied.
 f a product was perfectly inelastic, a supplier would be able to charge any
price that they wanted to, and customers will still be willing to buy that
product.
 An elastic product will have a change in the demand when there is a change
in the price where an inelastic product will have almost no change in the
demand.
Comparison between elastic and inelastic demand :
Basis for comparison Elastic Inelastic
Meaning When a little change in Inelastic demand refers to
the price of a product a change in the price of a
results in a substantial good result in no or slight
change in the quantity change in the quantity
demanded, it is known as demanded.
elastic demand.

Elasticity Quotient More than equal to 1 Less than 1


curve Shallow Steep
Price and total revenue Move in the opposite Move in the same
direction direction

Goods Comfort and luxury Necessity


Question No 3 :- Types of Elasticity
Answer :
The three main types of elasticity are now discussed in brief.

1)Price Elasticity
Definition and Explanation: The concept of price elasticity of demand is
commonly used in economic literature. Price elasticity of demand is the degree of
responsiveness of quantity demanded of a good to a change in its price. Precisely,
it is defined as:
"The ratio of proportionate change in the quantity demanded of a good caused by a
given proportionate change in price".
Formula: The formula for measuring price elasticity of demand is:
Price Elasticity = Percentage in Quantity Demand / Percentage Change in
price
Ed = Δq / p x P/Q
Example:
Let us suppose that price of a good falls from $10 per unit to $9 per unit in a day.
The decline in price causes the quantity of the good demanded to increase from
125 units to 150 units per day. The price elasticity using the simplified formula
will be:
Ed = Δq / p x P/Q
Δq = 150 - 125 = 25
Δp = 10 - 9 = 1
Original Quantity = 125
Original Price = 10
Ed = 25 / 1 x 10 / 125 = 2
The elasticity coefficient is greater than one. Therefore the demand for the good is
elastic.
Types: The concept of price elasticity of demand can be used to divide the goods in
to three groups.
(i) Elastic.

When the percent change in quantity of a good is greater than the percent
change in its price, the demand is said to be elastic. When elasticity of
demand is greater than one, a fall in price increases the total revenue
(expenditure) and a rise in price lowers the total revenue (expenditure).
(ii) Unitary Elasticity.

When the percentage change in the quantity of a good demanded equals


percentage in its price, the price elasticity of demand is said to have
unitary elasticity. When elasticity of demand is equal to one or unitary, a
rise or fall in price leaves total revenue unchanged.
(iii) Inelastic.

When the percent change in quantity of a good demanded is less than the
percentage change in its price, the demand is called inelastic. When
elasticity of demand is inelastic or less than one, a fall in price decreases
total revenue and a rise in its price increases total revenue.

(2) Income Elasticity

Definition and Explanation: Income is an important variable affecting the demand


for a good. When there is a change in the level of income of a consumer, there is a
change in the quantity demanded of a good, other factors remaining the same. The
degree of change or responsiveness of quantity demanded of a good to a change in
the income of a consumer is called income elasticity of demand. Income elasticity
of demand can be defined as:
"The ratio of percentage change in the quantity of a good purchased, per unit of
time to a percentage change in the income of a consumer".
Formula: The formula for measuring the income elasticity of demand is the
percentage change in demand for a good divided by the percentage change in
income. Putting this in symbol gives.
Ey = Percentage Change in Demand / Percentage Change in Income
Simplified formula:
Ey = Δq / Δp x P / Q
Example: A simple example will show how income elasticity of demand can be
calculated. Let us assume that the income of a person is $4000 per month and he
purchases six CD's per month. Let us assume that the monthly income of the
consumer increase to $6000 and the quantity demanded of CD's per month rises to
eight. The elasticity of demand for CD's will be calculated as under:

Δq = 8 - 6 = 2
Δp = $6000 - $4000 = $2000

Original quantity demanded = 6


Original income = $4000
Ey = Δq / Δp x P / Q = 2 / 200 x 4000 / 6 = 0.66
The income elasticity is 0.66 which is less than one.
Types: When the income of a person increases, his demand for goods also changes
depending upon whether the good is a normal good or an inferior good. For normal
goods, the value of elasticity is greater than zero but less than one. Goods with an
income elasticity of less than 1 are called inferior goods. For example, people buy
more food as their income rises but the % increase in its demand is less than the %
increase in income.
(3) Cross Elasticity
Definition and Explanation: The concept of cross elasticity of demand is used for
measuring the responsiveness of quantity demanded of a good to changes in the
price of related goods. Cross elasticity of demand is defined as:
"The percentage change in the demand of one good as a result of the percentage
change in the price of another good".
Formula:The formula for measuring, cross, elasticity of demand is:
Exy = % Change in Quantity Demanded of Good X / % Change in Price of
Good Y
The numerical value of cross elasticity depends on whether the two goods in
question are substitutes, complements or unrelated.
Types and Example:
(i) Substitute Goods.

When two goods are substitute of each other, such as coke and Pepsi, an
increase in the price of one good will lead to an increase in demand for
the other good. The numerical value of goods is positive.

For example: there are two goods. Coke and Pepsi which are close substitutes. If
there is increase in the price of Pepsi called good y by 10% and it increases the
demand for Coke called good X by 5%, the cross elasticity of demand would be:
Exy = %Δqx / %Δpy
Exy = 10% / 5% = 0.2
Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes.
(ii) Complementary Goods.

However, in case of complementary goods such as car and petrol,


cricket bat and ball, a rise in the price of one good say cricket bat by 7%
will bring a fall in the demand for the balls (say by 6%). The cross
elasticity of demand which are complementary to each other is,
therefore, 6% / 7% = 0.85 (negative).
(iii) Unrelated Goods.

The two goods which are unrelated to each other, say apples and pens, if
the price of apple rises in the market, it is unlikely to result in a change
in quantity demanded of pens. The elasticity is zero of unrelated goods.

Question No 4 :- Factor Determining Price Elasticity of Demand.


Answer :The Price elasticity of demand is not the same for all commodities. It
may be low depending upon number of factor. These factors which influence price
elasticity of demand. In brief, are as under :-

1) Nature of Commodities :-

In developing countries of the world, the per capital income of the people is
generally low. They spend a greater amount of their income on the purchase of
necessaries of life such as wheat, milk, cloth etc. They have to purchase these
commodities whatever be their price. The demand for goods of necessities is less
elastic or inelastic. The demand for luxury goods, on the other hand is greatly
elastic.

For example :

If the price of burger falls, its demand in the cities will go up.

2) Demand for Luxuries is Elastic :-

If the price of a luxury commodity increases the quantity demanded will be


not be same, the change in quantity demanded will be more than the change in
price and vice versa.

3) Proportion of Total Expenditure :-

If a consumer good absorbs only a small proportion of total expenditure. The


demand will not be much affected by a change in price. Hence, it will be inelastic.
Conversely, If it absorbs the bulk of total expenditure, the demand will be elastic.
4) Substitutes :-

If a good has greater number of close substitutes available in the market, the
demand for the good will be greatly elastic.

For example :

If the price of coca cola rises in the market, people will switch over to the
consumption of Pepsi Cola, which is its close substitude. So the demand for Coca
Cola is elastic.

5) Number of Uses of a Good :-

If a good can be put to a number of uses, its demand is greater elastic.

For example :

If the price of coal falls, its quantity demanded will rise considerably because
demand will be coming from households, industries, railways etc.

6) Joint Demand :-

If two goods are jointly demand, then the elasticity of demand depends upon
the elasticity of demand of the other jointly demanded good.
For example :

With the rise in price of cars, its demand is slightly affected, then the demand
for petrol will also be less elastic .

7) Goods, the use of which can be postponed :-

Most of us during the war postponed our purchases where we would,


e.g.,building a house, buying furniture or having a number of warm suits. We go in
for such things in a large measure when they are cheap. Demand for such goods is
elastic.

8) Income Level:

Elasticity of demand for any commodity is generally less for higher income
level groups in comparison to people with low incomes. It happens because rich
people are not influenced much by changes in the price of goods. But, poor people
are highly affected by increase or decrease in the price of goods. As a result,
demand for lower income group is highly elastic.

9) Level of price:

Level of price also affects the price elasticity of demand. Costly goods like
laptop, Plasma TV, etc. have highly elastic demand as their demand is very
sensitive to changes in their prices. However, demand for inexpensive goods like
needle, match box, etc. is inelastic as change in prices of such goods do not change
their demand by a considerable amount.

10)Proportion of The Income Spent of the Good :-


If the proportion of Income spent on the purchase of a good is very small, the
demand for such a good will be inelastic.

For example :

If the price of a box of matches or salt rises by 50%, it will not affect the
consumers demand for these goods. The demand for salt, match box therefore will
be inelastic. On the other hand, If the price of a car rises from 6 lakh to 9 lakh and
it takes a greater portion of the income of the consumers, its demand would fall.
The demand for car is elastic.

11 )Market Imperfections :-

Owing to ignorance about market trends, the demand for a good may not
increase when it price falls for the simple reason that consumers may not be aware
of the fall in price.

12) Technological Factors :-

Low price elasticity may be due to some technical reasons.

For example :

lowering of electricity rates may not increase consumption because the


consumers are unable to buy the necessary electric appliances.
13) Time Period :-

The elasticity of demand is greater in the long run than in the short run for the
simple reason that the consumer has more time to make adjustments in his scheme
of consumption. In other words, he is able to increase or decrease his demand for a
commodity
.
For example :

If the price of electricity goes up, it is very difficult to cut back its
consumption in the short run. However, If the rise in price persists, people will
plan substitution gas heater, fluorescent bulbs etc. So that they use less ^
electricity. So the electricity of demand will be greater in the long run than in the
short run.

14) Conclusion :-

The above discussion confirms us in the view that it is not possible to lay
down any hard and fast rule as to which commodity has an elastic demand and
which inelastic. When we want to know whether the demand is elastic or inelastic,
we must first know the class of people with reference to whom we wish to
ascertain the fact.

Question No 5 :- MEASUREMENT OF PRICE ELASTICITY OF


DEMAND.
Answer :

Price elasticity of demand is the rate of change in quantity demanded in response


to the change in the price.

1 ) PERFECTLY INELASTIC DEMAND:

When demand is perfectly inelastic, quantity demanded for a good does not
change in response to a change in price. Such as medicine.

P1
ECEC
PRIC

CE

O Q X

QUANTITY
Perfectly in elastic demand (vertical) demand curve

2) PERFECTLY ELASTIC DEMAND:

A perfectly elastic demand curve is represented by a straight horizontal line and


shows that the market demand for a product is directly tied to the price. In fact, the
demand is infinite at a specific price.

Y
CEEE
EEEE
PRI

P D

O Q Q1 X
QUANTITY

3) UNIT ELASTICITY OF DEMAND:


Unit elastic demand is referred to as a demand in which any change in the price of
a good leads to an equally proportional change in quantity demanded. The unit
elastic demand implies that the percentage change in quantity demanded is exactly
the same as the percentage change in price.

d
Y

P1
PRICE

d’
O Q X

QUANTITY

4) RELATIVELY INELASTICE DEMAND:

When the percentage change produced in demand is less than the percentage
change in the price of a product. For example, if the price of a product increases by
30% and the demand for the product decreases only by 10%, then the demand
would be called relatively inelastic.

d
Y

P1
PRI
C
E

d’
O Q1 Q X

DEMAND
5) RELATIVELY ELASTIC DEMAND:

Relatively elastic demand refers to the demand when the proportionate change
produced in demand is greater than the proportionate change in price of a product.

d
Y
P1
PRICE

P
d’

O Q Q1 X
QUANTITY

Relatively elastic demand


Question no. 06 :- Price elasticity and different curve technique.
Answer:

Price elasticity of demand is an economic measure of the change in the quantity


demanded or purchased of a product in relation to its price change. Expressed
mathematically.

An indifference curve, with respect to two commodities, is a graph showing those


combinations of the two commodities that leave the consumer equally well off or
equally satisfied—hence indifferent—in having any combination on the curve.

We can apply indifferent curve technique for the measurement of price elasticity.
For this purpose,we take into consideration the shape of the price consumption
curve. We can lay down the following proposition .

1. When the price consumption curve slopes downward, the price elasticity of the
demand is greater then unity or one ,i,e ,demand is elastic.

2 .When the shape of the price consumption curve is a horizontal straight line, the
price elasticity of demand is unity or one i,e its constant.

3. When the price consumption is curve is upward sloping, then the then the price
elasticity of demand is less than the unity i,e,the demand is inelastic.

Similarly, when we want to measure income elasticity of demand, we consider the


shape of income consumption curve instead of the price consumption curve.
Question No 7: Practical Application of Elasticity of demand .

Answer :

The concept of elasticity of demand is of great in the sphere of government finance


as well as in trade and commerce.

1. Taxation:

The tax will no doubt raises the prices but the demand being inelastic,
people must continue to buy the same quantity of the commodity. Thus the
demand will not decrease.

2. Monopoly prices:

In the same manner, the businessman, especially if he is a monopolist, will


have to consider the nature of demand while fixing his price. In case it is in
elastic, it will pay him to him to change a higher price and sell a smaller
quantity. If, on the other hand, the demand is elastic he will lower the prices,
stimulate demand and thus maximize his monopoly net revenue.

3. Joint products:

In such cases separate costs are not ascertainable the producers will be
guided mostly by demand and its nature fixing his price. The transport
authorities fix their rate according to this principle when we say that they
charge what the 'traffic will bear'

4. Increasing returns:

When an industry is subject to increasing returns the manufacturer lowers


the price to develop the market so that he may be able to produce more and
take full advantage of the economies of large scale production.
5. Output:

Elasticity of demand affects industrial output reduction in price will


certainly increases the sale in the market as a whole.

6. Wages:

Elasticity of demand also exerts its influence on wages. If demand for a


particular type of labour is relatively inelastic, it is easy to raise wages, but
not otherwise.

7. Poverty in plenty:

The concept of elasticity explains the paradox of poverty in the midst of


plenty. This is specially so if produce is perishable. A rich harvest may
actually fetch less money a poor one.

8. Effect on the economy:

The working of the economy in general is affected by the nature of


consumer demand. It affects the total volume of goods and services prod
used in the country. It also affects producers' demand for different factors of
production their a location and remuneration

9. Economies policies:

Modern governments regulate output and prices. The government can create
public utilities where demand is inelastic and monopoly element is present.
10.International trade:

The nature of demand for the internationally traded goods is helpful in


determining the quantum of again of gain accruing to the respective
countries. Thus is how it determines the terms of trade.

11.Price determination:

The concept of elasticity of demand is used in explaining the determination


of price under various market conditions. Price determination is forced to be
profitable if elasticity of demand in another. The monopolist can charge a
higher price in the market where elasticity of demand is less and a lower
price where elasticity of demand is greater.

12.Rate of foreign exchange:

With fixing the rate of exchange, the government has to consider the
elasticity or otherwise of its imports and exports.

13.Boundary between industries:

Cross elasticity of demand is also useful in indicating boundaries


between industries. Goods with high cross elasticity's constitute one
industry, where as goods with lower elasticity constitute different industries.

14. Market forms:

The concept of cross elasticity help[s to understand different market forms


infinite cross elasticity indicates perfect market forms infinite cross elasticity
indicates perfect competitions, where as zero or hear zero elasticity indicates
pure monopoly and high elasticity indicates imperfect competition

15.Classification of goods as substitutes and complement:

Goods are classified as substitutes on the basis of cross elasticity. Two


commodities may be considered as substitutes if cross elasticity is positive
and complements when elasticity is negative.

When all is said and done the concept of elasticity of demand is not merely
of theoretical interest. But it has also practical application in diverse
economic fields as explained above.
Question no 8: Explain the theoretical importance of elasticity of demand.

Answer:

Apart from the practical importance of the elasticity of demand, the concept play a
crucial role in economic theory and is extensively used as a tool of economic
analysis. The following point highlight the main areas of the theorical importance
of elasticity of demand.

1. Price Determination:

The concept of elasticity of demand id used in explaining the determination


of price under various market conditions. For instance, under perfect
competition, the demand curve facing an individual seller is perfectly elastic
which means that the producer can sell any amount by lowering the price a
bit. But under monopoly or imperfect competition, the demand is less than
perfectly elastic and the demand curve is downward sloping. Since the
demand is less elastic, the monopolist is in a position to exercise some
control over price and the buyer has to accept the price.

2. Relation Between Price Elasticity, Average Revenue and Marginal


Revenue.

There is a close relationship between price elasticity. Average revenue and


marginal revenue which the concept of elasticity helps to explain. This
relationship enables us to understand and compare the conditions of
equilibrium under different market conditions. The formula which explain
this is…

e
Price or AR = MR (e−1) Also Piece or

e
AR =MC (e−1) * since in equilibrium MR = MC
.
3. Price Discrimination.
The concept of elasticity of demand is useful in explaining the conditions
under which price discrimination by a monopolist becomes profitable. Price
discrimination is found to be profitable is elasticity of demand in one market
is different from elasticity of demand is less and a lower price where
elasticity of demand is less and a lower where elasticity is greater.

4. Measuring Degree of Monopoly Power.

Elasticity of demand is also used in measuring the degree of monopoly


power. Monopoly power means the power which a monopolist has to
influence price, It represents the difference between marginal cost and price.
This difference ultimately depends on elasticity of demand for the
monopolist’s product. The less is the elasticity of demand higher will be the
price and wider the difference between the marginal cost and greater the
monopoly power, and vice versa. The monopoly power is absent when there
is perfect competition because the seller has no control over price. He has to
accept the price as given as given. The demand curve facing him is perfectly
elastic. I e a horizontal straight line parallel to the axis of X.

5. Classification of Goods as Substitutes and Complements.

Goods are classified as substitute on the basis of cross elasticity. Two


commodities may be considered as substitute if cross elasticity is positive
and complements when elasticity is negative.

6. Boundary Between Industries.

Cross elasticity of demand is also useful in indicating boundaries between


industries. Goods with high cross elasticities constitute one industry, where
as goods with lower elasticity constitute different industries.

7. Classification of Goods as Substitutes and Complements.

Goods are classified as substitutes on the basic of cross elasticity. Two


commodities may be considered as substitutes if cross elasticity is positive
and complements when elasticity is negative.

8. Boundary Between Industries.


Cross elasticity of demand is also useful in indicating boundaries between
industries. Goods with high cross elasticity constitute one industry, where as
goods with lower elasticity constitute industries.

9. Market Forms.

The concept of cross elasticity helps to understand different market forms.


Infinite cross elasticity indicates perfect competition, whereas zero or zero
elasticity indicates pure monopoly and high elasticity indicates competition.

10.Incidence of Taxes.

The concept of elasticity of demand is used in explaining the incidence of


indirect taxes like sales tax and excise duty. Less is the elasticity of demand
higher the incidence, and vice versa. In case of inelastic(or less elastic)
demand the consumers have to buy the commodity and must bear the tax.

11.Theory of Distribution.

Elasticity of demand is useful in the determination of relative shares of the


various factors of production. If the demand for a factors of production is
less elastic, its share in the national dividend is higher, and vice versa. If
elasticity of substitution is high, the share will be low.

—◑—
Unit- III
Chapter: 13- Factors of production

Question - 01: Difinition of production.


Answer : Production is a process of combining various material inputs and
immaterial inputs in order to make something for consumption(output).
It is the act of creating an output, a good or service which has value and contributes
to the utility of individuals. For example (a)creation furniture (b)hervesting corn to
eat (c)the amount of cloth produce.
Moreover,it is essential to have the following characteristic in order to be
production.
 Combination of labor,raw materials and machinery.
 A literary or artistic work.
 The creation of utility.
 Inputs will be transformed into desired products.
 There will be one type of machine for each process

Question - 02 : Factors of production.

Answer : In economics the term "factor" is used for a group of productive


elements. And the method of turning raw materials(or inputs) into finished
goods(or outputs) in a manufacturing process is called production. So, the term
factors of production refers to all the resources required to produce goods and
service. There are four basic factors, including land, labour, capital and
organisation(or enterprise).
Now we shall briefly deal with them one by one.
12 Land : The first factors of production is land. Land has a broad definition as
a factor of production in that it refers to all natural resource. This includes
not just land, but anything that comes from the land. Some common natural
resources are water, oil, copper, natural gas, coal and forests. Land resources
are the raw materials in the production. These resources can be renewable
such as forests or non renewables such as oil or natural gas. The income that
resource owners earn in return for land resources is called rent.
13 Labour : The second factor of production is labour. Labour, as a factor of
production, involves any human input. It is any work done by people
contributing to production. The quality of labour depends on the workforces
skills, education and motivation. Generally speaking, the higher the quality
of labour, the more productive the workforce. Examples of labour range
from the very physical to primarily mental work that goes into production.
On the mental side of this factor of production are labourers like artists
producing art, or programmers creating software. On the more physical side
of labour might be food service workers, construction workers, or factory
workers. If someone has ever paid them for a job, They have contributed
labour resources to the production of goods or service. The income earned
by a labour resources is called wages. It is the largest source of income for
most people.
14 Capital : The third factor of production is capital. Capital typically refers to
money. But money is not a factor of production because it is not directly
involved in producing a good or service. Instead, it facilitates the processes
used in production by enabling entrepreneurs and company owners to
purchase capital goods. As a factor of production, capital refers to the
machinery, tools and buildings humans use to produce goods and services.
Capital differs based on the worker and the type of work being done. For
example, a tractor purchased for farming is capital.a doctor may use a
stethoscope and an examination room to provide medical service. A teacher
may use text books,desks, and a whiteboard to produce education service.
The income earned by owners of capital resources is interest.
15 Enterprise : The fourth factor of production is enterprise. Enterprise is the
factor of production that organises the other factors of production- land,
labour and capital to produce a goods or service. It undertake all the inherent
risks in the hope of making a profit. An individual, who creates an enterprise
is called entrepreneur. The success or failure of an enterprise depends on the
efficiency of the entrepreneur. The most successful entrepreneur are
innovators who find new ways to produce goods and services or who
develop new goods and services to bring to market. Entrepreneurs thrive in
economics where they have the freedom to start businesses and buy
resources freely. The payment to entrepreneurship is profit.
16 These factors are complementary in the sense that their co-operation on
combination is essential in the production process. The typical situation in
production is that a group of complementary factors is required between
which there is some degree of substitutability. Between labour and capital,
the relation is both of substitution and complementarity.
17 Specificity : A factor is said to specific when it can be used for one purpose
only and for none other, example, spare part of a particular machine.
18 Versatility : A factor is said to be versatile when it can be put to every and
any use.

These are, however, two extremes. No factor is completely specific or versatile.


That is why, a factor can be put to several uses but not all uses. A factor of low
versatility is called a specialised factor. The specific or specialised nature of the
factors of production plays an important role in the disposition of productive
resources.
Question - 03 : Concept of Land and peculiarities of Land

Answer: The term land has been given a special meaning in economics.It does not
mean soil as in the ordinary speech,but it is used in a much wider sense.In the word
of Marshall "Land means the materials and the forces which nature gives freely for
man's aid,in land and water in air and light and heat". Lands stands for all natural
resources which yield an income or which have exchange value.It represents those
natural resources which are useful and scarce,actually or potentially.
Peculiarities of Land : In contrast to the other factors of production,land presents
certain well marked peculiarities:
1. Land is nature's gift to man.
2. Land is fixed in quality.It is said that land has no supply price.That is,price
of land prevailing in the market cannot affect its supply;the price may be
high or low,it supply remains the same.
3. Land is permanent.There are inherent properties of the land which Ricardo
called original and indestructible.
4. Land looks mobility in the geographical sense.
5. Finally,land provides infinite variation of degrees of fertility and situation so
that no two pieces of land are exactly alike. This peculiarity explains the
concept of margine cultivation.

These are few peculiarities of land and they have a bearing on economic rent.

Question - 04 : Concept of labour & peculiarities of labour .

Answer: Generally, labour is meant by physical labor. But in economics the term
labor is used in a special and broad sense. Labor is the amount of physical, mental,
and social effort used to produce goods and services in an economy. In return,
laborers receive a wage to buy the goods and services they don't produce by
themselves. Labor is one of the four factors of production that drive supply. It
supplies the expertise, manpower, and service needed to turn raw materials into
finished products and services.
 peculiarities of labour: Labour is a commodity to be bought and sold but
unlike Other goods it has certain features as it is not only a means of
production but also an end of a production. Labour is a living factor of
production and therefore different and another factor of production.
Characteristics that make it different are known as the peculiarities of
labour.
 Labour is inseparable from the labourer: Labour and the labourer go
together. When the seller sells a commodity he does not necessarily go with
the commodity. But the labourer can supply his labour only when he goes
with it. Moreover, when a seller sells a commodity he parts with it. But
when a labourer sells his labour, he retains the quality with him. He may
gain the satisfaction out of his services, but he cannot be separated from his
labour.

 A Labourer sells his Labour and not Himself: A labourer sells his labour
for wages and not himself. ‘The worker sells work but he himself remains
his own property’. For example, when we purchase an animal, we become
owners of the services as well as the body of that animal. But we cannot
become the owner of a labourer in this sense.

 Labour is Perishable: Labour is more perishable than other factors of


production. It means labour cannot be stored. The labour of an unemployed
worker is lost forever for that day when he does not work. Labour can
neither be postponed nor accumulated for the next day. It will perish. Once
time is lost, it is lost forever.

 Weak Bargaining Power of Labour: The ability of the buyer to purchase


goods at the lowest price and the ability of the seller to sell his goods at the
highest possible price is called the bargaining power. A labourer sells his
labour for wages and an employer purchases labour by paying wages.
Labourers have a very weak bargaining power, because their labour cannot
be stored and they are poor, ignorant and less organised.

 Increase in Wages may reduce the Supply of Labour: The supply of


goods increases, when their prices increase, but the supply of labourers
decreases, when their wages are increased. For example, when wages are
low, all men, women and children in a labourer’s family have to work to
earn their livelihood. But when wage rates are increased, the labourer may
work alone and his wife and children may stop working. In this way, the
increase in wage rates decreases the supply of labourers. Labourers also
work for less hours when they are paid more and hence again their supply
decreases.
 Inelastic Supply of labour: The supply of labour is inelastic in a country at
a particular time. It means their supply can neither be increased or decreased
if the need demands so. For example, if a country has a scarcity of a
particular type of workers, their supply cannot be increased within a day,
month or year. Labourers cannot be ‘made to order’ like other goods.

The supply of labour can be increased to a limited extent by importing labour from
other countries in the short period. The supply of labour depends upon the size of
the population. Population cannot be increased or decreased quickly. Therefore, the
supply of labour is inelastic to a great extent. It cannot be increased or decreased
immediately.
Question - 05 : factors determining efficiency of labours.
Answer: Labour is a commodity that is supplied by labourers in exchange for a
wage paid by demanding firms. There are many factors which determining
efficiency of labours. The following points highlight the five important factors
affecting the efficiency of labour.
The factors are:
 Personal Qualities of Labourers.
 Working Conditions.
 Conditions of the Country.
 Organisational and Managerial Ability.
 Other Factors.

10) Personal Qualities of Labourers : The efficiency of a worker is


influenced by qualities which he achieves or possesses.

The important of them are as follows:


 Racial Qualities: It has been seen that every person inherits certain
qualities from the race to which he belongs.
 Inheritable Qualities: A child inherits the skill of his father by birth.
He will be more efficient if he enters profession of his father.
 Moral Qualities: Moral qualities increase the efficiency of the worker.
An honest, sincere and good character worker is liked by the
management and this quality helps in blooming the efficiency.
 Individual Qualities : If a worker is mentally alert possesses good
physique, intelligent,sober, honest, sincere, resourcefulness and is
responsible. He will possibly be known most efficient than others.
11) Working Conditions : The conditions under which the worker works
also influence his efficiency.

The Important of them are as order :


 Environment and Place of Work : If the factory is neat and well
ventilated and the surroundings are sanitary and attractive and there is
sufficient space for movement. A break after long term workings.
their efficiency will be higher.
 Working Hours : It must be noted that small working hours with a
lunch break always help increase the efficiency of labour. It has
indeed been proven that long hours of working means low efficiency.
 Rate and regularity of Wages : Efficiency of worker depends to a
great extent on wages which he receives. Also regular payment of
wages on a due date fixed increases efficiency of labour because
workers adjust their budgets accordingly, otherwise they are put to
much more inconvenience when wage payment is irregular and they
are not able to devote themselves whole heartedly to their work which
reduces their efficiency.
 Prospects of Promotion : If the worker knows that he/she will be
suitably rewarded and promoted to a higher grade when he/she will
produce more, then he/she will work diligently and his efficiency will
increase. On the other-hand, the trade in which such incentives do not
exist, the efficiency of labour will be low.
12) Conditions of the Country : Labours Efficiency is also dependent on
the social, political and economic conditions of the country.

Important factors are:


 Climatic Conditions : The climate of a place also determines the
efficiency of labour in a country. Workers who live and work under
hot climate becomes tired soon both physically and mentally. As a
result their efficiency declines. On the other-hand workers living and
working in cold and temperate regions are more alert and hence their
efficiency is high.
 Political Conditions and security : Political conditions also affect the
efficiency of labour. If the government of the country in which the
worker lives is strong enough to preserve peace at home and provide
security from anti-socialistic aggression .they'll feel secure and their
efficiency will be high.
13) Organisational and Managerial Ability : Organisational and
Managerial ability of the manager working in an organisation also affects the
efficiency of the worker.

Important factors are decribed below:


 Efficient Management: Efficient management of the organisation
affects the efficiency of labour. The worker will start working
efficiently. In inefficient management efficiency of worker will
decrease and working capacity will reduce.
 Proper Relationship between Employer and Employee: Efficiency of
labour also depends upon the employer-employee relations. If the
relations between the two are friendly and cardinal, efficiency of
labour will be high. But the relationship between the employer and
employees itself dependents upon the behaviour of the employer
towards the employees and that of trade unions towards the employer.
 Sympathetic Attitude of the Management:If the management
possesses a sympathetic attitude towards the workers, the workers will
give their best. On the other hand, a trade union which adopts militant
attitude towards the employer, will lower labour efficiency.
14) Other Factors : There are other factors also which affects the
efficiency of labour and their considerations has been considered important.

They are:
a. Labour Policy of the Government : Labour policy of the government
also affects the efficiency of a labourer. If the policy of the
government is favourable towards labourer, it will create confidence
in labourer and their efficiency will improve. If policy is unfavorable
the labourer may feel disappointed.
b. Trade Unions: If trade union is well organised the workers will have
upper hand and they will get more wages and their standard of living
will improve.
c. Sense of Patriotism:Country in which workers are loyal to the country
and have sense of patriotism the efficiency of workers will
automatically go up. Love for the country encouraged them to do
more efficiently.

Question no - 06 : Division of labour.


Answer: When making of an article is split up into several processes and each
process is entrusted to a separate set of workers, it is called division of labour.
Division of labour is an important characteristic of modern production. In fact,
there is hardly any producing unit of a respectable size which does not organize
production on the basis of division of labour. Division of labour is associated with
efficiency of production. “The division of labour is not a quaint practice of
eighteenth century pin factories; it is a fundamental principle of economics
organization.”
The division of labour is of the following main types:
Simple Division of Labour : This means division of society into major
occupations e.g., carpenters, blacksmiths, weavers etc. It may also be called
functional division of labour.
Complex Division of Labour : In this case, no group of workers makes a
complete article. Instead, the making of an article split up into a number of
processes and sub-processes and each process or sub-process is carried out by a
separate group of people. This is division of labour proper.
Territorial Division of Labour : This form of division of labour refers to certain
localities or cities. It’s also known as localization of industries. In these areas,
specifies kinds of industries is set up. Under this when a particular industry or in
the production of a particular commodity, it is called territorial division of labour.
Question no - 07 : The disadvantage of division labour
Answer: Bellow the advantage and the disadvantage of division labour :
Advantages : Several advantages are claimed for the system of division of labour.
Adam Smith's contribution to this part of the economic theory is still regarded as
classic.
Division of labour has proved beneficial in the following ways :
Increase in Productivity : Adam Smith takes the example of a pin - making
industry to illustrate the immense increase in productivity. He describes pin-
making as divided into 15 distinct operations. Ten men can make 48,000 pins in
a day, one worker may. therefore, be considered to have made 4800 pins in a
day. In the absence of division of labour and machinety. one man could scarcely
have made one pin in a day, and certainly not twenty
Increase in Dexterity and Skil : Practice makes a man perfect. After repetitive
performance of the same task, a worker becomes an expert.
Inventions are Facilitated : In division of labour, the movement becomes
mechanical and the worker can freely think while at the job. New ideas often
occur leading to inventions.
Introduction of Machinery Facilitated : When a man is doing the same job
over and over again, be will be able to think of some mechanical contrivance to
relieve himself. A machine is, there fore, bound to take over this simple
movement sooner or later.
Saving in Time : Under the system of division of labour, a worker has only to
do one process or a part of process. Less time is therefore, needed to learn a
specialized trade
Saving in Tools and Implements : When a worker has to perform a part job
only, eg., making the legs of a chair, he need not be supplied with a complete
set of tools. One set of tools can serve many workers at the same time.
Large-scale Production : Division of labour involves production on a large
scale. The community reaps all the economies of large - scale production
Production improves not only in quantity but also in quality since goods are
made by specialists.
Right Man in the Right Place : Under division of labour, workers are so
distributed among the various jobs that cach- worker is put in the right place.
There are no round pegs in square holes

Disadvantages : We have seen that division of labour enhances the productive


capacity of the community. But as chapman puts it,"Productiveness of a method of
production is not the sole test of its value to get many commodities is not the only
end in life. We have rather to see how man, for whom production is meant, has
been affected by the division of labour. Considered in this light, division of labour
has not proved to be an miod blessing
The following may be mentioned as some of the disadvantages of division of
labour
Monotony : Under division of labour, a worker has to do the same job over and
over again. The work becomes monotonous. It is drudgery, pure and simple.
The work ceases to be interesting.
Retards Human Development : A person's development, physical and mental,
is greatly affected by the job he is engaged in. Under division of labour a
worker has to repeat the same movement over and over again. His muscles and
mind move in the same direction. Repetitive movement cramps a person's mind
and narrows his outlook. Monotony is soul - killing.
Industry De-humanised : Under division of labour, many people combine to
produce an article. "Everybody's business is nobody's business." The worker
loses all sense of responsibility and pride in his work. The industry is thus de-
humanised.
Loss of Skill : The master craftsman loses his skill. He knows, for instance,
only either spinning or weaving, making the legs of the chair or its seat. He
does not know how to make the whole chair.
Risk of Unemployment : Knowing only a part of the job, the worker is in
danger of becoming unemployable. If he happens to lose his present job. he
may not be able to get similar job elsewhere. He thus becomes unemployable.

Disrupts Family Life : Division of Labour facilitates employment of women


and children. The influx of women into the factory disrupts domestic life and
the employment of children involves the deterio ration of valuable human
resources of the nation. It is a great national lass.
Question no - 8 : Explanation of localization of industries and
causes of localization
Answer:
Explanation of localization industries: Localization industries is meant the
tendency on the part of industries to be concentrated in regions which are most
suited for their development. Some industries are carried on and developed in
certain areas because of their natural or acquired advantages. For example in
Pakistan, sugar industry is localized in NWFP and Punjab, paper match box
industry in NWFP, cotton industry in Punjab and Sindh, simply on the basis of
nearness to source of raw material.
Causes of localization : The important causes which influence the localization of
industries are discussed as below:
(iv) Nearness to raw material : One of the very important factor which
affects the birth of an industry in certain areas is the nearness to sources of
raw material . The availability of raw material near the location of the
industry helps considerably in reducing the transport cost and so the total
cost of production of the commodity. It is due to this reason that most of the
industries are established in regions where the raw material is available in
abundance.  Concentration of jute industry in Bangladesh and sugar industry
in NWFP are mainly due to these factors.
(v) Availability of source of power : Availability of cheap power resources is
another important factor which influences the concentration of industries in
particular areas. If for instance, electricity is to be carried over to a long
distance where the industry is located or the coal which serves as raw
material is to be transported at a far-off distance from whereat is extracted, it
will not then he economical to set up the industry at such places which are
far away from the sources of power.
(vi) Physical and climate conditions : Physical and climatic conditions
have an important hearing on the growth of industry. If suitable climate and
desirable physical conditions exist for a particular industry, that will he
established and developed in that region then.
(vii) Nearness to market : Industries have a tendency to be localized in
those areas where the market is near at hand. The goods produced can be
easily brought in the market and there can be much saving in the cost of
transportation.
(viii) Supply of trained labor : Supply of trained labor is another great
attraction for the concentration of an industry in a particular area. If for
instance, one wishes to set up a cotton factory, it will be advantageous for
him to install it in Faisalabad or Okara.
(ix) Availability of capital : Industries may spring up in those areas
where capital is available at a lower rate.
(x) Momentum of an early start : Sometimes, it so happens, that an industry
gets itself established and developed in a particularly locality not due to the
reasons discussed above but Just by some chance or other. Later on, that
locality acquires reputation in the production of the commodity and more
industries are set up-there. For instance sports goods industry is located in
Sialkot for no reason other than this that it got an early start there.

 
Question no-9: Meaning of capital formation
Answer : Capital formation is a term used to describe the net capital accumulation
during an accounting period for a particular country. The term refers to additions
of capital goods, such as equipment, tools, transportation assets, and electricity.
Countries need capital goods to replace the older ones that are used to produce
goods and services. If a country cannot replace capital goods as they reach the end
of their useful lives, production declines. Generally, the higher the capital
formation of an economy, the faster an economy can grow its aggregate income.
As an example of capital formation, Caterpillar (CAT) is one of the largest
producers of construction equipment in the world. CAT produces equipment that
other companies use to create goods and services. The firm is a publicly traded
company, and raises funds by issuing stock and debt. If household savers choose to
purchase a new issue of Caterpillar common stock the firm can use the proceeds to
increase production and to develop new products for the firm’s customers. When
investors purchase stocks and bonds issued by corporations, the firms can put the
capital at risk to increase production and create new innovations for consumers.
These activities add to the country's overall capital formation.

Question No - 10 : Why low capital formation in


under-developed countries?
Answer : Lack of real capital is so characteristic a feature of all under-developed
economics that they are often called"capital poor economics".Low productivity in
under-developed countries, is mainly due to the small amount of capital per head
of population.
Low rate of capital formation in under-developed countries is due to following
reasons.
16.Low level of domestic savings:In under-developed countries, the level of
savings is very low. In other words, these countries save a very small
proportion of their current national income. In most of the underdeveloped
countries the rate of savings is between 5% and 10% , only because of the
stimulus provided by the planned development under the Five-Year
Plans.The level of savings in underdeveloped countries is very small mainly
because their level of national income or per capital income is very low. As
a result much of the income is consumed and little is left for investment
purposes. Under-developed countries are, in fact, caught up in the vicious
circle of poverty Low income—small savings—low investment—less
capital—less productivity, ending in low income.Apart from the low level of
absolute income, the low relative level of real income in under-developed
countries as compared with the advanced and rich countries also reduces
their capacity to save. There are great and growing inequalities between the
income levels and, therefore, living standards of different countries.
Increasing awareness of these inequalities have pushed tip the general
propensity to consume of the under-developed countries.
17.Low Rate of growth of national income and per capita income: Due to
lack of desired investments, capital formation has no increase. Hence, due to
low production, there is low national and per capita income and, in turn, this
forces to low capital formation.This situation tends to perpetuate itself and
the poor countries continue to be poor. The low rate of capital formation is a
partial link in a vicious circle in such countries. Unless, the vicious circle of
poverty is broken, the rate of capital formation cannot be raised.
18.Lack in demand and supply of capital:Low productivity in under-
developed countries, people have low real income and, thus, purchasing
power is low and so due to low demand, investment has effect which again
reduces national income and productivity and rate of capital formation
remains low.Due to lack of necessary supply of capital in under-developed
countries, the process of capital formation is not boosted up. As a result,
capital formation remains at low level.Because of low rate of real income
per capita in under-developed countries, there is low saving capability,
hence, there is less capital. Due to lack of capital, there cannot be established
basic business and industries so the production falls down.
19.Small size of market and backwardness of technology: Due to small size
of domestic market, investment is not encouraged in poor countries. It does
not expand the work of economic development and modern machines cannot
be used as extra quantity produced has no market access.Under-developed
countries also face the problem of technical knowledge. Production is
carried on old and less productive techniques. As a result, these countries
have low productivity and per capita production and income’s low quantity,
lowers the standard of the rate of capital formation.

These are few peculiarities of low rate of capital formation in under-developed


countries.

—◑—
Chapter: 18- Laws of return

Question no.1:Explain the law of diminishing return with its three aspects.

Answer: The law of diminishing return was supposed to have a special application
to agriculture.It is the practical experience of every farmer that “successive
applications of labor and capital to a given area of land most untimely, other things
remaining the same , yield a less than proportionate increase in produce.” If by
doubling labor and capital he could double the yield of his land and so on, it can be
easily seen that one acre of land could be made to produce as much wheal as could
suffice for the entire population of the world.That this cannot be done is simply
due to the operation of the law of diminishing returns.If investment is increased,the
total yield will no doubt increase,but at a diminishing rate .
Marshall stated the law thus: “An increase in capital and labor applied in the
cultivation of land causes in general less than proportionate increase in the amount
of produce raised, unless it happens to coincide with an improvement in the arts of
agriculture.” The phrase 'in general’ in this statement is important.It means that
there may be cases where the law does not hold good.It refers to limitations of the
law.

Three aspects of the law consider the table below .

Table : Three aspects of the Law of Diminishing Return


Number of Total Return Marginal Return Average Return
workers
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55
10 440 -55 44

From the Table,it appears that there are three different aspects of the law of
Diminishing Returns :
(1) Law of total Diminishing Returns (column 2 ).In this sense,the return begin to
diminish from the 9th worker..Every Successive worker employed does make
some addition to the total output.But the 8th adds nothing and the 9th and 10th are
a positive nuisance.As workers cannot be had gratis,no prudent farmer will employ
more than seven workers in the conditions represented by this table.
(2) Law of Diminishing Marginal Returns (column 3) Marginal returns go on
increasing up to the 3rd worker.This is so because the proportion of workers to
land was at first insufficient and the land was not being properly tilled. This phase
of cultivation is unstable and will not be found in practice.When the farmer knows
that he can get more than proportionate return by employing extra hand, he will
certainly do so .The marginal, i.e. ,the additional,return goes on falling from the
3rd man onwards till it drops down to zero at the 8th.The 9th and 10th men are
responsible in making the marginal return negetive.The point at which the addition
made to the total output by each successive unit of the variable factor starts
diminishing is known as the point of diminishing marginal returns.
It can be seen that the total output is at its maximum when marginal output is zero.
(3)Law of Diminishing Average Returns (column 4). The average return reaches
the maximum at the 4th worker. One step later than the marginal return reaches the
maximum.Then the marginal return falls more sharply.The two equalize
somewhere between the 4th and 5th, i.e., when the 5th worker works part-time.But
we do not employ men in fractions in real life.Therefore,it is not always possible to
equalize the marginal and the average returns.It is also clear that It is possible for
the average output to increase while the marginal output falls.
Question no-02:Law of variable proportions and the assumption of the law of
variable proportions.

The law of variable Proportions: The law of variable Proportions states that
keeping other input/factor fixed and increase quantity of only one factor/input
(variable factor/input), the total Production initially increase at an increases rate
then increases at a diminishing rate and finally at a negative rate. The law an
occupies a very important Place in economic theory.
Economists have explained the rule of the law of variable Proportions in different
ways. According to Stigler, "As equal increments of one input are added, the inputs
of other productive services being held constant, beyond a certain point the result
in increment product will decrease, the marginal product will diminish." Professor
Samuelson states the law thus, "An increase in some inputs relative to be the fixed
inputs will, in a given state of technology, cause output to increase; but after a
point the extra output resulting from the same additions of extra inputs will become
less and less."
The law of variable Proportions Describes the production function with one
variable factor while the quantities of other factors of production are fixed. That is,
it describes the input-output relation in a situation when the output is increased by
increasing the quantity of one input, keeping the other inputs constant. When the
quantity of one factor is increased and the quantities of the other factors of
production are kept constant, naturally the proportion between the variable factors
and the fixed factor is altered. That is, the ratio of the variable factor to that of the
fixed factors goes on increasing as a quantity of the variable factor is increased. It
is because that in this law we study the effect on output' of variations in factor
proportion, this law is called the law of variable proportions. Infect, the law of
variable proportions is the new name for the well known law of diminishing
returns. Up till Marshall, 4 was thought that there were three separate laws of
production, viz., the laws of diminishing, increasing and constant returns. The
modern economists are of the view that these three laws are not three separate laws
but are only three phases of one general law of variable proportions.
There is only one law which applies everywhere and which is called the Law of
Variable Proportions; 'This law applies to all fields of production like agriculture,
industries etc. although its different stages are to be found in different industries or
its different stages are larger or shorter indifferent industries.
We find from the statements of the law of variable proportions given above that
this law relates to the behavior of output as the quantity of one factor is varied
keeping the quantities of' the other factors constant. It states further that the
marginal product and the average product of the factor kept constant will
eventually diminish.
ASSUMPTIONS OF THE LAW OF VARIABLE PROPORTIONS

The main assumptions of the law of variable proportions are given below-

(a) It is assumed that the state of technology remains unaltered.


(b) It is also assumed that of the various inputs employed ill production Some at
least must be kept constant.
(c) It is assumed all variable factors are equally efficient
(d) It operates in short run as factors are classified as variable and fixed factor
(e) The law applies to all fixed factors including land
(f) Under law of variable proportions different units of variable factor can be
combined with fixed factor
(g) This law applies to the field of production only
(h) The effect of change in output due to change in variable factor can be easily
determined
(i) It is assumed that factors of production become imperfect substitutes of each
other beyond a certain limit
(j) The law of variable proportions is clearly based upon possibility of varying
proportions in which the various factors are combined in production. It does
not apply to cases where the factors have to be used in fixed proportions to
yield fixed products.
Question no 3:Limitations of the law of diminishing return.

The law of diminishing returns operates in the short run when we can’t change all
the factors of production. Further, it studies the change in output by varying the
quantity of one input.Technically, the law states that as we increase the quantity of
one input which is combined with other fixed inputs, the marginal physical
productivity of the variable input must eventually decline.

Marshall has explained the law of diminishing returns, in general terms which is
subject to criticism. This means that the law is not applicable in all cases.

The law of diminishing returns does not apply to all situations.There are several
exceptions to the law as it applies in agriculture.

1. New Soil
The law of diminishing returns does not hold well in case of new soil.When a
virgin soil is brought under cultivation, the additional return for each successive
dose of labor and capital may increase for a time.But after a point, the tendency of
diminishing return will set in.Hence, in case of a new soil,the law of diminishing
return does not apply in the beginning.

2. Improved Methods of Cultivation

Man's ingenuity is ever striving to counteract the operation of this law but
improving the techniques of cultivation. In modern times, when there are
improved methods of cultivation, this law is not applicable. The improved methods
of production are cropping pattern, new seeds, and fertilizer, mechanization and
irrigation facilities.But science can not keep pace with the increasing demand for
food. When these methods are used, there are good chances of more production.
Thus, there are chances of increasing returns even in agriculture sector.

3. Shortage of Capital

The law of diminishing returns does not apply in case of shortage of capital or
insufficiency of capital. If, we have ample stock of capital, the law of increasing
returns would operate and not the law of diminishing returns. These factors can
check the operation of the law of diminishing returns temporarily. But this law is
bound to apply ultimately. These can be delayed in the application of the law but
the law is definite to apply sooner or later.
These are the limitations of the law of diminishing return.Though, these
limitations, the law of diminishing returns has a very wide,almost universal
application. Whenever we found that some factors of production are fixed and can
not be varied, then the techniques of production remaining the same, diminishing
returns are bound to follow, sooner or later.There is no escape.

Question no 4: Law of increasing returns. Why the law of increasing returns


operates.

Law of increasing returns : In a given state of technology when the unites of


variable factors are increased with the units of other fixed factors, the marginal
productivity increase,it is called law of increasing returns.
Another aspect of the Universal law of variable proportions is the law of increasing
returns. An industry is subject to the law of increasing returns if extra investment
in the industry is following by more than proportionate returns,if the marginal
product increases.In terms of cost,the law of increasing returns means the lowering
of the marginal costs as industry is expanded.As marginal cost indicates price, we
can say that the law of increasing returns operates in an industry if,with every
expansion of its output,the price of the product falls.

The Law of increasing returns operates : We have already seen when economies
can be reaped if the scale of production is increased. Advantages of specialization
of labor and machinery and other commercial and miscellaneous economies make
it possible to lower the cost of production, and we have increasing returns.
Economies. Among the economies of mass production which contribute to greater
productivity at less cost may be mentioned.
(i)Use of non-human and none-animal power resources (water end wind power,
steam, electricity, atomic energy);
(ii)automatic self-adjusting mechanism;
(iii)use of standardized, interchangeable parts;
(iv)breakdown of complex processes into simple repetitive operations;
(v)Specialization of functions and division of labor and
(vi)many other technological factors.
No Scarcity of Factors. The law of diminishing returns operates when there is
dearth of an essential factor. But if there is no dearth, the law of increasing returns
will operate.”The expansion of an industry,provided that there is no dearth of
suitable agents of production,tends to be accompained,other things being equal, by
increasing returns.”
Right combination. The law of diminishing returns operates when the factors have
been combined in wrong proportions. Now when we try to correct the
combination,increasing returns will follow till the balance is completely restored.
Full use of indivisable Factors. The concept of indivisibility,too,has a close bearing
on the law of increasing returns. A manufacturer sets up a plant to cope with a park
demand,but in actual practice it may be producing below capacity.In that case, if
an addition is made to some other factors or factors, the indivisible factor will be
more fully employed, and increasing returns will follow.
Question no. 5: Distinction between the law of returns and returns to scale.
Law of returns:

The law of returns states that with every additional unit in one factor of production
while all other factors are held constant, the incremental output per unit will
decrease at some point.

For example, a restaurant hiring more cooks while keeping the same kitchen space
can increase total output to a point, but every additional cook takes up space,
eventually leading to smaller increases in output as there are too many cooks in the
kitchen. The total output can decrease at some point, resulting in negative returns if
too many cooks get in each other's way and eventually become unproductive.

Returns to scale:

Returns to scale refers to the proportion between the increase in total input and the
resulting increase in output.

For example, if a soap manufacturer doubles its total input but gets only a 40%
increase in total output, then it can be said to have experienced decreasing returns
to scale. If the same manufacturer ends up doubling its total output, then it has
achieved constant returns to scale. If the output increased by 120%, then the
manufacturer experienced increasing returns to scale.

Comparison chart:

Law of returns Returns to scale


Law of returns primarily looks at Returns to scale is a measure focused
changes in variable inputs. on changing fixed inputs.
Law of returns are categorized into There are three types of returns to
two types. scale. They are:
1) The law of variable proportion 1) Increasing returns to scale
seeking to analyse production in the 2) Constant returns to scale
short period. 3) Diminishing returns to scale.
2) The law of returns to scale seeking
to analyze production in long period.
In law of returns, only one factor In returns to scale, the entire set of
changes. inputs is changed.
In law of returns, diminishing returns In returns to scale, it depends on the
is like a final truth. There may be industry and the process. Therefore,
increasing returns initially but we may have constant returns to scale
eventually, diminishing returns will going on for forever.
set in.

Unit: IV- Product Pricing.


Chapter: 22- Market and Market Structure

Question No. 1- Meaning of Market

Answer:

In Economics, the term “Market” does not refer to a particular place as such but it
refers to a market for a commodity or commodities. It refers to an arrangement
whereby buyers and sellers come in close contact with each other directly or
indirectly to sell and buy goods.

Further, it follows that for the existence of a market, buyers and sellers need not
personally meet each other at a particular place. They may contact each other by
any means such as a telephone or telex. Thus, the term “Market” is used in
economics in a typical and specialised sense. It does not refer only to a fixed
location. It refers to the whole area of operation of demand and supply. Further, it
refers to the conditions and commercial relationships facilitating transactions
between buyers and sellers. Therefore, a market signifies any arrangement in
which the sale and purchase of goods take place.

Further some more definitions are modern definitions of market are as


follows:

‘‘Originally’’, says Jevons, “A market was a public place in a town where


provisions and other objects were exponsed for sale; But the world has been
generalised so as to mean anybody of persons who are in intimate business
relations and carry-on extensive transactions in any commodity.
A great city may contain as many markets as there are important branches of trade,
and these markets may or may not be localized.
But the idea of locality is not necessary. The traders may be spread over a hole
town, or region, or a country and yet from a market, if they are, by means of fair,
meetings, published price lists, the post-office or otherwise, in close
communication with each other.”
As Chapmen has said – The term market refers not necessarily to a place but
always to commodity or commodities and the buyers and sellers of the same who
are in direct competition with each other.
According to Prof. Benham – “We must therefore, define a market as any area
over which buyers and sellers are in such close touch with one another either
directly or through dealers that the prices obtainable in one part of the market
affect the prices in other parts.”
Also, In the words of Cournot, a French economist, "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 buyers and sellers are in such free intercourse
with one another that the price of the same goods tends to equality easily and
quickly."

From the above definitions following facts may be noted:

1. The existence of a commodity. For example- The market for gold or silver,
cotton, wheat and rice etc. Thus, there will be as many markets as are commodities
and if there be several types or variance of a commodity, then each type or variety
will have a separate market of its own.

2. That there be buyers and sellers who are in touch with one another either
through post, telegraph, telephone or through middlemen.

3. That there is perfect competition among buyers and sellers so that through such
competition, the price of the commodity in question is influenced.

Thus, the essentials of a market are; (a) A commodity which is dealt with; (b)The
existence of buyers and sellers; (c)A place, be it certain region, a country or the
entire world; and (d) Such Intercourse between buyers and sellers that only 1 price
should prevail for the same commodity at the same time.

Question No. 2- Size of Market

Answer:
Historically, the size of a market has coincided with its domestic market. However,
in a globalized world, a country’s market may or may not coincide with its political
borders. Market size is therefore defined as a combination of country size and
foreign markets.

Economic research, in line with the current GCI, suggests two ways through which
market size affects productivity: economies of scale in production and incentives
for innovation.
In general, market size produces efficiency gains by allowing for specialization—
an idea that remains as true today as when Adam Smith proposed it in 1776.
Furthermore, large markets can take advantage of economies of scale in the
production of goods and services. Public goods tend to have high fixed costs and
low marginal costs, and consequently the per capita cost of services such as justice,
defense, and infrastructure decreases in places where a greater number of taxpayers
pay for them.

In the case of some commodities, the market is very wide covering the whole
country or even the whole world, whereas in certain other cases, the size of the
market is very limited covering a small village. The size of the market depends
upon several factors:
Character the commodity. In order to have wide market, a commodity must be (i)
portable, (ii)durable, (iii)suitable for sampling, grading and exact description; and
(iv)such as its supply can be increased. Such commodities are wheat, gold,
government securities etc. Bulky articles like bricks and perishable like fresh fruit
and vegetables have a narrow market.

Nature of demand. A commodity, which is in Universal demand (e.g. gold and


silver) will have a white market. Similarly, commodity of general consumption has
a wide market.

Means of communication and transport. The size of the market depends upon
the extent to which means of communication and transport have been developed. A
properly developed transport and communication system has enabled commodities
be carried long distances and establish wide contacts. This has widened the market.
Peace and security. Obviously, goods cannot be marketed in distant places unless
peace and order prevail. In war-time, due to insecurity in war zones, markets get
restricted. Thus, the extent of the market depends on the peace prevailing in the
region.

Currency and credit system. If the currency and credit system of the country are
well developed marketing can be conveniently and profitably carried on over
extensive areas. The extent of the market very largely depends on the state of the
currency and the confidence it inspires.

Policy of the state. Markets may be restricted by the policy of the state.
Prohibitive duties and quotes restrict the market. The zoning system (e.g., wheat
zones) which allows free movement of goods only within a certain zone has the
same effect. Thus, a government policy can also affect the extent of the market.

degree of Division of Labour. We know that division of labour is limited by the


extent of the market. the Converse of this is also true. That is, in its turn, depends
upon the degree of division of labour. The greater the division of labour the
cheaper the articles and wider the market.

Question No. 3- Classification of Market


Answer:

Market:
Market is a mechanism, here the buyers and sellers meet either directly or
indirectly to exchange their goods and services for monetary benefits.
Classification of market:
Markets may be classified;
1. On the Basis of Area:
under this area following markets have been included:
 Local
 National
 International

Local: When the competition between purchaser and seller is localized and
limited at a specific market then it is called Local Market. In this market mostly
perishable goods are purchased and sold.
For example: Sale of vegetable, fish, egg etc.

National: It is a market in which the demand of the goods is in the nation as a


whole where we are living.
For example: Bengali book in Bangladesh can have national market. Outside
Bangladesh we may not have market of Bengali book because of language.

International:
If the competition of goods is world-wide, the market will be international.
For example: Gold, silver, oil is known as an international market.

2. On the basis of Time:


On the basis of time Marshall has divided market as under:
 Very short period market
 Short period market
 Long period market

Very short period: The supply of goods is stable; therefore, the price of goods is
determined according to the demand of the goods. If the demand cut down the
price will fall and vice-versa.
For example: The demand of vegetables, fish or eggs etc.
Short period market: The market is slightly longer than very short period. Here
the supply can be slightly adjusted.
For example: The demand of fish or milk or eggs.

Long period market: If the demand for goods increases, there is time to increase
the supply. Here the price is influenced more by supply of the goods.

3. On the basis of Competition:


On the basis of competition market has been divided under two heads:
(i) Perfect market
(ii) Imperfect market

Perfect market:
A theoretical market in which buyers and sellers are a large number and well
informed that monopoly is absent and market price cannot be manipulated.

Imperfect Market:
A market is said to be imperfect when some buyers or sellers or both are not aware
of the offers being made by others. Naturally, therefore, different prices come to
prevail for the same time in an imperfect market.
Following are the classification of Imperfect Market:
a. Monopoly
b. Duopoly
c. Oligopoly

Monopoly: In monopoly, there is a single producer or seller who control the


market. There is no close substitute for his product.
For example: Google, Microsoft etc. are the example of monopoly.

Duopoly: In duopoly, there are two sellers, selling either a homogeneous product
or a differentiated product. These two sellers enjoy a monopoly in the sale of the
product produced by them.
For example: smartphones- Apple & Android, soft drink: Coca-cola & Pepsi etc.

Oligopoly: Olig = a few & Poly= sellers


A few sellers may be producing and selling either a homogeneous or a
differentiated product.
For example: Cell phone provider, the major social media outlet (Facebook, twitter
and Instagram) function as an Oligopoly.

4. On the basis of Function:


On the basis of function market has been divided under four heads:
They are:
 Mixed market
 Specialized market
 Sample market
 Marketing by grades

Mixed market: Mixed market is that market where several types of goods are
purchased and sold simultaneously. All goods are available at one place. This is
also called “General Market”.

Specialized Market: Specialized market is that market where only one kind of
goods are sold and purchased.
For example: Only wheat market or cloths market. This type of market is mostly
found in Metropolitan Town.

Sample market: Sample market is that where goods are purchased and sold as
specimen of any variety of goods. In this market purchaser only sees the specimen
of goods and places order for the good.
For example: Woolen cloths are purchased by seeing only sample booklets.

Marketing by grades: In this market, goods are purchases and sold according to
grades. It means the goods are first classified into various grades as per the quality
of the goods.

5. On the other basis:


Under this type of market has been divided as:
 Fair market
 Black market or Illegal market
Fair market: In this market the goods are purchased and sold on the price fixed by
the government and no other price can be charged by any other seller.

Black Market or Illegal market: In this market the seller charges higher price
fixed by the government. This price is taken by seller secretly. This is also known
as illegal price or smuggling price.

Question No. 4- Perfect market and Imperfect market


Answer:
Definition of perfect market:
A Perfect Competition market is that type of market in which the number of buyers
and sellers is very large, all are engaged in buying and selling a homogeneous
product without any artificial restrictions and possessing perfect knowledge of the
market at a time.
perfect competition markets especially in the long run are very helpful for the
customers because they can get the products at the lowest market price value.
For example, there are few perfect markets; those selling commodities, such as
agricultural products, represent the closest approximation of a perfect market.

Advantages of Perfect Competition:


1.They allocate resources in the most efficient way- both productively (P=MC) and
allocatively efficient (P> MC) in the long run.
2.There is no information failure as all knowledge is spread out evenly
3.Only normal profits made just cover their opportunity cost
4.Maximum consumer surplus and economic welfare

Disadvantage of perfect market:


1.Competition Between Sellers.
2.The Lack of Research and Development.
3.Unbalanced Prices.
4.Demand Changes.

Definition of imperfect market:


A market in which buyers and sellers do not have complete information about a
particular product, where it is difficult to compare prices of products because they
are different from each other etc. is called imperfect market.
For example, traders in the financial market do not possess perfect or even
identical knowledge about financial products. The traders and assets in a financial
market are not perfectly homogeneous.

Advantage of imperfect market:


1.Greater choice: Goods are not homogenous, but are close substitutes, therefore
consumers have a greater choice of goods or services.

2.Normal Profit: In the long-run consumers are not being exploited as the firm is
earning normal profits.

3.Lower prices: Competition between firms in the industry will help lower prices
and make them more competitive for consumers.

4.Innovative goods or services: Innovation is encouraged as firms will constantly


strive to gain a competitive edge over their rivals, hence, consumers get the benefit
of modern up-to-date goods or services.

5.Access to information: Consumers may have more information available to


them because of the extensive competitive advertising used within the industry.

Disadvantage of imperfect market:


1.It is a type of economy in which the government intervenes constantly, because
of its prices in the market.
2.If prices rise disproportionately, they may lose customers and with this, the
product will fail in the market.
3.Companies must work together to achieve greater demand.
4.There is competition among the sellers because they are few and everyone knows
the product well.

There are four types of imperfect markets:


1.Monopoly: Only one seller
2.Oligopoly: Few sellers of goods
3.Monopolistic competition: Many sellers with highly differentiated product
4.Monopsony: Only one buyer of a product
Question No. 5- CONDITION OF PERFECT MARKET

Answer

Perfect market: A perfect market is market that is structured to have no


anomalies that would otherwise interfere with the best prices being obtained.
Examples of this perfect market structure are:

 A large number of buyers


 A large number of sellers
 Products are homogeneous
 Information is freely available to everyone in the market
 There is no collusion between the market participants
 Every participant is a price taker, not having the ability to influence
market prices

There are few perfect markets; those selling commodities, such as agricultural
products, represent the closest approximation of a perfect market.

For a market to be perfect the following conditions are essential:

● Free and Perfect Competition


● Cheap and Efficient Transport and Communication
● Wide Extend

Free and Perfect Competition:

In a perfect market, there are no restrictions either on the buyers or on the sellers,
they should be absolutely free to buy from or sell to anybody they like. There
should be no monopolies.
Perfect competition is a benchmark, or "ideal type," to which real-life market
structures can be compared. Perfect competition is theoretically the opposite of
a monopoly, in which only a single firm supplies a good or service and that firm
can charge whatever price it wants since consumers have no alternatives and it is
difficult for would-be competitors to enter the marketplace.

Under perfect competition, there are many buyers and sellers, and prices
reflect supply and demand. Companies earn just enough profit to stay in business
and no more. If they were to earn excess profits, other companies would enter the
market and drive profits down. 
Cheap and Efficient Transport and Communication:

Same price for the commodity will not rule if the information about changes in
prices cannot be quickly transmitted or if the commodity cannot be cheaply or
speedily transported. Transport and communication should be quick. Thus cheap
and efficient means of transport and communication are must.
 Since efficient transportation is linked with social welfare and economic
opportunities, investments in transportation infrastructure are expected to create
positive multiplying effects. However, developing countries have been impacted
by a lack of transport infrastructure investments, a lack of capacity, managerial
deficiencies, a lack of coordination between modes and challenges in supporting
national and international distribution imperatives. Globalisation has been
associated with rising mobilities of passengers and freight and has spurred
investments in the development of ports, airports, railways and highways across a
wide range of countries and contexts. Impacts are contingent upon the existing
level of development and the existing quality and efficiency of infrastructure as
well as modal preferences.

Wide Extend:

Sometimes a wide market is regarded as the same thing as the perfect market. For a
wide market, the commodity should have permanent and universal demand. The
commodity should be portable, durable, gradable and should have wide demand.
The extent of a market depends on the nature of the commodity, whether it is
durable or perishable, and the nature of demand for it, whether it is steady or
fluctuating.
Question No. 6- Market forms or market structures
Answer:
“Market structures” refer to the different market characteristics that determine
relations between sellers to each another, of sellers to buyers and more. There are
several basic defining characteristics of a market structure, such as the following:

 The commodity or item that’s sold and the extent of production


differentiation.
 The ease or difficulty of entering and exiting the market.
 The distribution of market share for the largest firms.
 The number of companies in the market.
 The number of buyers and how they work with or against the sellers to
dictate price and quantity.
 The relationship between sellers.
A variety of market structures will characterize an economy. Such market
structures essentially refer to the degree of competition in a market.
There are other determinants of market structures such as the nature of the goods
and products, the number of sellers, number of consumers, the nature of the
product or service, economies of scale etc. The type of market depends on the
degree of commodities prevailing in the market. Broadly speaking, there are two
types of competition prevailing in the market-
(a) Perfect competition (b) Imperfect competition.

Perfect competition and pure competition: Modern economists draw a


distinction between perfect competition and pure competition. Perfect competition
is wider concept. Pure or perfect competition is a market structure defined by a
large number of small firms competing against each other. A single firm doesn’t
have significant marketing power, and as a result, the industry produces an optimal
level of output because firms don’t have the ability to influence market prices.
Supply and demand determine the amount of goods and services produced, along
with the market prices set by the companies in the market. Products are identical to
competitors’ products, and there are no significant barriers to entering and exiting
the market. In order that there should be perfect competition, the market should
satisfy not only the conditions of pure competition but also a few more.

B. Imperfect competition: Imperfect competition is the real-world competition.


Today some of the industries and sellers follow it to earn surplus profits. In this
market scenario, the seller enjoys the luxury of influencing the price in order to
earn more profits.
If a seller is selling a non-identical good in the market, then he can raise the prices
and earn profits. High profits attract other sellers to enter the market and sellers,
who are incurring losses, can very easily exit the market.
Imperfect competition may also take several forms e.g. monopolistic competition,
oligopoly, duopoly or monopoly.
Thus, at once extreme stands perfect competition and at the other monopoly. In
between these two extremes, there are all degrees of competition or lack of
competition. The following chart shows at a glance different types of market forms
on the basis of the nature of competition: -

Types of market No. of firms Nature of commodity

Perfect or pure Infinite Homogeneous


competition
Imperfect competition:

1.Monopolistic Many Differentiated


competition

Homogeneous
2. Perfect oligopoly A few

Differentiated
3. Imperfect oligopoly A few
Pure or absolute One Homogeneous
monopoly
Question No. 7- Pure Competition
Answer:

INTRODUCTION
Pure competition is a market situation where there is a large number of
independent sellers offering identical products. It means it is a term for an industry
where competition is stagnant and relatively non-competitive. Companies within
the pure competition category have little control of price or distribution of
products. Pure competition is said to exist in a market where-
 There are a large number of buyer and sellers;
 Products are homogenous; and
 There is freedom of entry and exists of buyer and sellers.
In the sense of perfect competition is not only pure but also free from other
perfection. It is a broader concept of pure competition. The essentials feature of
pure competition is the absence of any monopoly element.
In the word of Chamberlin, pure competition means “competition unalloyed with
monopoly elements,” whereas perfect competition involves “perfection in many
other respects than the absence of monopoly”. It is possible to come across pure
competition in real life but not perfect competition. Structure influences conduct
which, in turn, affects performance.

Pure Competition

Meaning:
Pure competition is a market situation where there is a large number of
independent sellers offering identical products. It means it is a term for an industry
where competition is stagnant and relatively non-competitive. Companies within
the pure competition category have little control of price or distribution of
products.
Pure competition involves-
 Very large number
 Standardized product
 Price Takers
 Free entry and exit

A very large number– a very large number of independently acting sellers, e.g.,
farm product, stock market, foreign exchange market.

Standardized product- Identical and homogeneous product. As long as the price


is the same, the consumers will be indifferent about which seller they buy the
product from

Price taker- Individual firm exert no significant control over the market price.
Each firm’s quantity is too small to affect the market supply or price.
Competitive are price takers, they cannot affect the price, but adjust to it.
None of the sellers can ask for a higher price.
None will sell at a lower price.

Free entry and free exit- New firms can freely enter and existing firms can freely
leave the market. No significant, technological, financial, or other obstacles
prohibit new firms from selling their output in the market.

DEFINITION
The purely competitive markets are used as the benchmark to evaluate market
performance. It is generally believed that market structure influences the behavior
and performance of agents with in the market. Structure influences conduct which,
in turn, affects performance. Pure competition and Monopoly are at each end of the
spectrum of markets. In fact probably neither occur in market economies. Pure
competition and monopoly are the boundaries and the “real world” (wherever that
is) lies somewhere between the two extremes. Pure competition provides the
benchmark that can be use to evaluate markets. The physician who attends you
knows that 98.6o is a benchmark. Your temperature may not be precisely 98.6o,
but if it deviates significantly, that deviation suggests problems. It might be in your
best interests to know what the “normal” temperature is and the cause of the
deviation from “normal.”

CHARACTERISTICS
There are three characteristics of pure competition:
Large number of buyers and sellers: There are a large number of buyers and
sellers and no one can influence the price of the commodity. A firm produces a
small part of the total market output and as such a change in its output will not
affect the market supply much. The price is determined by the industry as a whole.
Therefore, a firm is a price taker rather than the price maker.
Homogenous products: The products of all firms in the industries are
homogenous. The buyers are unconcerned about the source of the product; no
single seller’s product is preferred to that of any other seller. Similarly, sellers also
do not care to whom they sell and no preferences among the buyers exist in the
market. Homogeneity of the product refers to the “physical characteristics” of the
product, such as color size, etc. and to the “environmental factors”, such as the
location of the seller, credit facilities, etc. The products are therefore
indistinguishable from one another or are perfect substitutes for one another. This
implies that the firm can sell any amount of the product at the prevailing price
only.

Free entry and exit from industry: The new firms are free to enter the industry
and the existing firms are free to leave the industry. There are no restrictions as
such on the entry and exit on the firms. When the existing firms make excess
profits in the short run, other firms are attracted by it and enter the industry. On the
other hand, when the existing firms incur losses in the short run, some firms would
leave the industry. This ensures that the firms earn only normal profits in the long
run and as a result, there will not be any tendency for the firms to enter or leave the
industry.

Shape of Demand Curve in Pure Competition


When there is pure competition, the average revenue curve (AR) or demand curve
of a firm is a horizontal straight line which means that any firm can sell any
quantity at the prevailing price. Since the number of firms is very large, no
individual firm has the power to vary the market price. Also, since the products are
identical from the consumer’s point of view, the price paid by them cannot be
different. This is represented by the following diagram

AR=MR

Output x
Average Revenue and Marginal Revenue

OX and OY are the two awes. Along OX is represented the output and along OY
the Price Revenue. At OP price, a seller can sell as much as he likes. He cannot
charge more and he will not charge less. If he raises the price, he will lose all his
customers and if he charges less, he will be unnecessarily losing.
Question No.8- Perfect Competition
Answer:
There is said to be perfect competition when every purchaser and seller is so small
relative to the entire market that he can not influence the market price that
increasing or decreasing his purchases or his output.
Perfect competition is wider term than pure competition. Besides, the two
conditions of pure competition are the homogeneity of the product and the
existence of large number of dealers, several other conditions must also be fulfilled
to make it perfect competition.
Thus, the conditions of perfect competition are: -
(a) Large number of buyers and sellers
(b) Homogenous product
(These conditions of pure competition have already been discussed above)
€ Free entry or exit. There should be no restrictions, legal or other otherwise, on
the firm’s entry into or exit from, the industry. In this situation all the firms will be
making just normal profit. If the profit is more than normal, new firms will enter
and the extra profit will be competed away; and if, on the other hand, profit is less
than normal, some firms will quit, raising the profits for the remaining firms. But
if there are restrictions on the entry if new firms may continue to enjoy super
normal profit. Only when there are no restrictions on entry or exit, the firms will
earn normal profit.
(d) Perfect knowledge. Another assumption of perfect competition is that the
purchasers and sellers should be fully aware of the prices that are being offered and
accepted. In case there is ignorance among the dealers, the same price can not rule
in the market for the same commodity. When the producers and the customers
have the full knowledge of the prevailing price, nobody will offer more and none
will accept less. And the same price will rule through out the market. The
producers can sell at the price as much as they like and the buyers also can buy as
much as they like.
€ Nature of transport costs. If the same price is to rule in a market, it is necessary
that no cost of transport is there, the prices must differ to that extent in different
sectors of the market.
(f) Perfect Mobility of the factors of production. The mobility is essential in order
to enable the firms to adjust their supply to demand. If the demand extends supply,
additional factors will move into the industry and in the opposite case, move out.
Mobility of the factors of production is essential to enable the firms and the
industry to achieve an equilibrium position.

Mr. Robinson thus defines perfect competition, ‘‘When the number of firms being
large, so that a change in the output of any of them has a negligible effect. Upon
the total output of the commodity. The commodity is perfectly homogenous in the
sense that the buyers are alike in respect of their preferences (or indifference)
between one firm and its rivals, the competition is perfect, and the elasticity of
demand for the individual firm is finite.’’

Here is a comprehensive definition: ‘‘Perfect competition is the name given to an


industry or to a market characterized to a large number of buyers and sellers all
engaged in the purchase and sale of a homogenous commodity, with perfect
knowledge, of market prices and qualities. No discrimination and perfect mobility
of resources.

Chamberlin thus brings but the decision between pure competition and perfect
competition. ‘‘Purity requires only the absence of monopoly, which is realized
when there are many buyers and sellers of the same (perfectly standardized)
product. Perfection is concerned with other matters as well: mobility of resources,
perfect knowledge, etc. Perfection is a different thing from its purity, meaning by
the latter its freedom. From monopoly elements.’’
In short, Pure or perfect competition is a theoretical market structure in which the
following criteria are met:

 All firms sell an identical product (the product is a “commodity” or


“homogeneous”).
 All firms are price takers (they cannot influence the market price of their
product).
 Market share has no influence on prices.
 Buyers have complete or “perfect” information—in the past, present and
future—about the product being sold and the prices charged by each firm.
 Resources for such a labor are perfectly mobile.
 Firms can enter or exit the market without cost.

This can be contrasted with the more realistic imperfect competition, which exists
whenever a market, hypothetical or real, violates the abstract tenets of neoclassical
pure or perfect competition.

Since all real markets exist outside of the plane of the perfect competition model,
each can be classified as imperfect. The contemporary theory of imperfect versus
perfect competition stems from the Cambridge tradition of post-classical economic
thought.
Question no 9: Imperfect Competition

Answer:
Imperfect competition takes three main forms: -
1. Monopolistic Competition;
2. Oligopoly, and
3. Monopoly.

1. Monopolistic Competition: The model of monopolistic competition


describes a common market structure in which firms have many
competitions, but each one sells a slightly different product.

Monopolistic competition as a market structure was first identified in the


1930s by American economist Edward Chamberlin and English economist
Joan Robinson.

Many small businesses operate under conditions of monopolistic


competition, including independently owned and operated high-street
stores and restaurants. In the case of restaurants, each one offers something
different and possesses an element of uniqueness but all are essentially
competing for the same customers. Under monopolistic competition, the
demand curve or sales curve or what is also called average revenue (AR)
curve, is not a horizontal straight line. It is on the other hand, a downward
sloping curve. This means that the seller can sell more by reducing price,
whereas under perfect competition, he need not reduce the price for he can
sell any amount at the prevailing price. Under monopolistic competition,
the producer can charge higher prices, because his customers are attached
to him.

2. Oligopoly: The word Oligopoly is defined from two Greek word – “Oligi
“means few and “Polein” means to sell.
Oligopoly is defined as a market structure with a small number of firms,
none of which can keep the others from having significant influence. The
basic characteristic of an oligopolistic situation is the fact that every output
policies of his rivals. This is due to the fact that the number of sellers is not
very large and each seller controls a substantial portion of the supply.
Oligopoly differs from monopoly and monopolistic in this that, in
monopoly, there is a single seller, in monopolistic competition, there is
quite large number of them, but in oligopoly, there is only a small number
of sellers.

 Oligopoly Without Product Differentiation: Under


oligopoly theory is fundamentally the same as in other forms
of competition with this difference that the larger the number
of firms the greater will be differences in marginal costs and
more remote will be the possibility of collision or agreement
whether tacit or explicit. The price which will be fixed in
oligopoly without product differentiation is thus
indeterminate.

 Oligopoly with Product Differentiation: In case there is a


product differentiation, monopoly agreements are even less
likely. Since products are not similar, any producer in
oligopoly can raise or lower his price without any fear of
losing customers or immediate reactions from his rivals. The
price, in the long run, may settle at a level between the
monopoly price and that in cut-throat competition.

3. Monopoly: The word Monopoly is a Latin word. “Mono” means single


and “Poly” means seller.

Monopoly is a form of market organization in which there is only one


seller of the commodity. There are no substitutes for his product. He
controls the entire supply and he can fix the price. He is the firm and he
also constitute the industry. It is a one-firm industry. Under monopoly, the
distinction between the firm and industry disappears. The average revenue
(AR) curve always slops downwards to the right as in monopoly
competition, but it is less elastic in monopoly than in monopolistic
competition. In monopoly, there is no need to differentiate products
because no close substitutes are available. It is one product, homogeneous
and completely under the control of the

Question No. 10- CRITERIA FOR CLASSIFICATION OF MARKET


Answer:
We have already seen the classification of markets. Three criteria for the
classification of markets are often suggested:
These are:
1) Substitutability of products criterion
2) Inter-Dependence criterion
3) Ease of entry criterion

Now I will classify markets in accordance with the three criteria mentioned above.

1)Products substitutability criterion

The first important criterion is the products substitutability criterion which is


measured by the cross price elasticity of demand for the products. The cross-price
elasticity of demand measures the degree of responsiveness of quantity demand for
a product to a change in the prices of related goods.
dqi pi
ep.ji = dpi . qj

This formula measures the degree to which the sales of the firm are affected by the
price charged by the firm in the industry. If the elasticity is high, the products of
the two firms will be close substitutes. In the case of perfect substitutes (i.e.
Homogeneous products), the price cross-elasticity between every pair of products
are differentiated, but can be substituted for one another, the price cross-elasticity
will be finite and positive. If products are not substitutes, their price cross-elasticity
will tend to zero.

(2) Inter-Dependence Criterion:

The second criterion is the inter-dependence criterion which is closely related to


the number of firms in the industry and the degree of product differentiation.

The degree of interdependence of the firms will be measured by an unconventional


quantity cross elasticity for the products of any two firms, thus
dpi qi
eqji = dqj . pj
This formula measures the proportionate change in the price of jth firm resulting
from an infinitesimally small change in the quantity produced by the ith firm. The
higher the value of this elasticity the stronger the inter-dependence of the firms.in
case the number of the firms in the industry is large, each file will tend to ignore
the reactions of the competitors whether the products are close substitutes or not.
In a case like this, the quantity cross elasticity between each pair of the products
will tend to be zero. But if the number of firms in the market is small e.g.,
oligopoly, there will be marked interdependence even when the products are
differentiated. The quantity cross-elasticity in this case will be finite.
In the case of a monopolist both elasticities will be zero, because there is only one
firm in the industry and there are no close substitutes.

(3) Ease of Entry Criterion:

Let me now explain the ‘condition of entry’ which is expressed by the following
notations:

E = Pa – Pc/Pc

E stands for the condition of entry, Pc is the price under perfect competition, and
Pa is the actual price charged by firms. It is obvious that if the Value of E is
reduced to zero (i.e., there is no barrier to entry into the market), the market is said
to be a perfectly competitive one and monopolistically competitive one. Under
monopoly, entry is blockaded.

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