CA Foundation ECO Study Material May22 Nov22

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PREFACE
The Board of Studies, ICAI presents the study material for Foundation. The contents have been designed
and developed with an objective to synchronize the syllabus with International Accountancy bodies, to
instill and enhance the necessary pre-requisites for becoming a well-rounded, competent and globally
competitive Accounting Professional.
The level of complexity of the study material is as per standards accorded by IAESB comprising an ideal
mix of subjective and objective examination pattern to ensure discerning students get through and seek
admission to the CA Course. Learning outcomes for each chapter/unit have been detailed which the
students have to demonstrate for achieving the desired level of technical competence.
Economics deals with problems and questions that affect almost all kinds of individuals in their capacities
as consumers and producers. Therefore, economic literacy is essential for everyone. Business
Economics,which has been introduced at the Foundation level of the Revised CA course, has been
developed keeping in mind the fact that CAs now a days have to take up the role of not merely an
accountant or auditor, but a business solution provider. Business Economics which integrates economic
theory with business practice will help them in the process of business decision making.
There are five chapters in Business Economics namely, Introduction to Business Economics, Theory of
Demand and Supply, Theory of Production and Cost, Price Determination in Different Markets and
Business Cycles. An attempt has been made to make this study material as self-contained as possible.
The economic concepts have been explained in a clear, thorough way, using various applications to
illustrate the use of theory and to reinforce students’ understanding of it. Care has been taken to explain
the principles and concepts in a lucid and easy language with the help of diagrams, pictures, tables and
illustrations so as to enable students, with even minimal backgrounds in Economics, to understand the
concepts properly. To facilitate learning, every chapter concludes with a summary. Also, each chapter
contains lots of multiple choice questions to aid students test their understanding of the subject and their
skills in applying economic theory to real world situation. At the end of the study material, glossary
explaining important words has also been given.
Suggestions for further improvements are heartily welcomed.
.3
PAPER – 4: BUSINESS ECONOMICS AND BUSINESS AND COMMERCIAL KNOWLEDGE

(One paper – Two hours – 100 Marks)
PART I: BUSINESS ECONOMICS (60 Marks)
Objective:
To develop an understanding of the concepts and theories in Business Economics and apply such concepts
and theories in simple problem solving.
Contents:
1. Introduction to Business Economics

(i) Meaning and scope of Business Economics
(ii) Basic Problems of an Economy and Role of Price Mechanism.
2. Theory of Demand and Supply
(i) Meaning and Determinants of Demand, Law of Demand and Elasticity of Demand – Price,
Income and Cross Elasticity
(ii) Theory of Consumer’s Behaviour – Marshallian approach and Indifference Curve approach
(iii) Meaning and Determinants of Supply, Law of Supply and Elasticity of Supply, Market
Equilibrium and Social Efficiency
(iv) Demand Forecasting
3. Theory of Production and Cost
(i) Meaning and Factors of Production
(ii) Laws of Production – The Law of Variable Proportions and Laws of Returns to Scale,
Producer’s Equilibrium
(iii) Concepts of Costs – Short-run and long-run costs, Average and Marginal Costs, Total, Fixed
and Variable Costs
4. Price Determination in Different Markets
(i) Various forms of Markets – Perfect Competition, Monopoly, Monopolistic Competition and
Oligopoly
(ii) Price Determination in these Markets
(iii) Price- Output Determination under different Market Forms
5. Business Cycles
(i) Meaning
(ii) Phases
(iii) Features
(iv) Causes behind these Cycles
PART – II : BUSINESS AND COMMERCIAL KNOWLEDGE (40 MARKS)

Objective:
To develop an understanding of common business and commercial concepts and to keep abreast with
developments in the business and commercial world.
Contents
1. Introduction to Business
Nature of Business, Profession and Employment. Objectives of Business. Economic and Non-
Economic Activities, Forms of Business Organizations.
2. Business Environment
Micro and Macro Environment, Elements of Micro Environment – Consumers/Customers, Competitors,
Organization, Market, suppliers, Intermediaries, Elements of Macro Environment – Demographic,
Economic, Political-legal, Socio-cultural, Technological, Global Environment.
3. Business organizations
Overview of leading Indian and Global Companies.
4. Government Policies for Business Growth
Policies creating conducive business environment such as Liberalization, Privatization, Foreign Direct
Investment.
5. Organizations facilitating Business
(i) Indian regulatory bodies - RBI, SEBI, CCI,IRDA
(ii) Indian Development Banks –NABARD
6. Common Business Terminologies
(i) Finance Terminologies.
(ii) Marketing Terminologies.
(iii) Stock & Commodity Markets Terminologies.
(iv) Banking Terminologies.
(v) Other Business Terminologies.
Note: Students are expected to read at least one financial newspaper and one business magazine on a regular
basis. They may also watch a business channel to remain updated about the developments related to
commercial world.
.5
CONTENTS
Pages
Chapter 1 – Nature & Scope of Business Economics ..................................................................... 1.1 – 1.24

Unit I Introduction .................................................................................................................................. 1.1
1.0 Introduction .................................................................................................................................... 1.2
1.1 Definitions of Business Economics .................................................................................................. 1.5
1.2 Nature of Business Economics ........................................................................................................ 1.5
1.3 Scope of Business Economics ........................................................................................................ 1.8
Summary ...................................................................................................................................... 1.10

Unit II: Basic Problems of an Economics & Role of Price Mechanism .................................................. 1.11
2.0 Basic Problems of an Economy ..................................................................................................... 1.11
2.1. Capitalist Economy ....................................................................................................................... 1.13
2.2 Socialist Economy ....................................................................................................................... 1.16

2.3 The Mixed Economy ..................................................................................................................... 1.18
Summary ...................................................................................................................................... 1.19
Test Your Knowledge Questions ................................................................................................... 1.19
Chapter 2 – Theory of Demand and Supply

Unit I Law of Demand and Elasticity of Demand.................................................................................... 2.1
1.0 Meaning of Demand ........................................................................................................................ 2.3
1.1 What Determines Demand .............................................................................................................. 2.3
1.2 Demand Function ........................................................................................................................... 2.6
1.3 Law of Demand ............................................................................................................................ 2.7
1.4 Expansion and Contraction of Demand .......................................................................................... 2.13
1.5 Elasticity of Demand ..................................................................................................................... 2.17
1.6 Income Elasticity of Demand ......................................................................................................... 2.30
1.7 Cross- Price Elasticity of Demand ................................................................................................. 2.33
1.8 Advertisement Elasticity ................................................................................................................ 2.36
1.9 Demand Forecasting ..................................................................................................................... 2.37
Summary ...................................................................................................................................... 2.45

Unit II: Theory of Consumer Behaviour ................................................................................................. 2.47
2.0 Nature of Human Wants ................................................................................................................ 2.47
2.1. Classification of Wants………………………………………………………………………………………….2.48
2.2 What is Utility? .......................................................................................................................... 2.48
2.3 Marginal Utility Analysis ................................................................................................................ 2.49
2.4 Consumer Surplus ........................................................................................................................ 2.55
2.5 Indifference Curve Analysis........................................................................................................... 2.59
Summary ...................................................................................................................................... 2.69
Unit III: Supply ......................................................................................................................................... 2.70

3.0 Introduction .................................................................................................................................. 2.70
3.1. Determinants of Supply ................................................................................................................. 2.70

3.2 Law of Supply ............................................................................................................................... 2.72
3.3 Movements on Supply Curve- increase or decrease in the quantity supplied .................................. 2.74
3.4 Shifts in Supply Curve – increase or decrease in supply ............................................................... 2.74
3.5 Elasticity of Supply ....................................................................................................................... 2.75

3.6 Equilibrium Price........................................................................................................................... 2.80
Summary ...................................................................................................................................... 2.82

Chapter 3 – Theory of Production and Cost

Unit I Theory of Production .................................................................................................................... 3.1
1.0 Meaning of Production .................................................................................................................... 3.2
1.1 Factors of Production ..................................................................................................................... 3.4

1.2 Production Function ...................................................................................................................... 3.15
1.3 Production Optimisation ................................................................................................................ 3.23

Summary ...................................................................................................................................... 3.25
.7
Unit II: Theory of Cost ............................................................................................................................ 3.28

2.0 Cost Concepts .............................................................................................................................. 3.28
2.1. Cost Function ............................................................................................................................... 3.30
2.2 Short Run Total Costs................................................................................................................... 3.31
2.3 Long Run Average Cost Curve ...................................................................................................... 3.36
2.4 Economies & Diseconomies of Scale ............................................................................................ 3.38
Summary ...................................................................................................................................... 3.41
Chapter 4 – Price Determination in Different Markets

Unit I Meaning and Types of Markets ..................................................................................................... 4.1
1.0 Meaning of Market .......................................................................................................................... 4.2
1.1 Types of Market Structures ............................................................................................................. 4.5
1.2 Concepts of Total Revenue, Average Revenue and Marginal Revenue ........................................... 4.6
Summary ...................................................................................................................................... 4.12
Unit II: Determination of Prices .............................................................................................................. 4.13

2.0 Introduction .................................................................................................................................. 4.13
2.1. Determination of Prices – A General View ..................................................................................... 4.13
2.2 Changes in Demand and Supply ................................................................................................... 4.15

2.3 Simultaneous Changes In Demand And Supply…………………………………………………………….4.17
Summary ...................................................................................................................................... 4.21

Unit III Price Output Determination under Different Market Forms ....................................................... 4.22
3.0 Perfect Competition ...................................................................................................................... 4.22
3.1. Monopoly...................................................................................................................................... 4.32
3.2 Imperfect Competition- Monopolistic Competition ......................................................................... 4.42

3.3 Oligopoly ...................................................................................................................................... 4.46
Summary ...................................................................................................................................... 4.51

Chapter 5 – Business Cycles

Unit I Business Cycles ........................................................................................................................... 5.1
5.0 Introduction .................................................................................................................................... 5.2
5.1 Phase of Business Cycle ................................................................................................................ 5.2
5.2 Features of Business Cycle ............................................................................................................. 5.7
5.3 Causes of Business Cycles ............................................................................................................. 5.8
5.4 Relevance of Business Cycles in Business Decision Making .......................................................... 5.10
Summary ...................................................................................................................................... 5.11

Glossary .................................................................................................................................................. i – iv
Questions for Practice ........................................................................................................................ i – xviii
Additional Questions ..................................................................................................................... A-1 – A-38
CHAPTER 1
NATURE AND SCOPE OF BUSINESS

ECONOMICS
UNIT -1: INTRODUCTION
LEARNING OUTCOMES
At the end of this Chapter, you will be able to:

 Explain the Meaning of Economics.
 Describe the Meaning and Nature of Business Economics.
 Describe the Scope of Business Economics.
CHAPTER OVERVIEW
NATURE AND SCOPE OF BUSINESS ECONOMICS
Basic Economic
Definition Scope Nature Problems
● A Science
Micro Macro ● Based on Micro Economics
Economics Economics What to Produce?
● Incroporates elements of How to Produce?
Macro Economics For whom to Produce?
● An Art
● Pragmatic
● Normative
1.2 BUSINESS ECONOMICS
1.0 INTRODUCTION
1.0.0 What is Economics about?
The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means ‘household’. Till 19th century,
Economics was known as ‘Political Economy.’ The book named ‘An Inquiry into the Nature and Causes of the
Wealth of Nations’ (1776) usually abbreviated as ‘The Wealth of Nations’, by Adam Smith is considered as the
first modern work of Economics.
Before we start with the meaning of Business Economics, it is important for us to understand what Economics
is about. For this, consider the following situation:
It is your birthday and your mother gives you ` 1000 as birthday gift. You are free to spend the money as you
like. What will you do? You have many options before you, such as:
Option 1 : You can give a party to your friends and spend the whole money on them.
Option 2 : You can buy yourself a dress for ` 1000.
Option 3 : You can go for a movie and eat in a restaurant of your choice.
Option 4 : You can buy yourself a book and save the rest of the money.
What do you notice? You have many options before you. Given a choice, you would like to spend not only on
your friends, but would also like to go for a movie, eat in a restaurant, buy a dress and a book and save some
money. However, you cannot have all of them at the same time. Why? Because you have only `1000 with you.
Had your mother given you ` 2000, you might have satisfied more of your desires. But, she has not. Now, you
find yourself in a dilemma as to which of the above options to choose. You will have to go for one option or a
combination of one or more options. What do you do? You evaluate the various alternatives and choose the
one that gives you the greatest satisfaction. Similar dilemma is faced by every individual, every society and
every country in this world. Life is like that. Since we cannot have everything we want with the resources we
have, we are forever forced to make choices. Therefore, we choose to satisfy only some of our wants leaving
many other wants unsatisfied.
These two fundamental facts that:
(i) ‘Human beings have unlimited wants’; and
(ii) ‘The means to satisfy these unlimited wants are relatively scarce’ form the subject matter of
Economics
Let us now examine what Economics studies about. Economics is the study of the processes by which the
relatively scarce resources are allocated to satisfy the competing unlimited wants of human beings in a society.
Of course, the available resources will be efficiently used when they are allocated to their highest valued uses.
Economics is, thus, the study of how we work together to transform the scarce resources into goods and
services to satisfy the most pressing of our infinite wants and how we distribute these goods and services
among ourselves.
This definition of Economics, with the narrow focus on using the relatively scarce resources to satisfy human
wants, is the domain of modern neo classical micro economic analysis. Despite being correct, it is incomplete
as it brings to our mind the picture of a society with fixed resources, skills and productive capacity, deciding on
.3 NATURE AND SCOPE OF BUSINESS ECONOMICS 1.3
what specific kinds of goods and services it ought to produce with the given resources and how they ought to
be distributed among the members of the society. However, two of the most important concerns of modern
economies are not fully covered by this concept.
On the one hand, we find that the productive capacity of modern economies has grown tremendously.
Population and labour force have increased, new sources of raw materials have been discovered, and new and
better plant and equipment have been made available on farms and in factories and mines. Not only has the
quantity of available productive resources increased, their quality has also improved substantially. Better
education and newly acquired skills have raised the productivity of labour force, and has led to the discovery of
completely new kinds of natural resources such as shale gas and new alternative greener sources of energy
such as solar and wind power. On the other hand, we know that the resulting growth in production and income
has not been smooth. There have been periods in which output not only failed to grow, but also actually
declined sharply (Global Financial Crisis 2007 and Corona Pandemic 2019). During such periods, factories,
workers and other productive resources have remained idle due to insufficient demand.
Economics, therefore, concerns itself not just with the crucial concern of how a nation allocates its scarce
productive resources to various uses; it also deals with the processes by which the productive capacity of these
resources is increased and with the factors which, in the past, have led to sharp fluctuations in the rate of
utilisation of these resources.
In the day-to-day events, we come across several economic issues such as changes in the price of individual
commodities as well as in the general price level; economic prosperity and higher standards of living of some
countries despite general poverty and poor standards of living in others; and some firms making extraordinary
profits while others close down etc. These are matters fundamentally connected with economic analysis. The
study of Economics will enable us to develop an analytical approach that helps us in understanding and
analysing a wide range of economic issues. It would also provide us with a number of models and frameworks
that can be applied in different situations. The tools of Economics assist in choosing the best course of action
from among the different alternative courses of action available to the decision maker. However, it is necessary
to remember that most economic problems are of complex nature and are affected by several forces, some of
which are rooted in Economics and others in political set up, social norms, etc. The study of Economics cannot
ensure that all problems will be appropriately tackled; but, without doubt, it would enable a student to examine
a problem in its right perspective and would help him in discovering suitable measures to deal with the same.
1.0.1 Meaning of Business Economics
Having understood the meaning of Economics, let us now understand what Business Economics is. For this,
consider the following situation:
Mr. G. Ramamurthy, the CEO of Worldwide Food Limited, on completion of his presentation turned to his Board
of Directors and raised the question “Well ladies and gentlemen, what you say? Shall we go into soft drink
business?”
“Give us some time, Sir” remarked Swaminathan. “You are asking us to approve a major decision which will
have long term impact on the direction of the company”.
“I understand your concern for the company but now the time has come for us to expand our business. Soft
drinks market is growing fast and it is closely related to our core business: food” answered Ramamurthy.
“But competition from White Soft Drinks Ltd. and Black Nectar Ltd. is tough. They are already into this business
for years” remarked another board member.

“That is right. But we must not forget that the statistics show that there is still room for growth in this market. And
also, food business is near maturity.” Replied Ramamurthy.
“Don’t forget that even Swati Foods tried entering the soft drink market and failed miserably”, remarked Ashok
Agrawal, another board member. “Moreover, the projections you are showing are based on last ten years’ data.
What is the guarantee that the trend will continue? He questioned. “Also, we should not forget that Indians have
become health conscious and who knows tomorrow what will people prefer?” He continued.
“Well friends, all your concerns are logical, and believe me; I have given much thought to these ‘ifs’ and ‘buts’.
My people have spent many days analysing all available data to arrive at a judgement. Our analysis indicates a
strong possibility of earning above-average return on investment in this market, a return that will be more than
what we are earning in food industry. We are already working on the details of production, cost, pricing,
distribution, financing etc. I fear, if we wait for long, we will be missing an opportunity that may not come again
for long. Let’s go ahead and make the most of it” remarked Ramamurthy.
What do you notice in the hypothetical example given above? The management of the company is faced with
the problem of decision making.
As we are aware, the survival and success of any business depends on sound decisions. Decision making
refers to the process of selecting an appropriate alternative that will provide the most efficient means of
attaining a desired end, from two or more alternative courses of action. Decision making involves evaluation of
feasible alternatives, rational judgment on the basis of information and choice of a particular alternative which
the decision maker finds as the most suitable. As explained above, the question of choice arises because our
productive resources such as land, labour, capital, and management are limited and can be employed in
alternative uses. Therefore, more efficient alternatives must be chosen and less efficient alternatives must be
rejected.
The management of a business unit generally needs to make strategic, tactical and operational decisions. A
few examples of issues requiring decision making in the context of businesses are illustrated below:
♦ Should our firm be in this business?
♦ Should the firm launch a product, given the highly competitive market environment?
♦ If the firm decided on launching the product, which available technique of production should be used?
♦ From where should the firm procure the necessary inputs and at what prices so as to have competitive
edge in the market?
♦ Should the firm make the components or buy them from other firms?
♦ How much should be the optimum output and at what price should the firm sell?
♦ How will the product be placed in the market? Which customer segment should we focus on and how
to improve the customer experience? Which marketing strategy should be chosen? How much should
be the marketing budget?
♦ How to combat the risks and uncertainties involved?
Decision making on the above as well as similar issues is not simple and straightforward as the economic
environment in which the firm functions is highly complex and dynamic. The problem gets aggravated because,
most of the time, decisions are to be taken under conditions of imperfect knowledge and uncertainty. Decision
making, therefore, requires that the management be equipped with proper methodology and appropriate
analytical tools and techniques. Business Economics meets these needs of the management by providing a
huge corpus of theory and techniques. Briefly put, Business Economics integrates economic theory with
business practice.
Business Economics, also referred to as Managerial Economics, generally refers to the integration of economic
theory with business practice. While the theories of Economics provide the tools which explain various
concepts such as demand, supply, costs, price, competition etc., Business Economics applies these tools in the
process of business decision making. Thus, Business Economics comprises of that part of economic
knowledge, logic, theories and analytical tools that are used for rational business decision making. In brief, it is
Applied Economics that fills the gap between economic theory and business practice.
Business Economics has close connection with Economic theory (Micro as well as Macro-Economics),
Operations Research, Statistics, Mathematics and the Theory of Decision-Making. A professional business
economist has to integrate the concept and methods from all these disciplines in order to understand and
analyse practical managerial problems. Business Economics is not only valuable to business decision makers,
but also useful for managers of ‘not-for-profit’ organisations such as NGO, and voluntary organisations.
1.1 DEFINITIONS OF BUSINESS ECONOMICS

Business Economics may be defined as the use of economic analysis to make business decisions involving the
best use of an organization’s scarce resources.
Joel Dean defined Business Economics in terms of the use of economic analysis in the formulation of business
policies. Business Economics is essentially a component of Applied Economics as it includes application of
selected quantitative techniques such as linear programming, regression analysis, capital budgeting, break
even analysis and cost analysis.
Our approach in this text is to focus on the heart of Business Economics i.e. the Micro Economic
Theory of the behaviour of consumers and firms in competitive and not-competitive markets. This
theory provides managers with a basic framework for making key business decisions about the
allocation of their firm’s scarce resources.
1.2 NATURE OF BUSINESS ECONOMICS

Economics has been broadly divided into two major parts i.e. Micro Economics and Macro Economics. Before
explaining the nature of Business Economics, it is pertinent to understand the distinction between these two.
Micro
Subject- Economics
matter of
Economics
Macro
Economics
Micro Economics is basically the study of the behaviour of different individuals and organizations within an
economic system. In other words, Microeconomics examines how the individual units (consumers or firms)
make decisions as to how to efficiently allocate their scarce resources. Here, the focus is on a small number of
or group of units rather than all the units combined, and therefore, it does not explain what is happening in the
wider economic environment.
We mainly study the following in Micro-Economics:
(i) Product pricing;
(ii) Consumer behaviour;
(iii) Factor pricing;
(iv) The economic conditions of a section of people;
(v) Behaviour of firms; and
(vi) Location of industry.
Macro Economics, in contrast, is the study of the overall economic phenomena or the economy as a whole,
rather than its individual parts. Accordingly, in Macro-Economics, we study the behaviour of the large economic
aggregates, such as, the overall levels of output and employment, total consumption, total saving and total
investment, exports, imports and foreign investment and also how these aggregates shift over time. It analyzes
the overall economic environment in which the firms, governments and households operate and make
decisions. However, it should be kept in mind that this economic environment represents the overall effect of
the innumerable decisions made by millions of different consumers and producers.
A few areas that come under Macro Economics are:
(i) National Income and National Output;
(ii) The general price level and interest rates;
(iii) Balance of trade and balance of payments;
(iv) External value of currency;
(v) The overall level of savings and investment; and
(vi) The level of employment and rate of economic growth.
While Business Economics is basically concerned with Micro Economics, Macro economic analysis also has
got an important role to play. Macroeconomics analyzes the background of economic conditions in an
economy which will immensely influence the individual firm’s performance as well as its decisions. Business
firms need a thorough understanding of the macroeconomic environment in which they have to function. For
example, knowledge regarding conditions of inflation and interest rates will be useful for the business
economist in framing suitable policies. Moreover, the long-run trends in the business world are determined by
the prevailing macroeconomic factors.
Having understood the meaning of Micro and Macro Economics, we shall examine the nature of Business
Economics:
Nature of Business Economics

The economic world is extremely complex as there is a lot of interdependence among the decisions and
activities of economic entities. Economic theories are hypothetical and simplistic in character as they are based
on economic models built on simplifying assumptions. Therefore, usually, there is a gap between the
propositions of economic theory and happenings in the real economic world in which the managers make
decisions. Business Economics enables application of economic logic and analytical tools to bridge the gap
between theory and practice.
The following points will describe the nature of Business Economics:
 Business Economics is a Science: Science is a systematized body of knowledge which establishes
cause and effect relationships. Business Economics integrates the tools of decision sciences such as
Mathematics, Statistics and Econometrics with Economic Theory to arrive at appropriate strategies for
achieving the goals of the business enterprises. It follows scientific methods and empirically tests the
validity of the results.
 Based on Micro Economics: Business Economics is based largely on Micro-Economics. A business
manager is usually concerned about achievement of the predetermined objectives of his organisation
so as to ensure the long-term survival and profitable functioning of the organization. Since Business
Economics is concerned more with the decision making problems of individual establishments, it relies
heavily on the techniques of Microeconomics.
 Incorporates elements of Macro Analysis: A business unit does not operate in a vacuum. It is
affected by the external environment of the economy in which it operates such as, the general price
level, income and employment levels in the economy and government policies with respect to taxation,
interest rates, exchange rates, industries, prices, distribution, wages and regulation of monopolies. All
these are components of Macroeconomics. A business manager must be acquainted with these and
other macroeconomic variables, present as well as future, which may influence his/ her business
environment.
 Business Economics is also an Art as it involves practical application of rules and principles for the
attainment of set objectives.
 Use of Theory of Markets and Private Enterprises: Business Economics largely uses the theory of
markets and private enterprise. It uses the theory of the firm and resource allocation in the backdrop of
a private enterprise economy.
 Pragmatic in Approach: Micro-Economics is abstract and purely theoretical and analyses economic
phenomena under unrealistic assumptions. In contrast, Business Economics is pragmatic in its
approach as it tackles practical problems which the firms face in the real world.
 Interdisciplinary in Nature: Business Economics is interdisciplinary in nature as it incorporates tools
from other disciplines such as Mathematics, Operations Research, Management Theory, Accounting,
marketing, Finance, Statistics and Econometrics.
 Normative in Nature: Economic theory has developed along two lines – positive and normative. A
positive or pure science analyses cause and effect relationship between variables in an objective and
scientific manner, but it does not involve any value judgement. In other words, it states ‘what is’ of the
state of affairs and not what ‘ought to be’. In other words, it is descriptive in nature in the sense that it
describes the economic behaviour of individuals or society without prescriptions about the desirability
or otherwise of such behaviour. As against this, a normative science involves value judgements. It is
prescriptive in nature and suggests ‘what should be’ a particular course of action under given
circumstances. Welfare considerations are embedded in normative science.
Business Economics is generally normative or prescriptive in nature. It suggests the application of
economic principles with regard to policy formulation, decision-making and future planning. However, if
the firms are to establish valid decision rules, they must thoroughly understand their environment. This
requires the study of positive or descriptive economic theory. Thus, Business Economics combines the
essentials of normative and positive economic theory, the emphasis being more on the former than the
latter.
1.3 SCOPE OF BUSINESS ECONOMICS

The scope of Business Economics is quite wide. It covers most of the practical problems a manager or a firm
faces. There are two categories of business issues to which economic theories can be directly applied, namely:
1. Internal issues or operational issues (this can be solved using Micro Economics)
2. External issues or environmental issues (this can be solved using Macro Economics)
Now we will see both of them one by one -
1. Microeconomics applied to Internal or Operational Issues
Operational issues include all those issues that arise within the organization and fall within the purview and
control of the management. These issues are internal in nature. Issues related to choice of business and its
size, product decisions, technology and factor combinations, pricing and sales promotion, financing and
management of investments and inventory are a few examples of operational issues. The following
Microeconomic theories deal with most of these issues.
♦ Demand Analysis and Forecasting: Demand analysis pertains to the behaviour of consumers in the
market. It studies the nature of consumer preferences and the effect of changes in the determinants of
demand such as, price of the commodity, consumers’ income, prices of related commodities,
consumer tastes and preferences etc.
Demand forecasting is the technique of predicting future demand for goods and services on the basis
of the past behaviour of factors which affect demand. Accurate forecasting is essential for a firm to
enable it to produce the required quantities at the right time and to arrange, well in advance, for the
various factors of production viz., raw materials, labour, machines, equipment, buildings etc. Business
Economics provides the manager with the scientific tools which assist him in forecasting demand.
♦ Production and Cost Analysis: Production theory explains the relationship between inputs and
output. A business economist has to decide on the optimum size of output, given the objectives of the
firm. He has also to ensure that the firm is not incurring undue costs. Production analysis enables the
firm to decide on the choice of appropriate technology and selection of least - cost input-mix to achieve
technically efficient way of producing output, given the inputs. Cost analysis enables the firm to
recognise the behaviour of costs when variables such as output, time period and size of plant change.
The firm will be able to identify ways to maximize profits by producing the desired level of output at the
minimum possible cost.
♦ Inventory Management: Inventory management theories pertain to rules that firms can use to
minimise the costs associated with maintaining inventory in the form of ‘work-in-process,’ ‘raw
materials’, and ‘finished goods’. Inventory policies affect the profitability of the firm. Business
economists use methods such as ABC analysis, simple simulation exercises and mathematical models
to help the firm maintain optimum stock of inventories.
♦ Market Structure and Pricing Policies: Analysis of the structure of the market provides information
about the nature and extent of competition which the firms have to face. This helps in determining the
degree of market power (ability to determine prices) which the firm commands and the strategies to be
followed in market management under the given competitive conditions such as, product design and
marketing. Price theory explains how prices are determined under different kinds of market conditions
and assists the firm in framing suitable price policies.
♦ Resource Allocation: Business Economics, with the help of advanced tools such as linear
programming, enables the firm to arrive at the best course of action for optimum utilisation of available
resources.
♦ Theory of Capital and Investment Decisions: For maximizing its profits, the firm has to carefully
evaluate its investment decisions and carry out a sensible policy of capital allocation. Theories related
to capital and investment provides scientific criteria for choice of investment projects and in
assessment of the efficiency of capital. Business Economics supports decision making on allocation of
scarce capital among competing uses of funds.
♦ Profit Analysis: Profits are, most often, uncertain due to changing prices and market conditions. Profit
theory guides the firm in the measurement and management of profits under conditions of uncertainty.
Profit analysis is also immensely useful in future profit planning.
♦ Risk and Uncertainty Analysis: Business firms generally operate under conditions of risk and
uncertainty. Analysis of risks and uncertainties helps the business firm in arriving at efficient decisions
and in formulating plans on the basis of past data, current information and future prediction.
2. Macroeconomics applied to External or Environmental Issues
Environmental factors have significant influence upon the functioning and performance of business. The major
macro-economic factors relate to:
♦ The type of economic system
♦ Stage of business cycle
♦ The general trends in national income, employment, prices, saving and investment.
♦ Government’s economic policies like industrial policy, competition policy, and fiscal policy, foreign
trade policy and globalization policies.
♦ Working of central banks and financial sector and capital market and their regulation.
♦ Socio-economic organisations like trade unions, producer and consumer unions and cooperatives.
♦ Social and political environment.
Business decisions cannot be taken without considering these present and future environmental factors. As
the management of the firm has no control over these factors, it should fine-tune its policies to minimise their
adverse effects.
SUMMARY
 An economy exists because of two facts, i.e. human wants are unlimited and the resources are scarce.
 Economics is the study of processes by which the relatively scarce resources are allocated to satisfy
the competing unlimited wants of human beings in a society.
 The subject matter of Economics is divided into two parts – Micro and Macro Economics
 Microeconomics examines how the individual units (consumers or firms) make decisions as to how to
efficiently allocate their scarce resources.
 Macroeconomics study the behaviour of the large economic aggregates, such as, the overall levels of
output and employment, total consumption, total saving and total investment exports and imports, and
how these aggregates shift over time.
 Business Economics integrates economic theory with business practice and relies on economic
analysis in the formulation of business policies.
 While Business Economics is basically concerned with Micro Economics, Macro economic analysis
has got an important role to play. Macroeconomics analyzes the environment in which the business
has to function.
 Business Economics is a normative science which is interdisciplinary and pragmatic in approach.
 There are two categories of business issues to which economic theories can be directly applied,
namely: Microeconomics applied to operational or internal Issues and Macroeconomics applied to
environmental or external issues.
 Business Economics makes use of microeconomic analysis such as, demand analysis and forecasting,
production and cost Analysis, inventory management, market structure and pricing policies, resource
allocation, theory of capital and investment decisions, profit analysis and risk and uncertainty analysis.
 Business Economics also considers Macroeconomics related to economic systems, business cycles,
national income, employment, prices, saving and investment, Government’s economic policies and
working of financial sector and capital market.
Study of Inventory Management, Product and Promotion Policy, Resource Allocation, Capital
Budgeting, Risk and Uncertainty Analysis are outside the scope of this book. They will be taught in
other subjects – Financial Management, Strategic Management etc. at higher levels of CA course.
UNIT 2: BASIC PROBLEMS OF AN ECONOMY AND ROLE OF

PRICE MECHANISM
LEARNING OUTCOMES
At the end of this Chapter, you will be able to:
♦ Explain the Basic Problems faced by an Economy.
♦ Describe how Different Economies Solve their Basic Economic Problems.
♦ Explain the Role of Price Mechanism in Solving the Basic Problems of an Economy.
2.0 BASIC PROBLEMS OF AN ECONOMY

As mentioned in the last unit, all countries, without exceptions, face the problem of scarcity. Their resources
(natural productive resources, man-made capital goods, consumer goods, money and time etc.) are limited and
these resources have alternative uses. For example, coal can be used as a fuel for the production of industrial
goods; it can be used for producing electricity, for domestic cooking purposes and for many other purposes.
Similarly, financial resources can be used for many purposes. If the resources were unlimited, people would be
able to satisfy all their wants and there would be no economic problem. Alternatively, if a resource has only a
single use, then also the economic problem would not arise.
Every economic system, be it capitalist, socialist or mixed, has to deal with this central problem of scarcity of
resources relative to the wants for them. This is generally called ‘the central economic problem’. The central
economic problem is further divided into four basic economic problems. These are:
♦ What to produce?
♦ How to produce?
♦ For whom to produce?
♦ What provisions (if any) are to be made for economic growth?
What to
produce?
Central What provisios

How to
Economic are to be made
produce?
Problems for economic
growth?
For whom
to
produce?
(i) What to produce? : Since the resources are limited, every society has to decide which goods and
services should be produced and how many units of each good (or service) should be produced. An
economy has to decide whether more guns should be produced or more butter should be produced; or
whether more capital goods like machines, equipment’s, dams etc., will be produced or more
consumer goods such as, cell phones will be produced. Not only the society has to decide about what
goods are to be produced, it has also to decide in what quantities each of these goods would be
produced. In a nutshell, a society must decide how much wheat, how many hospitals, how many
schools, how many machines, how many meters of cloths etc. have to be produced.
(ii) How to produce? : There are various alternative techniques of producing a commodity. For
example, cotton cloth can be produced using handlooms, power looms or automatic looms. Production
with handlooms involves use of more labour and production with automatic loom involves use of more
machines and capital. A society has to decide whether it will produce cotton cloth using labour-
intensive techniques or capital-intensive techniques. Likewise, for all goods and services, it has to
decide whether to use labour- intensive techniques or capital - intensive techniques. Obviously, the
choice would depend on the availability of different factors of production (i.e. labour and capital) and
their relative prices. It is in the society’s interest to use those techniques of production that make the
best use of the available resources.
(iii) For whom to produce? : Another important decision which a society has to take is ‘for whom’ it
should produce. A society cannot satisfy each and every want of all the people. Therefore, it has to
decide on who should get how much of the total output of goods and services, i.e. How the goods
(and services) should be distributed among the members of the society. In other words, it has to
decide about the shares of different people in the national cake of goods and services.
(iv) What provision should be made for economic growth? : A society would not like to use all
its scarce resources for current consumption only. This is because, if it uses all the resources for
current consumption and no provision is made for future production, the society’s production capacity
would not increase. This implies that incomes or standards of living of the people would remain
stagnant, and in future, the levels of living may actually decline. Therefore, a society has to decide how
much saving and investment (i.e. how much sacrifice of current consumption) should be made for
future progress.
We shall now examine the term ‘economic system’. An economic system refers to the sum total of
arrangements for the production and distribution of goods and services in a society. In short, it is defined as the
sum of the total devices which give effect to economic choice. It includes various individuals and economic
institutions.
You must be wondering how different economies of the world would be solving their central problems. In order
to understand this, we divide all the economies into three broad classifications based on their mode of
production, exchange, distribution and the role which their governments plays in economic activity. These are:
- Capitalist economy
- Socialist economy
- Mixed economy
2.1 CAPITALIST ECONOMY

Capitalism, the predominant economic system in the modern global economy, is an economic system in which
all means of production are owned and controlled by private individuals for profit. In short, private property is
the mainstay of capitalism and profit motive is its driving force. Decisions of consumers and businesses
determine economic activity. Ideally, the government has a limited role in the management of the economic
affairs under this system. Some examples of a capitalist economy may include United States and United
Kingdom, Hong Kong, South Korea etc. However, many of them are not pure form of capitalism but show some
features of being a capitalist economy. An economy is called capitalist or a free market economy or laissez-
faire economy if it has the following characteristics:
1) Right to private property: The right to private property means that productive factors such as land,
factories, machinery, mines etc. can be under private ownership. The owners of these factors are free
to use them in any manner in which they like and bequeath it as they desire. The government may,
however, put some restrictions for the benefit of the society in general.
2) Freedom of enterprise: Each individual, whether consumer, producer or resource owner, is free to
engage in any type of economic activity. For example, a producer is free to set up any type of firm and
produce goods and services of his choice.
3) Freedom of economic choice: All individuals are free to make their economic choices regarding
consumption, work, production, exchange etc.
4) Profit motive: Profit motive is the driving force in a free enterprise economy and directs all economic
activities. Desire for profits induces entrepreneurs to organize production so as to earn maximum
profits.
5) Consumer Sovereignty: Consumer is supposed to be the king under capitalism. Consumer
sovereignty means that buyers ultimately determine which goods and services will be produced and in
what quantities. Consumers have unbridled freedom to choose the goods and services which they
would consume. Therefore, producers have to produce goods and services which are preferred by the
consumers. In other words, based on the purchases they make, consumers decide how the economy's
limited resources are allocated.
6) Competition: Competition is the most important feature of the capitalist economy. Competition brings
out the best among buyers and sellers and results in efficient use of resources.
7) Absence of Government Interference: A purely capitalist economy is not centrally planned,
controlled or regulated by the government. In this system, all economic decisions and activities are
guided by self-interest and price mechanism which operates automatically without any direction and
control by the governmental authorities.
2.1.0 How do capitalist economies solve their central problems?

A capitalist economy has no central planning authority to decide what, how and for whom to produce. In the absence
of any central authority, it looks like a miracle as to how such an economy functions. If the consumers want cars and
producers choose to make cloth and workers choose to work for the furniture industry, there will be total confusion
and chaos in the country. However, this does not happen in a capitalist economy. Such an economy uses the
impersonal forces of market demand and supply or the price mechanism to solve its central problems.
Deciding ‘what to produce’ The aim of an entrepreneur is to earn as much profits as possible. This causes
businessmen to compete with one another to produce those goods which consumers wish to buy. Thus, if
consumers want more cars, there will be an increase in the demand for cars and as a result their prices will
increase. A rise in the price of cars, costs remaining the same, will lead to more profits. This will induce
producers to produce more cars. On the other hand, if the consumers’ demand for cloth decreases, its price
would fall and profits would go down. Therefore, business firms have less incentive to produce cloth and less of
cloth will be produced. Thus, more of cars and less cloth will be produced in such an economy. In a capitalist
economy (like the USA, UK and Germany) the question regarding what to produce is ultimately decided by
consumers who show their preferences by spending on the goods which they want.
Deciding ‘how to produce’: An entrepreneur will produce goods and services choosing that technique of
production which renders his cost of production minimum. If labour is relatively cheap, he will use labour-
intensive method and if labour is relatively costlier he will use capital-intensive method. Thus, the relative prices
of factors of production help in deciding how to produce.
Deciding ‘for whom to produce’: Goods and services in a capitalist economy will be produced for those who
have buying capacity. The buying capacity of an individual depends upon his income. How much income he will
be able to make depends not only on the amount of work he does and the prices of the factors he owns, but
also on how much property he owns. Higher the income, higher will be his buying capacity and higher will be
his demand for goods in general.
Deciding about consumption, saving and investment: Consumption and savings are done by consumers and
investments are done by entrepreneurs. Consumers’ savings, among other factors, are governed by the rate of
interest prevailing in the market. Higher the level of income and interest rates, higher will be the savings.
Investment decisions depend upon the rate of return on capital. The greater the profit expectation (i.e. the
return on capital), the greater will be the investment in a capitalist economy. The rate of interest on savings and
the rate of return on capital are nothing but the prices of capital.
Thus, we see above that what goods are produced, by which methods they are produced, for whom they are
produced and what provisions should be made for economic growth are decided by price mechanism or market
mechanism.
2.1.1 Merits of Capitalist Economy

1. Capitalism is self-regulating and works automatically through price mechanism. There is no need of
incurring costs for collecting and processing of information and for formulating, implementing and
monitoring policies.
2. The existence of private property and the driving force of profit motive result in greater efficiency and
incentive to work.
3. The process of economic growth is likely to be faster under capitalism. This is because the investors
try to invest in only those projects which are economically feasible.
4. Resources are used in activities in which they are most productive. This results in optimum allocation
of the available productive resources of the economy.
5. There is usually high degree of operative efficiency under the capitalist system.
6. Cost of production is minimized as every producer tries to maximize his profit by employing methods of
production which are cost-effective.
7. Capitalist system offer incentives for efficient economic decisions and their implementation.
8. Consumers are benefitted as competition forces producers to bring in a large variety of good quality
products at reasonable prices. This, along with freedom of choice, ensures maximum satisfaction to
consumers. This also results in higher standard of living.
9. Capitalism offers incentives for innovation and technological progress. The country as a whole benefits
through growth of business talents, development of research, etc.
10. Capitalism preserves fundamental rights such as right to freedom and right to private property.
Therefore, the participants enjoy maximum amount of autonomy and freedom.
11. Capitalism rewards men of initiative and enterprise and punishes the imprudent and inefficient.
12. Capitalism usually functions in a democratic framework.
13. The capitalist set up encourages enterprise and risk taking and emergence of an entrepreneurial class
willing to take risks.
2.1.2 Demerits of Capitalism

1. There is vast economic inequality and social injustice under capitalism. Inequalities reduce the
aggregate economic welfare of the society as a whole and split the society into two classes namely the
‘haves’ and the ‘have-nots’, sowing the seeds of social unrest and class conflict.
2. Under capitalism, there is precedence of property rights over human rights.
3. Economic inequalities lead to wide differences in economic opportunities and perpetuate unfairness in
the society.
4. The capitalist system ignores human welfare because, under a capitalist set up, the aim is profit and
not the welfare of the people.
5. Due to income inequality, the pattern of demand does not represent the real needs of the society.
6. Exploitation of labour is common under capitalism. Very often this leads to strikes and lock outs.
Moreover, there is no security of employment. This makes workers more vulnerable.
7. Consumer sovereignty is a myth as consumers often become victims of exploitation. Excessive
competition and profit motive work against consumer welfare.
8. There is misallocation of resources as resources will move into the production of luxury goods. Less
wage goods will be produced on account of their lower profitability.
9. Less of merit goods like education and health care will be produced. On the other hand, a number of
goods and services which are positively harmful to the society will be produced as they are more
profitable.
10. Due to unplanned production, economic instability in terms of over production, economic depression,
unemployment etc., is very common under capitalism. These result in a lot of human misery.
11. There is enormous waste of productive resources as firms spend huge amounts of money on
advertisement and sales promotion activities.
12. Capitalism leads to the formation of monopolies as large firms may be able to drive out small ones by
fair or foul means.
13. Excessive materialism as well as conspicuous and unethical consumption leads to environmental
degradation.
2.2 SOCIALIST ECONOMY

The concept of socialist economy was propounded by Karl Marx and Frederic Engels in their work ‘The
Communist Manifesto’ published in 1848. In this economy, the material means of production i.e. factories,
capital, mines etc. are owned by the whole community represented by the State. All members are entitled to get
benefit from the fruits of such socialised planned production on the basis of equal rights. A socialist economy is
also called as “Command Economy” or a “Centrally Planned Economy”. Here, the resources are allocated
according to the commands of a central planning authority and therefore, market forces have no role in the
allocation of resources. Under a socialist economy, production and distribution of goods are aimed at
maximizing the welfare of the community as a whole.
Some important characteristics of this economy are:
(i) Collective Ownership: There is collective ownership of all means of production except small farms,
workshops and trading firms which may remain in private hands. As a result of social ownership, profit-
motive and self- interest are not the driving forces of economic activity as it is in the case of a market
economy. The resources are used to achieve certain socio-economic objectives.
(ii) Economic planning: There is a Central Planning Authority to set and accomplish socio- economic
goals; that is why it is called a centrally planned economy. The major economic decisions, such as
what to produce, when and how much to produce, etc., are taken by the central planning authority.
(iii) Absence of Consumer Choice: Freedom from hunger is guaranteed, but consumers’ sovereignty
gets restricted by selective production of goods. The range of choice is limited by planned production.
However, within that range, an individual is free to choose what he likes most.
The right to work is guaranteed, but the choice of occupation gets restricted because these are
determined by the central planning authority on the basis of certain socio-economic goals before the
nation.
(iv) Relatively Equal Income Distribution: A relative equality of income is an important feature of
Socialism. Among other things, differences in income and wealth are narrowed down by lack of
opportunities to accumulate private capital. Educational and other facilities are enjoyed more or less
equally; thus the basic causes of inequalities are removed.
(v) Minimum role of Price Mechanism or Market forces: Price mechanism exists in a socialist
economy; but it has only a secondary role, e.g., to secure the disposal of accumulated stocks. Since
allocation of productive resources is done according to a predetermined plan, the price mechanism as
such does not influence these decisions. In the absence of the profit motive, price mechanism loses its
predominant role in economic decisions. The prices prevailing under socialism are ‘administered
prices’ which are set by the central planning authority on the basis of socio-economic objectives.
(vi) Absence of Competition: Since the state is the sole entrepreneur, there is absence of competition
under socialism.
The erstwhile U.S.S.R. was an example of socialist economy from 1917 to 1990. In today’s world there is no
country which is purely socialist. Other examples include Vietnam, China and Cuba. North Korea, the world’s
most totalitarian state, is another example of a socialist economy.
2.2.0 Merits of Socialism

1. Equitable distribution of wealth and income and provision of equal opportunities for all help to maintain
economic and social justice.
2. Rapid and balanced economic development is possible in a socialist economy as the central planning
authority coordinates all resources in an efficient manner according to set priorities.
3. Socialist economy is a planned economy. In a socialistic economy, there will be better utilization of
resources and it ensures maximum production. Wastes of all kinds are avoided through strict economic
planning. Since competition is absent, there is no wastage of resources on advertisement and sales
promotion.
4. In a planned economy, unemployment is minimised, business fluctuations are eliminated and stability
is brought about and maintained.
5. The absence of profit motive helps the community to develop a co-operative mentality and avoids class
war. This, along with equality, ensures better welfare of the society.
6. Socialism ensures right to work and minimum standard of living to all people.
7. Under socialism, the labourers and consumers are protected from exploitation by the employers and
monopolies respectively.
8. There is provision of comprehensive social security under socialism and this makes citizens feel
secure.
2.2.1 Demerits of Socialism

1. Socialism involves the predominance of bureaucracy and the resulting inefficiency and delays.
Moreover, there may also be corruption, red tapism, favouritism, etc.
2. It restricts the freedom of individuals as there is state ownership of the material means of production
and state direction and control of nearly all economic activity.
3. Socialism takes away the basic rights such as the right of private property.
4. It will not provide necessary incentives to hard work in the form of profit.
5. Administered prices are not determined by the forces of the market on the basis of negotiations
between the buyers and the sellers. There is no proper basis for cost calculation. In the absence of
such practice, the most economic and scientific allocation of resources and the efficient functioning of
the economic system are impossible.
6. State monopolies created by socialism will sometimes become uncontrollable. This will become more
difficult to regulate than the private monopolies under capitalism.
7. Under socialism, the consumers have limited freedom of choice. Therefore, what the state produces
has to be accepted by the consumers.
8. No importance is given to personal efficiency and productivity. Labourers are not rewarded according
to their efficiency. This acts as a disincentive to work.
9. The extreme form of socialism is not at all practicable.
2.3 THE MIXED ECONOMY

The mixed economic system depends on both markets and governments for allocation of resources. In fact,
every economy in the real world makes use of both markets and governments and therefore is mixed
economy in its nature. In a mixed economy, the aim is to develop a system which tries to include the best
features of both the controlled economy and the market economy while excluding the demerits of both. It
appreciates the advantages of private enterprise and private property with their emphasis on self-interest and
profit motive. Vast economic development of England, the USA etc. is due to private enterprise. At the same
time, it is noticed that private property, profit motive and self-interest of the market economy may not promote
the interests of the community as a whole and as such, the Government should remove these defects of private
enterprise. For this purpose, the Government itself must run important and selected industries and eliminate the
free play of profit motive and self-interest. Private enterprise which has its own significance is also allowed to
play a positive role in a mixed economy. However, the state imposes necessary measures to control and to
regulate the private sector to ensure that they function in accordance with the welfare objectives of the nation.
2.3.0 Features of Mixed Economy

Co-existence of private and public sector: The first important feature of a mixed economy is the
co-existence of both private and public enterprise.
In fact, in a mixed economy, there are three sectors of industries:
(a) Private sector: Production and distribution in this sector are managed and controlled by private
individuals and groups. Industries in this sector are based on self-interest and profit motive. The
system of private property exists and personal initiative is given full scope. However, private enterprise
may be regulated by the government directly and/or indirectly by a number of policy instruments.
(b) Public sector: Industries in this sector are not primarily profit-oriented, but are set up by the State for
the welfare of the community.
(c) Combined sector: A sector in which both the government and the private enterprises have equal
access, and join hands to produce commodities and services, leading to the establishment of joint
sectors.
Mixed economy has the following merits available to capitalist economies and socialist economies.
1. Economic freedom and existence of private property which ensures incentive to work.
2. Price mechanism and competition forces the private sector to promote efficient decision- making and
better resource allocation.
3. Consumers are benefitted through consumers’ sovereignty and freedom of choice.
4. Appropriate incentives for innovation and technological progress.
5. Encourages enterprise and risk taking.
6. Advantages of economic planning and rapid economic development on the basis of plan priorities.
7. Comparatively greater economic and social equality and freedom from exploitation due to greater state
participation and direction of economic activities.
8. Disadvantages of cut-throat competition averted through government’s legislative measures such as
environment and labour regulations.
However, mixed economy is not always a ‘golden path’ between capitalism and socialism. It could also suffer
from substantial uncertainties. Mixed economy, sometimes, is characterised by excessive controls by the state
resulting in reduced incentives and constrained growth of the private sector, poor implementation of planning,
higher rates of taxation, lack of efficiency, corruption, wastage of resources, undue delays in economic
decisions and poor performance of the public sector. Moreover, it is very difficult to maintain a proper balance
between the public and private sectors. In the absence of strong governmental initiatives, the private sector is
likely to grow disproportionately. The system would then resemble capitalism with all its disadvantages.
SUMMARY
 The basic problem of scarcity gives rise to many of the economic problems.
 Unlimited human wants and scarcity of resources lead to the central economic problems like what to
produce, how to produce and for whom to produce.
 The basic economic problems of what, how and for whom to produce are solved by different
economies in different ways.
 A capitalist economy uses the tool of price mechanism, a socialist economy uses the tool of central
planning and a mixed economy uses a mix of both price mechanism and central planning to solve its
basic economic problems.
TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Economists regard decision making as important because:
(a) The resources required to satisfy our unlimited wants and needs are finite, or scarce.
(b) It is crucial to understand how we can best allocate our scarce resources to satisfy society’s
unlimited wants and needs.
(c) Resources have alternative uses.
(d) All the above.

2. Business Economics is
(a) Abstract and applies the tools of Microeconomics.

(b) Involves practical application of economic theory in business decision making.
(c) Incorporates tools from multiple disciplines.
(d) (b) and (c) above.
3. In Economics, we use the term scarcity to mean;
(a) Absolute scarcity and lack of resources in less developed countries.
(b) Relative scarcity i.e. scarcity in relation to the wants of the society.
(c) Scarcity during times of business failure and natural calamities.
(d) Scarcity caused on account of excessive consumption by the rich.
4. What implication(s) does resource scarcity have for the satisfaction of wants?
(a) Not all wants can be satisfied.
(b) We will never be faced with the need to make choices.
(c) We must develop ways to decrease our individual wants.
(d) The discovery of new natural resources is necessary to increase our ability to satisfy wants.
5. Which of the following is a normative statement?
(a) Planned economies allocate resources via government departments.

(b) Most transitional economies have experienced problems of falling output and rising prices
over the past decade.
(c) There is a greater degree of consumer sovereignty in market economies than planned
economies.
(d) Reducing inequality should be a major priority for mixed economies.

6. In every economic system, scarcity imposes limitations on
(a) households, business firms, governments, and the nation as a whole.
(b) households and business firms, but not the governments.

(c) local and state governments, but not the federal government.
(d) households and governments, but not business firms.
7. Macroeconomics is also called——— economics.

(a) applied
(b) aggregate
(c) experimental
(d) none of the above
8. An example of ‘positive’ economic analysis would be:
(a) an analysis of the relationship between the price of food and the quantity purchased.
(b) determining how much income each person should be guaranteed.
(c) determining the ‘fair’ price for food.

(d) deciding how to distribute the output of the economy.
9. A study of how increases in the corporate income tax rate will affect the national unemployment rate is
an example of
(a) Macro-Economics.
(b) Descriptive Economics.
(c) Micro-economics.
(d) Normative economics.
10. Which of the following does not suggest a macro approach for India?
(a) Determining the GNP of India.
(b) Finding the causes of failure of ABC Ltd.
(c) Identifying the causes of inflation in India.
(d) Analyse the causes of failure of industry in providing large scale employment
11. Ram: My corn harvest this year is poor.

Krishan: Don’t worry. Price increases will compensate for the fall in quantity supplied.
Vinod: Climate affects crop yields. Some years are bad, others are good.
Madhu: The Government ought to guarantee that our income will not fall.
In this conversation, the normative statement is made by
(a) Ram (b) Krishan
(c) Vinod (d) Madhu
2. Consider the following and decide which, if any, economy is without scarcity:
(a) The pre-independent Indian economy, where most people were farmers.
(b) A mythical economy where everybody is a billionaire.

(c) Any economy where income is distributed equally among its people.
(d) None of the above.
13. Which of the following is not a subject matter of Micro-economies?
(a) The price of mangoes.
(b) The cost of producing a fire truck for the fire department of Delhi, India.
(c) The quantity of mangoes produced for the mangoes market.

(d) The national economy’s annual rate of growth.
14. The branch of economic theory that deals with the problem of allocation of resources is
(a) Micro-Economic theory. (b) Macro-economic theory.
(c) Econometrics. (d) none of the above.
15. Which of the following is not the subject matter of Business Economics?
(a) Should our firm be in this business?
(b) How much should be produced and at price should be kept?
(c) How will the product be placed in the market?
(d) How should we decrease unemployment in the economy?

16. Which of the following is a normative economic statement?
(a) Unemployment rate decreases with industrialization
(b) Economics is a social science that studies human behaviour.

(c) The minimum wage should be raised to ` 200/- per day
(d) India spends a huge amount of money on national defence.
17. Which of the following would be considered a topic of study in Macroeconomics?

(a) The effect of increase in wages on the profitability of cotton industry
(b) The effect on steel prices when more steel is imported
(c) The effect of an increasing inflation rate on living standards of people in India
(d) The effect of an increase in the price of coffee on the quantity of tea consumed
18. The difference between positive and normative Economics is:

(a) Positive Economics explains the performance of the economy while normative Economics
finds out the reasons for poor performance.
(b) Positive Economics describes the facts of the economy while normative Economics involves
evaluating whether some of these are good or bad for the welfare of the people.
(c) Normative Economics describes the facts of the economy while positive Economics involves
evaluating whether some of these are good or bad for the welfare of the people.
(d) Positive Economics prescribes while normative Economics describes.
19. Which of the following is not within the scope of Business Economics?
(a) Capital Budgeting (b) Risk Analysis
(c) Business Cycles (d) Accounting Standards
20. Which of the following statements is incorrect?
(a) Business economics is normative in nature.
(b) Business Economics has a close connection with statistics.
(c) Business Economist need not worry about macro variables.

(d) Business Economics is also called Managerial Economics.
21. Economic goods are considered scarce resources because they
(a) cannot be increased in quantity.
(b) do not exist in adequate quantity to satisfy the requirements of the society.
(c) are of primary importance in satisfying social requirements.
(d) are limited to man made goods.

22. In a free market economy the allocation of resources is determined by
(a) voting done by consumers (b) a central planning authority.
(c) consumer preferences. (d) the level of profits of firms.

23. A capitalist economy uses ____________________ as the principal means of allocating resources.
(a) demand (b) supply
(c) efficiency (d) prices

24. Which of the following is considered as a disadvantage of allocating resources using the market
system?
(a) Income will tend to be unevenly distributed.
(b) People do not get goods of their choice.

(c) Men of Initiative and enterprise are not rewarded.
(d) Profits will tend to be low.

25. Which of the following statements does not apply to a market economy?
(a) Firms decide whom to hire and what to produce.
(b) Firms aim at maximizing profits.
(c) Households decide which firms to work for and what to buy with their incomes.
(d) Government policies are the primary forces that guide the decisions of firms and households.
26. In a mixed economy

(a) all economic decisions are taken by the central authority.
(b) all economic decisions are taken by private entrepreneurs.
(c) economic decisions are partly taken by the state and partly by the private entrepreneurs.
(d) none of the above.
27. The central problem in economics is that of
(a) comparing the success of command versus market economies.
(b) guaranteering that production occurs in the most efficient manner.
(c) guaranteering a minimum level of income for every citizen.
(d) allocating scarce resources in such a manner that society’s unlimited needs or wants are
satisfied in the best possible manner.
28. Capital intensive technique would get chosen in a
(a) labour surplus economy where the relative price of capital is lower.
(b) capital surplus economy where the relative price of capital is lower.
(c) developed economy where technology is better.
(d) developing economy where technology is poor.
29. Which of the following is not one of the four central questions that the study of economics is supposed
to answer?
(a) Who produces what? (b) When are goods produced?
(c) Who consumes what? (d) How are goods produced?

30. Larger production of ____goods would lead to higher production in future.
(a) consumer goods (b) capital goods
(c) agricultural goods (d) public goods
31. The economic system in which all the means of production are owned and controlled by private
individuals for profit.
(a) Socialism (b) Capitalism
(c) Mixed economy (d) Communism

32. Macro Economics is the study of ________________________.
(a) all aspects of scarcity.
(b) the national economy and the global economy as a whole.
(c) big businesses.
(d) the decisions of individual businesses and people.
33. Freedom of choice is the advantage of
(c) Communism (d) None of the above
34. Exploitation and inequality are minimal under:

(c) Mixed economy (d) None of the above
35. Administered prices refer to:

(a) Prices determined by forces of demand and supply
(b) Prices determined by sellers in the market
(c) Prices determined by an external authority which is usually the government

(d) None of the above
36. In Economics, the central economic problem means:
(a) Output is restricted to the limited availability of resources
(b) Consumer do not have as much money as they would wish

(c) There will always be certain level of unemployment
(d) Resources are not always allocated in an optimum way

37. Scarcity definition of Economics is given by-
(a) Alfred Marshall
(b) Samuelson
(c) Robinson
(d) Adam Smith
38. The definition “Science which deals with wealth of Nation” was given by:
(a) Alfred Marshall
(b) A C Pigou
(c) Adam Smith
(d) J B Say
39. Which of the following is not one of the features of capitalist economy?
(a) Right of private property
(b) Freedom of choice by the consumers
(c) No profit, No Loss motive
(d) Competition
40. There is need of economic study, because –
(a) The resources are limited
(b) The wants are unlimited

(c) The resources are unlimited
(d) Both a and b
41. The benefit of economic study is –

(a) It ensure that all problems will be appropriately tackled
(b) It helps in identifying problems
(c) It enable to examine a problem in its right perspective
(d) It gives exact solutions to every problem
42. The managerial economics –

(a) Is Applied Economics that fills the gap between economic theory and business practice
(b) Is just a theory concept

(c) Trains managers how to behave in recession
(d) Provides the tools which explain various concepts
43. Which of the following statements is correct?
(a) Micro economics is important for study of a particular household and a particular firm
(b) Macro economics is important for study of economic conditions of a country
(c) None of the above
(d) Both a and b
44. Mr. Satish hired a business consultant to guide him for growth of his business. The consultant visited
his factory and suggested some changes with respect to staff appointment, loan availability and so on.
Which approach is that consultant using?
(a) Micro economics
(b) Macro economics
(c) None of the above
(d) Both a and b

45. Profit motive is a merit of
(a) Socialism
(b) Capitalism
(c) Mixed economy
46. _______ is also called as command economy

(a) Socialist
(b) Capitalist
(c) Mixed economy
Answers
1. (d) 2 (d) 3 (b) 4. (a) 5. (d) 6. (a)
7. (b) 8. (a) 9. (a) 10. (b) 11. (d) 12. (d)
13. (d) 14. (a) 15. (d) 16. (c) 17. (c) 18. (b)
19. (d) 20. (c) 21. (b) 22. (c) 23. (d) 24. (a)
25. (d) 26. (c) 27. (d) 28. (b) 29. (b) 30. (b)
31. (b) 32. (b) 33. (b) 34. (a) 35. (c) 36. (a)
37. (c) 38. (c) 39. (c) 40. (d) 41. (c) 42. (a)
43. (d) 44. (a) 45. (b) 46. (a)
CHAPTER 2
THEORY OF DEMAND AND

SUPPLY
UNIT -1: LAW OF DEMAND AND ELASTICITY OF DEMAND
LEARNING OUTCOMES
At the end of this Unit, you will be able to:

♦ Explain the meaning of Demand.
♦ Describe what Determines Demand.
♦ Explain the Law of Demand.
♦ Explain the difference between Movement along the Demand Curve and Shift of
the Demand Curve.
♦ Define and Measure Elasticity.
♦ Apply the Concepts of Price, Cross and Income Elasticities.
♦ Explain the Determinants of Elasticity.
♦ Explain the Importance of Demand Forecasting in Business.
♦ Describe the various Forecasting Techniques.
CHAPTER OVERVIEW
Consider the following hypothetical situation:

Aroma Tea Limited is considering diversifying its business. A meeting of the board of directors is called. While
discussing the matter, Rajeev Aggarwal, the CEO of Aroma Tea Limited asks, Sanjeev Bhandari, the marketing
head, “What do you think Sanjeev, should we enter into green tea business also?What does the market pulse say?
Who all are there in this market? How will the demand for green tea affect the demand for our black tea? Is green tea
a luxury good or is it a necessity now? What are the key determinants of the demand for green tea? Will coffee
drinkers or soft drinkers shift to green tea? The answers to these questions will help us better understand how to
price and position our brand in the market. “Before we rush into this line, I want a report on exactly why you believe
green tea will be the star of our company in the coming five years?”
As an entrepreneur of a firm or as a manager of a company, you would often face situations in which you have to
answer questions similar to the above. Why do prices change when events such as weather changes, wars,
pandemics or new discoveries occur? Why is it that some producers are able to charge higher prices than others?
The answers to these and a thousand other questions can be found in the theory of demand and supply.
The market system is governed by market mechanism. Demand and supply are the forces that make market
economies work. These two together determine the price and quantity sold of a commodity or service. While buyers
constitute the demand side of the market, sellers make the supply side of that market. Since business firms produce
goods and services to be sold in the market, it is important for them to know how much of their products would be
wanted by buyers during a given period of time. The buyers include consumers, businesses and even government.
The quantity that the buyers buy at a given price determines the size of the market. As we are aware, as far as a firm
is concerned, the size of the market is a significant determinant of its prospects.
When a market is competitive, its behaviour is suitably described by the demand and supply model. We understand
that the terms demand and supply refer to the behaviour of buyers and sellers respectively as they interact each
.3 THEORY OF DEMAND AND SUPPLY 2.3
other in markets. A thorough understanding of the demand and supply theory is therefore essential for any business
firm. We shall study the theory of demand in this Unit. The theory of supply will be discussed in Unit-3.
1.0 MEANING OF DEMAND

The term ‘demand’ refers to the quantity of a good or service that buyers are willing and able to purchase at various
prices during a given period of time. It is to be noted that demand, in Economics, is something more than the desire
to purchase, though desire is one element of it. For example, people may desire much bigger houses, luxurious cars
etc. But there are also constraints that they face such as prices of products and limited means to pay.Thus, wants or
desires together with the real world constraints determine what they buy. The effective demand for a thing depends
on (i) desire (ii) means to purchase and (iii) willingness to use those means for that purchase. Unless desire is
backed by purchasing power or ability to pay and willingness to pay, it does not constitute demand. Effective demand
alone would figure in economic analysis and business decisions.
Two things are to be noted about the quantity demanded.
(i) The quantity demanded is always expressed at a given price. At different prices different quantities of a
commodity are generally demanded.
(ii) The quantity demanded is a flow. We are concerned not with a single isolated purchase, but with a
continuous flow of purchases and we must therefore express demand as ‘so much per period of time’ i.e.,
one thousand dozens of oranges per day, seven thousand dozens of oranges per week and so on.
In short “By demand, we mean the various quantities of a given commodity or service which consumers would buy in
one market during a given period of time, at various prices, or at various incomes, or at various prices of related
goods”.
1.1 WHAT DETERMINES DEMAND?

Knowledge of the common determinants of demand for a product or service and the nature of relationship between
demand and its determinants are essential for a business firm for estimating the market demand for its products.
There are a number of factors which influence the demand for a commodity. All these factors are not equally
important. Moreover, some of these factors cannot be easily measured or quantified. The important factors that
determine demand are given below.
(i) Price of the commodity: Obviously, the good’s own price is a key determinant of its demand. Ceteris
paribus i.e. other things being equal, the demand for a commodity is inversely related to its price. It implies
that a rise in the price of a commodity brings about a fall in the quantity purchased and vice-versa. This
happens because of income and substitution effects.
(ii) Price of related commodities: Related commodities are of two types: (i) complementary goods and (ii)
competing goods or substitutes.
Complementary goods and services are those that are bought or consumed together or simultaneously.
Examples are: tea and sugar, automobile and petrol and pen and ink. The increase in the demand for one
causes an increase in the demand for the other. When two commodities are complements, a fall in the price
of one (other things being equal) will cause the demand for the other to rise. For example, a fall in the price
of petrol-driven cars would lead to a rise in the demand for petrol. Similarly, computers and computer
software are complementary goods. A fall in the price of computers will cause a rise in the demand for
software. The reverse will be the case when the price of a complement rises. An increase in the price of a
complementary good reduces the demand for the good in question. Thus, we find that, there is an inverse
relation between the demand for a good and the price of its complement.
Two commodities are called competing goods or substitutes when they satisfy the same want and can be
used with ease in place of one another. For example, tea and coffee, ink pen and ball pen, different brands
of toothpaste etc. are substitutes for each other and can be used in place of one another easily. When
goods are substitutes, if the price of a product being purchased goes up, buyers may switch to a cheaper
substitute. This decreases the demand for the product at a given price, but increases the demand for the
substitute. Similarly, a fall in the price of a product (ceteris paribus) leads to a fall in the quantity demanded
of its substitutes. For example, if the price of tea falls, people will try to substitute it for coffee and demand
more of it and less of coffee i.e. the demand for tea will rise and that of coffee will fall. Therefore, there is
direct or positive relation between the demand for a product and the price of its substitutes.
(iii) Disposable Income of the consumer: The purchasing power of a buyer is determined by the level of his
disposable income. Other things being equal, the demand for a commodity depends upon the disposable
income of the potential purchasers. In general, increase in disposable income tends to increase the demand
for particular types of goods and services at any given price. A decrease in disposable income generally
lowers the quantity demanded at all possible prices.
The nature of relationship between disposable income and quantity demanded depends upon the nature of
goods. A basic description of the nature of goods is useful in describing the effect of income on demand.
Normal goods are those that are demanded in increasing quantities as consumers’ income increases. Most
goods and services fall under the category of normal goods. Household furniture, clothing, automobiles,
consumer durables and semi durables etc. fall in this category. When income is reduced (for example due
to recession), demand for normal goods falls.
There are some commodities for which the quantity demanded rises only up to a certain level of income and
decreases with an increase in money income beyond this level. These goods are called inferior goods.
Essential consumer goods such as food grains, fuel, cooking oil, necessary clothing etc. satisfy the basic
necessities of life and are consumed by all individuals in a society. A change in consumers’ income,
although will cause an increase in demand for these necessities, but this increase will be less than
proportionate to the increase in income. This is because as people become richer, there is a relative decline
in the importance of food and other non durable goods in the overall consumption basket and a rise in the
importance of durable goods such as a TV, car, house etc. Demand for luxury goods and prestige goods
arise beyond a certain level of consumers’ income and keep rising as income increases.
Business managers should be fully aware of the nature of goods which they produce (or the nature of need
which their products satisfy) and the nature of relationship of quantities demanded with changes in buyers’
incomes. For assessing the current as well as future demand for their products, they should also recognize
the movements in the macro economic variables that affect buyers’ incomes.
(iv) Tastes and preferences of buyers: The demand for a commodity also depends upon the tastes and
preferences of buyers and changes in them over a period of time. Goods which are modern or more in
fashion command higher demand than goods which are of old design or are out of fashion. Consumers may
perceive a product as obsolete and discard it before it is fully utilised and then prefer another good which is
currently in fashion. For example, there is greater demand for the latest digital devices and trendy clothing
and we find that more and more people are discarding these goods currently in use even though they could
have used it for some more years.
External effects on utility such as' demonstration effect',' bandwagon effect’, Veblen effect and ‘snob effect’
do play important roles in determining the demand for a product. Demonstration effect, a term coined by
James Duesenberry, refers to the desire of people to emulate the consumption behaviour of others. In
other words, people buy or have things because they see that other people are able to have them. For
example, an individual’s demand for cell phone may be affected by his seeing a new model of cell phone in
his neighbour’s or friend’s house, either because he likes what he sees or because he figures out that if his
neighbour or friend can have it, he too can.
Bandwagon effect refers to the extent to which the demand for a commodity is increased due to the fact that
others are also consuming the same commodity. It represents the desire of people to purchase a
commodity in order to be fashionable or stylish or to conform to the people they wish to be associated
with.
By ‘snob effect’ we refer to the extent to which the demand for a consumers' good is decreased owing to the
fact that others are also consuming the same commodity. This represents the desire of people to be
exclusive; to be different; to dissociate themselves from the "common herd." For example, when a product
becomes common among all, some people decrease or altogether stop its consumption.
Highly priced goods are consumed by status seeking rich people to satisfy their need for conspicuous
consumption. This is called ‘Veblen effect’ (named after the American economist Thorstein Veblen).For
example, expensive cars and jewels. The distinction between the snob effect and the Veblen effect is that
the former is a function of the consumption of others and the latter is a function of price.We conclude that
people have tastes and preferences and these do change - sometimes, due to external and sometimes due
to internal causes - and influence demand.
Knowledge regarding tastes and preferences is extremely valuable for the manufacturers and marketers as
it would help them appropriately design new models of products and services and plan production to suit the
changing tastes and needs of the customers.
(v) Consumers’ Expectations
Consumers’ expectations regarding future prices, income, supply conditions etc. influence current demand.
If the consumers expect increase in future prices, increase in income and shortages in supply, more
quantities will be demanded. If they expect a fall in price or fall in income they will postpone their purchases
of nonessential commodities and therefore, the current demand for them will fall.Levels of consumer and
business confidence about their future economic situations also affect spending and demand.
Other factors: Apart from the above factors, the demand for a commodity depends upon the following
factors:
(a) Size of population: Generally, larger the size of population of a country or a region, larger would
be the number of buyers and the quantity demanded in the market would be higher at every price.
The opposite is the case when population is less.
(b) Age Distribution of population: If a larger proportion of people belong to older age groups
relative to younger age groups, there will be increased demand for geriatric care services,
spectacles, walking sticks, etc and less demand for children’s books. Similarly, if the population
consists of more of children, demand for toys, baby foods, toffees, etc. will be more. Likewise, if
there is migration from rural areas to urban areas, there will be decrease in demand for goods and
services in rural areas.
(c) The level of National Income and its Distribution: The level of national income is a crucial
determinant of market demand. Higher the national income, higher will be the demand for all
normal goods and services. The wealth of a country may be unevenly distributed so that there are
a few very rich people while the majority is very poor. Under such conditions, the propensity to
consume of the country will be relatively less, because the propensity to consume of the rich
people is less than that of the poor people. Consequently, the demand for consumer goods will be
comparatively less. If the distribution of income is more equal, then the propensity to consume of
the country as a whole will be relatively high indicating higher demand for goods.
(d) Consumer-credit facility and interest rates: Availability of credit facilities induces people to
purchase more than what their current incomes permit them. Credit facilities mostly determine the
demand for investment and for durable goods which are expensive and require bulk payments at
the time of purchase. Low rates of interest encourage people to borrow and therefore demand will
be more.
(e) Government policies and regulations; The governments influence demand through its taxation,
purchases, expenditure, and subsidy policies. While taxes increase prices and decrease the
quantity demanded, subsidies decrease the prices and increase the quantity demanded. For
example taxes on luxurious goods and subsidies for solar panels. Similarly total bans, restrictions
and higher taxes may be used by government to restrict the demand for socially undesirable goods
and services. Government’s policy on international trade also will affect the domestic demand for
goods and services.
Apart from above, factors such as weather conditions, business conditions, stage of business
cycle, wealth, levels of education, marital status, socioeconomic class, group membership, habits
of the consumer, social customs and conventions, salesmanship and advertisements also play
important roles in influencing demand.
1.2 THE DEMAND FUNCTION

As we know, a function is a symbolic statement of a relationship between the dependent and the independent
variables.
The demand function states in equation form, the relationship between the demand for a product (the dependent
variable) and its determinants (the independent or explanatory variables).Any other factors that are not explicitly
listed in the demand function are assumed to be irrelevant or held constant. A simple demand function may be
expressed as follows:
Qx = f (PX, Y, Pr,)
Where Qx is the quantity demanded of product X
PX is the price of the commodity
Y is the money income of the consumer, and

Pr is the price of related goods
The demand function stated as above does not indicate the exact quantitative relationship between Qx and PX, M and
Pr,. For this, we need to write the demand function in a particular form with specified values of the explanatory
variables appearing on the right-hand side. For example; we may write Qx = 45 + 2y + 1 Pr, – 2 P. In this unit, we
will be studying demand as a function of only price, keeping everything else constant.
1.3 THE LAW OF DEMAND

Most of us have an implicit understanding of the law of demand. The law of demand is one of the most important
laws of economic theory. The law states the nature of relationship between the quantity demanded of a product and
its price. Prof. Alfred Marshall defined the Law thus: “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
increases with a fall in price and diminishes with a rise in price”.
The law of demand states that other things being equal, when the price of a good rises the quantity demanded of the
good will fall. Thus, there is an inverse relationship between price and quantity demanded, ceteris paribus. The ‘other
things’ which are assumed to be equal or constant are the prices of related commodities, income of consumers,
tastes and preferences of consumers, and all factors other than price which influence demand. (Refer section 1.1
above). If these factors which determine demand also undergo a change, then the inverse price-demand relationship
may not hold good. For example, if incomes of consumers increase, then an increase in the price of a commodity,
may not result in a decrease in the quantity demanded of it. Thus, the constancy of these ‘other factors’ is an
important assumption of the law of demand.
The quantity demanded is the amount of a good or service that consumers are willing to buy at a given price, holding
constant all the other factors that influence purchases. The quantity demanded of a good or service can exceed the
quantity actually sold.
The Law of Demand may be illustrated with the help of a demand schedule and a demand curve.
1.3.0 The Demand Schedule

A demand schedule is a table showing the quantities of a good that buyers would choose to purchase at different
prices, per unit of time, with all other variables held constant. To illustrate the relation between the quantity of a
commodity demanded and its price, we may take a hypothetical data for prices and quantities of ice-cream. A
demand schedule is drawn upon the assumption that all the other influences remain unchanged. It thus attempts to
isolate the influence exerted by the price of the good upon the amount sold.
Table 1: Demand Schedule of an Individual Buyer
Quantity of ice-cream demanded
Price per cup of ice-cream (per week)
(in Rupees) (Cups)
A 60 0
B 50 2
C 40 4
D 30 6
E 20 8
F 10 10
G 0 12
Table 1 shows how many cups of ice-cream this particular buyer buys each week at different prices of ice-cream,
holding constant everything else that influences how much of ice-cream this particular consumer wants to buy. If ice-
cream is free (price =0), she consumes 12 cups of ice-cream per week. As the price rises, she buys fewer and fewer
cups of ice-cream. When the price reaches ` 60 per cup, she does not buy ice-cream at all. The above table depicts
an inverse relationship between price and quantity of ice-cream demanded. We may note that that the demand
schedule obeys the law of demand: As the price of ice-cream increases, ceteris paribus, the quantity demanded falls.
1.3.1 The Demand Curve

A demand curve is a graphical presentation of the demand schedule. By convention, the vertical axis of the graph
measures the price per unit of the good. The horizontal axis measures the quantity of the good, which is usually
expressed in some physical measure per time period. By plotting each pair of values as a point on a graph and
joining the resulting points, we get the individual’s demand curve for a commodity. It shows the relationship between
the quantities of a good that buyers are willing to buy and the price of the good. We can now plot the data from Table
1 on a graph.
In Fig. 1, we have shown such a graph and plotted the seven points corresponding to each price-quantity
combination shown in Table 1. The demand curve hits the vertical axis at price ` 60 indicating that no quantity is
demanded when the price is ` 60 (or higher). The demand curve hits the horizontal quantity axis at 12, the amount
ice-cream that the consumer wants if the price is zero. Point A shows the same information as the first row of Table
1, and Point G shows the same information as does the last row of the table.
Fig. 1 : Demand Curve for Ice-cream
We now draw a smooth curve through these points. The curve is called the demand curve for ice-cream and shows
the quantity of ice-cream that the consumer would like to buy at each price. The negative or downward slope
indicates that the quantity demanded increases as the price falls. Consumers are usually ready to buy more if the
price is lower. Briefly put, more of a good will be purchased at lower prices. Thus, the downward sloping demand
curve is in accordance with the law of demand which, as stated above, describes an inverse price-demand
relationship.
The slope of a demand curve is - ∆P/∆Q (i.e the change along the vertical axis divided by the change along the
horizontal axis). The negative sign of this slope is consistent with the law of demand.
The demand curve for a good does not have to be linear or a straight line; it can be curvilinear- meaning its slope
may vary along the curve.If the change in quantity demanded does not follow a constant proportion, then the demand
curve will be non linear. However, linear demand curves provide a convenient tool for analysis.
1.3.2 Market Demand Schedule

The market demand for a commodity gives the alternative amounts of the commodity demanded per time period, at
various alternative prices, by all the buyers in the market. In other words, it is the total quantity that all the buyers of a
commodity are willing to buy per unit of time at a given price, other things remaining constant. The market demand
for a commodity thus depends on all the factors that determine the individual’s demand and, in addition, on the
number of buyers of the commodity in the market.
When we add up the various quantities demanded by different consumers in the market, we can obtain the market
demand schedule. How the summation is done is illustrated in Table 2. Suppose there are only two individual buyers
of good X in the market namely, A and B. The Table 2 shows their individual demand at various prices.
Table 2: Market Demand Schedule of Good X (per day)
Quantity demanded by
Price of Good X in (Rs) A B Total Market Demand
0 3 2 5
10 2 1 3
20 1 0 1
30 0 0 0
When we add the quantities demanded at each price by consumers A and B, we get the total market demand. Thus,
when good X is free or price is zero per unit, the market demand for commodity ‘X’ is 5 units (i.e.3+2). When price
rises to Rs 10, the market demand is 3 units. At a price of Rs. 20, only one unit is demanded in the market. At price
Rs 30, both A and B do not buy good X and therefore, market demand is zero. The market demand schedule also
indicates inverse relationship between price and quantity demanded of ‘X’.
Fig. 2 : The Market Demand Curve for Good X
1.3.3 The Market Demand Curve

The market demand curve for good X represents the quantities of good X demanded by all buyers in the market for
good X. The market demand curve is obtained by horizontal summation of all individual demand curves.
If we plot the market demand schedule on a graph, we get the market demand curve. Figure 2 shows the market
demand curve for commodity ‘X’. The two consumers A and B have different individual demand curves
corresponding to their different preferences for good X. The two individual demand curves are shown in Figure 2
along with the market demand curve for good X. When there are more than two consumers in the market for some
good, the same principle continues to apply and the market demand curve would be the horizontal summation of all
the market participants' individual demand curves. The market demand curve, like the individual demand curve,
slopes downwards to the right because it is nothing but the lateral summation of individual demand curves.
In addition to the demand schedule and the demand curve, the buyers' demand for a good can also be expressed
algebraically, using a demand equation. The demand equation relates the price of the good, denoted by P, to the
quantity of the good demanded, denoted by Q.
The straight-line demand curve where we hold everything else constant is described by alineardem and function. We
can write a demand function as follows:
Q = a - bP
Where ‘a’ is the vertical intercept and ‘b’ is the slope.
For example: For a demand function Q = 100 ‐2P,
a Q Q
=P – : P 50 –
=
b b 2
1.3.4 Rationale of the Law of Demand

Normally, the demand curves slope downwards. This means people buy more at lower prices. We shall now try to
understand why do demand curves slope downwards? Put in other words, why do people buy more at lower prices?
Different economists have given different explanations for the operation of the of law of demand. These are given
below :
(1) Price Effect of a fall in price: The price effect which indicates the way the consumer's purchases of good
X change, when its price changes, is the sum of its two components namely: substitution effect and income
effect.
(a) Substitution effect: Hicks and Allen have explained the law in terms of substitution effect and
income effect. The substitution effect describes the change in demand for a product when its
relative price changes. When the price of a commodity falls, the price ratio between items change
and it becomes relatively cheaper than other commodities. Assuming that the prices of all other
commodities remain constant, it induces consumers to substitute the commodity whose price has
fallen for other commodities which have now become relatively expensive. The result is that the
total demand for the commodity whose price has fallen increases. This is called substitution effect.
When the price falls, the substitution effect is always positive; i.e it will always cause more to be
demanded. The substitution effect will be stronger when:
(a) the goods are closer substitutes
(b) there is lower cost of switching to the substitute good
(c) there is lower inconvenience while switching to the substitute good
(b) Income effect: The increase in demand on account of an increase in real income is known as
income effect. When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money or he can buy more of the same commodity with the same amount of
money. In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases. A part or whole of the resulting increase in real income can now be
used to buy more of the commodity in question, given that the good is normal.Therefore, the
demand for that commodity (whose price has fallen) increases. However, there is one exception. In
the case of inferior goods, the income effect works in the opposite direction to the substitution
effect. In the case of inferior goods, the expansion in demand due to a price fall will take place only
if the substitution effect outweighs the income effect.
(2) Utility maximising behaviour of Consumers: A consumer is in equilibrium (i.e. maximises his
satisfaction) when the marginal utility of the commodity and its price equalize. According to Marshall, the
consumer has diminishing utility for each additional unit of a commodity and therefore, he will be willing to
pay only less for each additional unit. A rational consumer will not pay more for lesser satisfaction. He is
induced to buy additional units only when the prices are lower. The operation of diminishing marginal utility
and the act of the consumer to equalize the utility of the commodity with its price result in a downward
sloping demand curve.
(3) Arrival of new consumers: When the price of a commodity falls, more consumers start buying it because
some of those who could not afford to buy it earlier may now be able to buy it. This raises the number of
consumers of a commodity at a lower price and hence the demand for the commodity in question increases.
(4) Different uses: Many commodities have multiple uses. When the price of such commodities are high (or
rises) they will be put to limited uses only. If the prices of such commodities fall, they will be put to more
number of uses and therefore their demand will increase. Thus, the increase in the number of uses
consequent to a fall in price make the buyer demand more of such commodities making the demand curve
slope downwards. For example: Electricity
1.3.5 Exceptions to the Law of Demand

According to the law of demand, other things being equal, more of a commodity will be demanded at lower prices
than at higher prices. The law of demand is valid in most cases; however there are certain cases where this law does
not hold good. The following are the important exceptions to the law of demand.
(i) Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous consumption are
used by the rich people as status symbol for enhancing their social prestige or /and for displaying wealth.
These articles will not conform to the usual law of demand as they become more attractive only if their
prices are high or keep going up. This was found out by Veblen in his doctrine of “Conspicuous
Consumption” and hence this effect is called Veblen effect or prestige goods effect. Veblen effect takes
place as some consumers measure the utility of a commodity by its price i.e., if the commodity is expensive
they think that it has got more utility. As such, they buy less of this commodity at low price and more of it at
high price. Diamonds are often given as an example of this case. Higher the price of diamonds, higher is the
prestige value attached to them and hence higher is the demand.
(ii) Giffen goods: Sir Robert Giffen, a Scottish economist and statistician, was surprised to find out that as the
price of bread increased, the British workers purchased more bread and not less of it. This was something
against the law of demand. Why did this happen? The reason given for this is that, when the price of bread
went up, it caused such a large decline in the purchasing power of the poor people that they were forced to
cut down the consumption of meat and other more expensive foods. Since bread, even when its price was
higher than before, was still the cheapest food article, people consumed more of it and not less when its
price went up.
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’. Generally those goods
which are inferior, with no close substitutes available and which occupy a substantial place in consumers’
budget are called ‘Giffen goods’. All Giffen goods are inferior goods; but all inferior goods are not Giffen
goods. Examples of Giffen goods are coarse grains like bajra, low quality rice and wheat etc.
(iii) Conspicuous necessities: The demand for certain goods is affected by the demonstration effect of the
consumption pattern of a social group to which an individual belongs. These goods, due to their constant
usage, become necessities of life. For example, in spite of the fact that the prices of television sets,
refrigerators, air-conditioners etc. have been continuously rising, their demand does not show any tendency
to fall.
(iv) Future expectations about prices: It has been observed that when the prices are rising, households,
expecting that the prices in the future will be even higher, tend to buy larger quantities of such commodities.
For example, when there is wide-spread drought, people expect that prices of food grains would rise in
future. They demand greater quantities of food grains even as their price rises. On the contrary, if prices are
falling and people anticipate further fall, rather than buying more, they postpone their purchases. However,
it is to be noted that here it is not the law of demand which is invalidated. There is a change in one of the
factors which was held constant while deriving the law of demand, namely change in the price expectations
of the people.
(v) Incomplete information and irrational behaviour: The law has been derived assuming consumers to be
rational and knowledgeable about market-conditions. However, at times, consumers have incomplete
information and therefore make inconsistent decisions regarding purchases. Similarly, in practice, a
household may demand larger quantity of a commodity even at a higher price because it may be ignorant of
the ruling price of the commodity. Under such circumstances, the law will not remain valid.
Sometimes, consumers tend to be irrational and make impulsive purchases without any rational calculations
about the price and usefulness of the product and in such contexts the law of demand fails.
(vi) Demand for necessaries: The law of demand does not apply much in the case of necessaries of life.
Irrespective of price changes, people have to consume the minimum quantities of necessary commodities.
(vii) Speculative goods: In the speculative market, particularly in the market for stocks and shares, more will be
demanded when the prices are rising and less will be demanded when prices decline.
The law of demand will also fail if there is any significant change in other factors on which demand of a commodity
depends. If there is a change in income of the household, or in the prices of related commodities or in tastes and
fashion etc., the inverse demand and price relation may not hold good.
1.4 EXPANSION AND CONTRACTION OF DEMAND

The demand schedule, demand curve and the law of demand all show that when the price of a commodity falls, its
quantity demanded increases, other things being equal. When, as a result of decrease in price, the quantity
demanded increases, in Economics, we say that there is an expansion of demand and when, as a result of increase
in price, the quantity demanded decreases, we say that there is a contraction of demand. For example, suppose the
price of apples is Rs 100/ per kilogram and a consumer buys one kilogram at that price. Now, if other things such as
income, prices of other goods and tastes of the consumers remain the same but the price of apples falls to Rs 80 per
kilogram and the consumer now buys two kilograms of apples, we say that there is a change in quantity demanded
or there is an expansion of demand. On the contrary, if the price of apples rises to Rs 150 per kilogram and the
consumer then buys only half a kilogram, we say that there is a contraction of demand.
The phenomena of expansion and contraction of demand are shown in Figure 3. The figure shows that when price is
OP, the quantity demanded is OM, given other things equal. When as a result of increase in price (O PII), the quantity
demanded falls to OL, we say that there is ‘a fall in quantity demanded’ or ‘contraction of demand’ or ‘an upward
movement along the same demand curve’. Similarly, as a result of fall in price to OPI, the quantity demanded rises to
ON, we say that there is an ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a downward movement on the
same demand curve.’
Fig. 3 : Expansion and Contraction of Demand
1.4.1 Increase and Decrease in Demand

Till now we have assumed that the other determinants of demand remain constant when we are analysing the
demand for a commodity. It should be noted that expansion and contraction of demand take place as a result of
changes in the price while all other determinants of price viz. income, tastes, propensity to consume and price of
related goods remain constant. The‘ other factors remaining constant’ means that the position of the demand curve
remains the same and the consumer moves downwards or upwards on it.
There are factors other than price (non-price factors) or conditions of demand which might cause either an increase
or decrease in the quantity of a particular good or service that buyers are prepared to demand at a given price. What
happens if there is a change in consumers’ tastes and preferences, income, the prices of the related goods or other
factors on which demand depends? As an example, let us consider what happens to the demand for commodity X if
the consumer’s income increases:
Table 3 shows the possible effect of an increase in income of the consumer on the quantity demanded of commodity
X.
Table 3 : Two demand schedules for commodity X
Price Quantity of ‘X’ demanded when Quantity of ‘X’ demanded when average
average household income is Rs household income is
(Rs) 5,000 per month Rs 10,000 per month
A 5 10 15 A1
B 4 15 20 B1
C 3 20 25 C1
D 2 35 40 D1
E 1 60 65 E1
Fig. 4: Figure Showing Two Demand Curves at Different Incomes

The two sets of data are plotted in Figure 4 as DD pertaining to demand when average household income is
Rs 5000/ and D’D’ when income is Rs.10, 000/. We find that with increase in income, the demand curve for X has
shifted [in this case it has shifted to the right]. The shift from DD to D’D’ indicates an increase in the desire to
purchase ‘X’ at each possible price. For example, at the price of Rs 4 per unit, 15 units are demanded when average
household income is Rs 5,000 per month. When the average household income rises to Rs 10,000 per month, 20
units of X are demanded at price Rs 4. You can find similar increase in demand at each price. Since this increase
would occur regardless of what the market price is, the result would be a shift to the right of the entire demand curve.
Alternatively, we can ask what price consumers would be willing to pay to purchase a given quantity, say 15 units of
X. With greater income, they should be willing to pay a higher price of Rs 5 instead of 4. A rise in income thus shifts
the demand curve to the right, whereas a fall in income will have the opposite effect of shifting the demand curve to
the left.
Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an
increase in demand. Any change that decreases the quantity demanded at every price shifts the demand curve to
the left, and is called a decrease in demand.
Figure 5(a) and (b) illustrate increase and decrease in demand respectively. When there is an increase in demand,
the demand curve shifts to the right and more quantity will be purchased at a given price (Q1 instead of Q at price P).
A decrease in demand causes the entire demand curve to shift to the left and we find that less quantity is bought at
the same price P.
Fig. 5(a): Rightward shift in the Fig. 5(b): Leftward shift in the
demand Curve demand Curve
The table below summarises the effect of non - price determinants on demand
Changes in determinants other than price that Changes in determinants other than price that
cause increase in demand cause Decrease in Demand (Leftward shift of
(Rightward shift of demand curvewhen more is demand curvewhen less is demanded at each
demanded at each price) price)
Rise in income in the case of normal goods A fall in income in case of normal goods, and a
rise in income in case of inferior goods
Increase in wealth in the case of normal goods Decrease in wealth in case of normal goods,
and an increase in wealth in case of inferior
goods
Rise in the price of a substitute good Fall in the price of a substitute good
Fall in the price of a complement Rise in the price of a complement
An increase in the number of buyers A decrease in the number of buyers
A change in tastes in favour of the commodity A change in tastes against the commodity
A redistribution of income to groups of people Redistribution of income away from groups of
who favour the commodity people who favour the commodity.
An expectation that price will rise in the future An expectation that price will fall in the future
Government policies encouraging Government regulations discouraging
consumptionof the good . Eg. Grant of consumption e.g. ban on cigarette smoking /
consumer subsidies ban on consumption.
1.4.2 Movements along the Demand Curve vs. Shift of Demand Curve
It is important for the business decision-makers to understand the distinction between a movement along a demand
curve and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded because of price changes, other
factors remaining constant. A shift of the demand curve indicates that there is a change in demand at each possible
price because one or more other factors, such as incomes, tastes or the price of some other goods, have changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift of the whole curve
because one or more of the factors which were assumed to remain constant earlier have changed. When the
economists speak of change in quantity demanded he means movement along the same curve (i.e., expansion or
contraction of demand) which has happened due to fall or rise in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting from changes in factors
such as income, tastes, prices of other goods etc. and ‘change in quantity demanded’ represents movement upwards
or downwards on the same demand curve resulting from a change in the price of the commodity.
When demand increases due to factors other than price, firms can sell more at the existing prices resulting in
increased revenue. The objective of advertisements and all other sales promotion activities by any firm is to shift the
demand curve to the right and to reduce the elasticity of demand. (The latter will be discussed in the next section).
However, the additional demand is not free of cost as firms have to incur expenditure on advertisement and sales
promotion devices.
1.5 ELASTICITY OF DEMAND

Till now we were concerned with the direction of the changes in prices and quantities demanded. From the point of
view of a business firm, it is more important to know the extent of the relationship or the degree of responsiveness of
demand to changes in its determinants.
Often, we would want to know how sensitive is the demand for a product to its price; for example, if price increases
by 5 percent, how much will the quantities demanded change? Also, how much change in demand will be there if the
average income rises by 5 percent? What effect will an advertising campaign have on sales? Economists use a
number of different types of elasticities to answer questions like these so as to make demand predictions and to
recommend changes in strategies.
Consider the following situations:
(1) As a result of a fall in the price of headphones from Rs 500 to Rs 400, the quantity demanded increases
from 100headphones to 150 headphones.
(2) As a result of fall in the price of wheat from Rs 20 per kilogram to Rs 18 per kilogram, the quantity
demanded increases from 500 kilograms to 520 kilograms.
(3) As a result of fall in the price of salt from Rs 9 per kilogram to Rs 7.50, the quantity demanded increases
from 1000 kilogram to 1005 kilograms.
What do you notice? You notice that the demand for headphones, wheat and salt responds in the same direction to
price changes. The difference lies in the degree of response of demand. The differences in responsiveness of
demand can be found out by comparing the percentage changes in prices and quantities demanded.Here lies the
concept of elasticity.
The amount of a commodity purchased is a function of many variables such as price of the commodity, prices of the
related commodities, income of the consumers and other factors on which demand depends. A change in one of
these independent variables will cause a change in the dependent variable, namely, the amount purchased per unit
of time. The elasticity of demand measures the relative responsiveness of the amount purchased per unit of time to a
change in any one of these independent variables while keeping others constant. In general, the coefficient of
elasticity is defined as the proportionate change in the dependent variable divided by the proportionate change in the
independent variable.
Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one
of the variables on which demand depends. More precisely, elasticity of demand is the percentage change in
quantity demanded divided by the percentage change in one of the variables on which demand depends.
We may find different measures of elasticity such as price elasticity, cross elasticity, income elasticity, advertisement
elasticity and elasticity of substitution. It is to be noted that when we talk of elasticity of demand, unless and until
otherwise mentioned, we talk of price elasticity of demand. In other words, it is price elasticity of demand which is
usually referred to as elasticity of demand.
1.5.1 Price Elasticity of Demand

Perhaps, the most important measure of elasticity of demand is the price elasticity of demand which measures the
sensitivity of quantity demanded to ‘own price’ or the price of the good itself. The concept of price elasticity of
demand is important for a firm for two reasons.
• Knowledge of the nature and degree of price elasticity allows firms to predict the impact of price changes on
its sales.
• Price elasticity guides the firm’s profit-maximizing pricing decisions.
Price elasticity of demand expresses the responsiveness of quantity demanded of a good to a change in its price,
given the consumer’s income, his tastes and prices of all other goods. In other words, it is measured as the
percentage change in quantity demanded divided by the percentage change in price, other things remaining equal.
The price elasticity of demand (also referred to as PED) tells us the percentage change in quantity demanded for
each one percent (1%) change in price. That is,
% change in quantity demaned
Price Elasticity = Ep =
% change in Price
The percentage change in a variable is just the absolute change in the variable divided by the original level of the
variable.
Therefore,
Change in quantity
× 100
Original Quantity
Ep =
Change in Price
× 100
Original Price
Change in quantity Original Price

OR Ep = ×
Original Quantity Change in price
In symbolic terms
∆q p ∆q p
Ep = × = ×
q ∆p ∆p q
Where Ep stands for price elasticity

q stands for original quantity
p stands for original price
∆ stands for a change.
A negative sign on the elasticity of demand illustrates the law of demand: less quantity is demanded as the price
rises. Notice that the change in quantity was due solely to the price change. The other factors that potentially could
affect sales (income and the competitor’s price) did not change
The greater the value of elasticity, the more sensitive quantity demanded is to price. Strictly speaking, the value of
∆q
price elasticity varies from minus infinity to approach zero. This is because has a negative sign. In other words,
∆p
since price and quantity are inversely related (with a few exceptions) price elasticity is negative.
While interpreting the coefficient of price elasticity, we consider only the magnitude of the price elasticity- i.e. its
absolute size. For example, if Ep = -1.22, we say that the elasticity is 1.22 in magnitude. That is, we ignore the
negative sign and consider only the numerical value of the elasticity. Thus if a 1% change in price leads to 2%
change in quantity demanded of good A and 4% change in quantity demanded of good B, then we get elasticity of A
and B as 2 and 4 respectively, showing that demand for B is more elastic or responsive to price changes than that of
A. Had we considered minus signs, we would have concluded that the demand for A is more elastic than that for B,
which is not correct. Hence, by convention, we take the absolute value of price elasticity and draw conclusions.
A numerical example for price elasticity of demand:
ILLUSTRATION 1
The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded of the good increases from 10 units
to 15 units. Find the coefficient of price elasticity.
SOLUTION
Price elasticity = (-) ∆ q / ∆ p × p/q = 5/2 × 6/10 = (-) 1.5
ILLUSTRATION 2
A 5% fall in the price of a good leads to a 15% rise in its demand. Determine the elasticity and comment on its value.
SOLUTION
% change in quantity demanded
Price Elasticity = Ep =
% change in Price
= 15% / 5% = 3
Comment: The good in question has elastic demand

ILLUSTRATION 3
The price of a good decreases from ` 100 to ` 60 per unit. If the price elasticity of demand for it is 1.5 and the original
quantity demanded is 30 units, calculate the new quantity demanded.
SOLUTION
∆q p
Ep = ×
∆p q
∆q 100
Here 1.5 = × =18
40 30
Therefore new quantity demanded = 30+18 = 48 units
ILLUSTRATION 4
The quantity demanded by a consumer at price Rs 9 per unit is 800 units. Its price falls by 25% and
quantity demanded rises by 160 units. Calculate its price elasticity of demand.
SOLUTION
Change in quantity demanded = 160
Therefore, % change in quantity demanded = = 20%
% change in price = 25%
% change in q
Ed =
% change in p
20
∴ Ea = = 0.8
25
ILLUSTRATION 5
A consumer buys 80 units of a good at a price of Rs 4 per unit. Suppose price elasticity of demand is - 4. At what
price will he buy 60 units?
SOLUTION
∆q p
Ed = ×
∆p q
20 4
Or 4 = ×
x – 4 80
1
Or 4 =
x–4
∴ x = 4.2 per unit
1.5.2 Point Elasticity

The point elasticity of demand is the price elasticity of demand at a particular point on the demand curve. The
concept of point elasticity is used for measuring price elasticity where the change in price is infinitesimal. Price
elasticity is a key element in applying marginal analysis to determine optimal prices. Since marginal analysis works
by evaluating “small” changes taken with respect to an initial decision, it is useful to measure elasticity with respect to
an infinitesimally small change in price.
Point elasticity makes use of derivative rather than finite changes in price and quantity. It may be defined as:
–dq p
Ep = ×
dp q
dq
Where is the derivative of quantity with respect to price at a point on the demand curve, and p and q are the
dp
price and quantity at that point. Economists generally use the word “elasticity” to refer to point elasticity.
Fig 6: Point Elasticity

Point elasticity is, therefore, the product of price quantity ratio at a particular point on the demand curve and the
reciprocal of the slope of the demand line.
1.5.3 Measurement of Elasticity on a Linear Demand Curve – Geometric Method

By definition, the price elasticity of demand is the change in quantity associated with a change in price (∆Q/∆P)
times the ratio of price to quantity (P/Q) Therefore, .the price elasticity of demand depends not only on the slope of
the demand curve but also on the price and quantity. The elasticity, therefore, varies along the curve as price and
quantity change. The slope of a linear demand curve is constant. However, the elasticity at different points on a
linear demand curve would be different. When price is high price is high and quantity is small, the elasticity is high.
The elasticity becomes smaller as we move down the curve.
Given a straight line demand curve tT, (Fig.6 above) point elasticity at any point say R can be found by using the
formula
RT lower segment
=
Rt upper segment
Using the above formula we can get elasticity at various points on the demand curve.
Fig .7: Elasticity at Different Points on the Demand Curve

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the mid-point it is equal to one, at
point t, it is infinity and at T it is zero.
1.5.4 Arc-Elasticity
Often we may be required to calculate price elasticity over some portion of the demand curve rather than at a single
point. In other words, the elasticity may be calculated over a range of prices. When price and quantity changes are
discrete and large we have to measure elasticity over an arc of the demand curve.
When price elasticity is to be found between two prices (or two points on the demand curve say, A and B in figure 8)
the question arises as to which price and quantity should be taken as base. This is because elasticities found by
using original price and quantity figures as base will be different from the one derived by using new price and
quantity figures. Therefore, in order to avoid confusion, rather than choose the initial or the final price and quantity,
the mid-point method is used i.e. the averages of the two prices and quantities are taken as (i.e. original and new)
base. The midpoint formula is an approximation to the actual percentage change in a variable, but it has the
advantage of consistent elasticity values when price moves in either directions.
Fig. 8: Arc Elasticity

The arc elasticity can be found out by using the formula: We drop the minus sign and use the absolute value.
Q 2 –Q1
(Q +Q )/2
Ep = 2 1
P2 –P1
(P2 +P1 )/2
Q 2 –Q1 P2 +P1
Ep = ×
Q 2 +Q1 P2 –P1
Where P1, Q1are the original price and quantity and P2, Q2are the new ones.
Thus, if we have to find elasticity of demand for headphones between:
P1= Rs.500 Q1= 100
P2 = Rs. 400 Q2= 150
We will use the formula
Q 2 –Q1 P2 +P1
Ep = ×
Q 2 +Q1 P2 –P1
50 900
Or Ep = ×
250 100
or Ep = 1.8
The arc elasticity will always lie somewhere (but not necessarily in the middle) between the point elasticities
calculated at the lower and the higher prices.
1.5.5 Interpretation of the Numerical Values of Elasticity of Demand

Economists have found it useful to divide the demand behaviour into different categories, based on values of price
elasticity. Since we draw demand curves with price on the vertical axis and quantity on the horizontal axis, ∆Q/∆P =
(1/slope of curve). As a result, for any price and quantity combination, the steeper the slope of the curve, the less
elastic is demand.
The numerical value of elasticity of demand can assume any value between zero and infinity.
Elasticity is zero, (Ep= 0) if there is no change at all in the quantity demanded when price changes i.e. when the
quantity demanded does not respond at all to a price change. In other words, any change in price leaves the quantity
demanded unchanged and consumers will buy a fixed quantity of a good regardless of its price. Perfectly inelastic
demand is as an extreme case of price insensitivity and is therefore only a theoretical category with less practical
significance. The vertical demand curve in figure 8(a) represents perfectly or completely inelastic demand,
Elasticity is one, or unitary, (Ep= 1) if the percentage change in quantity demanded is equal to the percentage
change in price. Figure 8 (b) shows special case of unit-elastic demand, where the demand curve is a rectangular
hyperbola.
Elasticity is greater than one (Ep > 1) when the percentage change in quantity demanded is greater than the
percentage change in price. In such a case, demand is said to be elastic. [Figure8 (d)]. In other words, the quantity
demanded is relatively sensitive to price changes. When drawn, the elastic demand line is fairly flat.
Elasticity is less than one (Ep < 1) when the percentage change in quantity demanded is less than the percentage
change in price. In such a case, demand is said to be inelastic.[Figure 8 (e)]In this situation, when price falls the
buyers are unable or unwilling to significantly contract demand. In other words, the quantity demanded is relatively
insensitive to price changes. When drawn, the inelastic demand line is fairly steep.
Elasticity is infinite, (Ep= ∞) when a ‘small price reduction raises the demand from zero to infinity. The demand
curve is horizontal at the price level (where the demand curve touches the vertical axis).As long as the price stays at
one particular level any quantity might be demanded. Moving back and forth along this line, we find that there is a
change in the quantity demanded but no change in the price. If there is a slight increase in price, they would not buy
anything from the particular seller. That is, even the smallest price rise would cause quantity demanded to fall to
zero. Roughly speaking, when you divide a number by zero, you get infinity, denoted by the symbol∞. So a
horizontal demand curve implies an infinite price elasticity of demand. This type of demand curve is found in a
perfectly competitive market. The horizontal demand curve in figure 8 (c) represents perfectly or infinitely elastic
demand,
Table 4 : Elasticity Measures, Meaning and Nomenclature
Numerical measure of Verbal description Terminology

elasticity
Zero Quantity demanded does not change as price Perfectly (or completely)
changes inelastic
Greater than zero, but less Quantity demanded changes by a smaller Inelastic
than one percentage than does price
One Quantity demanded changes by exactly the Unit elasticity
same percentage as does price
Greater than one, but less Quantity demanded changes by a larger Elastic
than infinity percentage than does price
Infinity Purchasers are prepared to buy all they can Perfectly (or infinitely) elastic
obtain at some price and none at all at an
even slightly higher price
Now that we are able to classify goods according to their price elasticity, let us see whether the goods mentioned
below are price elastic or inelastic.
Sl. No. Name of the Calculation of Elasticity Nature of Elasticity
Commodity Q – Q 1 P2 + P1
Ep = 2 ×
Q 2 + Q 1 P2 – P1
1. Headphones 100 − 150 500 + 400 Elastic

× = 1.8 > 1
100 + 150 500 − 400
2. Wheat 500 − 520 20 + 18 Inelastic
× = 0.37 < 1
500 + 520 20 − 18
3. Common Salt 1000 − 1005 9 + 7.50 Inelastic
× = 0.02743 < 1
1000 + 1005 9 − 7.50
What do we note in the above hypothetical example? We note that the demand for headphones is quite elastic, while
demand for wheat is quite inelastic and the demand for salt is almost the same even after a reduction in price.
The price elasticity of demand for the vast majority of goods is somewhere between the two extreme cases of zero
and infinity. Generally, in real world situations also, we find that the demand for goods like refrigerators, TVs, laptops,
fans, etc. is elastic; the demand for goods like wheat and rice is inelastic; and the demand for salt is highly inelastic
or perfectly inelastic. Why do we find such a difference in the behaviour of consumers in respect of different
commodities? We shall explain later at length those factors which are responsible for the differences in elasticity of
demand for various goods. Before that, we will consider another method of calculating price-elasticity which is called
total outlay method.
1.5.6 Total Outlay Method of Calculating Price Elasticity

The price elasticity of demand for a commodity and the total expenditure or outlay made on it are significantly related
to each other. As the total expenditure (price of the commodity multiplied by the quantity of that commodity
purchased) made on a commodity is the total revenue received by the seller (price of the commodity multiplied by
quantity of that commodity sold of that commodity), we can say that the price elasticity and total revenue received
are closely related to each other. By analysing the changes in total expenditure (or total revenue) in response to a
change in the price of the commodity, we can know the price elasticity of demand for it.
Price Elasticity of demand equals one or Unity: When, as a result of the change in price of a good, the total
expenditure on the good or the total revenue received from that good remains the same, the price elasticity for the
good is equal to unity. This is because the total expenditure made on the good can remain the same only if the
proportional change in quantity demanded is equal to the proportional change in price. Thus, if there is a given
percentage increase (or decrease) in the price of a good and if the price elasticity is unitary, total expenditure of the
buyer on the good or the total revenue received from it will remain unchanged.
Price elasticity of demand is greater than unity: When, as a result of increase in the price of a good, the total
expenditure made on the good or the total revenue received from that good falls or when as a result of decrease in
price, the total expenditure made on the good or total revenue received from that good increases, we say that price
elasticity of demand is greater than unity. In our example of headphones, as a result of fall in price of headphones
from Rs 500 to Rs 400, the total revenue received from headphones increases from Rs 50,000 (500 x 100) to
Rs 60,000 (400 x 150), indicating elastic demand for headphones. Similarly, had the price of headphones increased
from Rs 400 to Rs 500, the demand would have fallen from 150 to 100 indicating a fall in the total revenue received
from Rs 60,000 to Rs 50,000 showing elastic demand for headphones.
Price elasticity of demand is less than unity: When, as a result of increase in the price of a good, the total
expenditure made on the good or the total revenue received from that good increases or when as a result of
decrease in its price, the total expenditure made on the good or the total revenue received from that good falls, we
say that the price elasticity of demand is less than unity. In the example of wheat above, as a result of fall in the
price of wheat from Rs 20 per kg. to Rs 18 per kg. the total revenue received from wheat falls from Rs 10,000
(20 x 500) to Rs 9360 (18 x 520) indicating inelastic demand for wheat. Similarly, we can show that as a result of
increase in the price of wheat from Rs 18 to Rs 20 per kg, the total revenue received from wheat increase from Rs
9360 to Rs 10,000 indicating inelastic demand for wheat.
The main drawback of this method is that by using this we can only say whether the demand for a good is elastic or
inelastic; we cannot find out the exact coefficient of price elasticity.
Why should a business firm be concerned about elasticity of demand? The reason is that the degree of elasticity of
demand predicts how changes in the price of a good will affect the total revenue earned by the producers from the
sale of that good. The total revenue is defined as the total value of sales of a good or service. It is equal to the price
multiplied by the quantity sold.
1.5.7 Total Revenue

Total revenue (TR) = Price × Quantity sold
Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of
a good, there are two effects which act in opposite directions on revenue.
• Price effect: After a price increase (decrease), each unit sold sells at a higher (lower) price, which tends to
raise (lower) the revenue.
• Quantity effect: After a price increase (decrease), fewer (more) units are sold, which tends to lower
(increase) the revenue.
What will be the net effect on total revenue? It depends on which effect is stronger. If the price effect which tends to
raise total revenue is the stronger of the two effects, then total revenue goes up. If the quantity effect, which tends to
reduce total revenue, is the stronger, then total revenue goes down.
The price elasticity of demand tells us what happens to the total revenue when price changes: its size determines
which effect, the price effect or the quantity effect, is stronger.
If demand for a good is unit-elastic (the price elasticity of demand is equal to one; Figure 9), an increase in price or
decrease in price does not change total revenue. In this case, the quantity effect and the price effect exactly balance
each other. When price rises from P to P1, the gain in revenue (Area A ) is equal to loss in revenue due to lost sales(
Area B)
Figure 9: Total revenue when Elasticity = 1

If demand for a good is inelastic (the price elasticity of demand is less than one), a higher price increases total
revenue. In this case, the quantity effect is weaker than the price effect. On the contrary, when demand is inelastic, a
fall in price reduces total revenue because the quantity effect is dominated by the price effect. Refer Figure 8 (e)
above.
If demand for a good is elastic (the price elasticity of demand is greater than one), an increase in price reduces total
revenue and a fall in price increases total revenue. In this case, the quantity effect is stronger than the price effect.
Refer Figure 8 (d) above.
Table 5 below summarizes the relationship between price elasticity and total revenue.
Table 5: The Relationship between Price elasticity and Total Revenue (TR)
Demand
Elastic Unitary Elastic Inelastic
Price increase TR Decreases TR remains same TR Increases
Price decrease TR Increases TR remains same TR Decreases
1.5.8 Determinants of Price Elasticity of Demand

In the above section we have explained what price elasticity is and how it is measured. Now an important question is:
What are the factors which determine whether the demand for a good is elastic or inelastic? We will consider the
following important determinants of price elasticity.
(1) Availability of substitutes: One of the most important determinants of elasticity is the degree of
substitutability and the extent of availability of substitutes. Some commodities like butter, cabbage, car, soft
drink etc. have close substitutes. These are margarine, other green vegetables, other brands of cars, other
brands of cold drinks respectively. A change in the price of these commodities, the prices of the substitutes
remaining constant, can be expected to cause quite substantial substitution – a fall in price leading
consumers to buy more of the commodity in question and a rise in price leading consumers to buy more of
the substitutes.
Commodities such as salt, housing, and all vegetables taken together, have few, if any, satisfactory
substitutes and a rise in their prices may cause a smaller fall in their quantity demanded. Thus, we can say
that goods which typically have close or perfect substitutes have highly elastic demand curves. Moreover,
wider the range of substitutes available, the greater will be the elasticity. For example, toilet soaps,
toothpastes etc have wide variety of brands and each brand is a close substitute for the other.
It should be noted that while as a group, a good or service may have inelastic demand, but when we
consider its various brands, we say that a particular brand has elastic demand. Thus, while the demand for
a generic good like petrol is inelastic, the demand for Indian Oil’s petrol is elastic. Similarly, while there are
no general substitutes for health care, there are substitutes for one doctor or hospital. Likewise, the demand
for common salt and sugar is inelastic because good substitutes are not available for these.
(2) Position of a commodity in the consumer’s budget: The greater the proportion of income spent on a
commodity; generally the greater will be its elasticity of demand and vice- versa. The demand for goods like
common salt, matches, buttons, etc. tend to be highly inelastic because a household spends only a fraction
of their income on each of them. On the other hand, demand for goods like rental apartments and clothing
tends to be elastic since households generally spend a good part of their income on them. When the good
absorbs a significant share of consumers’ income, it is worth their time and effort to find a way to reduce
their demand when the price goes up.
(3) Nature of the need that a commodity satisfies: In general, luxury goods are price elastic because one
can easily live without a luxury. In contrast, necessities are price inelastic. Thus, while the demand for a
home theatre is relatively elastic, the demand for food and housing, in general, is inelastic. If it is possible to
postpone the consumption of a particular good, such good will have elastic demand. Consumption of
necessary goods cannot be postponed and therefore, their demand is inelastic.
(4) Number of uses to which a commodity can be put: The more the possible uses of a commodity, the
greater will be its price elasticity and vice versa. When the price of a commodity which has multiple uses
decreases, people tend to extend their consumption to its other uses. To illustrate, milk has several uses. If
its price falls, it can be used for a variety of purposes like preparation of curd, cream, ghee and sweets. But,
if its price increases, its use will be restricted only to essential purposes like feeding the children and sick
persons.
(5) Time period: The longer the time-period one has, the more completely one can adjust. Time gives buyers
the opportunity to find alternatives or substitutes, or change their habits. A simple example of the effect can
be seen in motoring habits. In response to a higher petrol price, one can, in the short run, make fewer trips
by car. In the longer run, not only can one make fewer trips, but he can purchase a car with a smaller
engine capacity when the time comes for replacing the existing one. Hence one’s demand for petrol falls by
more when one has made long term adjustments to higher prices.
(6) Consumer habits: If a person is a habitual consumer of a commodity, no matter how much its price
change, the demand for the commodity will be inelastic. If buyers have rigid preferences demand will be
less price elastic.
(7) Tied demand: The demand for those goods which are tied to others is normally inelastic as against those
whose demand is of autonomous nature. For example printers and ink cartridges.
(8) Price range: Goods which are in very high price range or in very low price range have inelastic demand, but
those in the middle range have elastic demand.
(9) Minor complementary items: The demand for cheap, complementary items to be used together with a
costlier product will tend to have an inelastic demand.
Knowledge of the price elasticity of demand and the factors that may change it is of key importance to
business managers because it helps them recognise the effect of a price change on their total sales and
revenues. Firms aim to maximise their profits and their pricing strategy is highly decisive in attaining their
goals. Knowledge of the price elasticity of demand for the goods they sell helps them in arriving at an
optimal pricing strategy.
If the demand for a firm’s product is relatively elastic, the managers need to recognize that lowering the
price would expand the volume of sales and result in an increase in total revenue. On the contrary, when
the demand is elastic, they have to be very cautious about increasing prices because a price increase will
lead to a decline in total revenue as fall in sales would be more than proportionate. If the firm finds that the
demand for their product is relatively inelastic, the firm may safely increase the price and thereby increase
its total revenue as they can be assured of the fact that the fall in sales on account of a price rise would be
less than proportionate.
Knowledge of price elasticity of demand is important for governments while determining the prices of goods
and services provided by them, such as, transport and telecommunication. Further, it also helps the
governments to understand the nature of responsiveness of demand to increase in prices on account of
additional taxes and the implications of such responses on the tax revenues. Elasticity of demand explains
why the governments are inclined to raise the indirect taxes on those goods that have a relatively inelastic
demand, such as alcohol and tobacco products.
1.6 Income Elasticity of Demand

The income elasticity of demand is a measure of how much the demand for a good is affected by changes in
consumers’ incomes. Estimates of income elasticity of demand are useful for businesses to predict the possible
growth in sales as the average incomes of consumers grow over time.
Income elasticity of demand is the degree of responsiveness of the quantity demanded of a good to changes in the
income of consumers. In symbolic form,
Percentge change in demand
Ei =
Percentge change in income
This can be given mathematically as follows:

∆Q ∆Y
Ei
= ÷
Q Y
∆Q Y
= ×
Q ∆Y
∆Q Y
Ei = ×
∆Y Q
Ei = Income elasticity of demand
∆Q = Change in demand
Q = Original demand
Y = Original money income
∆Y = Change in money income
There is a useful relationship between income elasticity for a good and the proportion of income spent on it. The
relationship between the two is described in the following three propositions:
1. If the proportion of income spent on a good remains the same as income increases, then income elasticity
for that good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the income elasticity for that
good is greater than one. The demand for such goods increase faster than the rate of increase in income
3. If the proportion of income spent on a good decrease as income rises, then income elasticity for the good is
positive but less than one. The demand for income-inelastic goods rises, but substantially slowly compared
to the rate of increase in income. Necessities such as food and medicines tend to be income- inelastic
Income elasticity of goods reveals a few very important features of demand for the goods in question.
If income elasticity is zero, it signifies that the demand for the good is quite unresponsive to changes in income.
When income elasticity is greater than zero or positive, then an increase in income leads to an increase in the
demand for the good. This happens in the case of most of the goods and such goods are called normal goods. For
all normal goods, income elasticity is positive. However, the degree of elasticity varies according to the nature of
commodities.
When the income elasticity of demand is negative, the good is an inferior good. In this case, the quantity demanded
at any given price decreases as income increases. The reason is that when income increases, consumers choose to
consume superior substitutes.
Another significant value of income elasticity is that of unity. When income elasticity of demand is equal to one, the
proportion of income spent on goods remains the same as consumer’s income increases. This represents a useful
dividing line. If the income elasticity for a good is greater than one, it shows that the good bulks larger in consumer’s
expenditure as he becomes richer. Such goods are called luxury goods. On the other hand, if the income elasticity is
less than one, it shows that the good is either relatively less important in the consumer’s eye or, it is a good which is
a necessity.
The following examples will make the above concepts clear:
(a) The income of a household rises by 10%, the demand for wheat rises by 5%.
(b) The income of a household rises by 10%, the demand for T.V. rises by 20%.
(c) The incomes of a household rises by 5%, the demand for bajra falls by 2%.
(d) The income of a household rises by 7%, the demand for commodity X rises by 7%.
(e) The income of a household rises by 5%, the demand for buttons does not change at all.
Using formula for income elasticity,
Percentage change in demand
i.e. Ei =
Percentage chagne in income
We will find income-elasticity for various goods. The results are as follows:
Income-elasticity for the

S. No. Commodity Remarks
household
5% Since 0 < .5 < 1, wheat is a normal
a Wheat = .5(Ei < 1)
10% good and fulfils a necessity.
20% Since 2 > 1, T.V. is a luxurious
b T.V. = 2(Ei > 1)
10% commodity.
Since –.4 < 0, Bajra is an inferior
( − )2%
c Bajra = (–) .4(Ei < 0) commodity in the eyes of the
5%
household.
7% Since income elasticity is 1, X has
d X = 1(E
=i 1)
7% unitary income elasticity.
0%
e Buttons = 0(E
=i 0) Buttons have zero income-elasticity.
5%
It is to be noted that the words ‘luxury’, ‘necessity’, ‘inferior good’ do not signify the strict dictionary meanings here. In
economic theory, we distinguish them in the manner shown above.
An important feature of income elasticity is that income elasticities differ in the short run and long run. For nearly all
goods and services the income elasticity of demand is larger in the long run than in the short run
Knowledge of income elasticity of demand is very useful for a business firm in estimating the future demand for its
products. Knowledge of income elasticity of demand helps firms measure the sensitivity of sales for a given product
to incomes in the economy and to predict the outcome of a business cycle on its market demand. For instance, if EY
= 1, sales move exactly in step with changes in income. If EY >1, sales are highly cyclical, that is, sales are sensitive
to changes in income. For an inferior good, sales are countercyclical, that is, sales move in the opposite direction of
income and EY < 0. This knowledge enables the firm to carry out appropriate production planning and management
ILLUSTRATION 6
Income Elasticity of Demand
A car dealer sells new as well as used cars. Sales during the previous year were as follows;
Car type Price Quantity ( Nos)

New 6 .5 lakhs 400
Used 60,000 4000
During the previous year, other things remaining the same, the real incomes of the customers rose on average by
10%. During the last year sales of new cars increased to 500, but sales of used cars declined to 3,850.
What is the income elasticity of demand for the new as well as used cars? What inference do you draw from these
measures of income elasticity?
SOLUTION
Income Elasticity of demand for new cars
Percentage change in income = 10%, given
Percentage change in quantity of new cars demanded = (∆ Q/Q) X 100 = (100/400 ) X100 = 25%
Income elasticity of demand = 25%/ 10% = + 2.5
New car is therefore income elastic. Since income elasticity is positive, new car is a normal good.
Income Elasticity of demand for used cars
Percentage change in income = 10%, given
% change in quantity of used cars demanded = (∆ Q/Q )X 100 =( -1 50/4000 ) x100 = - 3.75%Income elasticity of
demand = – 3.75/ 10= –.375
Since income elasticity is negative, used car is an inferior good.
1.7. CROSS - PRICE ELASTICITY OF DEMAND

1.7.1 Price of Related Goods and Demand
The demand for a particular commodity may change due to changes in the prices of related goods. These related
goods may be either complementary goods or substitute goods. This type of relationship is studied under ‘Cross
Demand’. Cross demand refers to the quantities of a commodity or service which will be purchased with reference to
changes in price, not of that particular commodity, but of other inter-related commodities, other things remaining the
same. It may be defined as the quantities of a commodity that consumers buy per unit of time, at different prices of a
‘related article’, ‘other things remaining the same’. The assumption ‘other things remaining the same’ means that the
income of the consumer and also the price of the commodity in question will remain constant.
(a) Substitute Products and Demand
In the case of substitute commodities, the cross demand curve slopes upwards (i.e. positively) showing that more
quantities of a commodity, will be demanded whenever there is a rise in the price of a substitute commodity. In figure
10, the quantity demanded of tea is given on the X axis. Y axis represents the price of coffee which is a substitute for
tea. When the price of coffee increases, due to the operation of the law of demand, the demand for coffee falls. The
consumers will substitute tea in the place of coffee. The price of tea is assumed to be constant. Therefore, whenever
there is an increase in the price of one commodity, the demand for the substitute commodity will increase.
Fig. 10 : Substitutes
(b) Complementary Goods
In the case of complementary goods, as shown in the figure 11 below, a change in the price of a good will have an
opposite reaction on the demand for the other commodity which is closely related or complementary. For instance,
an increase in demand for solar panels will necessarily increase the demand for batteries. The same is the case with
complementary goods such as bread and butter; car and petrol, electricity and electrical gadgets etc. Whenever
there is a fall in the demand for solar panels due to a rise in their prices, the demand for batteries will fall, not
because the price of batteries has gone up, but because the price of solar panels has gone up. So, we find that there
is an inverse relationship between price of a commodity and the demand for its complementary good (other things
remaining the same).
Fig. 11: Complementary Goods

We shall now look into the cross - price elasticity of demand.
The cross-price elasticity of demand between two goods measures the effect of the change in one good’s price on
the quantity demanded of the other good. Here, we consider the effect of changes in relative prices within a market
on the pattern of demand. A change in the demand for one good in response to a change in the price of another
good represents cross elasticity of demand of the former good for the latter good. It is equal to the percentage
change in the quantity demanded of one good divided by the percentage change in the other good’s price.
Percentage change in quantity demanded of good X
Ec =
Percentage chagne in price of good Y
Symbolically, (mathematically)
∆q x ∆p y
Ec ÷
qx py
∆qx p y
Ec ÷
∆p y q x
Where Ec stands for cross elasticity.
qx stands for original quantity demanded of X.

∆qx stands for change in quantity demanded of X
py stands for the original price of good Y.
∆py stands for a small change in the price of Y.
In the case of the cross-price elasticity of demand, the sign (plus or minus) is very important: it tells us whether
the two goods are complements or substitutes.
When two goods X and Y are substitutes, the cross-price elasticity of demand is positive: a rise in the price of Y
increases the demand for X and causes a rightward shift of the demand curve. When the cross-price elasticity
of demand is positive, its size is a measure of how closely substitutable the two goods are. Greater the cross
elasticity, the closer is the substitute. Higher the value of cross elasticity, greater will be the substitutability.
• If two goods are perfect substitutes for each other, the cross elasticity between them is infinite.
• If two goods are close substitutes, the cross-price elasticity will be positive and large.
• If two goods are not close substitutes, the cross-price elasticity will be positive and small.
• If two goods are totally unrelated, the cross-price elasticity between them is zero.
When two goods are complementary (tea and sugar) to each other, the cross elasticity between them is negative so
that a rise in the price of one leads to a fall in the quantity demanded of the other causing a leftward shift of the
demand curve. The size of the cross-price elasticity of demand between two complements tells us how strongly
complementary they are: if the cross-price elasticity is only slightly below zero, they are weak complements; if it is
negative and very high, they are strong complements.
However, one need not base the classification of goods on the basis of the above definitions. While the goods
between which cross elasticity is positive can be called substitutes, the goods between which cross elasticity is
negative are not always complementary. This is because negative cross elasticity is also found when the income
effect of the price change is very strong.
The concept of cross elasticity of demand is useful for a manager while making decisions regarding changing the
prices of his products which have substitutes and complements. If cross elasticity to change in the price of
substitutes is greater than one, the firm may lose by increasing the prices and gain by reducing the prices of his
products. With proper knowledge of cross elasticity, the firm can plan policies to safeguard against fluctuating prices
of substitutes and complements.
Cross- price elasticity of demand
ILLUSTRATION 7
A shopkeeper sells only two brands of note books Imperial and Royal. It is observed that when the price of Imperial
rises by 10% the demand for Royal increases by 15%.What is the cross price elasticity for Royal against the price of
Imperial?
SOLUTION
Percentage change in quantity demanded of good X
Ec =
Percentage chagne in price of good Y
15%
Ec = = + 1.5
10%
The two brands of note book Imperial and Royal are substitutes with significant substitutability
ILLUSTRATION 8
The cross price elasticity between two goods X and Y is known to be - 0.8. If the price of good Y rises by 20%, how
will the demand for X change?
SOLUTION
Inserting the values in the formula:
-0.8 = X/ 20%
% change in quantity demanded of X = 20% x - 0.8 = - 16%
Since cross elasticity is negative, X and Y are complementary goods
ILLUSTRATION 9
The price of 1kg of tea is ` 30. At this price 5kg of tea is demanded. If the price of coffee rises from ` 25 to
` 35 per kg, the quantity demanded of tea rises from 5kg to 8kg. Find out the cross price elasticity of tea.
SOLUTION
∆q x p y x = tea
Cross elasticity = × Here
∆p y q x y = coffee
8 – 5 25 3 25
Ec = × =× = + 1.5
10 5 10 5
The elasticity of demand of tea is +1.5 showing that the demand of tea is highly elastic with respect to coffee. The
positive sign shows that tea and coffee are substitute goods.
ILLUSTRATION 10
The price of 1 kg of sugar is Rs 50. At this price 10 kg is demanded. If the price of tea falls from Rs 30 to Rs 25 per
kg, the consumption of sugar rises from 10 kg to 12 kg. Find out the cross price elasticity and comment on its value.
SOLUTION
∆q x p y x = Sugar
Cross elasticity = × Here
∆p y q x y = Tea
2 30
= × (–) 1.2
=
– 5 10
Since the elasticity is -1.2, we can say that sugar and tea are complementary in nature.
1.8 ADVERTISEMENT ELASTICITY

Advertisement elasticity of sales or promotional elasticity of demand is the responsiveness of a good’s demand to
changes in the firm’s spending on advertising. The advertising elasticity of demand measures the percentage change
in demand that occurs given a one percent change in advertising expenditure. Advertising elasticity measures the
effectiveness of an advertisement campaign in bringing about new sales.
Advertising elasticity of demand is typically positive. Higher the value of advertising elasticity greater will be the
responsiveness of demand to change in advertisement. Advertisement elasticity varies between zero and infinity. It is
measured by using the formula;
% Change in quantity demanded
Ea =
% change in spending on advertising
∆Qd/Qd
Ea =
∆A/A
Where ∆ Qd denotes increase in demand
∆ A denotes additional expenditure on advertisement
Qd denotes initial demand
A denotes initial expenditure on advertisement
Elasticity Interpretation
Ea = 0 Demand does not respond at all to increase in advertisement expenditure
Ea >0 but < 1 Increase in demand is less than proportionate to the increase in advertisement
expenditure
Ea = 1 Demand increase in the same proportion in which advertisement expenditure increase
Ea> 1 Demand increase at a higher rate than increase in advertisement expenditure
As far as a business firm is concerned, the measure of advertisement elasticity is useful in understanding the
effectiveness of advertising and in determining the optimum level of advertisement expenditure.
1.9 DEMAND FORECASTING

1.9.0 Meaning
Forecasting, in general, refers to knowing or measuring the status or nature of an event or variable before it
occurs. Forecasting of demand is the art and science of predicting the probable demand for a product or a service at
some future date on the basis of certain past behaviour patterns of some related events and the prevailing trends at
present. It should be kept in mind that demand forecasting is not simple guessing, but it refers to estimating demand
scientifically and objectively on the basis of certain facts and events relevant to forecasting.
1.9.1 Usefulness
The significance of demand or sales forecasting in the context of business policy decisions can hardly be over
emphasized. Forecasting of demand plays a vital role in the process of planning and decision-making, whether at the
national level or at the level of a firm. The effectiveness of the plans of business managers depends upon the level of
accuracy with which future events can be predicted. The importance of demand forecasting has increased all the
more on account of mass production and production in response to demand.
A good forecast enables the firm to perform efficient business planning. Forecasts offer information for budgetary
planning and cost control in functional areas of finance and accounting. Good forecasts help in efficient production
planning, process selection, capacity planning, facility layout and inventory management. A firm can plan production
scheduling well in advance and obtain all necessary resources for production such as inputs and finances. Capital
investments can be aligned to demand expectations and this will check the possibility of overproduction and
underproduction, excess of unused capacity and idle resources. Marketing personnel often rely on sales forecasting
in making key decisions. Demand forecasts also provide the necessary information for formulation of suitable pricing
and advertisement strategies.
It is said that no forecast is completely fool-proof and correct. However, the very process of forecasting helps in
evaluating various forces which affect demand and is in itself a rewarding activity because it enables the forecasting
authority to know about various forces relevant to the study of demand behaviour.
1.9.2 Scope of Forecasting

Demand forecasting can be at the national or international level depending upon the area of operation of the given
economic institution. It can also be confined to a given product or service supplied by a small firm in a local area. The
scope of the forecasting task will depend upon the area of operation of the firm in the present as well as what is
proposed in future. Much would depend upon the cost and time involved in relation to the benefit of the information
acquired through the study of demand. The necessary trade-off has to be struck between the cost of forecasting and
the benefits flowing from such forecasting.
1.9.3 Types of Forecasts

(i) Macro-level forecasting deals with the general economic environment prevailing in the economy as
measured by the Index of Industrial Production (IIP), national income and general level of employment etc.
(ii) Industry- level forecasting is concerned with the demand for the industry’s products as a whole. For
example, demand for cement in India.
(iii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product, say, the demand for
ACC cement
Based on time period, demand forecasts may be short term demand forecasting and long term demand forecasting.
(i) Short term demand forecasting covers a short span of time, depending of the nature of industry. It is done
usually for six months or less than one year and is generally useful in tactical decisions.
(ii) Long term forecasts are for longer periods of time, say two to five years and more. It provides information
for major strategic decisions of the firm such as expansion of plant capacity.
1.9.4 Demand Distinctions

Business managers should have a clear understanding of the kind of demand which their products have. Before we analyse
the different methods of forecasting demand, it is important for us to understand the demand distinctions which are as follows:
(a) Producer’s goods and Consumer’s goods
(b) Durable goods and Non-durable goods
(c) Derived demand and Autonomous demand
(d) Industry demand and Company demand
(e) Short-run demand and Long-run demand
(a) Producer’s goods and Consumer’s goods

Producer’s goods are those which are used for the production of other goods- either consumer goods or
producer goods themselves. Examples of such goods are machines, plant and equipments. Consumer’s
goods are those which are used for final consumption. Examples of consumer’s goods are readymade
clothes, prepared food, residential houses, etc.
(b) Demand for Durable goods and Non-durable goods
Goods may be further sub-divided into durable and non-durable goods. Non durable goods are those which
cannot be consumed more than once. Raw materials, fuel and power, packing items etc are examples of
non durable producer goods. Beverages, bread, milk etc are examples of non-durable consumer goods.
These will meet only the current demand. On the other hand, durable goods do not quickly wear out, can be
consumed more than once and yield utility over a period of time. Examples of durable consumer goods are:
cars, refrigerators and mobile phones. Building, plant and machinery, office furniture etc are durable
producer goods. The demand for durable goods is likely to be derived demand. Further, there are semi-
durable goods such as, clothes and umbrella.
(c) Derived demand and Autonomous demand
The demand for a commodity that arises because of the demand for some other commodity called ‘parent
product’, ‘is called derived demand. For example, the demand for cement is derived demand, being directly
related to building activity. In general, the demand for producer goods or industrial inputs is derived
demand. Also the demand for complementary goods is derived demand. If the demand for a product is
independent of the demand for other goods, then it is called autonomous demand. It arises on its own out of
an innate desire of the consumer to consume or to possess the commodity. But this distinction is purely
arbitrary and it is very difficult to find out which product is entirely independent of other products.
(d) Demand for firm’s product and industry demand
The term industry demand is used to denote the total demand for the products of a particular industry, e.g.
the total demand for steel in the country. On the other hand, the demand for firm’s product denotes the
demand for the products of a particular firm, i.e. the quantity that a firm can dispose off at a given price over
a period of time. E.g. demand for steel produced by the Tata Iron and Steel Company. The demand for a
firm’s product when expressed as a percentage of industry demand signifies the market share of the firm.
(e) Short - run demand and Long-run demand
This distinction is based on time period. Short run demand refers to demand with its immediate reaction to
changes in product price and prices of related commodities, income fluctuations, ability of the consumer to
adjust their consumption pattern, their susceptibility to advertisement of new products etc.
Long-run demand refers to demand which exists over a long period. Most generic goods have long term
demand. Long term demand depends on long term income trends, availability of substitutes, credit facilities
etc. In short, long run demand is that which will ultimately exist as a result of changes in pricing, promotion
or product improvement, after enough time is allowed to let the market adjust to the new situation. For
example, if electricity rates are reduced, in the short run, the existing users will make greater use of electric
appliances. In the long run, more and more people will be induced to buy and use electric appliances.
The above distinction is important because each of these goods exhibit distinctive characteristics which
should be taken into account while analysing demand for them.
1.9.5 Factors Affecting Demand for Non-Durable Consumer Goods

There are three basic factors which influence the demand for these goods:
(i) Disposable income: Other things being equal, the demand for a commodity depends upon the disposable
income of the household. Disposable income is found out by deducting personal taxes from personal
income.
(ii) Price: Other things being equal, the demand for a commodity depends upon its own price and the prices of
related goods (its substitutes and complements). While the demand for a good is inversely related to its own
price and the price of its complements, it is positively related to the price of its substitutes.
(iii) Demography: This involves the characteristics of the population, human as well as non-human, using the
product concerned. For example, it may pertain to the number and characteristics of children in a study of
demand for toys and characteristics of automobiles in a study of the demand for tyres or petrol.
Non durables are purchased for current consumption only. From a business firm’s point of view, demand for non
durable goods gets repeated depending on the nature of the non durable goods. Usually, non durable goods come in
wide varieties and there is competition among the sellers to acquire and retain customer loyalty.
1.9.6 Factors Affecting the Demand for Durable-Consumer Goods

Demand for durable goods has certain special characteristics. Following are the important factors that affect the
demand for durable goods.
(i) A consumer can postpone the replacement of durable goods. Whether a consumer will go on using the
good for a long time or will replace it depends upon factors like his social status, prestige, level of money
income, rate of obsolescence etc.
(ii) These goods require special facilities for their use e.g. roads for automobiles, and electricity for refrigerators
and radios. The existence and growth of such factors is an important variable that determines the demand
for durable goods
(iii) As consumer durables are used by more than one person, the decision to purchase may be influenced by
family characteristics like income of the family, size, age distribution and sex composition. Likely changes in
the number of households should be considered while determining the market size of durable goods.
(iv) Replacement demand is an important component of the total demand for durables. Greater the current
holdings of durable goods, greater will be the replacement demand. Therefore, all factors that determine
replacement demand should be considered as a determinant of the demand for durable goods.
(v) Demand for consumer durables is very much influenced by their prices and credit facilities available to buy
them.
1.9.7 Factors Affecting the Demand for Producer Goods

Since producers’ goods or capital goods help in further production, the demand for them is derived demand, derived
from the demand of consumer goods they produce. The demand for them depends upon the rate of profitability of
user industry and the size of the market of the user industries. Hence data required for estimating demand for
producer goods (capital goods) are:
(i) growth prospects of the user industries;
(ii) norms of consumption of capital goods per unit of installed capacity.

An increase in the price of a substitutable factor of production, say labour, is likely to increase the demand for capital
goods. On the contrary, an increase in the price of a factor which is complementary may cause a decrease in the
demand for capital.
Higher the profit making prospects, greater will be the inducement to demand capital goods. If firms are optimistic
about selling a higher output in future, they will have greater incentive to invest in producer goods. Advances in
technology enabling higher efficiency at reduced cost on account of higher productivity of capital will have a positive
impact on investment in capital goods. Investments in producer goods will be greater when lower interest rates
prevail as firms will have lower opportunity cost of investments and lower cost of borrowing.
1.9.8 Methods of Demand Forecasting

There is no easy method or simple formula which enables an individual or a business to predict the future with
certainty or to escape the hard process of thinking. The firm has to apply a proper mix of judgment and scientific
formulae in order to correctly predict the future demand for a product. The following are the commonly available
techniques of demand forecasting:
(i) Survey of Buyers’ Intentions: The most direct method of estimating demand in the short run is to ask
customers what they are planning to buy during the forthcoming time period, usually a year. This method
involves direct interview of potential customers. Depending on the purpose, time available and costs to be
incurred, the survey may be conducted by any of the following methods:
• Complete enumeration method where nearly all potential customers are interviewed about their
future purchase plans
• Sample survey method under which only a scientifically chosen sample of potential customers are
interviewed
• End–use method, especially used in forecasting demand for inputs, involves identification of all
final users, fixing suitable technical norms of consumption of the product under study, application
of the norms to the desired or targeted levels of output and aggregation.
Thus, under this method the burden of forecasting is put on the customers. However, it would not be wise to
depend wholly on the buyers’ estimates and they should be used cautiously in the light of the seller’s own
judgement. A number of biases may creep into the surveys. The customers may themselves misjudge their
requirements, may mislead the surveyors or their plans may alter due to various factors which are not
identified or visualised at the time of the survey.
This method is useful when bulk of sale is made to industrial producers who generally have definite future
plans. In the case of household customers, this method may not prove very helpful for several reasons viz.
irregularity in customers’ buying intentions, their inability to foresee their choice when faced with multiple
alternatives, and the possibility that the buyers’ plans may not be real, but only wishful thinking.
(ii) Collective opinion method: This method is also known as sales force opinion method or grass roots
approach. Firms having a wide network of sales personnel can use the knowledge, experience and skills of
the sales force to forecast future demand. Under this method, salesmen are required to estimate expected
sales in their respective territories. The rationale of this method is that salesmen being closest to the
customers are likely to have the most intimate feel of the reactions of customers to changes in the market.
These estimates of salesmen are consolidated to find out the total estimated sales. These estimates are
reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of
others. These revised estimates are further examined in the light of factors like proposed changes in selling
prices, product designs and advertisement programmes, expected changes in competition and changes in
secular forces like purchasing power, income distribution, employment, population, etc. The final sales
forecast would emerge after these factors have been taken into account.
Although this method is simple and based on first hand information of those who are directly connected with
sales, it is subjective as personal opinions can possibly influence the forecast. Moreover salesmen may be
unaware of the broader economic changes which may have profound impact on future demand. Therefore,
forecasting could be useful in the short run, for long run analysis however, a better technique is to be
applied.
(iii) Expert Opinion method: In general, professional market experts and consultants have specialised
knowledge about the numerous variables that affect demand. This, coupled with their varied experience,
enables them to provide reasonably reliable estimates of probable demand in future. Information is elicited
from them through appropriately structured unbiased tools of data collection such as interview schedules
and questionnaires.
The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA, provides a useful way
to obtain informed judgments from diverse experts by avoiding the disadvantages of conventional panel
meetings. Under this method, instead of depending upon the opinions of buyers and salesmen, firms solicit
the opinion of specialists or experts through a series of carefully designed questionnaires. Experts are
asked to provide forecasts and reasons for their forecasts. Experts are provided with information and
opinion feedbacks of others at different rounds without revealing the identity of the opinion provider. These
opinions are then exchanged among the various experts and the process goes on until convergence of
opinions is arrived at. The following chart shows the Delphi process.
Fig: 12 The Delphi process

The Delphi method is best suited in circumstances where intractable changes are occurring and the relevant
knowledge is distributed among experts spread over different geographical locations. For example, the
method may be used for forecasting national energy demand 50 years from now, long term transportation
needs, environmental issues and long term human resource forecasting to mention a few. Delphi technique
is widely accepted due to its broader applicability, absence of group pressure, capability to tap collective
human expertise and intelligence and ability to address complex questions. It also has the advantages of
speed and cheapness.
(iv) Statistical methods: statistical methods have proved to be very useful in forecasting demand. Forecasts
using statistical methods are considered as superior methods because they are more scientific, reliable and
free from subjectivity. The important statistical methods of demand forecasting are:
(a) Trend Projection method: This method, also known classical method, is considered as a ‘naive’
approach to demand forecasting. A firm which has been in existence for a reasonably long time
would have accumulated considerable data on sales pertaining to different time periods. Such
data, when arranged chronologically, yield a ‘time series’. The time series relating to sales
represent the past pattern of effective demand for a particular product. Such data can be used to
project the trend of the time series.
The trend projection method assumes that factors responsible for the past trend in demand will
continue to operate in the same manner and to the same extent as they did in the past in
determining the magnitude and direction of demand in future. The popular techniques of trend
projection based on time series data are; graphical method and fitting trend equation or least
square method.
(i) Graphical Method: This method, also known as ‘free hand projection method’ is the
simplest and least expensive. This involves plotting of the time series data on a graph
paper and fitting a free-hand curve to it passing through as many points as possible. The
direction of the curve shows the trend. This curve is extended into the future for deriving
the forecasts. The direction of this free hand curve shows the trend. The main draw-back
of this method is that it may show the trend but the projections made through this method
are not very reliable.
(ii) Fitting trend equation: Least Square Method: It is a mathematical procedure for fitting a
line to a set of observed data points in such a manner that the sum of the squared
differences between the calculated and observed value is minimised. This technique is
used to find a trend line which best fit the available data. This trend is then used to project
the dependant variable in the future. This method is very popular because it is simple and
in-expensive. Moreover, the trend method provides fairly reliable estimates of future
demand.
The least square method is based on the assumption that the past rate of change of the variable
under study will continue in the future. The forecast based on this method may be considered
reliable only for the period during which this assumption holds. The major limitation of this method
is that it cannot be used where trend is cyclical with sharp turning points of troughs and peaks.
Also, this method cannot be used for short term forecasts.
(b) Regression analysis: This is the most popular method of forecasting demand. Under this method,
a relationship is established between the quantity demanded (dependent variable) and the
independent variables (explanatory variables) such as income, price of the good, prices of related
goods etc. Once the relationship is established, we derive regression equation assuming the
relationship to be linear. The equation will be of the form Y = a + bX. There could also be a
curvilinear relationship between the dependent and independent variables. Once the regression
equation is derived, the value of Y i.e. quantity demanded can be estimated for any given value of
X.
(v) Controlled Experiments: Under this method, future demand is estimated by conducting market studies
and experiments on consumer behaviour under actual, though controlled, market conditions. This method is
also known as market experiment method. An effort is made to vary separately certain determinants of
demand which can be manipulated, for example, price, advertising, etc., and conduct the experiments
assuming that the other factors would remain constant. Thus, the effect of demand determinants like price,
advertisement, packaging, etc., on sales can be assessed by either varying them over different markets or
by varying them over different time periods in the same market. The responses of demand to such changes
over a period of time are recorded and are used for assessing the future demand for the product. For
example, different prices would be associated with different sales and on that basis the price-quantity
relationship is estimated in the form of regression equation and used for forecasting purposes. It should be
noted however, that the market divisions here must be homogeneous with regard to income, tastes, etc.
The method of controlled experiments is used relatively less because this method of demand forecasting is
expensive as well as time consuming. Moreover, controlled experiments are risky too because they may
lead to unfavourable reactions from dealers, consumers and competitors. It is also difficult to determine
what conditions should be taken as constant and what factors should be regarded as variable so as to
segregate and measure their influence on demand. Besides, it is practically difficult to satisfy the condition
of homogeneity of markets.
Market experiments can also be replaced by ‘controlled laboratory experiments’ or ‘consumer clinics’ under
which consumers are given a specified sum of money and asked to spend in a store on goods with varying
prices , packages, displays etc. The responses of the consumers are studied and used for demand
forecasting.
(vi) Barometric method of forecasting: The various methods suggested till now are related with the product
concerned. These methods are based on past experience and try to project the past into the future. Such
projection is not effective where there are economic ups and downs. As mentioned above, the projection of
trend cannot indicate the turning point from slump to recovery or from boom to recession. Therefore, in
order to find out these turning points, it is necessary to find out the general behaviour of the economy.
Just as meteorologists use the barometer to forecast weather, the economists use economic indicators to
forecast trends in business activities. This information is then used to forecast demand prospects of a
product, though not the actual quantity demanded. For this purpose, an index of relevant economic
indicators is constructed. Movements in these indicators are used as basis for forecasting the likely
economic environment in the near future.
There are leading indicators, coincidental indicators and lagging indicators. The leading indicators move up
or down ahead of some other series. For example, the heavy advance orders for capital goods give an
advance indication of economic prosperity. Increase in the number of construction permits for new houses
will be reflected in corresponding increase in the number of sheets of glass ordered several months later.
The coincidental indicators, however, move up and down simultaneously and are witnessed at around the
same time the changes they signal occur. Since these happen almost in real time, they do not offer much
predictive insight, but provide a fair reading of the current scenario. For example, Figures on retail sales,
rate of unemployment and Index of Industrial Production (IIP).
The lagging indicators follow a change after some time lag. The heavy household electrical connections
confirm the fact that heavy construction work was undertaken during the past with a lag of some time.
SUMMARY
• Buyers constitute the demand side of the market; sellers make the supply side of that market. The quantity
that consumers buy at a given price determines the size of the market.
• Demand means desire or wish to buy and consume a commodity or service backed by adequate ability to
pay and willingness to pay
• The important factors that determine demand are price of the commodity, price of related commodities,
income of the consumer, tastes and preferences of consumers, consumer expectations regarding future
prices, size of population, composition of population, the level of national income and its distribution,
consumer-credit facility and interest rates.
• The law of demand states that people will buy more at lower prices and less at higher prices, other things
being equal.
• A demand schedule is a table that shows various prices and the corresponding quantities demanded. The
demand schedules are of two types; individual demand schedule and market demand schedule.
• According to Marshall, the demand curve slopes downwards due to the operation of the law of diminishing
marginal utility. However, according to Hicks and Allen it is due to income effect and substitution effect.
• The demand curve usually slopes downwards; but exceptionally slopes upwards under certain
circumstances as in the case of conspicuous goods, Giffen goods, conspicuous necessities, future
expectations about prices, demand for necessaries and speculative goods.
• When the quantity demanded decreases due to a rise in own price, it is contraction of demand. On the
contrary, when the price falls and the quantity demanded increases it is extension of demand.
• The demand curve will shift to the right when there is a rise in income (unless the good is an inferior one), a
rise in the price of a substitute, a fall in the price of a complement, a rise in population and a change in
tastes in favour of commodity. The opposite changes will shift the demand curve to the left.
• Elasticity of demand refers to the degree of sensitiveness or responsiveness of demand to a change in any
one of its determinants. Elasticity of demand is classified mainly into four kinds. They are price elasticity of
demand, income elasticity of demand, advertisement elasticity and cross elasticity of demand.
• Price elasticity of demand refers to the percentage change in quantity demanded of a commodity as a result
of a percentage change in price of that commodity. Because demand curve slopes downwards and to the
right, the sign of price elasticity is negative. We normally ignore the sign of elasticity and concentrate on the
coefficient. Greater the absolute coefficient, greater is the price elasticity.
• In point elasticity, we measure elasticity at a given point on a demand curve. When the price change is
somewhat larger or when price elasticity is to be found between two prices or two points on the demand
curve, we use arc elasticity
• Income elasticity of demand is the percentage change in quantity demanded of a commodity as a result of a
percentage change in income of the consumer. Goods and services are classified as luxuries, normal or
inferior, depending on the responsiveness of spending on a product relative to percentage change in
income.
• The cross elasticity of demand is the percentage change in the quantity demanded of commodity X as a
result of a percentage change in the price of some related commodity Y. Products can be substitutes, and
their cross elasticity is then positive; cross elasticity is negative for products that are complements.
• Advertisement elasticity of sales or promotional elasticity of demand measures the responsiveness of a
good’s demand to changes in the firm’s spending on advertising.
• Forecasting of demand is the art and science of predicting the probable demand for a product or a service
at some future date on the basis of certain past behaviour patterns of some related events and the
prevailing trends in the present.
• The commonly available techniques of demand forecasting are survey of buyers’ intentions, collective
opinion method, expert opinion method, barometric method, and statistical methods such as trend
projection method, graphical method, least square method, regression analysis, and market studies such
as controlled experiments, and controlled laboratory experiments,
UNIT – 2 : THEORY OF CONSUMER BEHAVIOUR
LEARNING OUTCOMES
At the end of this unit, you should be able to:

♦ Explain the meaning of utility.
♦ Describe how consumers try to maximize their satisfaction by spending on different

goods.
♦ Explain the law of diminishing marginal utility with examples.
♦ Describe the concept of consumer surplus with examples.
♦ Describe the meaning of indifference curve and the price line and show how these help in explaining
consumer equilibrium.
2.0 NATURE OF HUMAN WANTS

In economics, the term ‘want’ refers to a wish, desire or motive to own or/and use goods and services that give
satisfaction. Wants may arise due to physical, psychological or social factors. Since the resources are limited, we
need to make a choice between the urgent wants and the not so urgent wants.
1. All wants of human beings exhibit some characteristic features.
2. Wants are unlimited in number. All wants cannot be satisfied.
3. Wants differ in intensity. Some are urgent ,others are less intensely felt
4. Each want is satiable
5. Wants are competitive. They compete each other for satisfaction because resources are scarce in relation
to wants
6. Wants are complementary. Some wants can be satisfied only by using more than one good or group of
goods
7. A particular want may be satisfied in alternative ways
8. Wants are subjective and relative.
9. Wants vary with time, place, and person
10. Some wants recur again whereas others do not occur again and again
11. Wants may become habits and customs
12. Wants are affected by income, taste, fashion, advertisements and social norms and customs
13. Wants arise from multiple causes such as physical and psychological instincts, social obligations and
individual’s economic and social status
2.1 CLASSIFICATION OF WANTS

In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
Necessaries are those which are essential for living. Necessaries are further sub-divided into necessaries for life or
existence, necessaries for efficiency and conventional necessaries. Necessaries for life are things necessary to meet
the minimum physiological needs for the maintenance of life such as minimum amount of food, clothing and shelter.
Man requires something more than the necessities of life to maintain longevity, energy and efficiency of work, such
as nourishing food, adequate clothing, clean water, comfortable dwelling, education, recreation etc. These are
necessaries for efficiency. Conventional necessaries arise either due to pressure of habit or due to compelling social
customs and conventions. They are not necessary either for existence or for efficiency.
Comforts:
While necessaries make life possible comforts make life comfortable and satisfying. Comforts are less urgent than
necessaries. Tasty and wholesome food, good house, clothes that suit different occasions, audio-visual and labour
saving equipments etc .make life more comfortable.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not essential for living. Items such as
expensive clothing, exclusive vintage cars, classy furniture and goods used for vanity etc. fall under this category.
The above categorization is not rigid as a thing which is a comfort or luxury for one person or at one point of time
may become a necessity for another person or at another point of time. As all of us are aware, the things which were
considered luxuries in the past have become comforts and necessaries today.
2.2 WHAT IS UTILITY?

The concept of utility is used in neo classical Economics to explain the operation of the law of demand. Following
Jeremy Bentham, John Stuart Mill, and other nineteenth-century British economist-philosophers, economists apply
the term utility to "that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or
happiness”. Utility is thus the want satisfying power of a commodity. The utility of a consumer is a measure of the
satisfaction that the consumer expects to obtain from consumption of goods and services when he spends money on
a stock of commodity which has the capacity to satisfy his want. Utility is thus the anticipated satisfaction by the
consumer, and satisfaction is the tangible satisfaction derived.
A commodity has utility for a consumer even when it is not consumed. Utility is a subjective and relative entity and
varies from person to person. A commodity has different levels of utility for the same person at different places or at
different points of time. It should be noted that utility is not the same thing as usefulness. From the economic
standpoint, even harmful things like liquor may be said to have utility because people want them. Thus, in
Economics, the concept of utility is ethically neutral.
Utility hypothesis forms the basis of the theory of consumer behaviour. From time to time, different theories have
been advanced to explain consumer behaviour and thus to explain consumer’s demand for the product. Two
important theories are (i) Marginal Utility Analysis propounded by Alfred Marshall, and (ii) Indifference Curve Analysis
propounded by J.R. Hicks and R.G.D.Allen.
2.3 THE MARGINAL UTILITY ANALYSIS

The marginal utility theory, formulated by Alfred Marshall, a British economist, seeks to explain how a consumer
chooses to spend his income on different goods and services so as to maximize his utility. Marginal utility theory
treats consumers as striving to maximize utility which is a quantitative measure of the consumer’s well-being or
satisfaction. According to Marshall, utility is the numerical score in terms of’utils’ representing the satisfaction that a
consumer obtains from the consumption of a particular good. (Utils refer to the hypothetical measuring unit of utility).
This theory is based on certain assumptions. But before stating the assumptions, let us understand the meaning of
the terms total utility and marginal utility.
(a) Total utility: Assuming that utility is quantitatively measurable and additive, total utility may be defined as
the sum of utility derived from different units of a commodity consumed by a consumer. Total utility is the
sum of marginal utilities derived from the consumption of different units i.e.
TU= MU1+MU2+.....+MUn
WhereMU1, MU2,.....,MUn etc are marginal utilities of the successive units of a commodity.
(b) Marginal utility: The marginal utility of a good or service is the change in total utility generated by
consuming one additional unit of that good or service. In other words, it is the utility derived from the
marginal or one additional unit consumed or possessed by the individual.
Marginal utility = the addition made to the total utility by the addition of consumption of one more unit of a
commodity.
Symbolically,
MUn = TUn - TUn-1

Where,
MUn is the marginal utility of the nth unit,
TUn is the total utility of the nth unit, and
TUn-1 is the total utility of the (n-1)th unit.
2.3.1. Assumptions of Marginal Utility Analysis

The marginal utility analysis is stated with respect to certain conditions. It simply means that this law has certain
assumptions and without these, the law may not hold true.
(1) Rationality: A consumer is rational and attempts to attain maximum satisfaction from his limited money
income.
(2) Cardinal Measurability of Utility: According to the neoclassical economists, utility is a cardinal concept
i.e., utility is a measurable and quantifiable entity. It implies that utility can be measured in cardinal numbers
and may be assigned a cardinal number like 1, 2, 3 etc. Marshall and some other economists used a
psychological unit of measurement of utility called utils.Thus, a person can say that he derives utility equal
to 10 utils from the consumption of 1 unit of commodity A and 5 from the consumption of 1 unit of
commodity B. Since a consumer can quantitatively express his utility, he can easily compare different
commodities and express which commodity gives him greater utility and by how much. Utilities from
different units of the commodity can be added as well.
(3) According to this theory, money is the measuring rod of utility. The amount of money which a person is
prepared to pay for a unit of a good, rather than go without it, is a measure of the utility which he derives
from the good.
(4) The theory also assumes all the other factors ‘constant’ such as price of the commodity, tastes and
preferences, income, habits, temperament and fashion. If any of these changes, the marginal utility may not
decline and thus the law would not hold true.
(5) The theory assumes continuity in consumption and that there is no time gap or interval between
consumption of different units.
(6) The different units of the commodity consumed are assumed to be homogeneous or identical in nature. If
the units show variation or differ in taste, quality or any such similar aspects, then the law may not hold true.
If successive units are of superior quality, diminishing utility may not occur.
(7) The different units consumed should consist of standard units. For instance spoonfuls of juice or spoonfuls
of coffee are too small units and in such cases we could consider the normal units as a glass of juice or a
cup of coffee. Moreover, the commodity which is consumed by the consumer should be divisible in nature.
(8) The assumption of constancy of the marginal utility of money holds that the marginal utility of money
remains constant throughout when the individual is spending money on a good. This assumption, although
not realistic, has been made in order to facilitate the measurement of utility of commodities in terms of
money. If the marginal utility of money changes as income changes, the measuring-rod of utility becomes
unstable and therefore would be inappropriate for measurement.
(9) The hypothesis of independent utility implies that the total utility which a person gets from the whole
collection of goods purchased by him is simply the sum total of the separate utilities of the goods. The
theory ignores complementarity between goods.
2.3.2 The Law of Diminishing Marginal Utility

One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility.
The law of diminishing marginal utility which states that each successive unit of a good or service consumed adds
less to total utility than the previous unit, is based on an important fact that while total wants of a person are virtually
unlimited, each single want is satiable i.e., each want is capable of being satisfied. Since each want is satiable, as a
consumer consumes more and more units of a good, the intensity of his want for the good goes on decreasing and a
point is reached where the consumer no longer wants it. Thus, the greater the amount of a good a consumer has, the
less an additional unit is worth to him or her.
Marshall, who was the exponent of the marginal utility analysis, stated the law as follows:
“The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every
increase in the stock that he already has.”In other words, ‘as a consumer increases the consumption of any one
commodity keeping constant the consumption of all other commodities, the marginal utility of the variable commodity
must eventually decline”.
This law describes a very fundamental tendency of human nature. In simple words, it says that as a consumer
consumes more units of a good, the extra satisfaction that he derives from an extra unit of a good goes on falling. It
is to be noted that it is the marginal utility and not the total utility which declines with the increase in the consumption
of a good.
We may illustrate the law with the help of an example. Consider Table 6, in which we have presented the total utility
and marginal utility derived by a person from chocolate bars consumed per day keeping constant all other factors
that affect utility.
Table 6 : Total and Marginal Utility Schedule
Quantity of chocolate bar

Total utility Marginal utility
consumed per day
1 20 20
2 34 14
3 45 11
4 50 5
5 50 0
6 46 -4
When one chocolate bar is consumed, the total utility derived by the person is 20 utils (unit of utility) and the marginal
utility derived is also 20 utils. With the consumption of 2nd chocolate bar, the total utility rises to 34 and the
corresponding marginal utility is14.With the second chocolate bar the consumer enjoys greater total utility: but the
extra utility derived from the second is smaller than that he derived from the first.
We see that till the consumption of chocolate bars increases to 4, the marginal utility from the additional chocolate
bars goes on diminishing (i.e., the total utility goes on increasing at a diminishing rate). The 5th chocolate bar adds
no utility and therefore, the total utility remains the same at 50. At this level of consumption, the consumer reaches
the ‘satiation’ point and gets no extra satisfaction or utility from consuming more of it. Once this point of satiation is
reached, the consumer would refuse any extra unit of chocolate even if it were free.
However, if the chocolate bars consumed increases to 6, instead of giving positive marginal utility, the sixth
chocolate bar gives negative marginal utility or disutility and it may cause him discomfort. We find that consuming the
6 th chocolate bar actually reduces the consumer’s total utility from 50 to 46.
From table 6, we find that for every one-unit increment in chocolate consumption, the marginal utility is equal to the
change in total utility. Total utility increases every time the consumer consumes more units of chocolate bar till he
reaches the point of satiation, but the additional utility he derives from each successive chocolate bar gets smaller
and smaller as he consumes more. Putting it differently, the rate at which total utility increases gets smaller and
smaller as consumption increases.
From Table 6, we also find that there are some well defined relationships between total utility and marginal utility.
(1) Total utility rises as long as MU is positive, but at a diminishing rate because MU is diminishing
(2) Marginal utility diminishes throughout
(3) When marginal utility is zero, the total utility is maximum. It is the satiation point.
(4) When marginal utility is negative, total utility is diminishing
(5) MU is the rate of change of total utility or it is the slope of TU curve
(6) MU can be positive ,zero or negative
The information in Table 6 above can be graphically presented to show the relationship between total utility and
marginal utility (Fig. 13).
Fig. 13:Utility Derived from Chocolates Consumed Per Day

In Figure 13, we see that there is a close relationship between the graph of total utility in panel (a) and the
corresponding graph of marginal utility in panel (b). Diminishing marginal utility is seen in both panels of the figure
13; in panel (a), by the positive but decreasing slope (flattening out) of the total utility curve and in panel (b), by the
downward sloping marginal utility curve.
The marginal utility curve shows how marginal utility depends on the quantity of a good or serviceconsumed. As can
be seen from the figure, the marginal utility curve goes on declining throughout.
The principle of diminishing marginal utility is not always true. A few exceptions however, have been pointed out by
some economists. But it is true in large majority of cases, so that it serves as a foundation for the analysis of
consumer behaviour.
2.3.3 Limitations and Exceptions of the Law of Diminishing Marginal Utility

In the consumption of most goods and services, and for most people, the principle of diminishing marginal utility
holds true. However, the law of diminishing marginal utility has certain exceptions and is valid only under certain
conditions.
(1) The law of diminishing marginal utility is based on rigorous assumptions such as cardinal measurability of
utility, constancy of marginal utility of money, continuous consumption, homogeneity of units consumed.
The law would operate only when these unrealistic assumptions are met.
(2) Utility is not in fact independent. The shape of the utility curve may be affected by the presence or absence
of articles which are substitutes or complements. The utility obtained from tea may be seriously affected if
no sugar is available and the utility of bottled soft drinks will be affected by the availability of fresh juice.
(3) The law is not universal. There are many instances where the marginal utility does not fall or quite the
opposite may increase with increase in consumption or stock obtained. Such cases are considered as
exceptions to this law. For example, the law may not apply in the following situations
• The law may not apply in the case of prestigious goods and articles like gold, cash, diamonds etc.
where a greater quantity may increase the utility rather than diminish it.
• The law also may not hold well in the case of hobbies, rare collections etc where, with every
addition to the collection, the marginal utility will go on rising. Similarly, people who seek greater
knowledge and information will be more satisfied with every additional information secured by
them.
• The law may not be operating in cases such as creative art, painting, music, poetry etc as more of
these would generate greater satisfaction.
• The law does not hold good in the case of habit forming commodities like alcohol, cigarettes, and
computer games etc. because those who are habituated into these may experience increasing
utility with every additional intake.
• The law also fails in the case of people with miserly behaviour as accumulation of every additional
unit of money would give them greater levels of satisfaction.
However, we should keep in mind that in all the above mentioned cases, the fundamental assumptions necessary for
the law to operate are not met and as such they are not exceptions in the real sense.
2.3.4 Consumer Equilibrium in Single Commodity Case

The Law of diminishing marginal utility helps us to understand how a consumer reaches equilibrium .in case of a
single good. It states that as the quantity of a good with the consumer increases, marginal utility of the good
decreases. In other words, the marginal utility curve is downward sloping. A consumer will go on buying a good till
the marginal utility of the good becomes equal to the market price. In other words, the consumer will be in equilibrium
(will be deriving maximum satisfaction) in respect of the quantity ofone good when marginal utility of that good is
equal to its price.
Fig:14 Consumer Equilibrium –Single Commodity Case
In figure 14 , the consumer is in equilibrium at point E with OQ quantity of commodity .We find that at point E, the
marginal utility of the good for the consumer is equal to its price.ie MUx= Px.
What happens when there is a change in the price of the good? The equality between marginal utility and price is
disturbed when the price of the good falls. The consumer will consume more of the good so as to restore the equality
between the marginal utility and price. The marginal utility from the good will fall when he consumes more of the
good. He will continue consuming more till the marginal utility becomes equal to the new lower price. On the other
hand, when price of the good increases, he will buy less so as to equate the marginal utility to the higher price. We
can say that the downward sloping demand curve is directly derived from the marginal utility curve.
Figure14 above illustrates this case. At price P the consumer is at equilibrium at E; MUX = P. When price falls to P1,
the consumer extend his consumption to reach E1 where his MUX = P1.
MUX
The marginal utility of money spent on X MU m = =1
PX
In reality, a consumer spends his income on more than one good. In such cases, consumer equilibrium is
explained with the law of Equi-Marginal utility. According to this law, the consumer will be in equilibrium when
he is spending his money on different goods and services in such a way that the marginal utility of each good is
proportional to its price and the last rupee spent on each commodity yields him equal marginal utility.
The law states that the consumer is said to be at equilibrium, when the following condition is met:
MUx MUy
= = MUM
Px Py
MUx P
Or = x = MUM
MUy Py
MUx Px
Or =
MUy Py
2.4 CONSUMER SURPLUS

The concept of consumer surplus was propounded by Alfred Marshall. Consumer surplus is a measure of welfare
that people gain from consuming goods and services. It measures the benefits buyers receive from participating in a
market. This concept occupies an important place not only in economic theory but also in economic policies of
government and in decision-making of business firms.
The demand for a commodity depends on the utility of that commodity to a consumer. If a consumer gets more utility
from a commodity, he would be willing to pay a higher price and vice-versa. The willingness to payof each individual
consumer based on his utility determines the demand curve. When price is less than or equal to the willingness to
pay, the potential consumer purchases the good.
Itis common knowledge that consumers generally are ready to pay more for certain goods than what they actually
pay for them. This extra satisfaction which consumers get from their purchase of a good is referred to as consumer
surplus by Alfred Marshall. Consumer surplus is defined as the difference between the total amount that consumers
are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they
actually do pay (i.e. the market price).
Marshall defined the concept of consumer surplus as the “excess of the price which a consumer would be
willing to pay rather than go without a thing over that which he actually does pay”, is called consumers
surplus.”
Thus, consumer surplus = what a consumer is ready to pay - what he actually pays.
The concept of consumer surplus is derived from the law of diminishing marginal utility. As we know, according to the
law of diminishing marginal utility, the more of a thing we have, the lesser the marginal utility it has. In other words,
as we purchase more of a good, its marginal utility goes on diminishing. The consumer is in equilibrium when the
marginal utility of a good is equal to its price i.e., he purchases that many number of units of a good at which
marginal utility is equal to price (It is assumed that perfect competition prevails in the market). Since the price is the
same for all units of the good he purchases, he gets extra utility for all units consumed by him except for the one at
the margin. This extra utility or extra surplus for the consumer is called consumer surplus.
Consider Table 7 in which we have illustrated the measurement of consumer surplus in case of commodity X. There
is only one price for a commodity in the market at a particular point of time. The price of X is assumed to be Rs. 20.
Table 7: Measurement of Consumer Surplus
Marginal Utility (worth

No. of units Price (`Rs) Consumer Surplus
Rs)
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –
We see from the above table that when the consumer’s consumption increases from 1 to 2 units,
his marginal utility falls from 30 to 28. His marginal utility goes on diminishing as he increases his consumption of
good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that unit, and
since market price is assumed to be at Rs.20, the consumer enjoys a surplus on every unit of purchase till the 6th
unit. Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs30 and price fixed is Rs 20,
thus he is deriving a surplus of ` 10. Similarly, when he purchases 2 units of X, he enjoys a surplus of 8 [28 – 20].
This continues and he enjoys consumer surplus equal to 6, 4, 2 respectively from 3rd, 4th and 5th unit. When he
buys 6 units, he is in equilibrium because his marginal utility is equal to the market price or he is willing to pay a sum
equal to the actual market price and therefore, he enjoys no surplus. Thus, given the price of Rs 20 per unit, the total
surplus which the consumer will get, is worth 10 + 8 + 6 + 4 + 2 + 0 = 30.
The concept of consumer surplus is closely related to the demand curve for a product. The demand curve reflects
buyer’s willingness to pay; we can also use it to measure consumer surplus. As we know, the height of the demand
curve measures the value buyers place on the good as measured by their willingness to pay for it. We have already
seen above that the difference between the willingness to pay and the market price is each buyer’s consumer
surplus. The difference between his willingness to pay and the price that he actually pays is the net gain to the con-
sumer, the individual consumer surplus.
The total consumer surplus in a market which is the sum of all individual consumer surpluses in a market, is equal to
the area below the market demand curve but above the price. The term consumer surplus is often used to refer to
both individual and total consumer surplus.
Thus, the total area below the demand curve and above the price is the sum of the consumer surplus of all buyers in
the market.
The concept of consumer surplus can be illustrated graphically. Consider figure 15. On the X-axis we measure the
amount of the commodity and on the Y-axis the marginal utility and the price of the commodity. MU is the marginal
utility curve which slopes downwards, indicating that as the consumer buys more units of the commodity, its marginal
utility falls. Marginal utility shows the price which a person is willing to pay for the different units rather than go
without them. If OP is the price that prevails in the market, then the consumer will be in equilibrium when he buys OQ
units of the commodity, since at OQ units, marginal utility is equal to the given price OP. The last unit, i.e., Qth unit
does not yield any consumer surplus because here price paid is equal to the marginal utility of the Qth unit. For all
units before the Qth unit, the marginal utility is greater than price and thus these units fetch consumer surplus to the
consumer.
Fig. 15: Marshall’s Measure of Consumer Surplus

In Figure 15, the total utility is equal to the area under the marginal utility curve up to point Q i.e. ODRQ. But, given
the price equal to OP, the consumer actually pays OPRQ. The consumer derives extra utility equal to DPR which is
nothing but consumer surplus.(The portion of demand curve RD1 is not relevant for our consumer as MUx is less
than Px in this part and therefore, the consumer will not buy any quantity beyond Q.)
The consumer welfare derived from a good is the benefit a consumer gets from consuming that good minus what the
consumer paid to buy the good. Consumer surplus is the buyer's net gain from purchasing a good. Graphically, it is
the triangular area below the demand curve and above the price line. The size of the consumer surplus triangle
depends on the price of the good. A rise in the price of a good reduces consumer surplus; a fall in the price increases
consumer surplus. Thus, a higher price results in a smaller consumer surplus and a lower price generates a larger
consumer surplus. The change in consumer surplus on account of a fall in price can be illustrated with the help of
figure 16.
Fig.16: Change in Consumer Surplus Due to a Fall In Price

A fall in price from P to P1 increases consumer surplus from APE to A P1F.The increase in consumer surplus has
two components.
(a) The increase in consumer surplus of existing buyers who were earlier paying price P (the rectangle marked
b).
(b) The consumer surplus now available to the new buyers who started buying the commodity due to lower
prices (the triangle c)
2.4.1 Applications
The concept of consumer surplus has important practical applications. Few such applications are listed below:
(1) Consumer surplus is a measure of the welfare that people gain from consuming goods and services. It is
very important to a business firm to reflect on the amount of consumer surplus enjoyed by different
segments of their customers because consumers who perceive large surplus are more likely to repeat their
purchases.
(2) Understanding the nature and extent of surplus can help business managers make better decisions about
setting prices. If a business can identify groups of consumers with different elasticity of demand within their
market and the market segments which are willing and able to pay higher prices for the same products, then
firms can profitably use price discrimination.
(3) Large scale investment decisions involve cost benefit analysis which takes into account the extent of
consumer surplus which the projects may fetch.
(4) Knowledge of consumer surplus is also important when a firm considers raising its product prices
Customers who enjoyed only a small amount of surplus may no longer be willing to buy products at higher
prices. Firms making such decisions should expect to make fewer sales if they increase prices.
(5) Consumer surplus usually acts as a guide to finance ministers when they decide on the products on which
taxes have to be imposed and the extent to which a commodity tax has to be raised. It is always desirable
to impose taxes or increase the rates of taxes on commodities yielding high consumer surplus because the
loss of welfare to citizens will be minimal.
2.4.2 Limitations
It is often argued that this concept of consumer surplus is hypothetical and illusory. In real life, the surplus
satisfaction cannot be measured accurately.
(1) Consumer surplus cannot be measured precisely - because it is difficult to measure the marginal utilities of
different units of a commodity consumed by a person.
(2) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the
consumer surplus is always infinite.
(3) The consumer surplus derived from a commodity is affected by the availability of substitutes.
(4) There is no simple rule for deriving the utility scale of articles which are used for their prestige value (e.g.,
diamonds).
(5) Consumer surplus cannot be measured in terms of money because the marginal utility of money changes
as purchases are made and the consumer’s stock of money diminishes. (Marshall assumed that the
marginal utility of money remains constant. But this assumption is unrealistic).
(6) The concept can be accepted only if it is assumed that utility can be measured in terms of money or
otherwise. Many modern economists believe that this cannot be done.
2.5 INDIFFERENCE CURVE ANALYSIS

In the last section, we have discussed the marginal utility analysis of demand. A very popular alternative and a more
realistic method of explaining consumer demand is the ordinal utility approach. This approach uses a different tool
namely indifference curve to analyse consumer behaviour and is based on consumer preferences. The approach is
based on the belief that that human satisfaction, being a psychological phenomenon, cannot be measured
quantitatively in monetary terms as was attempted in Marshall’s utility analysis. Therefore, it is scientifically more
sound to order preferences than to measure them in terms of money. The consumer preference approach is,
therefore, an ordinal concept based on ordering of preferences compared with Marshall’s approach of cardinality.
2.5.0 Assumptions Underlying Indifference Curve Approach

(i) The foundation of consumer behaviour theory is the assumption that the consumer knows his own tastes
and preferences and possesses full information about all the relevant aspects of economic environment in
which he lives.
(ii) The consumer is rational and tends to take rational actions that result in a more preferred consumption
bundle over a less preferred bundle.
(ii) The indifference curve analysis assumes that utility is only ordinally expressible. The consumer is capable
of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus, if he is given
various combinations say A, B, C, D and E, he can rank them as first preference, second preference and so
on. However, if a consumer happens to prefer A to B, he cannot tell quantitatively how much he prefers A to
B.
(iii) Consumer choices are assumed to be transitive. If the consumer prefers combination A to B, and B to C,
then he must prefer combination A to C. In other words, he has a consistent consumption pattern.
(iv) If combination A has more commodities than combination B, then A must be preferred
to B. This is sometimes referred to as the “more is better” assumption or the assumption of non-satiation.
2.5.1 Indifference Curves

The ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based on indifference
curve which represent the consumer’s preferences graphically. An indifference curve is a curve which represents all
those combinations of two goods which give same satisfaction to the consumer. Since all the combinations on an
indifference curve give equal satisfaction to the consumer, the consumer is completely indifferent among them. Or, it
represents the set of all bundles of goods that a consumer views as being equally desirable. In other words, since all
the combinations provide the same level of satisfaction the consumer prefers them equally and does not mind which
combination he gets. An Indifference curve is also called iso-utility curve or equal utility curve.
To understand indifference curves, let us consider the example of a consumer who has one unit of food and 12 units
of clothing. Now, we ask the consumer how many units of clothing he is prepared to give up to get an additional unit
of food, so that his level of satisfaction does not change. Suppose the consumer says that he is ready to give up 6
units of clothing to get an additional unit of food. We will have then two combinations of food and clothing giving
equal satisfaction to the consumer: Combination A which has 1 unit of food and 12 units of clothing, and combination
B which has 2 units of food and 6 units of clothing. Similarly, by asking the consumer further how much of clothing he
will be prepared to forgo for successive increments in his stock of food so that his level of satisfaction remains
unaltered, we get various combinations as given in table 8:
Table 8 : Indifference Schedule
Combination Food Clothing MRS

A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1
Now, if we plot the above schedule, we will get the following figure.
In Figure 17, an indifference curve IC is drawn by plotting the various combinations given in the indifference
schedule. The quantity of food is measured on the X axis and the quantity of clothing on the Y axis. As in indifference
schedule, the combinations lying on an indifference curve will give the consumer the same level of satisfaction.
Fig. 17: A Consumer’s Indifference Curve
2.5.2 Indifference Curve Map

The entire utility function of an individual can be represented by an indifference curve map which is a collection of
indifference curves in which each curve corresponds to a different level of satisfaction. In short, a set of indifference
curves is called an indifference curve map. Each indifference curve is a set of points and each point shares a
common level of utility with the others. Combinations of goods lying on indifference curves which are farther from the
origin are preferred to those on indifference curves which are closer to the origin. Moving upward and to the right
from one indifference curve to the next represents an increase in utility, and moving down and to the left represents a
decrease. An indifference curve map thus depicts the complete picture of consumer tastes and preferences.
In Figure 18, an indifference curve map of a consumer is shown which consists of three indifference curves.
We have marked good X on X-axis and good Y on Y-axis. It should be noted that while the consumer is indifferent
among the combinations lying on the same indifference curve, he certainly prefers the combinations on the higher
indifference curve to the combinations lying on a lower indifference curve because a higher indifference curve
signifies a higher level of satisfaction. Thus, while all combinations of IC1 give him the same satisfaction, all
combinations lying on IC2 give him greater satisfaction than those lying on IC1.
Fig. 18 : Indifference Map
2.5.3. Marginal Rate of Substitution

The Marginal Rate of Substitution (MRS) is the rate at which a consumer is prepared to exchange goods X and Y,
holding the level of satisfaction constant (i.e., moving along an indifference curve).
The marginal rate of substitution along any segment of an indifference curve refers to the maximum rate at which a
consumer would willingly exchange units of Y for units of X. The MRS at any point on the indifference curve is equal
to the (absolute value of) the slope of the curve at that point. When measured at a point, the MRS xy tells us the
maximum rate at which a consumer would willingly trade good Y for a infinitesimal bit more of good X.
Consider Table-8. In the beginning the consumer is consuming 1 unit of food and 12 units of clothing. Subsequently,
he gives up 6 units of clothing to get an extra unit of food, his level of satisfaction remaining the same. The MRS here
is 6. Likewise when he moves from B to C and from C to D in his indifference schedule, the MRS are 2 and 1
respectively. Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a unit
gain of X in such a manner that the level of satisfaction remains the same.
Figure 19: Diminishing Marginal Rate of Substitution
We notice that MRS is falling i.e., as the consumer has more and more units of food, the trade –off or rate of
substitution becomes smaller and smaller; i.e. he is prepared to give up less and less units of clothing.( Refer figure
19). When a consumer moves down his indifference curve, he gains utility from the consumption of additional units of
good X, but loses an equal amount of utility due to reduced consumption of Y. But at each step, the utility levels from
which the consumer begins is different. At point A in figure 19, the consumer consumes only a small quantity of food;
and therefore his marginal utility of food at that point is high. At A, then, an additional unit of food adds a lot to his
total utility. But at A he already consumes a large quantity of clothing; his marginal utility of clothing at that point is
low. This means that it takes a large reduction in the quantity of clothing consumed to counterbalance the increased
utility he gets from the extra unit of food.
On the contrary, consider point C. we find that the consumer consumes a much larger quantity of food and a much
smaller quantity of clothing than at point A. This means that an additional unit of food adds only lesser utility, and a
unit of clothing forgone costs more utility, than at point A. So the consumer is willing to give up less units of clothing
in return for another unit of food at C(he gives up only 2 units of clothing for 1unit of food, whereas he gives up 6
units of clothing at point A for one unit of food).
Moving down the indifference curve—reducing consumption of clothing and increasing food consumption—will
produce two opposing effects on the consumer’s total utility: reduction in total utility due to reduced consumption of
clothing, and increase in total utility due to higher food consumption. In order to keep the levels of satisfaction
constant, these two effects must exactly cancel out as the consumer moves down the indifference curve. The
principle of diminishing marginal rate of substitution thus states that the more of good Y a person consumes in
proportion to good X, the less Y he or she is willing to substitute for another unit of X.
There are two reasons for this.
1. The want for a particular good is satiable so that when a consumer has more of it, his intensity of want for it
decreases. Thus, in our example, when the consumer has more units of food, his intensity of desire for
additional units of food decreases.
2. Most goods are imperfect substitutes of one another. MRS would remain constant if they could substitute
one another perfectly.
We know that along the indifference curve:
(Change in total utility due to lower clothing consumption) = (Change in total utility due to higher food consumption)
Change in total utility due to a change in clothing consumption = MU c × ΔQ c
Change in total utility due to a change in food consumption = MUf × ΔQf
Therefore, along the indifference curve:−MUc × ΔQc = MUf × ΔQf
Note that the left-hand side of the equation has a minus sign as it represents the loss in total utility from decreased
clothing consumption. This must equal the gain in total utility from increased food consumption, represented by the
right-hand side of the equation. Along the indifference curve:
∆Qc – MUf
=
∆Qf MUc
To generalize, the marginal rate of substitution of X for Y (MRSxy) is the slope of the indifference curve.
MUx
MRS xy =
MUy
As the number of units of Y the consumer is willing to sacrifice gets lesser and lesser, the marginal rate of
substitution gets smaller and smaller as we move down and to the right along an indifference curve. That is, the
indifference curve becomes flatter (less sloped) as we move down and to the right.
2.5.4 Properties of Indifference Curves

The following are the main characteristics or properties of indifference curves:
(i) Indifference curves slope downward to the right: This property implies that the two commodities can be
substituted for each other and when the amount of one good in the combination is increased, the amount of
the other good is reduced. This is essential if the level of satisfaction is to remain the same on an
indifference curve.
(ii) Indifference curves are always convex to the origin :It has been observed that as more and more of one
commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the
commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution. Thus, in our
example of food and clothing, as a consumer has more and more units of food, he is prepared to forego
less and less units of clothing. This happens mainly because the want for a particular good is satiable and
as a person has more and more of a good, his intensity of want for that good goes on diminishing. In other
words, the subjective value attached to the additional quantity of a commodity decreases fast in relation to
the other commodity whose total quantity is decreasing. This diminishing marginal rate of substitution gives
convex shape to the indifference curves.
However, there are two extreme situations.
(1) When two goods are perfect substitutes of each other, the consumer is completely indifferent as to
which to consume and is willing to exchange one unit of X for one unit of Y. His indifference curves
for these two goods are therefore straight, parallel lines with a constant slope along the curve, or
the indifference curve has a constant MRS.[Figure 20(A)].
(2) Goods are perfect complements when a consumer is interested in consuming these only in fixed
proportions. When two goods are perfect complementary goods (e.g. left shoe and right shoe), the
consumer consumes only bundles like A and B in figure 20(B) in which both X and Y in equal
proportions. With a bundle like A or B, he will not substitute X for Y because an extra piece of the
other good (here a single shoe) is worthless for him. The reason is that neither an additional left
shoe nor a right shoe without a paired one of each, adds to his total utility. In such a case, the
indifference curve will consist of two straight lines with a right angle bent which is convex to the
origin, or in other words, it will be L shaped. [Figure 20(B)] Avery interesting fact about this is that
in the case of perfect complements, the marginal rate of substitution is undefined because an
individual’s preferences do not allow any substitution between goods.
Fig. 20: Indifference Curve of Perfect Substitutes and perfect Complements

(iii) Indifference curves can never intersect each other: No two indifference curves will intersect each other
although it is not necessary that they are parallel to each other. In case of intersection the relationship
becomes logically absurd because it would show that higher and lower levels are equal, which is not
possible. This property will be clear from Figure 21.
Fig. 21 : Intersecting Indifference Curves

In figure21, IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same satisfaction to the
consumer. Similarly since A and C lie on IC2, they give same satisfaction to the consumer. This implies that
combination B and C are equal in terms of satisfaction. But a glance will show that this is an absurd
conclusion because certainly combination C is better than combination B because it contains more units of
commodities X and Y. Thus we see that no two indifference curves can touch or cut each other.
(iv) A higher indifference curve represents a higher level of satisfaction than the lower indifference
curve: This is because combinations lying on a higher indifference curve contain more of either one or both
goods and more goods are preferred to less of them.
(v) Indifference curve will not touch either axes :Another characteristic feature of indifference curve is that it
will not touch the X axis or Y axis. This is born out of our assumption that the consumer is considering
different combination of two commodities. If an indifference curve touches the Y axis at a point P as shown
in the figure 22, it means that the consumer is satisfied with OP units of Y commodity and zero units of X
commodity. This is contrary to our assumption that the consumer wants both commodities although in
smaller or larger quantities. Therefore an indifference curve will not touch either the X axis or Y axis.
Fig. 22: Impossible Indifference Curve
2.5.5 The Budget Line

From the ordinal utility analysis discussed above, we have understood one part of a person’s consumption behavior
namely, consumer preference. A higher indifference curve shows a higher level of satisfaction than a lower one.
Therefore, a consumer, in his attempt to maximise satisfaction will try to reach the highest possible indifference
curve. But in his pursuit of buying more and more goods and thus obtaining more and more satisfaction, he has to
work under two constraints: first, he has to pay the prices for the goods and, second, he has a limited money income
with which to purchase the goods.
Consumers maximize their well-being subject to constraints. The most important constraint all of us face in deciding
what to consume is the budget constraint. In other words, consumers almost always have limited income, which
constrains how much they can consume. A consumer’s choices are limited by the budget available to him. As we
know, his total expenditure for goods and services can fall short of the budget constraint, but may not exceed it.
Algebraically, we can write the budget constraint for two goods X and Y as:
PXQX + PYQY ≤ B
Where
PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X and Y chosen and B is the
total money available to the consumer.
The requirement illustrated by the equation above that a consumer must choose a consumption bundle that costs no
more than his or her income is known as the consumer’s budget constraint.A consumer’s consumption possibilities
are the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices.
We assume that the consumer in our analysis uses up his entire nominal money income to purchase the
commodities. So that his budget constraint is
PXQX + PYQY = B
The following table shows the combinations of Ice cream and chocolates a consumer can buy spending the entire
fixed money income of Rs.100, with the prices Rs 20 and Rs.10 respectively.
Table: 9 Consumption Possibilities

Ice Cream Chocolate
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0
The budget constraint can be explained by the budget line or price line. In simple words, a budget line
shows all those combinations of two goods which the consumer can buy spending his given money income
on the two goods at their given prices. All those combinations which are within the reach of the consumer
(assuming that he spends all his money income) will lie on the budget line. The consumer could, of course,
buy any bundle that cost less than Rs 100.(e.g. Point K )
Fig. 23: Price Line or the Budget Line

It should be noted that any point outside the given price line, say H, will be beyond the reach of the consumer and
any combination lying within the line, say K, shows under spending by the consumer.
The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’ of two
goods. i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other .
The budget line will shift when there is:
• A change in the prices of one or both products with the nominal income of the buyer (budget) remaining the
same.
• A change in the level of nominal income of the consumer with the relative prices of the two goods remaining
the same.
• A change in both income and relative prices
2.5.6 Consumer Equilibrium

Having explained indifference curves and budget line, we are in a position to explain how a consumer reaches
equilibrium position by choosing his optimal consumption bundle, given the constraints. A consumer is in equilibrium
when he is deriving maximum possible satisfaction from the goods and therefore is in no position to rearrange his
purchases of goods. We assume that:
(i) The consumer has a given indifference map which shows his scale of preferences for various combinations
of two goods X and Y.
(ii) He has a fixed money income which he has to spend wholly on goods X and Y.
(iii) Prices of goods X and Y are given and are fixed.
(iv) All goods are homogeneous and divisible, and
(v) The consumer acts ‘rationally’ and maximizes his satisfaction.
Fig. 24 : Consumer’s Equilibrium

To show which combination of two goods X and Y the consumer will buy to be in equilibrium we bring his indifference
map and budget line together.
We know by now, that the indifference map depicts the consumer’s preference scale between various combinations
of two goods and the budget line shows various combinations which he can afford to buy with his given money
income and prices of the two goods. Consider Figure 24, in which IC1, IC2, IC3, IC4 and IC5 are shown together
with budget line PL for good X and good Y. Every combination on the budget line PL costs the same. Thus
combinations R, S, Q, T and H cost the same to the consumer. The consumer’s aim is to maximise his satisfaction
and for this, he will try to reach the highest indifference curve.
Since there is a budget constraint, he will be forced to remain on the given budget line, that is he will have to choose
combinations from among only those which lie on the given price line. Which combination will our hypothetical
consumer choose? A consumer’s optimal choice should satisfy two criteria:
1. It will be a point on his budget line; and
2. It will lie on the highest indifference curve possible
The consumer can arrive this choice moving down his budget line starting from point R .While doing this, he will pass
through a variety of indifference curves (To make the diagram simple, we have drawn only a few). Suppose he
chooses R. We see that R lies on a lower indifference curve IC1, when he can very well afford S, Q or T lying on
higher indifference curves. Similar is the case for other combinations on IC1, like H. Again, suppose he chooses
combination S (or T) lying on IC2. But here again we see that the consumer can still reach a higher level of
satisfaction remaining within his budget constraints i.e., he can afford to have combination Q lying on IC3 because it
lies on his budget line. Now, what if he chooses combination Q? We find that this is the best choice because this
combination lies not only on his budget line but also puts him on the highest possible indifference curve i.e., IC3. The
consumer can very well wish to reach IC4 or IC5, but these indifference curves are beyond his reach given his
money income. Thus, the consumer will be at equilibrium at point Q on IC3. What do we notice at point Q? We notice
that at this point, his budget line PL is tangent to the indifference curve IC3. In this equilibrium position (at Q), the
consumer will buy OM of X and ON of Y.
At the tangency point Q, the slopes of the price line PL and the indifference curve IC3 are equal. The slope of the
MUx
indifference curve shows the marginal rate of substitution of X for Y (MRSxy) which is equal to while the slope
MUy
Px
of the price line indicates the ratio between the prices of two goods i.e.,
Py
At equilibrium point Q,
MUx Px
MRS
= xy =
MUy Py
Thus, we can say that the consumer is in equilibrium position when the price line is tangent to the indifference curve
or when the marginal rate of substitution of goods X and Y is equal to the ratio between the prices of the two goods.
We have seen that the consumer attains equilibrium at the point where the budget line is tangent to the indifference
curve and
MUx MUy
=
Px Py
In fact the slope of the indifference curve points to the rate at which the consumer is willing to give up good Y for
good X. The slope of the budget line tells us the rate at which the consumer is actually able to trade good X and
good Y. When both these are equal, he will be maximizing his satisfaction given the constraints.
The indifference curve analysis is superior to utility analysis: (i) it dispenses with the assumption of measurability of
utility (ii) it studies more than one commodity at a time (iii) it does not assume constancy of marginal utility of money
(iv) it segregates income effect from substitution effect.
SUMMARY
• The existence of human wants is the basis for all economic activities in the society. All desires, tastes and
motives of human beings are called wants in Economics.
• In Economics, wants are classified in to necessaries, comforts and luxuries.
• Utility refers to the want satisfying power of goods and services. It is not absolute but relative. It is a
subjective concept and it depends upon the mental attitude of people.
• There are two important theories of utility, the cardinal utility analysis and ordinal utility analysis.
• The law of diminishing marginal utility states that as a consumer increases the consumption of a commodity,
every successive unit of the commodity gives lesser and lesser satisfaction to the consumer.
• Consumer surplus is the difference between what a consumer is willing to pay for a commodity and what he
actually pays for it.
• Consumer surplus is the buyer's net gain from purchasing a good. Graphically, it is the triangular area below
the demand curve and above the price line.
• A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus
• The indifference curve theory, which is an ordinal theory, shows the household’s preference between
alternative bundles of goods by means of indifference curves.
• Marginal rate of substitution is the rate at which the consumer is prepared to exchange goods X and Y.
• The important properties of an Indifference curve are: Indifference curve slopes downwards to the right, it is
always convex to the origin, two ICs never intersect each other, it will never touch the axes and higher the
indifference curve higher is the level of satisfaction.
• When two goods are perfect substitutes of each other, indifference curves for these two goods are straight,
parallel lines with a constant slope along the curve, or the indifference curve has a constant MRS
• Goods are perfect complements when a consumer is interested in consuming only in fixed proportions.. In
such a case, the indifference curve will consist of two straight lines with a right angle bent which is convex
to the origin, or in other words, it will be L shaped.
• Budget line or price line shows all those combinations of two goods which the consumer can buy spending
his given money income on the two goods at their given prices.
• The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’
of two goods. i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other .
• The budget line will shift when there is: a change in the prices of one or both products with the nominal
income of the buyer (budget) remaining the same or when there is a change in the level of nominal income
of the consumer with the relative prices of the two goods remaining the same.
• A consumer is said to be in equilibrium when he is deriving maximum possible satisfaction from the goods
and is in no position to rearrange his purchase of goods.
The consumer attains equilibrium at the point where the budget line is tangent to the indifference curve and
MUx / Px =MUy /Py = MUz /Pz
UNIT – 3 : SUPPLY
LEARNING OUTCOMES
At the end of this Unit, you should be able to:
♦ Explain the meaning of supply.
♦ List and provide specific examples of determinants of supply and elasticity of supply.
♦ Describe the law of supply.
♦ Describe the difference between movements on the supply curve and shift of the supply curve.
♦ Explain the concept of elasticity of supply with examples.
♦ Illustrate how the concepts of demand and supply can be used to determine price.
3.0 INTRODUCTION
In a market economy, sellers of products and services constitute the supply side.The sellers may include individuals,
firms and governments. As the term ‘demand’ refers to the quantity of a good or service that the consumers are
willing and able to purchase at various prices during a given period of time, the term ‘supply’ refers to the amount of
a good or service that the producers are willing and able to offer to the market at various prices during a given period
of time.
Three important points apply to supply:
(i) Supply refers to what a firm offer for sale in the market, not necessarily to what they succeed in selling.
What is offered may not get sold.
(ii) Supply requires both willingness and ability to supply. Production cost is often the primary influence on
ability.
(iii) Supply is a flow. Supply is identified for a specified time period. The quantity supplied is ‘so much’ per unit
of time, per day, per week, or per year.
3.1 DETERMINANTS OF SUPPLY

Although price is an important consideration in determining the willingness and desire to part with commodities, there
are many other factors which determine the supply of a product or a service. These are discussed below:
(i) Price of the good: Other things being equal, the higher the relative price of a good the greater the quantity
of it that will be supplied. This is because goods and services are produced by the firm in order to earn
profits and, ceteris paribus, profits rise if the price of its product rises.
(ii) Prices of related goods: If the prices of other goods rise, they become relatively more profitable to the firm
to produce and sell than the good in question. When a seller can get a higher price for a good, producing
and selling it becomes more profitable. Producers will allocate more resources towards its production even
by drawing resources from other goods they produce. For example, a rise in the price of comic books will
encourage publishers to shift resources out of the production of other books (such as novels) and use them
in the production of comic books. As another example, if price of wheat rises, the farmers may shift their
land to wheat production away from corn and soya beans. It implies that, if the price of Y rises, the quantity
supplied of X will fall.
(iii) Prices of factors of production: Cost of production is a significant factor that affects supply. If the firm’s
cost exceeds what it can earn from selling the good, the firm sells nothing. A rise in the price of an input
causes a decrease in supply. When the cost of resources such as wages, raw material prices and interest
rates increase, producers decrease the amount they are willing to supply. Lower input costs indeed, make
production more profitable, encourage existing firms to expand production and new firms to enter the
market..
A rise in the price of a particular factor of production will cause an increase in the cost of making those
goods that use a great deal of that factor than in the costs of producing those that use relatively small
amount of the factor. For example, a rise in the cost of land will have a large effect on the cost of producing
wheat and a very small effect on the cost of producing automobiles. Thus, a change in the price of one
factor of production will cause changes in the relative profitability of different lines of production and will
cause producers to shift from one line to another and thus supplies of different commodities will change.
(iv) State of technology: The supply of a particular product depends upon the state of technology also. The
use of new technology in an industry (such as automation) increases production efficiency and reduces
production costs.
Inventions and innovations tend to make it possible to produce more or better goods with the same
resources, and thus they tend to increase the quantity supplied of some products and to reduce the quantity
supplied of products that are displaced. Availability of spare production capacity and the ease with which
factor substitution can be made and the cost of such substitution also determine supply.
(v) Government Policy: Government rules and regulations affect how much firms want to sell or are allowed to
sell. The production of a good may be subject to the imposition of commodity taxes such as excise duty,
sales tax and import duties. These taxes raise the cost of production and so the quantity supplied of a good
would increase only when its price in the market rises. Subsidies and other funding programmes to
producers, on the other hand, reduce the cost of production and thus provide an incentive to the firm to
increase supply. When government imposes restrictions such as import quota on consumer products and
inputs, rationing of input supply etc, production tends to fall.
(vi) Nature of competition and size of industry: Under competitive conditions, supply will be more than that
under monopolized conditions.
(vii) Expectations: Choices of firms in respect of selling the product now or later depends on expectations of
future prices. Sellers compare current prices with future prices. An increase in the anticipated future price of
a good or service reduces its supply today; and if sellers expect a fall in prices in future, more will be
supplied now.
(viii) Number of sellers: If there are large number of firms in the market, supply will be more. Besides, entry of
new firms, either domestic or foreign, causes the industry supply curve to shift rightwards.
Other Factors: The quantity supplied of a good also depends upon government’s industrial and foreign policies,
goals of the firm, infrastructural facilities, natural factors such as weather, floods, earthquake and man- made factors
such as war, labour strikes, communal riots etc.
3.2 THE LAW OF SUPPLY

In general, producers are prepared to sell their product for a price if that price is at least as high as the cost to
produce an additional unit of the product. Therefore, the willingness to supply depends on the price at which the
good can be sold as well as the cost of production for an additional unit of the good. The greater the difference
between those two values, the greater is the willingness of producers to supply the good.
Supply refers to the relationship of quantity supplied of a good with one or more related variables which have an
influence on the supply of the good. Normally, supply is related with price, but it can also be related with other factors
such as the type of technology used, scale of operations etc.
The law of supply can be stated as: Other things remaining constant, the quantity of a good produced and offered for
sale will increase as the price of the good rises and decrease as the price falls.
This law is based upon common sense, because the higher the price of the good, the greater the profits that can be
earned and thus greater the incentive to produce the good and offer it for sale. The law is known to be correct in a
large number of cases. There is an exception however. If we take the supply of labour at very high wages, we may
find that the supply of labour has decreased instead of increasing. Thus, the behaviour of supply depends upon the
phenomenon considered and the degree of possible adjustment in supply.
The behaviour of supply is also affected by the time period under consideration. In the short run, it may not be easy
to increase supply, but in the long run supply can be easily adjusted in response to changes in price.
The law of supply can be explained through a supply schedule and a supply curve. A supply schedule is the tabular
presentation of the law of supply. It shows the different prices of a commodity and the corresponding quantities that
suppliers are willing to offer for sale, with all other variables held constant. Consider the following hypothetical
supply schedule of good X.
Table 10: Supply Schedule of Good ‘X’
Quantity supplied
Price (Rs) (kg)
(per kg)
1 5
2 35
3 45
4 55
5 65
The table shows the quantities of good X that would be produced and offered for sale at a number of alternative
prices. At Re 1, for example, 5 kilograms of good X are offered for sale and at Rs. 3 per kg. 45 kg. would be
forthcoming for sale.
We can now plot the data in table 10 on a graph. In Figure 25, price is plotted on the vertical axis and quantity on the
horizontal axis, and various price-quantity combinations of the schedule 10 are plotted.
Fig. 25 : Supply Curve

When we draw a smooth curve through the plotted points, what we get is the supply curve of good X. The supply
curve is a graphical presentation of the supply schedule. The supply curve shows the quantity of a good that
producers are willing to sell at a given price, holding constant any other factor that might affect the quantity supplied.
The supply curve is thus a relationship between the quantity supplied and the price. To be more precise, the supply
curve shows simultaneously:
(a) the highest quantity willingly supplied by the suppliers at each price and
(b) the minimum price which will induce suppliers to offer the various quantities for sale
The supply curve slopes upwards towards right (positive slope) showing that as price increases, the quantity
supplied of X increases and vice-versa. This direct relationship between price and quantity is reflected in the positive
slope of the supply curve.
The market supply, like market demand, is the sum of supplies of a commodity made by all individual firms or their
supply agencies. The market supply of a commodity gives the amounts of the commodity supplied per time period at
various alternative prices by all the producers of this commodity in the market. It is derived by adding the quantity
supplied by each seller at different prices. The market supply curve for ‘X’ can be obtained by adding horizontally the
supply curves of various firms. The market supply is governed by the law of supply and depends on all the factors
that determine the individual producer’s supply and, in addition, on the number of producers of the commodity in the
market.
3.3 MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR

DECREASE IN THE QUANTITY SUPPLIED
When the supply of a good increase as a result of an increase in its price, we say that there is an increase in the
quantity supplied and there is an upward movement on the supply curve. A rise in market price causes an expansion
of supply; there is a upward movement on the supply curve and producers offer more for sale. When market price
falls, there is contraction of supply as producers have less incentive to offer products for sale in the market. (See
Figure 26)
Fig. 26 : Figure Showing Change in Quantity Supplied as a Result of Price Change
3.4 SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN

SUPPLY
While a change in quantity supplied is a movement along a given supply curve, a change in supply is a shift of the
supply curve. When the supply curve bodily shifts towards the right as a result of a change in one of the factors that
influence the quantity supplied other than the commodity’s own price, we say there is an increase in supply. When
the supply curve shifts to the right, more is offered for sale at each price. In figure 27(i), we find that at price P, the
quantity supplied rises from Q to Q1. When the factors other than price change and cause the supply curve to shift
to the left, we call it decrease in supply. When the supply curve shifts to the left, less quantity is offered for sale at
each price. In figure 27(ii), we find that at price P the quantity supplied falls from Q to Q1.
Fig. 27: Shifts in Supply Curves
Just as in the case of demand curves, a change in the price of a good itself will result in a movement along the
supply curve and a change in quantity supplied. A change in any variable other than own-price will cause a shift in
the supply curve, called a change in supply.
3.5 ELASTICITY OF SUPPLY

The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a change in its price.
Elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by the percentage
change in its price i.e.,
Percentage change in quantity supplied
Es =
Percentage change in Price
Change in quantity supplied
quantity supplied
Or
Change in price
Price
q
∆
q q p
or = ×
p p q
∆
p
Where q denotes original quantity supplied.

∆q denotes change in quantity supplied.
p denotes original price.
∆p denotes change in price.
Example
a. Suppose the price of commodity X increases from Rs 2,000 per unit to Rs 2,100 per unit and consequently
the quantity supplied rises from 2,500 units to 3,000 units. Calculate the elasticity of supply.
Here ∆q = 500 units ∆p = Rs.100
p = Rs. 2000 q = 2500 units
500 2000
∴E s = × = 4
100 2500
Elasticity of Supply = 4.
3.5.0 Types of Supply Elasticity

The elasticity of supply can be classified as under:
(i) Perfectly inelastic supply: If as a result of a change in price, the quantity supplied of a good remains
unchanged, we say that the elasticity of supply is zero or the good has perfectly inelastic supply (Es = 0.).
The vertical supply curve in Figure 28 shows that irrespective of price change, the quantity supplied remains
unchanged. In other words, the quantity supplied is unaffected by any change in price. As the elasticity
rises, the supply curve gets flatter, which shows that the quantity supplied responds more to changes in
price.
Fig. 28: Supply Curve of Zero Elasticity

(ii) Relatively less-elastic supply: If as a result of a change in the price of a good its supply changes less
than proportionately, we say that the supply of the good is relatively less elastic or elasticity of supply is less
than one. In this case, the coefficient of elasticity falls in the range 0 < Es < 1. The percentage change in
quantity is less than the percentage change in price. In other words, the quantity is not very responsive to
price. Figure 29 shows that the relative change in the quantity supplied (∆Q) is less than the relative change
in the price (∆P).
Fig. 29 : Showing Relatively Less Elastic Supply

(iii) Relatively greater-elastic supply :If elasticity of supply is greater than one i.e., when the quantity supplied
of a good changes substantially in response to a small change in the price of the good we say that supply is
relatively elastic. The percentage change in quantity is greater than the percentage change in price. The
coefficient of elasticity falls in the range 1 < E < ∞. Figure 30, shows that the relative change in the quantity
supplied (∆Q) is greater than the relative change in the price.
Fig. 30 : Showing Relatively Greater Elastic Supply

(iv) Unit-elastic : In this case, the coefficient of elasticity is one.(Es = 1). If the relative change in the quantity
supplied is exactly equal to the relative change in the price, the supply is said to be unitary elastic. The
percentage change in quantity is equal to the percentage change in price. Unit elasticity is essentially a
dividing line or boundary between the elastic and inelastic ranges. In Figure31, the relative change in the
quantity supplied (∆Q) is equal to the relative change in the price (∆P).
Fig. 31: Showing Unitary Elasticity

(v) Perfectly elastic supply: At the opposite extreme of zero elasticity supply is perfectly elastic. This occurs
as the price elasticity of supply approaches infinity and the supply curve becomes horizontal. Elasticity of
supply is said to be infinite (E = ∞)or perfectly elastic when nothing is supplied at a lower price and an
infinitesimally small change in price results in an infinitely large change in quantity supplied indicating that
producers will supply any quantity demanded at that price. Figure 32 shows infinitely elastic supply.
Fig. 32: Supply Curve of Infinite Elasticity

In some cases, the elasticity of supply is not constant but varies over the supply curve. Figure 33 shows the case of
an industry with limited capacity for production. For low levels of quantity supplied, firms respond substantially to
changes in price. When there is a small rise in price from P1 to P2 ,the quantity supplied increases more than
proportionately (Q1 to Q2).In this region, firms have idle capacity and therefore when price rises, they respond by
increase in quantity supplied using the idle capacity available. Once firms reach their full capacity, further increase in
production is possible only by building new plants and incurring expenses towards this. To induce firms to increase
output, price must rise substantially (P3 to P4) and supply becomes less elastic.
Fig. 33: Supply curve of Industry with Limited Production Capacity
3.5.1 Measurement of supply-elasticity

The elasticity of supply can be considered with reference to a given point on the supply curve or between two points
on the supply curve. When elasticity is measured at a given point on the supply curve, it is called point elasticity. Just
as in demand, point-elasticity of supply can be measured with the help of the following formula:
dp p
Es = ×
dp q
Es: The Supply function is given as q = -100 + 10p. Find the elasticity of supply using point method, when price is Rs
15.
dq p
E=
s ×
dp q
dq
Since = 10, p = Rs. 15, q = - 100 + 10 (15)
dp
q = 50
15
∴ Es =10×
50
or Es = 3
dq
Where is differentiation of the supply function with respect to price and p and q refer to price and quantity
dp
respectively.
Arc-Elasticity: Arc-elasticity i.e. elasticity of supply between two prices can be found out with the help of the
following formula:
Q 2 – Q1 P2 + P1
Es = ×
Q 2 + Q1 P2 – P1
Where P1 Q1are original price and quantity and P2 Q2are new price and quantity supplied.
Thus, if we have to find elasticity of supply when P1= Rs12, P2 = Rs 15, Q1 = 20 units and Q2= 50 units.
Then using the above formula, we will get supply elasticity as :

50 – 20 15 + 12
Es = ×
50 + 20 15 – 12
30 27
= × + 3.85
=
70 3
3.5.2 Determinants of Elasticity of Supply

The price elasticity of supply depends on the flexibility sellers have, to change the amount of the good they produce
and sell. The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.
Following are the general determinants of elasticity of supply:
1. If increase in production causes substantial increase in costs, producers will have less incentive to increase
quantity supplied in response to increase in price and therefore, price elasticity of supply would be less. If
there are constant costs or negligible rise in costs as output increases, supply will be elastic. Products that
involve more complex production processes or require relatively longer time to produce exhibit lower
elasticity of supply. For example the supply of aircrafts and cruise ships is less elastic compared to supply
of motor bikes.
2. The longer the period of time, the more responsive the quantity supplied to changes in price and the greater
the supply elasticity. A shorter time period does not allow sellers sufficient time to find resources and
alternatives and to adjust their production decisions to changes in price. In the long run, firms can build new
plants or new firms may be able to enter the market and increase the supply.
3. Supply is more elastic when there is large number of producers and there is high degree of competition
among them. Supply elasticity is also higher when there are fewer barriers of entry into the market.
4. Supply will be elastic if firms are not working to full capacity. If spare production capacity is available with
the firms, they can increase output without a rise in costs. The greater the spare capacity available, the
greater will be the elasticity of supply.
5. If key raw materials and inputs are easily and cheaply available, then supply will be elastic. If drawing
productive resources into the industry is easier, the supply curve is more elastic. In case it is difficult to
procure resources economically, the cost of production increases and supply will become less elastic.
6. If firms have adequate stocks of raw materials, components and finished products, they will be able to
respond with higher supply as price rises. Generally, those commodities which can be easily and
inexpensively stored without losing value may have elastic supply.
7. The ease with which factor substitution can be made and the costs of such factor substitution also
determine price elasticity of supply. If the factors of production used in the production of the commodity are
commonly available and can be easily substituted or increased, then the firms will be able to produce
quickly and respond to an increase in price. If a production process involves use of materials which are in
short supply, or those that take longer delivery period or which are highly specialized, then supply elasticity
will be low. If the labour employed is scarce or are required to be highly skilled and specific and if they
require longer training period, then elasticity of supply will be low. For example, physicians in healthcare
industry and chartered accountants in accounting service. .
8. If both capital and labour are occupationally mobile, then the elasticity of supply for a product is higher than
if capital and labour cannot be easily switched. For example, a printing press can easily switch between
printing magazines and greeting cards. Similarly falling prices of a particular vegetable encourage farmers
to switch to the production of another. Products which are more continuously produced have greater supply
elasticity than those which are produced infrequently.
9. Expectations about future prices also affect elasticity of supply. Expectation of substantial rise in prices in
future will make the sellers respond less to a current rise in price.
3.6. EQUILIBRIUM PRICE

In the previous sections, we have discussed both demand and supply theories. We shall now use demand and
supply to determine equilibrium market price. The equilibrium price in a market is determined by the intersection
between demand and supply. It is also called the market equilibrium. At this price, the amount that the buyers want to
buy is equal to the amount that sellers want to sell. The competitive market equilibrium represents the ‘unique’ point
at which both consumers and suppliers are satisfied with price and quantity. Equilibrium price is also called market
clearing price.
The determination of market price is the central theme of micro economic analysis. Hence, micro-economic theory is
also called price theory.
The following table presents the concept of the equilibrium price
Table 11: Supply and Demand Schedule
Price (Rs) Quantity Demanded Quantity Supplied Impact on price

5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward
The equilibrium between demand and supply is depicted in the diagram below. Demand and supply are in
equilibrium at point E where the two curves intersect each other. It means that only at price Rs. 3 the
quantity demanded is equal to the quantity supplied. The equilibrium quantity is 19 units and these are
exchanged at price Rs 3. If the price is more than the equilibrium level, excess supply will push the price
downwards as there are few takers in the market at this price. For example, in Table 11, if price is say Rs5,
quantity demanded is 6 units which is quite less than the quantity supplied (31 units). There will be excess
supply in the market which will force the sellers to reduce price if they want to sell off their product. Hence
the price will fall and continue falling till it reaches the level where the quantity demanded becomes equal to
the quantity supplied. Opposite will happen when quantity demanded is more than the quantity supplied at
a particular price.
Fig. 34: Equilibrium Price
3.6.1 Market Equilibrium and Social Efficiency

Social efficiency represents the net gains to society from all exchanges that are made in a particular market. It
consists of two components: consumer surplus and producer surplus. We have already learned that consumer
surplus is a measure of consumer welfare. There is welfare gain to producers as well when they participate in the
market, namely producer surplus. Producer surplus is the benefit derived by producers from the sale of a unit above
and beyond their cost of producing that unit. This occurs when the price they receive in the market is more than the
minimum price at which they would be prepared to supply. It is represented by the area above the supply curve and
below the price line
Fig. 35: Equilibrium Price and Social Efficiency

For all quantities below OQ, we find that there is a difference between the price that producers are willing to accept
for supplying the good and the price that prevails in the market (P).Producer surplus disappears when market price is
at equilibrium i.e the price at which sellers are willing to offer for sale is equal to the price that they receive.
From figure 35, we find that at price P, when the market is in equilibrium, social efficiency is achieved with both
producers and consumers enjoying maximum possible surplus.
SUMMARY
• Supply means the quantity of goods (or commodities) offered for sale at a particular price at a certain point
of time. Supply always relates to price.
• The determinants of supply other than its own price are: prices of the related goods, prices of factors of
production, state of technology, government policy and other factors.
• The law of supply states that when the price of the good rises, the corresponding quantity supplied
increases and when the price reduces, the quantity supplied also reduces. There is a direct relationship
between price and quantity supplied.
• The supply curve establishes the relationship between the amount of supply and the price. It is an upward
sloping curve showing a positive relationship between price and quantity supplied.
• When the supply of a good increases as a result of an increase in its price we say that there is an increase
in the quantity supplied and there is an upward movement on the supply curve. The reverse is the case
when there is a fall in the price of the good.
• Elasticity of supply means the responsiveness of supply to change in the price of the commodity.
• The elasticity of supply can be classified in to perfectly inelastic supply, relatively less-elastic supply,
relatively greater-elastic supply, unit-elastic and perfectly elastic supply.
• The measurement of supply-elasticity is of two types- point elasticity and arc-elasticity.
• Elasticity of supply can be considered with reference to a given point on the supply curve (point elasticity) or
between two points on the supply curve (arc elasticity).
• The general determinants of elasticity of supply are change in costs as output changes, complexity of
production processes, the time period, number of producers and degree of competition, barriers of entry into
the market, availability of spare production capacity, availability and stocks of key raw materials and
inputs, the ease of factor substitution and mobility and expectations about future prices
• Equilibrium price is one at which the wishes of both the buyers and the sellers are satisfied. At this price, the
amount that buyers want to buy and sellers want to sell will be equal.
• The welfare gain to producers is producer surplus, which is the benefit derived by producers from the sale of
a unit above and beyond their cost of producing that unit. This occurs when the price they receive in the
market is more than the minimum they would be prepared to supply for.
• At equilibrium price, when the market is in equilibrium, social efficiency is achieved with maximum social
surplus to both producers and consumers enjoying maximum possible surplus..
TEST YOUR KNOWLEDGE

1. Demand for a commodity refers to:
(a) desire backed by ability to pay for the commodity.
(b) need for the commodity and willingness to pay for it
(c) the quantity demanded of that commodity at acertain price.
(d) the quantity of the commodity demanded at a certain price during any particular period of time.
2. Contraction of demand is the result of :
(a) decrease in the number of consumers.
(b) increase in the price of the good concerned.
(c) increase in the prices of other goods.
(d) decrease in the income of purchasers.
3. All but one of the following are assumed to remain the same while drawing an individual’s demand curve for
a commodity. Which one is it?
(a) The preference of the individual.
(b) His monetary income.
(c) Price of the commodity
(d) Price of related goods.
4. Which of the following pairs of goods is an example of substitutes?
(a) Tea and sugar.
(b) Tea and coffee.

(c) Pen and ink.
(d) Shirt and trousers.
5. In the case of a straight line demand curve meeting the two axes, the price-elasticity of demand at the mid-
point of the line would be :
(a) 0
(b) 1
(c) 1.5
(d) 2
6. The Law of Demand, assuming other things to remain constant, establishes the relationship between:
(a) income of the consumer and the quantity of a good demanded by him.
(b) price of a good and the quantity demanded.
(c) price of a good and the demand for its substitute.
(d) quantity demanded of a good and the relative prices of its complementary goods.
7. Identify the factor which generally keeps the price-elasticity of demand for a good low:
(a) Variety of uses for that good.
(b) Very low price of a commodity
(c) Close substitutes for that good.
(d) High proportion of the consumer’s income spent on it.
8. Identify the coefficient of price-elasticity of demand when the percentage increase in the quantity of a good
demanded is smaller than the percentage fall in its price:
(a) Equal to one.
(b) Greater than one.
(c) Less than one.
(d) Zero.
9. In the case of an inferior good, the income elasticity of demand is:
(a) positive.
(b) Zero.
(c) Negative.
(d) infinite.
10. If the demand for a good is inelastic, an increase in its price will cause the total expenditure of the
consumers of the good to:
(a) Remain the same.
(b) Increase.
(c) Decrease.
(d) Any of these.
11. If regardless of changes in its price, the quantity demanded of a good remains unchanged, then the demand
curve for the good will be:
(a) horizontal.
(b) Vertical.
(c) positively sloped.
(d) negatively sloped.
12. Suppose the price of Pepsi increases, we will expect the demand curve of Coca Cola to:
(a) Shift towards left since these are substitutes
(b) Shift towards right since these are substitutes
(c) Remain at the same level
13. All of the following are determinants of demand except:
(a) Tastes and preferences.
(b) Quantity supplied.
(c) Income of the consumer
(d) Price of related goods.
14. A movement along the demand curve for soft drinks is best described as :
(a) An increase in demand.
(b) A decrease in demand.
(c) A change in quantity demanded.
(d) A change in demand.
15. If the price of Pepsi decreases relative to the price of Coke and 7-UP, the demand for :
(a) Coke will decrease.
(b) 7-Up will decrease.
(c) Coke and 7-UP will increase.
(d) Coke and 7-Up will decrease.
16. If a good is a luxury, its income elasticity of demand is:

(a) Positive and less than 1.
(b) Negative but greater than -1.
(c) Positive and greater than 1.
(d) Zero.
17. The price of hot dogs increases by 22% and the quantity of hot dogs demanded falls by 25%. This indicates
that demand for hot dogs is :
(a) Elastic.
(b) Inelastic.
(c) Unitarily elastic.
(d) Perfectly elastic.
18. If the quantity demanded of mutton increases by 5% when the price of chicken increases by 20%, the cross-
price elasticity of demand between mutton and chicken is
(a) -0.25
(b) 0.25
(c) -4
(d) 4
19. Given the following four possibilities, which one results in an increase in total consumer expenditure?
(a) Demand is unitary elastic and price falls.
(b) Demand is elastic and price rises.
(c) Demand is inelastic and price falls.
(d) Demand is inelastic and prices rises.
20. Which of the following statements about price elasticity of supply is correct?
(a) Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a
change in the price of that good
(b) Price elasticity of supply is computed as the percentage change in quantity supplied divided by the
percentage change in price
(c) Price elasticity of supply in the long run would be different from that of the short run
(d) All the above
21. Which of the following is an incorrect statement?
(a) When goods are substitutes, a fall in the price of one (ceteris paribus) leads to a fall in the quantity
demanded of its substitutes.
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(b) When commodities are complements, a fall in the price of one (other things being equal) will
cause the demand of the other to rise
(c) As the income of the consumer increases, the demand for the commodity increases always
and vice versa.
(d) When a commodity becomes fashionable people prefer to buy it and therefore its demand
increases
22. Suppose the price of movies seen at a theatre rises from Rs 120 per person to Rs 200 per person. The
theatre manager observes that the rise in price causes attendance at a given movie to fall from 300 persons
to 200 persons. What is the price elasticity of demand for movies? (Use Arc Elasticity Method)
(a) .5
(b) .8
(c) 1.0
(d) 1.2
23. Suppose a department store has a sale on its silverware. If the price of a plate-setting is reduced from
Rs 300 to Rs 200 and the quantity demanded increases from 3,000 plate-settings to 5,000 plate-settings,
what is the price elasticity of demand for silverware? (Use Arc Elasticity Method)
(a) .8
(b) 1.0
(c) 1.25
(d) 1.50
24. When the numerical value of cross elasticity between two goods is very high, it means
(a) The goods are perfect complements and therefore have to be used together
(b) The goods are perfect substitutes and can be used with ease in place of one another
(c) There is a high degree of substitutability between the two goods
(d) The goods are neutral and therefore cannot be considered as substitutes
25. If the local pizzeria raises the price of a medium pizza from ` 60 to ` 100 and quantity demanded falls from
700 pizzas a night to 100 pizzas a night, the price elasticity of demand for pizzas is :(Use Arc Elasticity
Method)
(a) .67
(b) 1.5
(c) 2.0
(d) 3.0
26. If electricity demand is inelastic, and electricity charges increase, which of the following is likely to occur?
(a) Quantity demanded will fall by a relatively large amount.
(b) Quantity demanded will fall by a relatively small amount.

(c) Quantity demanded will rise in the short run, but fall in the long run.
(d) Quantity demanded will fall in the short run, but rise in the long run.
27. Suppose the demand for meals at a medium-priced restaurant is elastic. If the management of the
restaurant is considering raising prices, it can expect a relatively:
(a) Large fall in quantity demanded.
(b) Large fall in demand.
(c) Small fall in quantity demanded.
(d) Small fall in demand.
28. Point elasticity is useful for which of the following situations?
(a) The bookstore is considering doubling the price of notebooks.
(b) A restaurant is considering lowering the price of its most expensive dishes by 50 percent.
(c) An auto producer is interested in determining the response of consumers to the price of cars being
lowered by Rs 100.
29. A decrease in price will result in an increase in total revenue if :
(a) The percentage change in quantity demanded in less than the percentage change in price.
(b) The percentage change in quantity demanded is greater than the percentage change in price.
(c) Demand is inelastic.
(d) The consumer is operating along a linear demand curve at a point at which the price is very low
and the quantity demanded is very high.
30. An increase in price will result in an increase in total revenue if :
(a) The percentage change in quantity demanded is less than the percentage change in price.
(b) The percentage change in quantity demanded is greater than the percentage change in price.
(c) Demand is elastic.
(d) The consumer is operating along a linear demand curve at a point at which the price is very high
and the quantity demanded is very low.
31. Demand for a good will tend to be more elastic if it exhibits which of the following characteristics?
(a) It represents a small part of the consumer’s income.
(b) The good has many substitutes available.
(c) It is a necessity (as opposed to a luxury).
(d) There is little time for the consumer to adjust to the price change.
32. Demand for a good will tend to be more inelastic if it exhibits which of the following characteristics?
(a) The good has many substitutes.
(b) The good is a luxury (as opposed to a necessity).
(c) The good is a small part of the consumer’s income.
(d) There is a great deal of time for the consumer to adjust to the change in prices.
33. Suppose a consumer’s income increases from Rs 30,000 to Rs ` 36,000. As a result, the consumer
increases her purchases of compact discs (CDs) from 25 CDs to 30 CDs. What is the consumer’s income
elasticity of demand for CDs? (Use Arc Elasticity Method)
(a) 0.5
(b) 1.0
(c) 1.5
(d) 2.0
34. Total utility is maximum when :
(a) Marginal utility is zero.
(b) Marginal utility is at its highest point.
(c) Marginal utility is negative
35. Which one is not an assumption of the theory of demand based on analysis of indifference curves?
(a) Given scale of preferences as between different combinations of two goods.
(b) Diminishing marginal rate of substitution.
(c) Diminishing marginal utility of money
(d) Consumers would always prefer more of a particular good to less of it, other things remaining the
same.
36. An indifference curve slopes down towards right since more of one commodity and less of another result in:
(a) Same level of satisfaction.
(b) Greater satisfaction.
(c) Maximum satisfaction.
(d) Any of the above
37. Suppose that workers in a steel plant managed to force a significant increase in their wage package. How
would the new wage contract be likely to affect the market supply of steel, other things remaining the same?
(a) Supply curve will shift to the left.
(b) Supply curve will shift to the right.
(c) Supply will not shift, but the quantity of cars produced per month will decrease.
(d) Supply will not shift, but the quantity of cars produced per month will increase.
(a) An indifference curve must be downward-sloping to the right.
(b) Convexity of a curve implies that the slope of the curve diminishes as one moves from left to right.
(c) The income elasticity for inferior goods to a consumer is positive
(d) The total effect of a change in the price of a good on its quantity demanded is called the price
effect.
39. The successive units of stamps collected by a little boy give him greater and greater satisfaction. This is a
clear case of
(a) Operation of the law of demand.
(b) Consumer surplus enjoyed in hobbies and rare collections
(c) Exception to the law of diminishing utility.
40. What will happen in the rice market if buyers are expecting higher rice prices in the near future?
(a) The demand for rice will increase and the demand curve will shift to the right
(b) The demand for rice will decrease and the demand curve will shift to the left
(c) The demand for rice will be unaffected as it is a necessity
(d) The demand for wheat will increase and the demand curve will shift to the right
41. In the case of a Giffen good, the demand curve will usually be :
(a) horizontal.
(b) downward-sloping to the right.
(c) vertical.
(d) upward-sloping to the right.
42. By consumer surplus, economists mean
(a) The area inside the budget line above the price of the commodity
(b) The area between the average revenue and marginal revenue curves.
(c) The difference between the maximum amount a person is willing to pay for a good and its market
price.
(d) The difference between the market price and the supply curve
43. Which of the following is a property of an indifference curve?
(a) It is convex to the origin due to diminishing marginal rate of substitution
(b) The marginal rate of substitution is constant as you move along an indifference curve.
(c) Marginal utility is constant as you move along an indifference curve.
(d) Total utility is greatest where the budget line line cuts the indifference curve.
44. When economists speak of the utility of a certain good, they are referring to
(a) The demand for the good.
(b) The usefulness of the good in consumption.
(c) The expected satisfaction derived from consuming the good.
(d) The rate at which consumers are willing to exchange one good for another.
45. A vertical supply curve parallel to Y axis implies that the elasticity of supply is :
(a) Zero
(b) Infinity
(c) Equal to one
(d) Greater than zero but less than infinity.
46. For a normal good with a downward sloping demand curve:
(a) The price elasticity of demand is negative; the income elasticity of demand is negative.
(b) The price elasticity of demand is positive; the income elasticity of demand is negative.
(c) The price elasticity of demand is positive; the income elasticity of demand is positive.
(d) The price elasticity of demand is negative; the income elasticity of demand is positive.
47. An increase in the supply of a good is caused by :
(a) Improvements in its production technology
(b) Fall in the prices of other goods which can be produced using the same inputs .
(c) Fall in the prices of factors of production used in its production .
(d) all of the above.
48. Elasticity of supply refers to the degree of responsiveness of supply of a good to changes in its:
(a) Demand.
(b) Price.
(c) Cost of production.
(d) State of technology.
49. A horizontal supply curve parallel to the quantity axis implies that the elasticity of supply is :
(a) Zero.
(b) Infinite.
(c) Equal to one.

(d) Greater than zero but less than one.
50. Contraction of supply is the result of :
(a) Decrease in the number of producers.
(b) Decrease in the price of the good concerned.
(c) Increase in the prices of other goods.
(d) Decrease in the outlay of sellers.
51. Conspicuous goods are also known as
(a) Prestige goods
(b) Snob goods
(c) Veblen goods
(d) All of the above
52. The quantity purchased remains constant irrespective of the change in income. This is known as
(a) negative income elasticity of demand
(b) income elasticity of demand less than one
(c) zero income elasticity of demand
(d) income elasticity of demand is greater than one
53. As income increases, the consumer will go in for superior goods and consequently the demand for inferior
goods will fall. This means inferior goods have
(a) income elasticity of demand less than one
(b) negative income elasticity of demand
(d) unitary income elasticity of demand
54. When income increases the money spent on necessaries of life may not increase in the same proportion,
This means
(a) income elasticity of demand is zero
(b) income elasticity of demand is one
(c) income elasticity of demand is greater than one
(d) income elasticity of demand is less than one
55. The luxury goods like jewellery and fancy articles will have
(a) low income elasticity of demand
(b) high income elasticity of demand

56. A good which cannot be consumed more than once is known as
(a) Durable good
(b) Non-durable good
(c) Producer good
57. A relative price is
(a) price expressed in terms of money
(b) what you get paid for babysitting your cousin
(c) the ratio of one money price to another
(d) equal to a money price
58. A point below the budget line of a consumer
(a) Represents a combination of goods which costs the whole of consumer’s income
(b) Represents a combination of goods which costs less than the consumer’s income
(c) Represents a combination of goods which is unattainable to the consumer given his/her money
income
(d) Represents a combination of goods which costs more than the consumers’ income
59. Demand is the
(a) the desire for a commodity given its price and those of related commodities
(b) the entire relationship between the quantity demanded and the price of a good other things
remaining the same
(c) willingness to pay for a good if income is larger enough
(d) ability to pay for a good
60. Suppose potatoes have (-).0.4 as income elasticity. We can say from the data given that:
(a) Potatoes are superior goods.
(b) Potatoes are necessities.
(c) Potatoes are inferior goods.
(d) There is a need to increase the income of consumers so that they can purchase potatoes.
61. The price of tomatoes increases and people buy tomato puree. You infer that tomato puree and tomatoes
are
(a) Normal goods
(b) Complements
(c) Substitutes
(d) Inferior goods
62. Chicken and fish are substitutes. If the price of chicken increases, the demand for fish will
(a) Increase or decrease but the demand curve for chicken will not change
(b) Increase and the demand curve for fish will shift rightwards.
(c) Not change but there will be a movement along the demand curve for fish.
(d) Decrease and the demand curve for fish will shift leftwards.
63. Potato chips and popcorn are substitutes. A rise in the price of potato chips will —————— the demand
for popcorn and the quantity of popcorn sold will ———————
(a) increase; increase
(b) increase; decrease
(c) decrease; decrease
(d) decrease; increase
64. If the price of orange Juice increases, the demand for apple Juice will _____________.
(a) increase because they are substitutes
(b) decrease because they are substitutes
(c) remain the same because real income is increased
(d) decrease as real income decreases
65. An increase in the demand for computers, other things remaining same, will:
(a) Increase the number of computers bought.
(b) Decrease the price but increase the number of computers bought.
(c) Increase the price of computers.
(d) Increase the price and number of computers bought.
66. When total demand for a commodity whose price has fallen increases, it is due to:
(a) Income effect.
(b) Substitution effect
(c) Complementary effect
(d) Price effect
67. With a fall in the price of a commodity:
(a) Consumer’s real income increases
(b) Consumer’s real income decreases

(c) There is no change in the real income of the consumer
68. With an increase in the price of diamond, the quantity demanded also increases. This is because it is a:
(a) Substitute good
(b) Complementary good
(c) Conspicuous good
69. An example of goods that exhibit direct price-demand relationship is
(a) Giffen goods
(b) Complementary goods
(c) Substitute goods
70. In Economics, when demand for a commodity increases with a fall in its price it is known as:
(a) Contraction of demand
(b) Expansion of demand
(c) No change in demand
71. The quantity supplied of a good or service is the amount that
(a) is actually bought during a given time period at a given price
(b) producers wish they could sell at a higher price
(c) producers plan to sell during a given time period at a given price
(d) people are willing to buy during a given time period at a given price
72. Supply is the
(a) limited resources that are available with the seller
(b) cost of producing a good
(c) entire relationship between the quantity supplied and the price of good.
(d) Willingness to produce a good if the technology to produce it becomes available
73. In the book market, the supply of books will decrease if any of the following occurs except
(a) a decrease in the number of book publishers
(b) a decrease in the price of the book
(c) an increase in the future expected price of the book

(d) an increase in the price of paper used.
74. If price of computers increases by 10% and supply increases by 25%. The elasticity of supply is :
(a) 2.5
(b) 0.4
(c) (-) 2.5
(d) (-) 0.4
75. An increase in the number of sellers of bikes will increase the
(a) The price of a bike
(b) Demand for bikes
(c) The supply of bikes
(d) Demand for helmets
76. If the supply of bottled water decreases, other things remaining the same, the equilibrium price —————
—————— and the equilibrium quantity —————————
(a) increases ; decreases
(b) decreases; increases
(c) decreases; decreases
(d) increases; increases
77. A decrease in the demand for cameras, other things remaining the same will
(a) Increase the number of cameras bought
(b) Decrease the price but increase the number of cameras bought
(c) Decrease in quantity of camera demanded
(d) Decrease the price and decrease in the number of cameras bought.
78. Which of the following statements about inferior goods is/are false?
I. Inferior goods are those that we will never buy, no matter how cheap they are.
II. Inferior goods are those that we buy more of, if we become poorer.
III. Inferior goods are those that we buy more of, if we become richer.
(a) I and III only.
(b) I only
(c) III only.
(d) I, II, and III.
79. Comforts lie between

(a) inferior goods and necessaries
(b) luxuries and inferior goods
(c) necessaries and luxuries
80. In a very short period, the supply
(a) can be changed
(b) can not be changed
(c) can be increased
81. When supply curve moves to the left, it means
(a) lesser quantity is supplied at a given price
(b) larger quantity is supplied at a given price
(c) prices have fallen and quantity is supplied at a lower price
82. When supply curve moves to right, it means
(a) supply increases and more quantity is supplied at a given price
(b) supply decreases and less quantity is supplied at a given price
(c) supply remains constant at a given price
83. The elasticity of supply is defined as the
(a) responsiveness of the quantity supplied of a good to a change in its price
(b) responsiveness of the quantity supplied of a good without change in its price
(c) responsiveness of the quantity demanded of a good to a change in its price
(d) responsiveness of the quantity demanded of a good without change in its price
84. Elasticity of supply is measured by dividing the percentage change in quantity supplied of a good by ———
———————
(a) Percentage change in income
(b) Percentage change in quantity demanded of goods
(c) Percentage change in price
(d) Percentage change in taste and preference
85. Elasticity of supply is zero means

(a) perfectly inelastic supply
(b) perfectly elastic supply
(c) imperfectly elastic supply
86. Elasticity of supply is greater than one when
(a) Proportionate change in quantity supplied is more than the proportionate change in price.
(b) Proportionate change in price is greater than the proportionate change in quantity supplied.
(c) change in price and quantity supplied are equal
87. If the quantity supplied is exactly equal to the relative change in price then the elasticity of supply is
(a) Less than one
(b) Greater than one
(c) One
88. The price of a commodity decreases from Rs 6 to Rs 4 and the quantity demanded of the good increases
from 10 units to 15 units, find the coefficient of price elasticity.
(a) 1.5
(b) 2.5
(c) -1.5
(d) 0.5
89. The supply function is given as Q= -100 + 10P. Find the elasticity using point method, when price is ` 15.
(a) 4
(b) -3
(c) -5
(d) 3
90. The figure below shows the budget constraint of a consumer with an income of Rs. 900/- to spend on two
commodities, namely ice cream and chocolates.
The prices of these two commodities respectively are:

(a) Rs. 10 and Rs 20
(b) Rs 20 and Rs. 10
(c) Rs. 10 and Rs 5
91. ‘No matter what the price of coffee is, Arjun always spend a total of exactly 100 per week on coffee.’ The
statement implies that:
(a) Arjun is very fond of coffee and therefore he has an inelastic demand for coffee
(b) Arjun has elastic demand for coffee
(c) Arjun’s demand for coffee is relatively less elastic
(d) Arjun’s demand for coffee is unit elastic
92. A firm learns that the own price elasticity of a product it manufactures is 3.5. What would be the correct
action for this firm to take if it wishes to raise its total revenue?
(a) Lower the price because demand for the good is elastic.
(b) Raise the price because demand for the product is inelastic.
(c) Raise the price because demand is elastic.
(d) We need information in order to answer this question.
93. At higher prices people demand more of certain goods not for their worth but for their prestige value – This
is called
(a) Veblen effect
(b) Giffens paradox
(c) Speculative effect

94. If the price of air-conditioner increases from Rs 30,000 to Rs 30,010 and resultant change in demand is
negligible, we use the measure of __________ to measure elasticity.
(a) Point elasticity of demand since it is a small change
(b) Arc elasticity of demand since it is a small change
(c) Price elasticity based on average prices method
95. Given the following four possibilities, which one will result in an increase in total expenditure of the
consumer?
(a) Demand is unit elastic and price rises
(b) Demand is elastic and price rises
(c) Demand is inelastic and price falls
(d) demand is inelastic and price rises
96. The supply curve shifts to the right because of———————
(a) improved technology
(b) increased price of factors of production
(c) increased excise duty
(d) all of the above
(a) When the price falls the quantity demanded falls
(b) Seasonal changes do not affect the supply of a commodity
(c) Taxes and subsidies do not influence the supply of the commodity
(d) With lower cost, it is profitable to supply more of the commodity.
98. If the demand is more than supply, then the pressure on price will be
(a) Upward
(b) Downward
(c) Constant
99. The supply curve for highly perishable commodities during very short period is generally ——
(a) Elastic
(b) Inelastic
(c) Perfectly elastic

(d) Perfectly inelastic
100. Supply is a ___________ concept.
(a) Stock
(b) Flow and stock
(c) Flow
101. The cross elasticity between Rye bread and Whole Wheat bread is expected to be:
(a) Positive
(b) Negative
(c) Zero
(d) Can’t say
102. The cross elasticity between personal computers and soft wares is:
(a) Positive
(b) Zero
(c) Negative
(d) One
103. The cross elasticity between Bread and DVDs is:
(a) Positive
(b) Negative
(c) Zero
(d) One
(a) With the help of statistical tools, the demand can be forecasted with perfect accuracy
(b) The more the number of substitutes of a commodity, the more elastic is the demand.
(c) Demand for butter is perfectly elastic.
(d) Gold jewellery will have negative income elasticity.
105. Suppose the income elasticity of education in private school in India is 3.6. What does this indicate:
(a) Private school education is highly wanted by rich
(b) Private school education is a necessity.
(c) Private school education is a luxury.
(d) We should have more private schools.
106. If the organizers of an upcoming cricket match decide to increase the ticket price in order to raise its
revenues, what they have learned from past experience is;
(a) The percentage increase in ticket rates will be always equal the percentage decrease in tickets
sold
(b) The percentage increase in ticket rates will be always greater than the percentage decrease in
tickets sold
(c) The percentage increase in ticket rates will be less than the percentage decrease in tickets sold
(d) (a) and (c) above are true
107. Data on production of vegetables for the past two years showed that, despite stable prices, there is a
substantial decline in output of cabbage leading to lower supply into the market. Which of the following can
possibly be the reason?
(a) An increase in the price of cauliflower which is equally preferred by consumers
(b) Announcement of a subsidy by government on vegetable production
(c) More farmers producing cabbage and the increasing competition among them
(d) A substantial decrease in the price of capsicum
108. The following diagram shows the relationship between price of Good X and quantity demanded of Good Y.
What we infer from the diagram is ;
(a) Good X and Good Y are perfect complements

(b) Good X and Good Y are perfect substitutes
(c) Good X and Good Y are remote substitutes
(d) Good X and Good Y are close substitutes
109. The diagram given below shows
(a) A change in demand which may be caused by a rise in income and the good is a normal good
(b) A shift of demand curve caused by a fall in the price of a complementary good
(c) A change in demand which is caused by a rise in income and the good is an inferior good
(d) A shift of demand curve caused by a rise in the price of a substitute and the good is a normal good.
110. Which of the following alternatives would be true if the event presented in the following diagram occurs?
(a) A fall in wage costs of the firm along with a fall in consumer incomes
(b) A shortage of raw materials and consequent increase in raw material price
(c) An increase in subsidy by the government and a reduction in taxes
(d) Decrease in the market price of the commodity in question
111. The demand curve of a normal good has shifted to the right. Which of the four events would have caused
the shift?
(a) A fall in the price of a substitute with the price of the good unchanged
(b) A fall in the nominal income of the consumer and a fall in the price of the normal good
(c) A fall in the price of a complementary good with the price of the normal good unchanged
(d) A fall in the price of the normal good, other things remaining the same
112. If roller- coaster ride is a function of amusement park visit, then, if the price of amusement park entry falls
(a) The demand for roller- coaster rides will rise and the demand curve will shift to right
(b) The demand for roller coaster ride cannot be predicted as it depends on the tastes of consumers
for the ride
(c) There will be an expansion in the demand for roller coaster drive as it complementary
113. If a short run supply curve is plotted for the following table which presents price and quantity of fighter
aircrafts, what will be its shape?
Price in millions of $ Number of Aircrafts
124 28
140 28
150 28
160 28
175 28
(a) Horizontal straight line parallel to the quantity axis
(b) Steeply rising with elasticity less than one
(c) Vertical straight line parallel to Y axis
(d) A perfectly elastic supply curve
114. The average income of residents of two cities A and B and the corresponding change in demand for two
goods is given in the following table. Which of the following statements is true?
City %Increase In % change in % change in

Income demand for Good demand for Good
X Y
A 12 6.5 - 2.3
B 9 5.6 1.6
(a) Both goods are normal goods in both cities A and B

(b) Good X is a normal good in both cities ; good Y is an inferior good in city A
(c) Good X is a normal good in both cities ; good Y is an inferior good in city B
(d) Need more information to make an accurate comment
Refer to the figure below. Answer questions 115 and 116

115. If this consumer is spending her entire income and consuming at point B, what advise will you give her?
(a) No advise needed ,as she is maximizing her utility at B

(b) Consume more of Good X and less of Good Y
(c) Consume more of X and and less of Y and reach point K
(d) Consumer same quantity of Good Y and more of Good X
116. Which of the following statements is true about this consumer?
(a) The consumer is not maximizing her utility at point K
(b) The consumer is spending her entire income on both goods
(c) The consumer gets equal pleasure at points B and K
(d) All the above
Refer to the figure below. Answer questions 117 and 118
117. The effect on consumer surplus of a fall in price from E to F is
(a) A decrease in consumer surplus by EFGR

(b) A decrease in consumer surplus by AER
(c) A decrease in consumer surplus by EFCR
(d) None of The above
118. When price rises from F to E, the increase in revenue earned by the seller is
(a) Equivalent to area EFGR
(b) Equivalent to area EFCR
(c) Equivalent to area AER
119. How would that budget line be affected if the price of both goods fell?
(a) The budget line would not shift.
(b) The new budget line must be parallel to the old budget line.
(c) The budget line must be shifting to the left
(d) The new budget line will have the same slope as the original so long as the prices of both goods
change in the same proportion.
120. During a recession, economies experience increased unemployment and a reduced level of income. How
would a recession likely to affect the market demand for new cars?
(a) Demand curve will shift to the right.
(b) Demand curve will shift to the left.
(c) Demand will not shift, but the quantity of cars sold per month will decrease.
(d) Demand will not shift, but the quantity of cars sold per month will increase.
Answers
1. (d) 2. (b) 3. (c) 4. (b) 5. (b) 6. (b)
7. (b) 8. (c) 9. (c) 10. (b) 11. (b) 12. (b)
13. (b) 14. (c) 15. (d) 16. (c) 17. (a) 18. (b)
19. (d) 20. (d) 21. (c) 22. (b) 23. (c) 24. (c)
25. (d) 26. (b) 27. (a) 28. (c) 29. (b) 30. (a)
31. (b) 32. (c) 33. (b) 34. (a) 35. (c) 36. (a)
37. (a) 38. (c) 39. (c) 40. (a) 41. (d) 42. (c)
43. (a) 44. (c) 45. (a) 46. (d) 47. (d) 48. (b)
49. (b) 50. (b) 51. (d) 52. (c) 53. (b) 54. (d)
55. (b) 56. (b) 57. (c) 58. (b) 59. (b) 60. (c)
61. (c) 62. (b) 63. (a) 64. (a) 65. (d) 66. (d)
67. (a) 68. (c) 69. (a) 70. (b) 71. (c) 72. (c)
73. (b) 74. (a) 75. (c) 76. (a) 77. (c) 78. (a)
79. (c) 80. (b) 81. (a) 82. (a) 83. (a) 84. (c)
85. (a) 86. (a) 87. (c) 88. (a) 89. (d) 90. (b)
91. (d) 92. (a) 93. (a) 94. (a) 95. (d) 96 (a)
97. (d) 98. (a) 99. (d) 100. (c) 101 (a) 102 (c)
103. (c) 104 (b) 105 (c) 106. (b) 107 (a) 108. (d)
109 (c) 110 (b) 111 (c) 112 (a) 113 (c) 114 (b)
115 (b) 116 (d) 117 (d) 118 (a) 119 (d) 120 (b)
CHAPTER 3
THEORY OF PRODUCTION
AND COST
UNIT -1: THEORY OF PRODUCTION
LEARNING OUTCOMES
♦ Define Production and Describe Production Function.
♦ Describe the Characteristics of various Factors of Production.
♦ Distinguish between Short run and Long run Production Functions.
♦ Illustrate the Law of Diminishing Returns and Returns to Scale.
♦ Describe Production Optimisation using Isoquants and Iso -cost curves.
CHAPTER OVERVIEW
1.0 MEANING OF PRODUCTION

Production is a very important economic activity. As we are aware, the survival of any firm in a competitive
market depends upon its ability to produce goods and services at a competitive cost. One of the principal
concerns of business managers is the achievement of optimum efficiency in production by minimising the cost
of production. The performance of an economy is judged by the level of its production. The amount of goods
and services an economy is able to produce determines the richness or poverty of that economy. In fact, the
standard of living of people depends on the volume and variety of goods and services produced in a country.
Thus, the U.S.A. is a rich country just because its level of production is high.
In common parlance, the term ‘production’ is used to indicate an activity of making something material. The
growing of wheat, rice or any other agricultural crop by farmers and manufacturing of cement, radio-sets, wool,
machinery or any other industrial product is often referred to as production. What exactly do we mean by
production in Economics? In Economics the word ‘production’ is used in a wider sense to denote the process
by which man utilises resources such as men, material, capital, time etc, working upon them to transform them
.3 THEORY OF PRODUCTION AND COST 3.3
into commodities and services so as to make them satisfy human wants. In other words, production is any
economic activity which converts inputs into outputs which are capable of satisfying human wants. Whether it is
making of material goods or providing a service, it is included in production provided it satisfies the wants of
some people. Therefore, in Economics, activities such as making of cloth by an industrial worker, the services
of the retailer who delivers it to consumers, the work of doctors, lawyers, teachers, actors, dancers, etc. are
production.
According to James Bates and J.R. Parkinson “Production is the organized activity of transforming
resources into finished products in the form of goods and services; and the objective of production is
to satisfy the demand of such transformed resources”.
It should be noted that production should not be taken to mean as creation of matter because, according to the
fundamental law of science, man cannot create matter. What a man can do is only to create or add utility to
things that already exist in nature. Production can also be defined as creation or addition of utility. For example,
when a carpenter produces a table, he does not create the matter of which the wood is composed of; he only
transforms wood into a table. By doing so, he adds utility to wood which did not have utility before.
Production consists of various processes to add utility to natural resources for gaining greater satisfaction from
them by:
(i) Changing the form of natural resources. Most manufacturing processes consist of use of physical
inputs such as raw materials and transforming them into physical products possessing utility, e.g.,
changing the form of a log of wood into a table or changing the form of iron into a machine. This may
be called conferring utility of form.
(ii) Changing the place of the resources from a place where they are of little or no use to another place
where they are of greater use. This utility of place can be obtained by:
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines
and supplying them to markets.
(b) Transferring goods from where they give little or no satisfaction, to places where their utility is
more, e.g., tin in Malaya is of little use until it is brought to the industrialised centres where
necessary machinery and technology are available to produce metal boxes for packing.
Another example is: apples in Kashmir orchards have a little utility to farmers. But when the
apples are transported to markets where human settlements are thick and crowded like the
city centres, they afford more satisfaction to greater number of people. These examples
emphasise the additional utility conferred on goods, by all forms of transportation systems, by
transport workers and by the agents who assist in the movement and marketing of goods.
(iii) Making available materials at times when they are not normally available e.g., harvested food grains
are stored for use till next harvest. Canning of seasonal fruits is undertaken to make them available
during off-season. This may be called conferring of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants, transport
workers etc.
The fundamental purpose of all these activities is the same, namely to create utility in some manner. Thus,
production is nothing but creation of utilities in the form of goods and services. For example, in the production
of a woollen suit, utility is created in some form or the other. Firstly wool is changed into woollen cloth at the
spinning and weaving mill (utility created by changing the form). Then, it is taken to a place where it is to be
sold (utility added by transporting it). Since woollen clothes are used only in winter, they will be retained until
such time when they are required by purchasers (time utility). In the whole process, the services of various
groups of people are utilised (as that of mill workers, shopkeepers, agents etc.) to contribute to the
enhancement of utility. Thus, the entire process of production is nothing but creation of form utility, place utility,
time utility and/or personal utility.
It should be noted that the production process need not necessarily involve conversion of physical inputs into
physical output. For example, production of services such as those of lawyers, doctors, musicians, consultants
etc. involves intangible inputs to produce intangible output. But, production does not include work done within a
household by anyone out of love and affection, voluntary services and goods produced for self-consumption.
Intention to exchange in the market is an essential component of production.
The money expenses incurred in the process of production, i.e., for transforming resources into finished
products constitute the cost of production. Although cost of production is not taken into account for a pure
production analysis, it is an extremely vital matter for any business decision-making. Nevertheless, in the
theory of production, we would confine ourselves to laws of production, production function and methods of
production optimisation. However, it is necessary to remember that a production decision cannot depend
merely on physical productivity based on operating efficiency alone. The profitability of a productive activity
would depend upon the revenue realised from the output and the costs incurred in raising that output. Aspects
of cost and revenue will be discussed in the following units.
1.1 FACTORS OF PRODUCTION

Factors of production refer to inputs. An input is a good or service which a firm buys for use in its production
process. Production process requires a wide variety of inputs, depending on the nature of output. The process
of producing goods in a modern economy is very complex. A good has to pass through many stages and many
hands until it reaches the consumers’ hands in a finished form. Land, labour, capital and entrepreneurial ability
are the four factors or resources which make it possible to produce goods and services. Even a small piece of
bread cannot be produced without the active participation of these factors of production. While land is a free gift
of nature and refers to natural resources, the human endeavour is classified functionally and qualitatively into
three main components namely, labour, capital and entrepreneurial skills.
We may discuss these factors of production briefly in the following paragraphs.
1.1.0 Land
The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s surface alone, but
refers to all free gifts of nature which would include besides land in common parlance, natural resources,
fertility of soil, water, air, light, heat natural vegetation etc. It becomes difficult at times to state precisely as to
what part of a given factor is due solely to gift of nature and what part belongs to human effort made on it in the
past. Therefore, as a theoretical concept, we may list the following characteristics which would qualify a given
factor to be called land:
(i) Land is a free gift of nature: No human effort is required for making land available for production. It
has no supply price in the sense that no payment has been made to mother nature for obtaining land
(ii) Supply of land is fixed: Land is strictly limited in quantity. It is different from other factors of
production in that, no change in demand can affect the amount of land in existence. In other words, the
total supply of land is perfectly inelastic from the point of view of the economy. However, it is relatively
elastic from the point of view of a firm.
(iii) Land is permanent and has indestructible powers: Land is permanent in nature and cannot be
destroyed. According to Ricardo, land has certain original and indestructible powers and these
properties of land cannot be destroyed.
(iv) Land is a passive factor: Land is not an active factor. Unless human effort is exercised on land, it
does not produce anything on its own.
(v) Land is immobile: in the geographical sense. Land cannot be shifted physically from one place to
another. The natural factors typical to a given place cannot be shifted to other places.
(vi) Land has multiple uses: and can be used for varied purposes, though its suitability in all the uses is
not the same.
(vii) Land is heterogeneous: No two pieces of land are alike. They differ in fertility and situation.
1.1.1 Labour
The term ‘labour’, means any mental or physical exertion directed to produce goods or services. All human
efforts of body or of mind undergone partly or wholly with a view to secure an income apart from the pleasure
derived directly from the work is termed as labour. In other words, it refers to various types of human efforts
which require the use of physical exertion, skill and intellect. It is, however, difficult to say that in any human
effort all the three are not required; the proportion of each might vary. Labour, to have an economic
significance, must be one which is done with the motive of some economic reward. Anything done out of love
and affection, although very useful in increasing human well-being, is not labour in the economic sense of the
term. It implies that any work done for the sake of pleasure or love does not represent labour in Economics. It is
for this reason that the services of a house-wife are not treated as labour, while those of a maid servant are
treated as labour. If a person sings just for the sake of pleasure, it is not considered as labour despite the
exertion involved in it. On the other hand, if a person sings against payment of some fee, then this activity
signifies labour.
Characteristics of labour:
(1) Human Effort: Labour, as compared with other factors is different. It is connected with human efforts
whereas others are not directly connected with human efforts. As a result, there are certain human and
psychological considerations which may come up unlike in the case of other factors. Therefore, leisure,
fair treatment, favourable work environment etc. are essential for labourers.
(2) Labour is perishable: Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be
completely recovered by extra work on any other day. In other words, a labourer cannot store his
labour.
(3) Labour is an active factor: Without the active participation of labour, land and capital may not
produce anything.
(4) Labour is inseparable from the labourer: A labourer is the source of his own labour power. When a
labourer sells his service, he has to be physically present where they are delivered. The labourer sells
his labour against wages, but retains the capacity to work.
(5) Labour power differs from labourer to labourer: Labour is heterogeneous in the sense that labour
power differs from person to person. Labour power or efficiency of labour depends upon the labourers’
inherent and acquired qualities, characteristics of work environment, and incentive to work.
(6) All labour may not be productive: (i.e.) all efforts are not sure to produce resources.
(7) Labour has poor bargaining power: Labour has a weak bargaining power. Labour has no reserve
price. Since labour cannot be stored, the labourer is compelled to work at the wages offered by the
employers. For this reason, when compared to employers, labourers have poor bargaining power and
can be exploited and forced to accept lower wages. The labourer is economically weak while the
employer is economically powerful although things have changed a lot in favour of labour during 20 th
and 21st centuries.
(8) Labour is mobile: Labour is a mobile factor. Apparently, workers can move from one job to another or
from one place to another. However, in reality there are many obstacles in the way of free movement
of labour from job to job or from place to place.
(9) There is no rapid adjustment of supply of labour to the demand for it: The total supply of labour
cannot be increased or decreased instantly.
(10) Choice between hours of labour and hours of leisure: A labourer can make a choice between the
hours of labour and the hours of leisure. This feature gives rise to a peculiar backward bending shape
to the supply curve of labour. The supply of labour and wage rate is directly related. It implies that, as
the wage rate increases the labourer tends to increase the supply of labour by reducing the hours of
leisure. However, beyond a desired level of income, the labourer reduces the supply of labour and
increases the hours of leisure in response to further rise in the wage rate. That is, he prefers to have
more of rest and leisure than earning more money.
1.1.2 Capital
We may define capital as that part of wealth of an individual or community which is used for further production
of wealth. In fact, capital is a stock concept which yields a periodical income which is a flow concept. It is
necessary to understand the difference between capital and wealth. Whereas wealth refers to all those goods
and human qualities which are useful in production and which can be passed on for value, only a part of these
goods and services can be characterised as capital because if these resources are lying idle they will constitute
wealth but not capital.
Capital has been rightly defined as ‘produced means of production’ or ‘man-made instruments of production’. In
other words, capital refers to all man made goods that are used for further production of wealth. This definition
distinguishes capital from both land and labour because both land and labour are not produced factors. They
are primary or original factors of production, but capital is not a primary or original factor; it is a produced factor
of production. It has been produced by man by working with nature. Machine tools and instruments, factories,
dams, canals, transport equipment etc., are some of the examples of capital. All of them are produced by man
to help in the production of further goods.
Types of Capital:
Fixed capital is that which exists in a durable shape and renders a series of services over a period of time. For
example tools, machines, etc.
Circulating capital is another form of capital which performs its function in production in a single use and is
not available for further use. For example, seeds, fuel, raw materials, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good deal of
investment goes into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights and
benefits which cannot be perceived by senses. For example, copyrights, goodwill, patent rights, etc.
Individual capital is personal property owned by an individual or a group of individuals.
Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
Capital Formation: Capital formation means a sustained increase in the stock of real capital in a country. In
other words, capital formation involves production of more capital goods like, machines, tools, factories,
transport equipments, electricity etc. which are used for further production of goods. Capital formation is also
known as investment.
The need for capital formation or investment is realised not merely for replacement and renovation but for
creating additional productive capacity. In order to accumulate capital goods, some current consumption has to
be sacrificed and savings of current income are to be made. Savings are also to be channelised into productive
investment. The greater the extent that people are willing to abstain from present consumption, the greater the
extent of savings and investment that society will devote to new capital formation. If a society consumes all
what it produces and saves nothing, the future productive capacity of the economy will fall when the present
capital equipment wears out. In other words, if the whole of the current present capacity is used to produce
consumer goods and no new capital goods are made, production of consumer goods in the future will greatly
decline. It is prudent to cut down some of the present consumption and direct part of it to the making of capital
goods such as, tools and instruments, machines and transport facilities, plant and equipment etc. Higher rate of
capital formation will enhance production and productive capacity, increase the efficacy of production efforts,
accelerate economic growth and add to opportunities for employment.
Stages of capital formation: There are mainly three stages of capital formation which are as follows:
1. Savings: The basic factor on which formation of capital depends is the ability to save. The ability to
save depends upon the income of an individual. Higher incomes are generally followed by higher
savings. This is because, with an increase in income, the propensity to consume comes down and the
propensity to save increases. This is true not only for an individual but also for the economy as a
whole. A rich country has greater ability to save and thereby can get richer quickly compared to a poor
country which has no ability to save and therefore has limited capacity for growth in national income,
given the capital output ratio.
It is not only the ability to save, but the willingness to save also counts a great deal. Willingness to
save depends upon the individual’s concern about his future as well as upon the social set-up in which
he lives. If an individual is far sighted and wants to make his future secure, he will save more.
Moreover, the government can enforce compulsory savings on employed people by making insurance
and provident fund compulsory. Government can also encourage saving by allowing tax deductions on
income saved. In recent years, business community’s savings and government’s savings are also
becoming important.
2. Mobilisation of savings: It is not enough that people save money; the saved money should enter into
circulation and facilitate the process of capital formation. Availability of appropriate financial products
and institutions is a necessary precondition for mobilisation of savings. There should be a wide spread
network of banking and other financial institutions to collect public savings and to take them to
prospective investors. In this process, the state has a very important and positive role to play both in
generating savings through various fiscal and monetary incentives and in channelising the savings
towards priority needs of the community so that there is not only capital generation but also socially
beneficial type of capital formation.
3. Investment: The process of capital formation gets completed only when the real savings get converted
into real capital assets. An economy should have an entrepreneurial class which is prepared to bear
the risk of business and invest savings in productive avenues so as to create new capital assets.
1.1.3 Entrepreneur
Having explained the three factors namely land, labour and capital, we now turn to the description of the fourth
factor of production, namely, the entrepreneur. It is not enough to say that production is a function of land,
capital and labour. There must be some factor which mobilises these factors, combines them in the right
proportion, initiates the process of production and bears the risks involved in it. This factor is known as the
entrepreneur. He has also been called the organiser, the manager or the risk taker. But, in these days of
specialisation and separation of ownership and management, the tasks performed by a manager or organiser
have become different from that of the entrepreneur. While organisation and management involve decision-
making of routine and non-routine types, the task of the entrepreneur is to initiate production work and to bear
the risks involved in it.
Functions of an entrepreneur: In general, an entrepreneur performs the following functions:
(i) Initiating business enterprise and resource co-ordination: An entrepreneur senses business
opportunities, conceives project ideas, decides on scale of operation, products and processes and
builds up, owns and manages his own enterprise. The first and the foremost function of an
entrepreneur is to initiate a business enterprise. An entrepreneur perceives opportunity, organizes

resources needed for exploiting that opportunity and exploits it. He undertakes the dynamic process of
obtaining different factors of production such as land, labour and capital, bringing about co-ordination
among them and using these economic resources to secure higher productivity and greater yield. An
entrepreneur hires the services of various other factors of production and pays them fixed contractual
rewards: labour is hired at predetermined rate of wages, land or factory building at a fixed rent for its
use and capital at a fixed rate of interest. The surplus, if any, after paying for all factors of production
hired by him, accrues to the entrepreneur as his reward for his efforts and risk-taking. Thus, the reward
for an entrepreneur, that is a profit, is not certain or fixed. He may earn profits, or incur losses. Other
factors get the payments agreed upon, irrespective of whether the entrepreneur makes profits or
losses.
(ii) Risk bearing or uncertainty bearing: The ultimate responsibility for the success and survival of
business lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not
come true and the actual course of events may differ from what was anticipated and planned. The
economy is dynamic and changes occur every day. The demand for a commodity, the cost structure,
fashions and tastes of the people and government’s policy regarding taxation, credit, interest rate etc.
may change. All these changes bring about changes in the cost and/or demand conditions of a
business firm. It may happen that as a result of certain broad changes which were not anticipated by
the entrepreneur, the firm has to incur losses. Thus, the entrepreneur has to bear these financial risks.
Apart from financial risks, the entrepreneur also faces technological risks which arise due to the
inventions and improvement in techniques of production, making the existing techniques and machines
obsolete. The entrepreneur has to assess and bear the risks. However, Frank Knight is of the opinion
that profit is the reward for bearing uncertainties. An entrepreneur need not bear the foreseeable risks
such as of fire, theft, burglary etc. as these can be insured against. Uncertainties are different from
risks in the sense that these cannot be insured against and therefore, the entrepreneur has to bear
them. For example genuine business uncertainties such as change in tastes, emergence of
competition etc. cannot be foreseen or insured against. Thus, an entrepreneur earns profits because
he bears uncertainty in a dynamic economy where changes occur every day. While nearly all functions
of an entrepreneur can be delegated or entrusted with paid managers, risk bearing cannot be
delegated to anyone. Therefore, risk bearing is the most important function of an entrepreneur
(iii) Innovations: According to Schumpeter, the true function of an entrepreneur is to introduce
innovations. Innovation refers to commercial application of a new idea or invention to better fulfilment
of business requirements. Innovations, in a very broad sense, include the introduction of new or
improved products, devices and production processes, utilisation of new or improved source of raw-
materials, adoption of new or improved technology, novel business models, extending sales to
unexplored markets etc. According to Schumpeter, the task of the entrepreneur is to continuously
introduce new innovations. These innovations may bring in greater efficiency and competitiveness in
business and bring in profits to the innovator. A successful innovation will be imitated by others in due
course of time. Therefore, an innovation may yield profits for the entrepreneur for a short time but
when it is widely adopted by others, the profits tend to disappear. The entrepreneurs promote
economic growth of the country by introducing new innovations from time to time and contributing to
technological progress. But innovations involve risks and only a few individuals in the society are
capable of introducing new innovations. The greater the innovating ability, the greater the supply of
entrepreneurs in the economy, and greater will be the rate of technological progress.
Enterprise’s objectives and constraints
The standard assumption about an enterprise is that its business activity is carried out with the sole objective of
earning profits. However, in the real world, enterprises do not make decisions based exclusively on profit
maximisation objective alone. Since an enterprise functions in the economic, social, political and cultural
environment, its objectives will have to be set up in relation to its survival and growth in such environments.
Thus, the objectives of an enterprise may be broadly categorised under the following heads:
1) Organic objectives
2) Economic objectives
3) Social objectives
4) Human objectives
5) National objectives
1. Organic objectives: The basic minimum objective of all kinds of enterprises is to survive or to stay
alive. An enterprise can survive only if it is able to produce and distribute products or services at a
price which enables it to recover its costs. If an enterprise does not recover its costs of staying in
business, it will not be in a position to meet its obligations to its creditors, suppliers and employees
with the result that it will be forced into bankruptcy. Therefore, survival of an enterprise is essential for
the continuance of its business activity. Once the enterprise is assured of its survival, it will aim at
growth and expansion.
Growth as an objective has assumed importance with the rise of professional managers. R.L. Marris’s
theory of firm assumes that the goal that managers of a corporate firm set for themselves is to
maximise the firm’s balanced growth rate subject to managerial and financial constraints. In corporate
firms, the structural division of ownership and management, yields opportunity for mangers to set goals
which may not conform to the utility function of owner shareholders. It is pointed out that ability or
success of the managers is judged by their performance in promoting the growth or expansion of the
firm and rewards obtained by them are reflection of their success is achieving growth of the firms
managed by them. While owners want to maximise their utility function which relate to profit, capital,
market share and public reputation, the managers want to maximise their utility function which includes
variables such as salary, power, and status and job security. Although there is divergence and some
degree of conflict between these utility functions, Marris argues that most of the variables incorporated
in both of them are positively related to size of the firm and therefore, the two utility functions converge
into a single variable, namely, a steady growth in the size of the firm. The managers do not aim at
optimising profits; rather they aim at optimisation of the balanced rate of growth of the firm which
involves optimisation of the rate of increase of demand for the commodities of the firm and the rate of
increase of capital supply.
2. Economic objectives: The profit maximising behaviour of the firm has been the most basic
assumption made by economists over the last more than two hundred years and is still at the heart of
neo classical micro economic theory. This assumption is simple, rational and quantitative and is
amenable to equilibrium analysis. Under this assumption, the firm determines the price and output
policy in such a way as to maximize profits within the constraints imposed upon it such as technology,
finance etc. The investors expect that their company will earn sufficient profits in order to ensure fair
dividends to them and to improve the prices of their stocks. Not only investors but creditors and
employees are also interested in a profitable enterprise. Creditors will be reluctant to lend money to an
enterprise which is not making profits. Similarly, any increase in salaries, wages and perquisite of
employees can come only out of profits.
The definition of profits in Economics is different from the accountants’ definition of profits. Profit, in
the accounting sense, is the difference between total revenue and total costs of the firm. Economic
profit is the difference between total revenue and total costs, but total costs here costs include both
explicit and implicit costs. Accounting profit considers only explicit costs while economic profit reflects
explicit and implicit costs i.e. the cost of self-owned factors used by the entrepreneur in his own
business. Since economic profit includes these opportunity costs associated with self-owned factors, it
is generally lower than the accounting profit. When the economist speaks of profits, s/he means profits
after taking into account the capital and labour provided by the owners i.e. s/he differentiates between
normal profits and super normal profits. Normal profits include normal rate of return on capital invested
by the entrepreneur, remuneration for the labour and the reward for risk bearing function of the
entrepreneur.
Normal profit (zero economic profit) is a component of costs and therefore what a business owner
considers as the minimum necessary to continue in the business. Supernormal profit, also called
economic profit or abnormal profit is over and above normal profits. It is earned when total revenue is
greater than the total costs. Total costs in this case include a reward to all the factors, including normal
profit.
The profit maximisation objective has been subject to severe criticism in recent years. Many
economists have pointed out that all firms do not aim to maximise profits. Some firms try to achieve
security, subject to reasonable level of profits. H A Simon argues that firms have ‘satisficing’ behaviour
and strive for profits that are satisfactory. Baumol’s theory of sales maximisation holds that sales
revenue maximisation rather than profit maximisation is the ultimate goal of the business firms. He
cites empirical evidence for his hypothesis that sales rank ahead of profits as the main objective of the
enterprise. He asserts that it is quite a common experience that when an executive is asked about his
business, he will answer that his sales have been increasing (or decreasing) and talks about profits
only as an afterthought. He, however, points out that in their attempt to maximise sales, businessmen
do not completely ignore costs incurred on output and profits to be made.
In 1932, A. A. Berle and G.C. Means pointed out that in large business corporations, management is
separated from ownership and therefore the managers enjoy discretionary powers to set goals of the
firm they manage. Williamson’s model of maximisation of managerial utility function is an important
contribution to managerial theory of firms’ behaviour. The owners (shareholders) of joint stock
companies prefer profit maximisation; but managers maximise their own utility function subject to a
minimum profit, rather than maximising profit.
The objective of utility maximization has been discussed in the context of two types of firms: First in
case of firms owned and managed by the entrepreneur himself, utility maximisation implies that in
choosing an output level, the entrepreneur owner considers not only the money profits which he will
make, but also the sacrifice of leisure which he would have to make in doing the necessary activity for
producing that level of output. Second, in case of large joint stock companies, the utility function of
managers or executives of these companies includes not only the profits which they earn for the
shareholders but also the promotion of sales, maintaining lavish offices, seeking to have a larger
member of staff under their supervision etc. In this case, the manager will maximise his utility by
attaining a best combination of profits and the above mentioned other objectives. Cyert and March
suggests four possible functional goals in addition to profit goal namely, production goal, inventory
goal, sales goal and market share goal.
3. Social objectives: Since an enterprise lives in a society, it cannot grow unless it meets the needs of
the society. Some of the important social objectives of business are:
• To maintain a continuous and sufficient supply of unadulterated goods and articles of standard
quality.
• To avoid profiteering and anti-social practices.
• To create opportunities for gainful employment for the people in the society.
• To ensure that the enterprise’s output does not cause any type of pollution - air, water or
noise.
An enterprise should consistently endeavour to contribute to the quality of life of its community in
particular and the society in general. If it fails to do so, it may not survive for long.
4. Human objectives: Human beings are the most precious resources of an organisation. If they are
ignored, it will be difficult for an enterprise to achieve any of its other objectives. Therefore, the
comprehensive development of its human resource or employees’ should be one of the major
objectives of an organisation. Some of the important human objectives are:
• To provide fair deal to the employees at different levels
• To develop new skills and abilities and provide a work climate in which they will grow as
mature and productive individuals.
• To provide the employees an opportunity to participate in decision-making in matters affecting
them.
• To make the job contents interesting and challenging.
If the enterprise is conscious of its duties towards its employees, it will be able to secure their loyalty
and support.
5. National objectives: An enterprise should endeavour for fulfilment of national needs and aspirations
and work towards implementation of national plans and policies. Some of the national objectives are:
• To remove inequality of opportunities and provide fair opportunity to all to work and to
progress.
• To produce according to national priorities.
• To help the country become self-reliant and avoid dependence on other nations.
• To train young men as apprentices and thus contribute in skill formation for economic growth
and development.
Since all the enterprises have multiple goals, they need to set priorities. This requires appropriate balancing of
the objectives in order to determine the relative importance of each.
Various objectives of an enterprise may conflict with one another. For example, the profit maximisation
objective may not be wholly consistent with the marketing objective of increasing its market share which may
involve improvement in quality, slashing down of product prices, improved customer service, etc. Similarly, its
social responsibility objective may run into conflict with the introduction of technological changes which may
cause unemployment or environmental pollution. In such situations, the manager has to strike a balance
between the two so that both can be achieved with reasonable success.
In the above paragraphs, we have discussed the different objectives of an enterprise. However, no
comprehensive economic theory explaining the multitudes of behaviour of firms under various market
conditions (perfect competition, monopoly, etc.) has been developed so far. Therefore, in rest of this book, we
shall continue to assume that firms aim at maximising profits until and unless otherwise mentioned.
In the pursuit of this objective, an enterprise’s actions may get constrained by many factors. Important among
them are:
1. Lack of knowledge and information: The enterprise functions in an uncertain world where due to lack of
accurate information, many variables that affect the performance of the firm cannot be correctly
predicted for the current month or the current year, let alone for the future years. Similarly, the firms
may not know about the prices of all inputs and the characteristics of all relevant technologies. Under
such circumstances, it is very difficult to determine what the profit maximising price is.
2. There may be other constraints such as restrictions imposed in the public interest by the state on the
production, price and movement of factors. In practice, there are several hindrances for free mobility of
labour and capital. For example, trade unions may place several restrictions on the mobility of labour
or specialised training may be required to enable workers to change occupation. These contingencies
may make attainment of maximum profits a difficult task.
3. There may be infrastructural inadequacies and consequent supply chain bottlenecks resulting in
shortages and unanticipated emergencies. For example, there could be frequent power cuts, irregular
supply of raw-materials or non-availability of proper transport. This could put limitations on the power
of enterprises to maximise profits.
4. Changes in business and economic conditions which become contagious due to the highly connected
nature of economies, place constraints by causing demand fluctuations and instability in firms’ sales
and revenues. Besides, external factors such as sudden change in government policies with regard to
location, prices, taxes, production, etc. or natural calamities like fire, flood etc. may place additional
burdens on the business firms and defeat their plans. When firms are forced to implement policies in
response to fiscal limitations, legal, regulatory, or contractual requirements, these have adverse
consequences on the firms’ profitability and growth plans.
5. Events such as inflation, rising interest rates, unfavourable exchange rate fluctuations cause increased
raw material, capital and labour costs and affect the budgets and financial plans of firms. Significant
constraints are also imposed by the inability of firms to find skilled workforce at competitive wages as
well as due to the recurring need for personnel training.
Enterprise’s Problems
An enterprise faces a number of problems from its inception, through its life time and till its closure. We shall try
to get a few insights about them from the following discussion.
Problems relating to objectives: As mentioned earlier, an enterprise functions in the economic, social,
political and cultural environment. Therefore, it has to set its objectives in relation to its environment. The
problem is that these objectives are multifarious and very often conflict with one another. For example, the
objective of maximising profits is in conflict with the objective of increasing the market share which generally
involves improving the quality, slashing the prices etc. Thus the enterprise faces the problem of not only
choosing its objectives but also striking a balance among them.
Problems relating to location and size of the plant: An enterprise has to decide about the location of its
plant. It has to decide whether the plant should be located near the source of raw material or near the market. It
has to consider costs such as cost of labour, facilities and cost of transportation. Of course, the entrepreneur
will have to weigh the relevant factors against one another in order to choose the right location which is most
economical.
Another problem relates to the size of the firm. It has to decide whether it is to be a small scale unit or large
scale unit. Due consideration will have to be given to technical, managerial, marketing and financial aspects of
the proposed business before deciding on the scale of operations. It goes without saying that the management
must make a realistic evaluation of its strengths and limitations while choosing a particular size for a new unit.
Problems relating to selecting and organising physical facilities: A firm has to make decision on the nature
of production process to be employed and the type of equipments to be installed. The choice of the process
and equipments will depend upon the design chosen and the required volume of production. As a rule,
production on a large scale involves the use of elaborate, specialized and complicated machinery and
processes. Quite often, the entrepreneur has to choose from among different types of equipments and processes of
production. Such a choice will be based on the evaluation of their relative cost and efficiency. Having determined the
equipment to be used and the processes to be employed, the entrepreneur will prepare a layout illustrating the
arrangement of equipments and buildings and the allocation for each activity.
Problems relating to Finance: An enterprise has to undertake not only physical planning but also expert
financial planning. Financial planning involves (i) determination of the amount of funds required for the
enterprise with reference to the physical plans already prepared (ii) assessment of demand and cost of its
products (iii) estimation of profits on investment and comparison with the profits of comparable existing
concerns to find out whether the proposed investment will be profitable enough and (iv) determining capital
structure and the appropriate time for financing the enterprise etc.
Problems relating to organisation structure: An enterprise also faces problems relating to the organisational
structure. It has to divide the total work of the enterprise into major specialised functions and then constitute
proper departments for each of its specialized functions. Not only this, the functions of all the positions and
levels would have to be clearly laid down and their inter-relationship (in terms of span of control, authority,
responsibility, etc) should be properly defined. In the absence of clearly defined roles and relationships, the
enterprise may not be able to function efficiently.
Problems relating to marketing: Proper marketing of its products and services is essential for the survival and growth
of an enterprise. For this, the enterprise has to discover its target market by identifying its actual and potential
customers, and determine tactical marketing tools it can use to produce desired responses from its target
market. After identifying the market, the enterprise has to make decision regarding 4 P’s namely,
♦ Product: variety, quality, design, features, brand name, packaging, associated services, utility etc.
♦ Promotion: Methods of communicating with consumers through personal selling, social contacts,
advertising, publicity etc.
♦ Price: Policies regarding pricing, discounts, allowance, credit terms, concessions, etc.
♦ Place: Policy regarding coverage, outlets for sales, channels of distribution, location and layout of
stores, inventory, logistics etc.
Problems relating to legal formalities: A number of legal formalities have to be carried out during the time of
launching of the enterprise as well as during its life time and its closure. These formalities relate to assessing
and paying different types of taxes (corporate tax, excise duty, sales tax, custom duty, etc.), maintenance of
records, submission of various types of information to the relevant authorities from to time, adhering to various
rules and laws formulated by government (for example, laws relating to location, environmental protection and
control of pollution, size, wages and bonus, corporate management licensing, prices) etc.
Problems relating to industrial relations: With the emergence of the present day factory system of
production, the management has to devise special measures to win the co-operation of a large number of
workers employed in industry. Misunderstanding and conflict of interests have assumed enormous dimensions
that these cannot be easily and promptly dealt with. Industrial relations at present are much more involved and
complicated. Various problems which an enterprise faces with regard to industrial relations are - the problem of
winning workers’ cooperation, the problem of enforcing proper discipline among workers, the problem of
dealing with organised labour and the problem of establishing a state of democracy in the industry by
associating workers with the management of industry.
1.2 PRODUCTION FUNCTION

The production function is a statement of the relationship between a firm’s scarce resources (i.e. its inputs) and
the output that results from the use of these resources. More specifically, it states technological relationship
between inputs and output. The production function can be algebraically expressed in the form of an equation
in which the output is the dependent variable and inputs are the independent variables. The equation can be
expressed as:
Q = f (a, b, c, d …….n)
Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are the different factors (inputs)
and services used per unit of time.
Assumptions of Production Function: There are three main assumptions underlying any production function.
First we assume that the relationship between inputs and outputs exists for a specific period of time. In other
words, Q is not a measure of accumulated output over time.
Second, it is assumed that there is a given “state-of-the-art” in the production technology. Any innovation would
cause change in the relationship between the given inputs and their output. For example, use of robotics in
manufacturing or a more efficient software package for financial analysis would change the input-output
relationship.
Third assumption is that whatever input combinations are included in a particular function, the output resulting
from their utilization is at the maximum level.
The production function can be defined as:
The relationship between the maximum amount of output that can be produced and the input required
to make that output. It is defined for a given state of technology i.e., the maximum amount of output
that can be produced with given quantities of inputs under a given state of technical knowledge.
(Samuelson)
It can also be defined as the minimum quantities of various inputs that are required to yield a given
quantity of output.
The output takes the form of volume of goods or services and the inputs are the different factors of production
i.e., land, labour, capital and enterprise. To illustrate, for a company which produces beverages, the inputs
could be fixed assets such as plant and machinery; raw materials such as carbonated water, sweeteners and
flavourings and labour such as assembly line workers, support-staff and supervisory personnel.
For the purpose of analysis, the whole array of inputs in the production function can be reduced to two; L and
K. Restating the equation given above, we get:
Q = f (L, K). Where Q = Output
L= Labour
K= Capital
Short-Run Vs Long-Run Production Function
The production function of a firm can be studied in the context of short period or long period. It is to be noted
that in economic analysis, the distinction between short-run and long-run is not related to any particular
measurement of time (e.g. days, months, or years). In fact, it refers to the extent to which a firm can vary the
amounts of the inputs in the production process. A period will be considered short-run period if the amount of at
least one of the inputs used remains unchanged during that period. Thus, short-run production function shows
the maximum amount of a good or service that can be produced by a set of inputs, assuming that the amount of
at least one of the inputs used remains fixed (or unchanged). Generally, it has been observed that during the
short period or in the short run, a firm cannot install a new capital equipment to increase production. It implies
that capital is a fixed factor in the short run. Thus, in the short-run, the production function is studied by holding
the quantities of capital fixed, while varying the amount of other factors (labour, raw material etc.) This is done
when the law of variable proportion is studied.
The production function can also be studied in the long run. The long run is a period of time (or planning
horizon) in which all factors of production are variable. It is a time period when the firm will be able to install
new machines and capital equipments apart from increasing the variable factors of production. A long-run
production function shows the maximum quantity of a good or service that can be produced by a set of inputs,
assuming that the firm is free to vary the amount of all the inputs being used. The behaviour of production when
all factors are varied is the subject matter of the law of returns to scale.
1.2.0 Cobb-Douglas Production Function

A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and C.W. Cobb
of the U.S.A. studied the production function of the American manufacturing industries. In its original form, this
production function applies not to an individual firm but to the whole of manufacturing in the United States. In
this case, output is manufacturing production and inputs used are labour and capital.
Cobb-Douglas production function is stated as:
Q = KLa C (1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are positive constants.
The conclusion drawn from this famous statistical study is that labour contributed about 3/4th and capital about
1/4th of the increase in the manufacturing production. Although, the Cobb-Douglas production function suffers
from many shortcomings, it is extensively used in Economics as an approximation.
1.2.1 The Law of Variable Proportions or The Law of Diminishing Returns

In the short run, the input output relations are studied with one variable input (labour) with all other inputs held
constant. The laws of production under these conditions are known under various names as the law of variable
proportions (as the behaviour of output is studied by changing the proportion in which inputs are combined) the
law of returns to a variable input (as any change in output is taken as resulting from the additional variable
input) or the law of diminishing returns (as returns eventually diminish).
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. In other words, an increase in some
inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a
point, the extra output resulting from the same addition of extra input will become less and less.
Before discussing this law, if would be appropriate to understand the meaning of total product, average product
and marginal product.
Total Product (TP): Total product is the total output resulting from the efforts of all the factors of production
combined together at any time. If the inputs of all but one factor are held constant, the total product will vary
with the quantity used of the variable factor. Column (1) of Table 1 presents the quantity of variable factor
(labour) used along with the factors whose quantity is held constant and column (2) represent the total product
at various levels of use of the variable input.
Table 1: Product Schedule

Quantity of labour Total Product (TP) Average Product (AP) Marginal Product (MP)
(1) (2) (3) (4)
1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 440 110.0 110
5 520 104.0 80
6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 750 75.0 0
11 740 67.3 –10
We find that when one unit of labour is employed along with other factors of production, the total product is 100 units. When
two units of labour are employed, the total product rises to 210 units. The total product goes on rising as more and more
units of labour are employed. With 9 or 10 units of labour, the total product rises to maximum level of 750 units. When 11
units of labour are employed, total product falls to 740 units due to negative returns from the 11th unit of labour.
Average Product (AP): Average product is the total product per unit of the variable factor.
AP= Total Product

No.of units of Variable Factor
It is shown as a schedule in column (3) of Table 1. When one unit of labour is employed, average product is
100, when two units of labour are employed, average product rises to 105. This goes on, as shown in Table 1.
Marginal Product (MP): Marginal product is the change in total product per unit change in the quantity of
variable factor. In other words, it is the addition made to the total production by an additional unit of input.
Symbolically,
MPn = TPn – TPn-1
The computed value of the marginal product appears in the last column of Table 1. For example, the MP
corresponding to 4 units is given as 110 units. This reflects the fact that an increase in labour from 3 to 4 units,
has increased output from 330 to 440 units.
Relationship between Average Product and Marginal Product: Both average product and marginal product are
derived from the total product. Average product is obtained by dividing total product by the number of units of the
variable factor and marginal product is the change in total product resulting from a unit increase in the quantity of
variable factor. The relationship between average product and marginal product can be summed up as follows:
(i) when average product rises as a result of an increase in the quantity of variable input, marginal
product is more than the average product.
(ii) when average product is maximum, marginal product is equal to average product. In other words, the
marginal product curve cuts the average product curve at its maximum.
(iii) when average product falls, marginal product is less than the average product.
Table 1 and Figure 1 confirm the above relationship.
The Law of Variable Proportions or the Law of Diminishing Returns examines the production function with one
factor variable, keeping quantities of other factors fixed. In other words, it refers to input-output relationship,
when the output is increased by varying the quantity of one input. This law operates in the short run ‘when all
factors of production cannot be increased or decreased simultaneously (for example, we cannot build a plant or
dismantle a plant in the short run).
The law operates under certain assumptions which are as follows:
1. The state of technology is assumed to be given and unchanged. If there is any improvement in
technology, then marginal product and average product may rise instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases when all
factors are proportionately varied. When all the factors are proportionately varied, laws of returns to
scale are applicable.
3. The law does not apply to those cases where the factors must be used in fixed proportions to yield
output. When the various factors are required to be used in fixed proportions, an increase in one factor
would not lead to any increase in output i.e., marginal product of the variable factor will then be zero
and not diminishing.
4. We consider only physical inputs and outputs and not economic profitability in monetary terms.
The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the others
can be divided into three distinct stages or laws. In order to understand these three stages or laws, we may
graphically illustrate the production function with one variable factor. This is done in Figure 1.
In this figure, the quantity of variable factor is depicted on the X axis and the Total Product (TP), Average
Product (AP) and Marginal Product (MP) are shown on the Y-axis. As the figure shows, the TP curve goes on
increasing upto to a point and after that it starts declining. AP and MP curves first rise and then decline; MP
curve starts declining earlier than the AP curve.
The behaviour of these Total, Average and Marginal Products of the variable factor consequent on the increase
in its amount is generally divided into three stages (laws) which are explained below.
Fig. 1: Law of Variable Proportions
Stage 1: The Stage of Increasing Returns: In this stage, the total product increases at an increasing rate
upto a point (in figure upto point F), marginal product also rises and is maximum at the point corresponding to
the point of inflexion and average product goes on rising. From point F onwards during the stage one, the total
product goes on rising but at a diminishing rate. Marginal product falls but is positive. The stage 1 ends where
the AP curve reaches its highest point.
Thus, in the first stage, the AP curve rises throughout whereas the marginal product curve first rises and then
starts falling after reaching its maximum. It is to be noted that the marginal product although starts declining,
remains greater than the average product throughout the stage so that average product continues to rise.
Explanation of law of increasing returns: The law of increasing returns operates because in the beginning, the
quantity of fixed factors is abundant relative to the quantity of the variable factor. As more units of the variable factor
are added to the constant quantity of the fixed factors, the fixed factors are more intensively and effectively utilised
i.e., the efficiency of the fixed factors increases as additional units of the variable factors are added to them. This
causes the production to increase at a rapid rate. For example, if a machine can be efficiently operated when four
persons are working on it and if in the beginning we are operating it only with three persons, production is bound to
increase if the fourth person is also put to work on the machine since the machine will be effectively utilised to its
optimum. This happens because, in the beginning some amount of fixed factor remained unutilised and, therefore,
when the variable factor is increased, fuller utilisation of the fixed factor becomes possible and it results in increasing
returns. A question arises as to why the fixed factor is not initially taken in a quantity which suits the available
quantity of the variable factor. The answer is that, generally, those factors which are indivisible are taken as fixed.
Indivisibility of a factor means that due to technological requirements, a minimum amount of that factor must be
employed whatever be the level of output. Thus, as more units of the variable factor are employed to work with an
indivisible fixed factor, output greatly increases due to fuller utilisation of the latter. The second reason why we get
increasing returns at the initial stage is that as more units of the variable factor are employed, the efficiency of the
variable factor increases. This is because introduction of division of labour and specialisation becomes possible with
sufficient quantity of the variable factor and these results in higher productivity.
Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase at a diminishing rate until it
reaches its maximum at point H, where the second stage ends. In this stage, both marginal product and average product of
the variable factor are diminishing but are positive. At the end of this stage i.e., at point M (corresponding to the highest
point H of the total product curve), the marginal product of the variable factor is zero. Stage 2, is known as the stage of
diminishing returns because both the average and marginal products of the variable factors continuously fall during this
stage. This stage is very important because the firm will seek to produce within its range.
Explanation of law of diminishing returns: The question arises as to why we get diminishing returns after a
certain amount of the variable factor has been added to the fixed quantity of that factor. As explained above,
increasing returns occur primarily because of more efficient use of fixed factors as more units of the variable
factor are combined to work with it. Once the point is reached at which the amount of variable factor is
sufficient to ensure efficient utilisation of the fixed factor, any further increases in the variable factor will cause
marginal and average product to decline because the fixed factor then becomes inadequate relative to the
quantity of the variable factor. Continuing the above example, when four men were put to work on one machine,
the optimum combination was achieved. Now, if the fifth person is put on the machine, his contribution will be
nil. In other words, the marginal productivity will start diminishing.
The phenomenon of diminishing returns, like that of increasing returns, rests upon the indivisibility of the fixed
factor. Just as the average product of the variable factor increases in the first stage when better utilisation of
the fixed indivisible factor is being made, so the average product of the variable factor diminishes in the second
stage when the fixed indivisible factor is being worked too hard. Another reason offered for the operation of the
law of diminishing returns is the imperfect substitutability of one factor for another. Had the perfect substitute of
the scarce fixed factor been available, then the paucity of the scarce fixed factor during the second stage would
have been made up by increasing the supply of its perfect substitute with the result that output could be
expanded without diminishing returns.
Stage 3: Stage of Negative Returns: In Stage 3, total product declines, MP is negative, average product is
diminishing. This stage is called the stage of negative returns since the marginal product of the variable factor
is negative during this stage.
Explanation the law of negative returns: As the amount of the variable factor continues to be increased to a
constant quantity of the other, a stage is reached when the total product declines and marginal product
becomes negative. This is due to the fact that the quantity of the variable factor becomes too excessive relative
to the fixed factor so that they get in each other’s ways with the result that the total output falls instead of rising.
In such a situation, a reduction in the units of the variable factor will increase the total output.
Stage of Operation: An important question is in which stage a rational producer will seek to produce. A
rational producer will never produce in stage 3 where marginal product of the variable factor is negative. This
being so, a producer can always increase his output by reducing the amount of variable factor. Even if the
variable factor is free of cost, a rational producer stops before the beginning of the third stage.
A rational producer will also not produce in stage 1 as he will not be making the best use of the fixed factors
and he will not be utilising fully the opportunities of increasing production by increasing the quantity of the
variable factor whose average product continues to rise throughout stage 1. Even if the fixed factor is free of
cost in this stage, a rational entrepreneur will continue adding more variable factors.
It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called
stages of ‘economic absurdity’ or ‘economic non-sense’.
A rational producer will always produce in stage 2 where both the marginal product and average product of the
variable factors are diminishing. At which particular point in this stage, the producer will decide to produce
depends upon the prices of factors. The optimum level of employment of the variable factor (here labour) will be
determined by applying the principle of marginalism in such a way that the marginal revenue product of labour
is equal to the marginal wages. (The principle of marginalism is explained in detail in the chapter discussing
equilibrium in different types of markets.)
1.2.2 Returns to Scale

We shall now study about changes in output when all factors of production in a particular production function
are increased together. In other words, we shall study the behaviour of output in response to a change in the
scale. A change in scale means that all factors of production are increased or decreased in the same
proportion. Change in scale is different from changes in factor proportions. Changes in output as a result of the
variation in factor proportions, as seen before, form the subject matter of the law of variable proportions. On the
other hand, the study of changes in output as a consequence of changes in scale forms the subject matter of
returns to scale which is discussed below. It should be kept in mind that the returns to scale faced by a firm
are solely technologically determined and are not influenced by economic decisions taken by the firm or by
market conditions.
Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale in a given
proportion and output increases in the same proportion, returns to scale are said to be constant. Thus, if
doubling or trebling of all factors causes a doubling or trebling of output, then returns to scale are constant. But,
if the increase in all factors leads to more than proportionate increase in output, returns to scale are said to be
increasing. Thus, if all factors are doubled and output increases more than double, then the returns to scale are
said to be increasing. On the other hand, if the increase in all factors leads to less than proportionate increase
in output, returns to scale are decreasing. It is needless to say that this law operates in the long run when all
the factors can be changed in the same proportion simultaneously.
It should be remembered that increasing returns to scale is not the same as increasing marginal returns.
Increasing returns to scale applies to ‘long run’ in which all inputs can be changed. Increasing marginal returns
refers to the short run in which at least one input is fixed. The existence of fixed inputs in the short run gives
rise to increasing and later to diminishing marginal returns.
Constant Returns to Scale: As stated above, constant returns to scale means that with the increase in the
scale in some proportion, output increases in the same proportion. Constant returns to scale, otherwise called
as “Linear Homogeneous Production Function”, may be expressed as follows:
kQx = f( kK, kL)
= k (K, L)
If all the inputs are increased by a certain amount (say k) output increases in the same proportion (k). It has
been found that an individual firm passes through a long phase of constant returns to scale in its lifetime.
Increasing Returns to Scale: As stated earlier, increasing returns to scale means that output increases in a greater
proportion than the increase in inputs. When a firm expands, increasing returns to scale are obtained in the beginning.
For example, a wooden box of 3 ft. cube contains 9 times greater wood than the wooden box of 1 foot-cube. But the
capacity of the 3 foot- cube box is 27 times greater than that of the one foot cube. Many such examples are found in the
real world. Another reason for increasing returns to scale is the indivisibility of factors. Some factors are available in
large and lumpy units and can, therefore, be utilised with utmost efficiency at a large output. If all the factors are
perfectly divisible, increasing returns may not occur. Returns to scale may also increase because of greater possibilities
of specialisation of land and machinery.
Decreasing Returns to Scale: When output increases in a smaller proportion relative to an increase in all
inputs, decreasing returns to scale are said to prevail. When a firm goes on expanding by increasing all inputs,
decreasing returns to scale set in. Decreasing returns to scale eventually occur because of increasing
difficulties of management, coordination and control. When the firm has expanded to a very large size, it is
difficult to manage it with the same efficiency as earlier.
The Cobb-Douglas production function, explained earlier is used to explain “returns to scale” in production.
Originally, Cobb and Douglas assumed that returns to scale are constant. The function was constructed in such
a way that the exponents summed to a+1-a=1. However, later they relaxed the requirement and rewrote the
equation as follows:
Q = K La C b
Where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital, ‘K’ and ‘a’ and ‘b’ are positive
constants.
If a + b > 1 Increasing returns to scale result i.e. increase in output is more than the proportionate
increase in the use of factors (labour and capital).
a+b=1 Constant returns to scale result i.e. the output increases in the same proportion in which
factors are increased.
a+b<1 decreasing returns to scale result i.e. the output increases less than the proportionate
increase in the labour and capital.
1.3 PRODUCTION OPTIMISATION

Normally, a profit maximising firm is interested to know what combination of factors of production (or inputs)
would minimise its cost of production for a given output. This can be known by combining the firm’s production
and cost functions, namely isoquants and iso-cost lines respectively.
Isoquants: Isoquants are similar to indifference curves in the theory of consumer behaviour. An isoquant
represents all those combinations of inputs which are capable of producing the same level of output. Since an
isoquant curve represents all those combination of inputs which yield an equal quantity of output, the producer
is indifferent as to which combination he chooses. Therefore, Isoquants are also called equal-product curves,
production indifference curves or iso-product curves. The concept of isoquant can be easily understood with the
help of the following schedule.
Table 2 : Various combinations of X and Y to produce a given level of output
Factor combination Factor X Factor Y MRTS

A 1 12
B 2 08 4
C 3 05 3
D 4 03 2
E 5 02 1
When we plot the various combinations of factor X and factor Y, we get a curve IQ as shown in Figure 2.
Fig. 2 : Equal Product Curve or Isoquant
Isoquants have properties similar to indifference curves. Isoquants are negatively sloped, convex to the origin
due to diminishing marginal rate of technical substitution (MRTS) and are non-intersecting. However, there is
one important difference between the two: whereas in an indifference curve it is not possible to quantify the
level of satisfaction acquired by the consumer, the level of production acquired by the producer is easily
quantified. Thus, while isoquant IQ1 represents 100 units, curves IQ2, IQ3 etc. representing higher levels of
production can be drawn. While a curve on the right represents a higher level of output that on the left
represents a lower level of output.
Iso cost or Equal-cost Lines: Iso cost line, also known as budget line or the budget constraint line, shows the
various alternative combinations of two factors which the firm can buy with given outlay. Suppose a firm has
Rs. 1,000 to spend on the two factors X and Y. If the price of factor X is Rs. 10 and that of Y is Rs. 20, the firm
can spend its outlay on X and Y in various ways. It can spend the entire amount on X and thus buy 100 units of
X and zero units of Y or it can spend the entire outlay on Y and buy 50 units of it with zero units of X factor. In
between, it can have any combination of X and Y. Whatever be the combination of factors the firm chooses, the
total cost to the firm remains the same. In other words, all points on a budget line would cost the firm the same
amount.
We can show the iso-cost line diagrammatically also. The X-axis shows the units of factor X and Y-axis the
units of factor Y. When the entire ` 1,000 is spent on factor X, we get OB of factor X and when the entire
amount is spent on factor Y we get OA of factor Y . The straight line AB which joins points A and B will pass
through all combinations of factors X and Y which the firm can buy with outlay of ` 1,000. The line AB is called
iso-cost line.
Fig. 3: Iso-cost lines

Figure 3 shows various iso-cost lines representing different combinations of factors with different outlays.
Isoquants, which represent the technical conditions of production for a product and iso-cost lines which
represent various ‘levels of cost or outlay’ (given the prices of two factors) can help the firm to optimize its
production. It may try to minimise its cost for producing a given level of output or it may try to maximise the
output for a given cost or outlay. Suppose the firm has already decided about the level of output to be
produced. Then the question is with which factor combination the firm should try to produce the pre-decided
level of output. The firm will try to use the least-cost combination of factors. The least cost combination of
factors can be found by super-imposing the isoquant that represents the pre decided level of output on the iso-
cost lines. This is shown in Figure 4.
Fig. 4 : Least-cost Combination of Factors: Producer’s Equilibrium

Suppose the firm has decided to produce 1,000 units (represented by iso-quant P). These units can be
produced by any factor combination lying on P such as A, B, C, D, E, etc. The cost of producing 1,000 units
would be minimum at the factor combination represented by point C where the iso-cost line MM1 is tangent to
the given isoquant P. At all other points such as A, B, D, E the cost is more as these points lie on higher iso-
cost lines Compared to MM1. Thus, the factor combination represented by point C is the optimum combination
for the producer. It represents the least-cost of producing 1,000 units of output. It is thus clear that the tangency
point of the given isoquant with an iso-cost line represents the least cost combination of factors for producing a
given output.
SUMMARY
 Production is the outcome of the combined activity of the four factors of production viz, land, labour,
capital and organization. In simple terms production, means ‘creation of utility’. i.e. Utility of form, utility
of place, utility of time and personal utility.
 Production does not include work done out of love and affection, voluntary services and goods
produced for self-consumption. Intention to exchange in the market is an essential component of
production.
 Land includes all those free natural resources whose supply for the economy as a whole is fixed.
 Labour is all human efforts of body or of mind undergone partly or wholly with a view to secure an
income apart from the pleasure derived directly from the work.
 Capital is that part of wealth of an individual or community which is used for further production of
wealth. Capital, a stock concept, refers to produced means of production and it comprises of man-
made machines and materials which are used for further production.
 Capital formation, also known as investment, means a sustained increase in the stock of real capital in a
country. There are mainly three stages of capital formation viz. Savings which depends on ability to save and
willingness to save; Mobilisation of savings which depends on availability of financial institutions and products;
and Investment i.e. the process whereby the real savings get converted into real capital assets.
 Entrepreneur is the person who organises business; initiates production, remunerates other factors of
production, introduces innovations and bears the risk and uncertainties of business.
 The objectives of an enterprise may be broadly categorised under the following heads. (i) Organic
objectives (ii) Economic objectives (iii) Social objectives (iv) Human objectives (v) National objectives.
 An enterprise faces a number of problems from its inception, through its life time and till its closure.
These may relate to objectives, location, size, physical facilities, finance, organization structure,
marketing, legal formalities and industrial relations.
 Factors of production can be divided into two categories – Fixed factors are those factors whose
quantity remains unchanged with changes in output within a capacity and variable factors are those the
quantity of which change with a change in the level of output.
 Production function is the technical relationship between inputs and output. Samuelson describes
production function as the relationship between the maximum amount of output that can be produced
and the input required to make that output. It is defined for a given state of technology.
 The law of variable proportion or the law of diminishing returns is relevant when some factors are kept
fixed and others are varied. It is applicable to the short-run.
 There are three stages of the law of variable proportion – where law of increasing returns, law of
diminishing returns and law of negative returns operate.
 Total product is the total output resulting from the efforts of all the factors of production combined
together at any time.
 Marginal product is the change in total product per unit change in the quantity of variable factor.
 Average product is the total product per unit of the variable factor.
 The Law of returns to scale describes the relationship between inputs and output in the long run when
all inputs are changed in the same proportion. Returns to scale may be constant, increasing and
decreasing.
 Constant returns to scale occur when the inputs increase by some proportion and the output also
increases by the same proportion. It is also called linear homogeneous production function.
 Increasing returns to scale occur when the inputs increase by some proportion and the output
increases more than proportionately.
 Decreasing returns to scale occur when the inputs increase by some proportion and the output
increases less than proportionately.
 Isoquants or product indifference curves show all those combinations of different factors of production
which give the same output to the producer.
 Iso-cost lines show various combinations of two factors which the firm can buy with given expenditure
or outlay.
 By combining Isoquants and iso-cost lines, a producer can find out the combination of factors of
production which is optimum i.e. the combination of factors of production which would minimise his
cost of production.
 For producing a given output, the tangency point of the relevant isoquant (representing the output) with
an iso-cost line represents the least cost combination of factors.
UNIT 2 : THEORY OF COST
LEARNING OUTCOMES
 Explain the Meaning and Different Types of Costs.
 Define Cost Function and Explain the Difference between a Short-Run and Long-Run Cost Function.
 Explain the linkages between the Production Function and the Cost Function.
 Explain Economies and Diseconomies of Scale and Reasons for Their Existence.
In the previous unit, we have discussed the relationship between inputs and output in physical quantities. However, as
we are aware, business decisions are generally based on cost of production i.e. the money value of inputs and output is
considered. Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria, namely,
size of output, scale of operations, prices of factors of production and other relevant economic variables. In other words,
cost analysis is concerned with the financial aspects of production relations as against physical aspects which were
considered in production analysis. In order to have a clear understanding of the cost function, it is important for a
businessman to understand various concepts of costs.
2.0 COST CONCEPTS

Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of production which
he employs for production. He thus pays wages to workers employed, prices for the raw materials, fuel and
power used, rent for the building he hires and interest on the money borrowed for doing business. All these are
included in his cost of production and are termed as accounting costs. Accounting costs relate to those costs
which involve cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and
includes all the payments and charges made by the entrepreneur to the suppliers of various productive factors.
Accounting costs are expenses already incurred by the firm. Accountants record these in the financial
statements of the firm.
However, it generally happens that an entrepreneur invests a certain amount of capital in his business. If the
capital invested by the entrepreneur in his business had been invested elsewhere, it would have earned a
certain amount of interest or dividend. Moreover, an entrepreneur may devote his time to his own work of
production and contributes his entrepreneurial and managerial ability to do business. Had he not set up his own
business, he would have sold his services to others for some positive amount of money. Accounting costs do
not include these costs. These costs form part of economic cost. Thus, economic costs include: (1) the normal
return on money capital invested by the entrepreneur himself in his own business; (2) the wages or salary not
paid to the entrepreneur, but could have been earned if the services had been sold somewhere else. Likewise,
the monetary rewards for all factors owned by the entrepreneur himself and employed by him in his own
business are also considered a part of economic costs. Economic costs take into account these accounting
costs; in addition, they also take into account the amount of money the entrepreneur could have earned if he
had invested his money and sold his own services and other factors in the next best alternative uses.
Accounting costs are also called explicit costs whereas the cost of factors owned by the entrepreneur himself
and employed in his own business is called implicit costs. Thus, economic costs include both accounting costs
and implicit costs. Therefore, economic costs are useful for businessmen while making decisions.
The concept of economic cost is important because an entrepreneur must cover his economic cost if he wants
to earn normal profits. Normal profit is part of implicit costs. If the total revenue received by an entrepreneur
just covers both implicit and explicit costs, then he has zero economic profits. Super normal profits or positive
economic profits (abnormal profits) are over and above these normal profits. In other words, an entrepreneur is
said to be earning positive economic profits (abnormal profits) only when his revenues are greater than the sum
of his explicit costs and implicit costs.
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, say, wages,
materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned with the cost of the next best
alternative opportunity which was foregone in order to pursue a certain action. It is the cost of the missed
opportunity and involves a comparison between the policy that was chosen and the policy that was rejected.
For example, the opportunity cost of using capital is the interest that it can earn in the next best use with equal
risk.
A distinction between outlay costs and opportunity costs can be drawn on the basis of the nature of the
sacrifice. Outlay costs involve financial expenditure at some point of time and hence are recorded in the books
of account. Opportunity cost is the amount or subjective value that is foregone in choosing one activity over the
next best alternative. It relates to sacrificed alternatives; it is, in general not recorded in the books of account.
The opportunity cost concept is generally very useful for business managers and therefore it has to be
considered whenever resources are scarce and a decision involving choice of one option over other(s) is
involved. e.g., in a cloth mill which spins its own yarn, the opportunity cost of yarn to the weaving department is
the price at which the yarn could be sold. This has to be considered while measuring profitability of the weaving
operations.
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating the cost of higher
education, it is not the tuition fee and cost of books alone that are relevant. One should also take into account
the earnings foregone, other foregone uses of money which is paid as tuition fees and the value of missed
activities etc. as the cost of attending classes.
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those which have direct
relationship with a component of operation like manufacturing a product, organizing a process or an activity etc.
Since such costs are directly related to a product, process or machine, they may vary according to the changes
occurring in these. Direct costs are costs that are readily identified and are traceable to a particular product,
operation or plant. Even overhead costs can be direct as to a department; manufacturing costs can be direct to
a product line, sales territory, customer class etc. We must know the purpose of cost calculation before
considering whether a cost is direct or indirect.
Indirect costs are those which are not easily and definitely identifiable in relation to a plant, product, process or
department. Therefore, such costs are not visibly traceable to specific goods, services, operations, etc.; but are
nevertheless charged to different jobs or products in standard accounting practice. The economic importance of
these costs is that these, even though not directly traceable to a product, may bear some functional relationship
to production and may vary with output in some definite way. Examples of such costs are electric power and
common costs incurred for general operation of business benefiting all products jointly.
Incremental costs and Sunk costs: Theoretically, incremental costs are related to the concept of marginal
cost. Incremental cost refers to the additional cost incurred by a firm as result of a business decision. For
example, incremental costs will have to be incurred by a firm when it makes a decision to change its product
line, replace worn out machinery, buy a new production facility or acquire a new set of clients. Sunk costs refer
to those costs which are already incurred once and for all and cannot be recovered. They are based on past
commitments and cannot be revised or reversed if the firm wishes to do so. Examples of sunk costs are
expenses incurred on advertising, R& D, specialised equipments and fixed facilities such as railway lines. Sunk
costs act as an important barrier to entry of firms into business.
Historical costs and Replacement costs: Historical cost refers to the cost incurred in the past on the
acquisition of a productive asset such as machinery, building etc. Replacement cost is the money expenditure
that has to be incurred for replacing an old asset. Instability in prices make these two costs differ. Other things
remaining the same, an increase in price will make replacement costs higher than historical cost.
Private costs and Social costs: Private costs are costs actually incurred or provided for by firms and are
either explicit or implicit. They normally figure in business decisions as they form part of total cost and are
internalised by the firm. Social cost, on the other hand, refers to the total cost borne by the society on account
of a business activity and includes private cost and external cost. It includes the cost of resources for which the
firm is not required to pay price such as atmosphere, rivers, roadways etc. and the cost in terms of dis-utility
created such as air, water and environment pollution.
Fixed and Variable costs: Fixed or constant costs are not a function of output; they do not vary with output
upto a certain level of activity. These costs require a fixed expenditure of funds irrespective of the level of
output, e.g., rent, property taxes, interest on loans and depreciation when taken as a function of time and not of
output. However, these costs vary with the size of the plant and are a function of capacity. Therefore, fixed
costs do not vary with the volume of output within a capacity level.
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. They can be avoided only
when the operations are completely closed down. These are, by their very nature, inescapable or uncontrollable costs.
But, there are some costs which will continue even after the operations are suspended, as for example, for storing of old
machines which cannot be sold in the market. These are called shut down costs. Some of the fixed costs such as costs
of advertising, etc. are programmed fixed costs or discretionary expenses, because they depend upon the discretion of
management whether to spend on these services or not.
Variable costs are costs that are a function of output in the production period. For example, wages of casual
labourers and cost of raw materials and cost of all other inputs that vary with output are variable costs. Variable
costs vary directly and sometimes proportionately with output. Over certain ranges of production, they may vary
less or more than proportionately depending on the utilization of fixed facilities and resources during the
production process.
2.1 COST FUNCTION

Cost function refers to the mathematical relation between cost of a product and the various determinants of
costs. In a cost function, the dependent variable is unit cost or total cost and the independent variables are the
price of a factor, the size of the output or any other relevant phenomenon which has a bearing on cost, such as
technology, level of capacity utilization, efficiency and time period under consideration. Cost function is a
function which is obtained from production function and the market supply of inputs. It expresses the
relationship between costs and output. Cost functions are derived from actual cost data of the firms and are
presented through cost curves. The shape of the cost curves depends upon the cost function. Cost functions
are of two kinds: They are short-run cost functions and long-run cost functions.
2.2 SHORT RUN TOTAL COSTS

Total, fixed and variable costs: There are some factors which can be easily adjusted with changes in the
level of output. A firm can readily employ more workers if it has to increase output. Similarly, it can purchase
more raw materials if it has to expand production. Such factors which can be easily varied with a change in the
level of output are called variable factors. On the other hand, there are some factors such as building, capital
equipment, or top management team which cannot be so easily varied. It requires comparatively longer time to
make changes in them. It takes time to install new machinery. Similarly, it takes time to build a new factory.
Such factors which cannot be readily varied and require a longer period to adjust are called fixed factors.
Corresponding to the distinction between variable and fixed factors, we distinguish between short run and long
run periods of time. Short run is a period of time in which output can be increased or decreased by changing
only the amount of variable factors such as, labour, raw materials, etc. In the short run, quantities of fixed
factors cannot be varied in accordance with changes in output. If the firm wants to increase output in the short
run, it can do so only by increasing the variable factors, i.e., by using more labour and/or by buying more raw
materials. Thus, short run is a period of time in which only variable factors can be varied, while the quantities of
fixed factors remain unaltered. On the other hand, long run is a period of time in which the quantities of all
factors may be varied. In other words, all factors become variable in the long run.
Thus, we find that fixed costs are those costs which are independent of output, i.e., they do not change with
changes in output. These costs are a “fixed amount” which are incurred by a firm in the short run, whether the
output is small or large. Even if the firm closes down for some time in the short run but remains in business,
these costs have to be borne by it. Fixed costs include such charges as contractual rent, insurance fee,
maintenance cost, property taxes, interest on capital employed, managers’ salary, watchman’s wages etc. The
fixed cost curve is presented in figure 5.
Output
Fig. 5 : Completely Fixed Cost
Variable costs, on the other hand are those costs which change with changes in output. These costs include
payments such as wages of casual labour employed, prices of raw material, fuel and power used,
transportation cost etc. If a firm shuts down for a short period, it may not use the variable factors of production
and therefore, will not therefore incur any variable cost. Figure 6 presents completely variable cost curve drawn
under the assumption that variable costs change linearly with changes in output.
Fig. 6 : Completely Variable Cost

There are some costs which are neither perfectly variable, nor absolutely fixed in relation to the changes in the
size of output. They are known as semi-variable costs. It is well reflected in the Fig. 7. Example: Electricity
charges include both a fixed charge and a charge based on consumption.
Fig. 7 : Semi Variable Cost

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over certain range of output;
but suddenly jump to a new higher level when output goes beyond a given limit. E.g. Costs incurred towards the
salary of foremen will have a sudden jump if another foreman is appointed when the output crosses a particular limit.
Fig. 8 : A Stair-step Variable Cost
Fig. 9 : Short run Total Cost Curves

The total cost of a business is defined as the actual cost that must be incurred for producing a given quantity of
output. The short run total cost is composed of two major elements namely, total fixed cost and total variable
cost. Symbolically TC = TFC + TVC. We may represent total cost, total variable cost and fixed cost
diagrammatically.
In the diagram above, the total fixed cost curve (TFC) is a horizontal straight line parallel to X-axis as TFC
remains fixed for the whole range of output. This curve starts from a point on the Y-axis meaning thereby that
fixed costs will be incurred even if the output is zero. On the other hand, the total variable cost curve rises
upward indicating that as output increases, total variable cost increases. The total variable cost curve starts
from the origin because variable costs are zero when the output is zero. It should be noted that the total
variable cost initially increases at a decreasing rate and then at an increasing rate with increases in output.
This pattern of change in the TVC occurs due to the operation of the law of increasing and diminishing returns
to the variable inputs. Due to the operation of diminishing returns, as output increases, larger quantities of
variable inputs are required to produce the same quantity of output. Consequently, variable cost curve is
steeper at higher levels of output. The total cost curve has been obtained by adding vertically the total fixed
cost curve and the total variable cost curve. The slopes of TC and TVC are the same at every level of output
and at each point the two curves have vertical distance equal to total fixed cost. Its position reflects the amount
of fixed costs and its slope reflects variable costs.
Short run average costs
Average fixed cost (AFC) : AFC is obtained by dividing the total fixed cost by the number of units of output
TFC
produced. i.e. AFC= where Q is the number of units produced. Thus, average fixed cost is the fixed cost
Q
per unit of output. For example, if a firm is producing with a total fixed cost of ` 2,000/-. When output is 100
units, the average fixed cost will be ` 20. And now, if the output increases to 200 units, average fixed cost will
be ` 10. Since total fixed cost is a constant amount, average fixed cost will steadily fall as output increases.
Therefore, if we draw an average fixed cost curve, it will slope downwards throughout its length but will not
touch the X-axis as AFC cannot be zero. (Fig. 10)
Average variable cost (AVC) : Average variable cost is found out by dividing the total variable cost by the
TVC
number of units of output produced, i.e. AVC= where Q is the number of units produced. Thus, average
Q
variable cost is the variable cost per unit of output. Average variable cost normally falls as output increases
from zero to normal capacity output due to occurrence of increasing returns to variable factors. But beyond the
normal capacity output, average variable cost will rise steeply because of the operation of diminishing returns
(the concepts of increasing returns and diminishing returns have already been discussed earlier). If we draw an
average variable cost curve, it will first fall, then reach a minimum and then rise. (Fig. 10)
Fig. 10: Short run Average and Marginal Cost Curves

Average total cost (ATC): Average total cost is the sum of average variable cost and average fixed cost. i.e.,
ATC = AFC + AVC. It is the total cost divided by the number of units produced, i.e. ATC = TC/Q.The behaviour
of average total cost curve depends upon the behaviour of the average variable cost curve and the average
fixed cost curve. In the beginning, both AVC and AFC curves fall, therefore, the ATC curve will also fall sharply.
When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues to fall. This is because,
during this stage, the fall in AFC curve is greater than the rise in the AVC curve, but as output increases
further, there is a sharp rise in AVC which more than offsets the fall in AFC. Therefore, ATC curve first falls,
reaches its minimum and then rises. Thus, the average total cost curve is a “U” shaped curve. (Fig. 10)
Marginal cost: Marginal cost is the addition made to the total cost by the production of an additional unit of
output. In other words, it is the total cost of producing t units instead of t-1 units, where t is any given number.
For example, if we are producing 5 units at a cost of ` 200 and now suppose the 6th unit is produced and the
total cost is ` 250, then the marginal cost is ` 250 - 200 i.e., ` 50. And marginal cost will be ` 24, if 10 units
are produced at a total cost of ` 320 [(320-200) / (10-5)]. It is to be noted that marginal cost is independent of
fixed cost. This is because fixed costs do not change with output. It is only the variable costs which change with
a change in the level of output in the short run. Therefore, marginal cost is in fact due to the changes in
variable costs. Symbolically marginal cost may be written as:
∆TC
MC =
∆Q
∆TC = Change in Total cost
∆Q = Change in Output
or
MCn = TCn – TCn-1
Marginal cost curve falls as output increases in the beginning. It starts rising after a certain level of output. This
happens because of the influence of the law of variable proportions. The MC curve becomes minimum
corresponding to the point of inflexion on the total cost curve. The fact that marginal product rises first, reaches
a maximum and then declines ensures that the marginal cost curve of a firm declines first, reaches its minimum
and then rises. In other words marginal cost curve of a firm is “U” shaped (see Figure 10).
The behaviour of these costs has also been shown in Table 3.
Table 3 : Various Costs
Units of Total Total Total Average Average Average Marginal
output fixed cost variable cost cost fixed cost variable cost total cost cost
0 1000 0 1000 - - - -
1 1000 50 1050 1000.00 50.00 1050.00 50
2 1000 90 1090 500.00 45.00 545.00 40
3 1000 140 1140 333.33 46.67 380.00 50
4 1000 196 1196 250.00 49.00 299.00 56
5 1000 255 1255 200.00 51.00 251.00 59
6 1000 325 1325 166.67 54.17 220.83 70
7 1000 400 1400 142.86 57.14 200.00 75
8 1000 480 1480 125.00 60.00 185.00 80
9 1000 570 1570 111.11 63.33 174.44 90
10 1000 670 1670 100.00 67.00 167.00 100
11 1000 780 1780 90.91 70.91 161.82 110
12 1000 1080 2080 83.33 90.00 173.33 300
The above table shows that:

(i) Fixed costs do not change with increase in output upto a given level. Average fixed cost, therefore,
comes down with every increase in output.
(ii) Variable costs increase, but not necessarily in the same proportion as the increase in output. In the
above case, average variable cost comes down gradually till 4 units are produced. Thereafter it starts
increasing.
(iii) Marginal cost is the additional cost divided by the additional units produced. This also comes down first
and then starts increasing.
Relationship between Average Cost and Marginal Cost: The relationship between marginal cost and
average cost is the same as that between any other marginal-average quantities. The following are the points
of relationship between the two.
(1) When average cost falls as a result of an increase in output, marginal cost is less than average cost.
(2) When average cost rises as a result of an increase in output, marginal cost is more than average cost.
(3) When average cost is minimum, marginal cost is equal to the average cost. In other words, marginal
cost curve cuts average cost curve at its minimum point (i.e. optimum point).
Figure 10 confirms the above points of relationship.
2.3 LONG RUN AVERAGE COST CURVE

As stated above, long run is a period of time during which the firm can vary all of its inputs; unlike short run in
which some inputs are fixed and others are variable. In other words, whereas in the short run the firm is tied
with a given plant, in the long run the firm can build any size or scale of plant and therefore, can move from one
plant to another; it can acquire a big plant if it wants to increase its output and a small plant if it wants to reduce
its output. The long run being a planning horizon, the firm plans ahead to build the most appropriate scale of
plant to produce the future level of output. It should be kept in mind that once the firm has built a particular
scale of plant, its production takes place in the short run. Briefly put, the firm actually operates in the short run
and plans for the long run. Long run cost of production is the least possible cost of producing any given level of
output when all individual factors are variable. A long run cost curve depicts the functional relationship between
output and the long run cost of production.
In order to understand how the long run average cost curve is derived, we consider three short run average
cost curves as shown in Figure 11. These short run average cost curves (SACs) are also called ‘plant curves’.
In the short run, the firm can be operating on any short run average cost curve, given the size of the plant.
Suppose that there are the only three plants which are technically possible. Given the size of the plant, the firm
will be increasing or decreasing its output by changing the amount of the variable inputs. But in the long run,
the firm chooses among the three possible sizes of plants as depicted by short run average curves (SAC 1,
SAC2, and SAC3). In the long run, the firm will examine with which size of plant or on which short run average
cost curve it should operate to produce a given level of output, so that the total cost is minimum. It will be seen
from the diagram that up to OB amount of output, the firm will operate on the SAC 1, though it could also
produce with SAC2. Up to OB amount of output, the production on SAC1 results in lower cost than on SAC2. For
example, if the level of output OA is produced with SAC1, it will cost AL per unit and if it is produced with SAC2
it will cost AH and we can see that AH is more than AL. Similarly, if the firm plans to produce an output which is
larger than OB but less than OD, then it will not be economical to produce on SAC1. For this, the firm will have
to use SAC2. Similarly, the firm will use SAC3 for output larger than OD. It is thus clear that, in the long run, the
firm has a choice in the employment of plant and it will employ that plant which yields minimum possible unit
cost for producing a given output.
Fig. 11 : Short Run Average Cost Curves Fig. 12 : Long Run Average Cost Curves
Suppose, the firm has a choice so that a plant can be varied by infinitely small gradations so that there are
infinite number of plants corresponding to which there are numerous average cost curves. In such a case the
long run average cost curve will be a smooth curve enveloping all these short run average cost curves.
As shown in Figure 12, the long run average cost curve is so drawn as to be tangent to each of the short run
average cost curves. Every point on the long run average cost curve will be a tangency point with some short
run AC curve. If a firm desires to produce any particular output, it then builds a corresponding plant and
operates on the corresponding short run average cost curve. As shown in the figure, for producing OM, the
corresponding point on the LAC curve is G and the short run average cost curve SAC2 is tangent to the long
run AC at this point. Thus, if a firm desires to produce output OM, the firm will construct a plant corresponding
to SAC2 and will operate on this curve at point G. Similarly, the firm will produce other levels of output choosing
the plant which suits its requirements of lowest possible cost of production. It is clear from the figure that larger
output can be produced at the lowest cost with larger plant whereas smaller output can be produced at the
lowest cost with smaller plants. For example, to produce OM, the firm will be using SAC2 only; if it uses SAC3, it
will result in higher unit cost than SAC2. But, larger output OV can be produced most economically with a larger
plant represented by the SAC3. If we produce OV with a smaller plant, it will result in higher cost per unit.
Similarly, if we produce larger output with a smaller plant it will involve higher costs because of its limited
capacity.
It is to be noted that LAC curve is not tangent to the minimum points of the SAC curves. When the LAC curve is
declining, it is tangent to the falling portions of the short run cost curves and when the LAC curve is rising, it is
tangent to the rising portions of the short run cost curves. Thus, for producing output less than “OQ” at the
lowest possible unit cost, the firm will construct the relevant plant and operate it at less than its full capacity,
i.e., at less than its minimum average cost of production. On the other hand, for outputs larger than OQ the firm
will construct a plant and operate it beyond its optimum capacity. “OQ” is the optimum output. This is because
“OQ” is being produced at the minimum point of LAC and corresponding SAC i.e., SAC4. Other plants are either
used at less than their full capacity or more than their full capacity. Only SAC4 is being operated at the
minimum point.
The long run average cost curve is often called as ‘planning curve’ because a firm plans to produce any output
in the long run by choosing a plant on the long run average cost curve corresponding to the given output. The
long run average cost curve helps the firm in the choice of the size of the plant for producing a specific output
at the least possible cost.
Explanation of the “U” shape of the long run average cost curve: As has been seen in the diagram LAC
curve is a “U” shaped curve. This shape of LAC curve has nothing to do with the U shaped SAC which is due to
variable factor ratio because in the long run all factors are variable. U shaped LAC arises due to returns to
scale. As discussed earlier, when the firm expands, returns to scale increase. After a range of constant returns
to scale, the returns to scale finally decrease. On the same line, the LAC curve first declines and then finally
rises. Increasing returns to scale cause fall in the long run average cost and decreasing returns to scale result
in rise in long run average cost. Falling long run average cost and increasing economies of scale result from
internal and external economies of scale and rising long run average cost and diminishing returns to scale
result from internal and external diseconomies of scale. (Economies of scale will be discussed in the next
section.)
The long run average cost curve initially falls with increase in output and after a certain point it rises making a
boat shape. The long-run average cost (LAC) curve is also called the planning curve of the firm as it helps in
choosing an appropriate a plant on the decided level of output. The long-run average cost curve is also called
“Envelope curve”, because it envelopes or supports a family of short run average cost curves from below.
The above figure depicting long-run average cost curve is arrived at on the basis of traditional economic
analysis. It is flattened ‘U’ shaped. This type of curve could exist only when the state of technology remains
constant. But, empirical evidence shows modern firms face ‘L-shaped’ cost curve over a considerable quantity
of output. The L-shaped long run cost curve implies that initially when the output is increased due to increase in
the size of plant (and associated variable factors), per unit cost falls rapidly due to economies of scale. The
long-run average cost curve does not increase even after a sufficiently large scale of output as it continues to
enjoy economies of scale.
2.4 ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production
Production on a large scale is a very important feature of modern industrial society. As a consequence, the size
of business undertakings has greatly increased. Large-scale production offers certain advantages which help in
reducing the cost of production. Economies arising out of large-scale production can be grouped into two
categories; viz., internal economies and external economies. Internal economies are those economies of
production which accrue to the firm when it expands its output, so that the cost of production would come down
considerably and place the firm in a better position to compete in the market effectively. Internal economies
arise purely due to endogenous factors relating to efficiency of the entrepreneur or his managerial talents or the
type of machinery used or the marketing strategy adopted. These economies arise within the firm and are
available exclusively to the expanding firm. On the other hand, external economies are the benefits accruing to
each member firm of the industry as a result of expansion of the industry.
Internal Economies and Diseconomies: We saw that returns to scale increase in the initial stages and after
remaining constant for a while, they decrease. The question arises as to why we get increasing returns to scale
due to which cost falls and why after a certain point we get decreasing returns to scale due to which cost rises.
The answer is that initially a firm enjoys internal economies of scale and beyond a certain limit it suffers from
internal diseconomies of scale. Internal economies and diseconomies are of the following main kinds:
(i) Technical economies and diseconomies: Large-scale production is associated with economies of
superior techniques. As the firm increases its scale of operations, it becomes possible to use more
specialised and efficient form of all factors, specially capital equipment and machinery. For producing
higher levels of output, there is generally available a more efficient machinery which when employed to
produce a large output yields a lower cost per unit of output. The firm is able to take advantage of
composite technology whereby the whole process of production of a commodity is done as one
composite unit. Secondly, when the scale of production is increased and the amount of labour and
other factors become larger, introduction of greater degree of division of labour and specialisation
becomes possible and as a result cost per unit declines. There are some advantages available to a
large firm on account of performance of a number of linked processes. The firm can reduce the
inconvenience and costs associated with the dependence on other firms by undertaking various
processes from the input supply stage to the final output stage.
However, beyond a certain point, a firm experiences net diseconomies of scale. This happens because
when the firm has reached a size large enough to allow utilisation of almost all the possibilities of
division of labour and employment of more efficient machinery, further increase in the size of the plant
will bring about high long-run cost because of difficulties of management. When the scale of operations
becomes too large, it becomes difficult for the management to exercise control and to bring about
proper coordination.
(ii) Managerial economies and diseconomies: Managerial economies refer to reduction in managerial
costs. When output increases, specialisation and division of labour can be applied to management. It
becomes possible to divide its management into specialised departments under specialised personnel,
such as production manager, sales manager, finance manager etc. If the scale of production increases
further, each department can be further sub-divided; for e.g. sales can be split into separate sections
such as for advertising, exports and customer service. Since individual activities come under the
supervision of specialists, management’s efficiency and productivity will greatly improve.
Decentralisation of decision making and mechanisation of managerial functions further enhance the
efficiency and productivity of managers. Thus, specialisation of management enables large firms to
achieve reduction in managerial costs.
However, as the scale of production increases beyond a certain limit, managerial diseconomies set in.
Communication at different levels such as between the managers and labourers and among the
managers become difficult resulting in delays in decision making and implementation of decisions
already made. Management finds it difficult to exercise control and to bring in coordination among its
various departments. The managerial structure becomes more complex and is affected by greater
bureaucracy, red tapism, lengthening of communication lines and so on. All these affect the efficiency
and productivity of management and that of the firm itself.
(iii) Commercial economies and diseconomies: Production of large volumes of goods requires large
amount of materials and components. A large firm is able to place bulk orders for materials and
components and enjoy lower prices for them. Economies can also be achieved in marketing of the
product. If the sales staff is not being worked to full capacity, additional output can be sold at little or
no extra cost. Moreover, large firms can benefit from economies of advertising. As the scale of
production increases, advertising costs per unit of output fall. In addition, a large firm may also be able
to sell its by-products or process it profitably; something which might be unprofitable for a small firm.
There are also economies associated with transport and storage.
These economies become diseconomies after an optimum scale. For example, advertisement expenditure
and other marketing overheads will increase more than proportionately after the optimum scale.
(iv) Financial economies and diseconomies: A large firm has advantages over small firms in matters
related to procurement of finance for its business activities. It can, for instance, offer better security to
bankers and avail of advances with greater ease. On account of the goodwill enjoyed by large firms,
investors have greater confidence in them and therefore would prefer their shares which can be readily
sold on the stock exchange. A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after the optimum scale of
production. This may happen because of relatively greater dependence on external finances.
(v) Risk bearing economies and diseconomies: It is said that a large business with diverse and multi-
production capability is in a better position to withstand economic ups and downs, and therefore,
enjoys economies of risk bearing. However, risk may increase if diversification, instead of giving a
cover to economic disturbances, increases these.
External Economies and Diseconomies: Internal economies are economies enjoyed by a firm on account of
use of greater degree of division of labour and specialised machinery at higher levels of output. They are
internal in the sense that they accrue to the firm due to its own efforts. Besides internal economies, there are
external economies which are very important for a firm. External economies and diseconomies are those
economies and diseconomies which accrue to firms as a result of expansion in the output of the whole industry
and they are not dependent on the output level of individual firms. They are external in the sense that they
accrue to firms not out of their internal situation but from outside i.e. due to expansion of the industry. These
are available to one or more of the firms in the form of:
1. Cheaper raw materials and capital equipment: The expansion of an industry may result in
exploration of new and cheaper sources of raw material, machinery and other types of capital
equipments. Expansion of an industry results in greater demand for various kinds of materials and
capital equipments required by it. The firm can procure these on a large scale at competitive prices
from other industries. This reduces their cost of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result in the discovery
of new technical knowledge and in accordance with that, the use of improved and better machinery
and processes than before. This will change the technical co-efficient of production and enhance
productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers in that area are
well accustomed with the different productive processes and tend to learn a good deal from
experience. As a result, with the growth of an industry in an area, a pool of trained labour is developed
which has a favourable effect on the level of productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a number of ancillary
industries which specialise in the production and supply of raw materials, tools, machinery,
components, repair services etc. Input prices go down in a competitive market and the benefits of it
accrue to all firms in the form of reduction in cost of production. Likewise, new units may come up for
processing or recycling of the waste products of the industry. This will tend to reduce the cost of
production in general.
5. Better transportation and marketing facilities: The expansion of an industry resulting from entry of
new firms may make possible the development of an efficient transportation and marketing network.
These will greatly reduce the cost of production of the firms by avoiding the need for establishing and
running these services by themselves. Similarly, communication systems may get modernised
resulting in better and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology, labour, prices and products
may be easily and cheaply made available to the firms on account of publication of information
booklets and bulletins by industry associations or by governments in public interest.
However, external economies may cease if there are certain disadvantages which may neutralise the
advantages of expansion of an industry. We call them external diseconomies. External diseconomies are
disadvantages that originate outside the firm, especially in the input markets. An example of external
diseconomies is rise in various factor prices. When an industry expands the requirement of various factors of
production, such as raw materials, capital goods, skilled labour etc increases. Increasing demand for inputs
puts pressure on the input markets. This may result in an increase in the prices of factors of production,
especially when they are short in supply. Moreover, too many firms in an industry at one place may also result
in higher transportation cost, marketing cost and high pollution control cost. The government may also, through
its location policy, prohibit or restrict the expansion of an industry at a particular place.
SUMMARY
♦ Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria. It is
concerned with the financial aspects of production.
• Accounting costs are explicit costs and includes all the payments and charges made by the
entrepreneur to the suppliers of various productive factors.
• Economic costs take into account explicit costs as well as implicit costs. A firm has to cover its
economic cost if it wants to earn normal profits.
• Outlay costs involve actual expenditure of funds.
• Opportunity cost is concerned with the cost of the next best alternative opportunity which was
foregone in order to pursue a certain action.
• Direct costs are those which have direct relationship with a component of operation. They are
readily identified and are traceable to a particular product, operation or plant.
• Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant,
product, process or department. They not visibly traceable to any specific goods, services,
processes, departments or operations.
• Incremental cost refers to the additional cost incurred by a firm as a result of a business
decision.
• Sunk costs are already incurred once and for all, and cannot be recovered.
• Historical cost refers to the cost incurred in the past on the acquisition of a productive asset.
• Replacement cost is the money expenditure that has to be incurred for replacing an old asset.
• Private costs are costs actually incurred or provided for by firms and are either explicit or
implicit.
• Social cost, on the other hand, refers to the total cost borne by the society on account of a
business activity and includes private cost and external cost.
♦ The cost function refers to the mathematical relation between cost and the various determinants of
cost. It expresses the relationship between cost and output.
♦ Economists are generally interested in two types of cost functions; the short run cost function and the
long run cost function.
♦ Short-run cost functions are

• Fixed or constant costs which are not a function of output. These are inescapable or
uncontrollable.
• Variable costs are a function of output in the production period.
• Short run is a period of time in which output can be increased or decreased by changing only
the amount of variable factors such as, labour, raw material, etc. ,
• Long run is a period of time in which the quantities of all factors may be varied. In other words,
all factors become variable in the long run.
• Semi-variable costs are neither perfectly variable, nor absolutely fixed in relation to the
changes in the size of output.
• Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher
level when output goes beyond a given limit.
• Total cost of a business is defined as the actual cost that must be incurred for producing a
given quantity of output.
• AFC is obtained by dividing the total fixed cost by the number of units of output produced.
• Average variable cost is found out by dividing the total variable cost by the number of units of
output produced.
• Average total cost is the sum of average fixed cost and average variable cost.
• Marginal cost is the addition made to the total cost by the production of an additional unit of
output.
♦ Long run cost of production is the least possible cost of producing any given level of output when all
individual factors are variable.
• A long run cost curve depicts the functional relationship between output and the long run cost
of production.
• The long run average cost curve, often called a planning curve, is so drawn as to be tangent
to each of the short run average cost curves.
• LAC curve is not tangent to the minimum points of the SAC curves.
• Empirical evidence shows that the state of technology changes in the long-run. Therefore,
modern firms face ‘L-shaped’ cost curve over a considerable quantity of output.
♦ Economies of scale are of two kinds - external economies of scale and internal economies of scale.
• External economies of scale accrue to a firm due to factors which are external to a firm.
• Internal economies of scale accrue to a firm when it engages in large scale production.
• Increase in scale, beyond the optimum level, results in diseconomies of scale.
TEST YOUR KNOWLEDGE

1. Which of the following is considered production in Economics?
(a) Tilling of soil.
(b) Singing a song before friends.
(c) Preventing a child from falling into a manhole on the road.
(d) Painting a picture for pleasure.
2. Identify the correct statement:
(a) The average product is at its maximum when marginal product is equal to average product.
(b) The law of increasing returns to scale relates to the effect of changes in factor proportions.
(c) Economies of scale arise only because of indivisibilities of factor proportions.
(d) Internal economies of scale can accrue when industry expands beyond optimum.
3. Which of the following is not a characteristic of land?
(a) Its supply for the economy is limited.
(b) It is immobile.
(c) Its usefulness depends on human efforts.
(d) It is produced by our forefathers.
4. Which of the following statements is true?
(a) Accumulation of capital depends solely on income of individuals.
(b) Savings can be influenced by government policies.
(c) External economies go with size and internal economies with location.
(d) The supply curve of labour is an upward slopping curve.
5. In the production of wheat, all of the following are variable factors that are used by the farmer
except:
(a) the seed and fertilizer used when the crop is planted.
(b) the field that has been cleared of trees and in which the crop is planted.
(c) the tractor used by the farmer in planting and cultivating not only wheat but also corn and
barley.
(d) the number of hours that the farmer spends in cultivating the wheat fields.
6. The marginal product of a variable input is best described as:
(a) total product divided by the number of units of variable input.
(b) the additional output resulting from a one unit increase in the variable input.
(c) the additional output resulting from a one unit increase in both the variable and fixed inputs.
(d) the ratio of the amount of the variable input that is being used to the amount of the fixed input
that is being used.
7. Diminishing marginal returns implies:
(a) decreasing average variable costs.
(b) decreasing marginal costs.
(c) increasing marginal costs.
(d) decreasing average fixed costs.
8. The short run, as economists use the phrase, is characterized by:
(a) at least one fixed factor of production and firms neither leaving nor entering the industry.
(b) generally a period which is shorter than one year.
(c) all factors of production are fixed and no variable inputs.
(d) all inputs are variable and production is done in less than one year.
9. The marginal, average, and total product curves encountered by the firm producing in the short run
exhibit all of the following relationships except:
(a) when total product is rising, average and marginal product may be either rising or falling.
(b) when marginal product is negative, total product and average product are falling.
(c) when average product is at a maximum, marginal product equals average product, and total
product is rising.
(d) when marginal product is at a maximum, average product equals marginal product, and total
product is rising.
10. To economists, the main difference between the short run and the long run is that:
(a) In the short run all inputs are fixed, while in the long run all inputs are variable.
(b) In the short run the firm varies all of its inputs to find the least-cost combination of inputs.
(c) In the short run, at least one of the firm’s input levels is fixed.
(d) In the long run, the firm is making a constrained decision about how to use existing plant and
equipment efficiently.
11. Which of the following is the best definition of “production function”?
(a) The relationship between market price and quantity supplied.
(b) The relationship between the firm’s total revenue and the cost of production.
(c) The relationship between the quantities of inputs needed to produce a given level of output.
(d) The relationship between the quantity of inputs and the firm’s marginal cost of production.
12. The “law of diminishing returns” applies to:

(a) the short run, but not the long run.
(b) the long run, but not the short run.
(c) both the short run and the long run.
(d) neither the short run nor the long run.
13. Diminishing returns occur:
(a) when units of a variable input are added to a fixed input and total product falls.
(b) when units of a variable input are added to a fixed input and marginal product falls.
(c) when the size of the plant is increased in the long run.
(d) when the quantity of the fixed input is increased and returns to the variable input falls.
Use the following information to answer questions 14-16.
Hours of Labour Total Output Marginal Product
0 – –
1 100 100
2 – 80
3 240 –
14. What is the total output when 2 hours of labour are employed?
(a) 80 (b) 100
(c) 180 (d) 200
15. What is the marginal product of the third hour of labour?
(a) 60 (b) 80
(c) 100 (d) 240
16. What is the average product of the first three hours of labour?
(a) 60 (b) 80
(c) 100 (d) 240
17. Which cost increases continuously with the increase in production?
(a) Average cost. (b) Marginal cost.
(c) Fixed cost. (d) Variable cost.
18. Which of the following cost curves is never ‘U’ shaped?
(a) Average cost curve. (b) Marginal cost curve.
(c) Average variable cost curve. (d) Average fixed cost curve.
19. Total cost in the short run is classified into fixed costs and variable costs. Which one of the following is
a variable cost?
(a) Cost of raw materials. (b) Cost of equipment.
(c) Interest payment on past borrowings. (d) Payment of rent on building.
20. In the short run, when the output of a firm increases, its average fixed cost:
(a) increases. (b) decreases.
(c) remains constant. (d) first declines and then rises.
21. Which one of the following is also known as planning curve?
(a) Long run average cost curve. (b) Short run average cost curve.
(c) Average variable cost curve. (d) Average total cost curve.
22. If a firm moves from one point on a production isoquant to another, which of the following will not
happen.
(a) A change in the ratio in which the inputs are combined to produce output.
(b) A change in the ratio of marginal products of the inputs.
(c) A change in the marginal rate of technical substitution.
(d) A change in the level of output.
23. With which of the following is the concept of marginal cost closely related?
(a) Variable cost. (b) Fixed cost.
(c) Opportunity cost. (d) Economic cost.
(a) When the average cost is rising, the marginal cost must also be rising.
(b) When the average cost is rising, the marginal cost must be falling.
(c) When the average cost is rising, the marginal cost is above the average cost.
(d) When the average cost is falling, the marginal cost must be rising.
25. Which of the following is an example of “explicit cost”?
(a) The wages a proprietor could have made by working as an employee of a large firm.
(b) The income that could have been earned in alternative uses by the resources owned by the
firm.
(c) The payment of wages by the firm.
(d) The normal profit earned by a firm.
26. Which of the following is an example of an “implicit cost”?

(a) Interest that could have been earned on retained earnings used by the firm to finance
expansion.
(b) The payment of rent by the firm for the building in which it is housed.
(c) The interest payment made by the firm for funds borrowed from a bank.
(d) The payment of wages by the firm.
Use the following data to answer questions 27-29.
Output (O) 0 1 2 3 4 5 6
Total Cost (TC) ` 240 ` 330 ` 410 ` 480 ` 540 ` 610 ` 690
27. The average fixed cost of 2 units of output is :
(a) ` 80 (b) ` 85
(c) ` 120 (d) ` 205
28. The marginal cost of the sixth unit of output is :
(a) ` 133 (b) ` 75
(c) ` 80 (d) ` 450
29. Diminishing marginal returns start to occur between units:
(a) 2 and 3. (b) 3 and 4.
(c) 4 and 5. (d) 5 and 6.
30. Marginal cost is defined as:
(a) the change in total cost due to a one unit change in output.
(b) total cost divided by output.
(c) the change in output due to a one unit change in an input.
(d) total product divided by the quantity of input.
31. Which of the following is true of the relationship between the marginal cost function and the average
cost function?
(a) If MC is greater than ATC, then ATC is falling.
(b) The ATC curve intersects the MC curve at minimum MC.
(c) The MC curve intersects the ATC curve at minimum ATC.
(d) If MC is less than ATC, then ATC is increasing.
32. Which of the following statements is true of the relationship among the average cost functions?
(a) ATC = AFC – AVC. (b) AVC = AFC + ATC.
(c) AFC = ATC + AVC. (d) AFC = ATC – AVC.
33. Which of the following is not a determinant of the firm’s cost function?
(a) The production function. (b) The price of labour.
(c) Taxes. (d) The price of the firm’s output.
34. Which of the following statements is correct concerning the relationships among the firm’s cost
functions?
(a) TC = TFC – TVC. (b) TVC = TFC – TC.
(c) TFC = TC – TVC. (d) TC = TVC – TFC.
35. Suppose output increases in the short run. Total cost will:
(a) increase due to an increase in fixed costs only.
(b) increase due to an increase in variable costs only.
(c) increase due to an increase in both fixed and variable costs.
(d) decrease if the firm is in the region of diminishing returns.
36. Which of the following statements concerning the long-run average cost curve is false?
(a) It represents the least-cost input combination for producing each level of output.
(b) It is derived from a series of short-run average cost curves.
(c) The short-run cost curve at the minimum point of the long-run average cost curve represents
the least–cost plant size for all levels of output.
(d) As output increases, the amount of capital employed by the firm increases along the curve.
37. The negatively-sloped (i.e. falling) part of the long-run average total cost curve is due to which of the
following?
(a) Diseconomies of scale.
(b) Diminishing returns.
(c) The difficulties encountered in coordinating the many activities of a large firm.
(d) The increase in productivity that results from specialization.
38. The positively sloped (i.e. rising) part of the long run average total cost curve is due to which of the
following?
(a) Diseconomies of scale.
(b) Increasing returns.
(c) The firm being able to take advantage of large-scale production techniques as it expands its
output.
(d) The increase in productivity that results from specialization.
39. A firm’s average total cost is ` 300 at 5 units of output and ` 320 at 6 units of output. The marginal
cost of producing the 6th unit is :
(a) ` 20 (b) ` 120

(c) ` 320 (d) ` 420
40. A firm producing 7 units of output has an average total cost of ` 150 and has to pay
` 350 to its fixed factors of production whether it produces or not. How much of the average total cost
is made up of variable costs?
(a) ` 200 (b) ` 50
(c) ` 300 (d) ` 100
41. A firm has a variable cost of ` 1000 at 5 units of output. If fixed costs are ` 400, what will be the
average total cost at 5 units of output?
(a) ` 280 (b) ` 60
(c) ` 120 (d) ` 1400
42. A firm’s average fixed cost is ` 20 at 6 units of output. What will it be at 4 units of output?
(a) ` 60 (b) ` 30
(c) ` 40 (d) ` 20
(a) The services of a doctor are considered production.
(b) Man can create matter.
(c) The services of a housewife are considered production.
(d) When a man creates a table, he creates matter.
44. Which of the following is a function of an entrepreneur?
(a) Initiating a business enterprise. (b) Risk bearing.
(c) Innovating. (d) All of the above.
45. In describing a given production technology, the short run is best described as lasting:
(a) up to six months from now. (b) up to five years from now.
(c) as long as all inputs are fixed. (d) as long as at least one input is fixed.
46. If decreasing returns to scale are present, then if all inputs are increased by 10% then:
(a) output will also decrease by 10%. (b) output will increase by 10%.
(c) output will increase by less than 10%. (d) output will increase by more than 10%.
47. The production function is a relationship between a given combination of inputs and:
(a) another combination that yields the same output.
(b) the highest resulting output.
(c) the increase in output generated by one-unit increase in one output.

(d) all levels of output that can be generated by those inputs.
48. If the marginal product of labour is below the average product of labour, it must be true that:
(a) the marginal product of labour is negative.
(b) the marginal product of labour is zero.
(c) the average product of labour is falling.
(d) the average product of labour is negative.
49. The average product of labour is maximized when marginal product of labour:
(a) equals the average product of labour. (b) equals zero.
(c) is maximized. (d) none of the above.
50. The law of variable proportions is drawn under all of the assumptions mentioned below except the
assumption that:
(a) the technology is changing.
(b) there must be some inputs whose quantity is kept fixed.
(c) we consider only physical inputs and not economically profitability in monetary terms.
(d) the technology is given and stable.
51. What is a production function?
(a) Technical relationship between physical inputs and physical output.
(b) Relationship between fixed factors of production and variable factors of production.
(c) Relationship between a factor of production and the utility created by it.
(d) Relationship between quantity of output produced and time taken to produce the output.
52. Laws of production does not include ……
(a) returns to scale. (b) law of diminishing returns to a factor.
(c) law of variable proportions. (d) least cost combination of factors.
53. An iso quant shows
(a) All the alternative combinations of two inputs that can be produced by using a given set of
output fully and in the best possible way.
(b) All the alternative combinations of two products among which a producer is indifferent
because they yield the same profit.
(c) All the alternative combinations of two inputs that yield the same total product.
(d) Both (b) and (c).
54. Economies of scale exist because as a firm increases its size in the long run:
(a) Labour and management can specialize in their activities more.
(b) As a larger input buyer, the firm can get finance at lower cost and purchase inputs at a lower
per unit cost.
(c) The firm can afford to employ more sophisticated technology in production.
(d) All of these.
55. The production function:
(a) Is the relationship between the quantity of inputs used and the resulting quantity of product.
(b) Tells us the maximum attainable output from a given combination of inputs.
(c) Expresses the technological relationship between inputs and output of a product.
(d) All the above.
56. The production process described below exhibits.
Number of Workers Output
0 0
1 23
2 40
3 50
(a) constant marginal product of labour.
(b) diminishing marginal product of labour.
(c) increasing return to scale.
(d) increasing marginal product of labour.
57. Which of the following is a variable cost in the short run?
(a) rent of the factory.
(b) wages paid to the factory labour.
(c) interest payments on borrowed financial capital.
(d) payment on the lease for factory equipment.
58. The efficient scale of production is the quantity of output that minimizes
(a) average fixed cost. (b) average total cost.
(c) average variable cost. (d) marginal cost.
59. In the short run, the firm's product curves show that
(a) Total product begins to decrease when average product begins to decrease but continues to
increase at a decreasing rate.
(b) When marginal product is equal to average product, average product is decreasing but at its
highest.
(c) When the marginal product curve cuts the average product curve from below, the average
product is equal to marginal product.
(d) In stage two, total product increases at a diminishing rate and reaches maximum at the end of
this stage.
60. A fixed input is defined as
(a) That input whose quantity can be quickly changed in the short run, in response to the desire of
the company to change its production.
(b) That input whose quantity cannot be quickly changed in the short run, in response to the
desire of the company to change its production.
(c) That input whose quantities can be easily changed in response to the desire to increase or
reduce the level of production.
(d) That input whose demand can be easily changed in response to the desire to increase or
reduce the level of production.
61. Average product is defined as
(a) total product divided by the total cost.
(b) total product divided by marginal product.
(c) total product divided by the number of units of variable input.
(d) marginal product divided by the number of units of variable input.
(a) After the inflection point of the production function, a greater use of the variable input induces
a reduction in the marginal product.
(b) Before reaching the inevitable point of decreasing marginal returns, the quantity of output
obtained can increase at an increasing rate.
(c) The first stage corresponds to the range in which the AP is increasing as a result of utilizing
increasing quantities of variable inputs.
(d) All the above.
63. Marginal product, mathematically, is the slope of the
(a) total product curve. (b) average product curve.
(c) marginal product curve. (d) implicit product curve.
64. Suppose the first four units of a variable input generate corresponding total outputs of 200, 350, 450,
500. The marginal product of the third unit of input is:
(a) 50 (b) 100
(c) 150 (d) 200
65. Which of the following statements is false in respect of fixed cost of a firm?
(a) As the fixed inputs for a firm cannot be changed in the short run, the TFC are constant, except
when the prices of the fixed inputs change.
(b) TFC continue to exist even when production is stopped in the short run, but they exist in the
long run even when production is not stopped.
(c) Total Fixed Costs (TFC) can be defined as the total sum of the costs of all the fixed inputs
associated with production in the short run.
(d) In the short run, a firm’s fixed cost cannot be escaped even when production is stopped.
66. Diminishing marginal returns for the first four units of a variable input is exhibited by the total product
sequence:
(a) 50, 50, 50, 50 (b) 50, 110, 180, 260
(c) 50, 100, 150, 200 (d) 50, 90, 120, 140
67. Use the following diagram to answer the question given below it
The marginal physical product of the third unit of labour is _____, the MP of the _____ labour is
Negative
(a) Six; fourth (b) Six; third
(c) Six ; fifth (d) Six; sixth
68. In the third of the three stages of production:
(a) the marginal product curve has a positive slope.
(b) the marginal product curve lies completely below the average product curve.
(c) total product increases.
(d) marginal product is positive.
69. When marginal costs are below average total costs,
(a) average fixed costs are rising. (b) average total costs are falling.
(c) average total costs are rising. (d) average total costs are minimized.
70. A firm’s long-run average total cost curve is

(a) Identical to its long-run marginal-cost curve.
(b) Also its long-run supply curve because it explains the relationship between price and quantity
supplied.
(c) In fact the average total cost curve of the optimal plant in the short run as it tries to produce at
least cost.
(d) Tangent to all the curves of short-run average total cost.
71. In the long run, if a very small factory were to expand its scale of operations, it is likely that it would
initially experience
(a) an increase in pollution level. (b) diseconomies of scale.
(c) economies of scale. (d) constant returns to scale.
72. A firm’s long-run average total cost curve is.
(a) Identical to its long-run marginal-cost curve as all factors are variable.
(b) Also its long-run total cost curve because it explains the relationship cost and quantity
supplied in the long run.
(c) In fact the average total cost curve of the optimal plant in the short run as it tries to produce at
least cost.
(d) Tangent to all short-run average total cost the curves and represents the lowest average total
cost for producing each level of output.
73. Which of the following statements describes increasing returns to scale?
(a) Doubling of all inputs used leads to doubling of the output.
(b) Increasing the inputs by 50% leads to a 25% increase in output.
(c) Increasing inputs by 1/4 leads to an increase in output of 1/3.
74. The marginal cost for a firm of producing the 9th unit of output is ` 20. Average cost at the same level
of output is ` 15. Which of the following must be true?
(a) marginal cost and average cost are both falling
(b) marginal cost and average cost are both rising
(c) marginal cost is rising and average cost is falling
(d) it is impossible to tell if either of the curves are rising or falling
75. Implicit cost can be defined as
(a) Money payments made to the non-owners of the firm for the self-owned factors employed in
the business and therefore not entered into books of accounts.
(b) Money not paid out to the owners of the firm for the self-owned factors employed in a
business and therefore not entered into books of accounts.
(c) Money payments which the self-owned and employed resources could have earned in their
next best alternative employment and therefore entered into books of accounts.
(d) Money payments which the self-owned and employed resources earn in their best use and
therefore entered into book of accounts.
76. The most important function of an entrepreneur is to ____________.
(a) Innovate
(b) Bear the sense of responsibility
(c) Finance
(d) Earn profit
77. Economic costs of production differ from accounting costs of production because
(a) Economic costs include expenditures for hired resources while accounting costs do not.
(b) Accounting costs include opportunity costs which are deducted later to find paid out costs.
(c) Accounting costs include expenditures for hired resources while economic costs do not.
(d) Economic costs add the opportunity cost of a firm which uses its own resources.
78. In figure below, possible reason why the average variable cost curve approaches the average total
cost curve as output rises is:
(a) Fixed costs are falling while total costs are rising at rising output.
(b) Total costs are rising and average costs are also rising.
(c) Marginal costs are above average variable costs as output rises.
(d) Average fixed costs are falling as output rises.
79. Marginal cost changes due to changes in —————
(a) Total cost (b) Average cost
(c) Variable cost (d) Quantity of output

(a) Fixed costs vary with change in output.
(b) If we add total variable cost and total fixed cost we get the average cost.
(c) Marginal cost is the result of total cost divided by number of units produced.
(d) Total cost is obtained by adding up the fixed cost and total variable cost.
(a) The LAC curve is also called the planning curve of a firm.
(b) Total revenue = price per unit × number of units sold.
(c) Opportunity cost is also called alternative cost.
(d) If total revenue is divided by the number of units sold we get marginal revenue.
82. The vertical difference between TVC and TC is equal to-
(a) MC (b) AVC
(c) TFC (d) None of the above
Answers
1. (a) 2. (a) 3. (d) 4. (b) 5. (b) 6. (b)
7. (c) 8. a 9. (d) 10. (c) 11. (c) 12. (a)
13. (b) 14. (c) 15. (a) 16. (b) 17. (d) 18. (d)
19. (a) 20. (b) 21. (a) 22. (d) 23. (a) 24. (c)
25. (c) 26. (a) 27. (c) 28. (c) 29. (c) 30. (a)
31. (c) 32. (d) 33. (d) 34. (c) 35. (b) 36. (c)
37. (d) 38. (a) 39. (d) 40. (d) 41. (a) 42. (b)
43. (a) 44. (d) 45. (d) 46. (c) 47. (b) 48. (c)
49. (a) 50. (a) 51. (a) 52. (d) 53. (c) 54. (d)
55. (d) 56. (b) 57. (b) 58. (b) 59. (d) 60. (b)
61. (c) 62. (d) 63. (a) 64. (b) 65. (b) 66. (d)
67. (d) 68. (b) 69. (b) 70. (d) 71. (c) 72. (d)
73. (c) 74. (b) 75. (b) 76. (a) 77. (d) 78. (d)
79. (c) 80. (d) 81. (d) 82. (c)
CHAPTER 4
PRICE DETERMINATION
IN DIFFERENT MARKETS
UNIT -1: MEANING AND TYPES OF MARKETS
LEARNING OUTCOMES
♦ Explain the Meaning of Market in Economics.
♦ Describe the key Characteristics of the Four Basic market Types Used in Economic Analysis.
♦ Provide Explicit Real Examples of the Four Types of Markets.
♦ Explain the Behavioural Principles Underlying these Markets.
CHAPTER OVERVIEW
1.0 MEANING OF MARKET

We have seen in Chapter 1 that people cannot have all that they want because they need to pay price for
goods and services and the resources at their disposal are scarce. We have come across some goods which
are free or having zero prices i.e. we need not make any payment for them. Example: air, sunlight etc. These
are called free goods. Free goods being abundant in supply do not have scarcity and need no cost to obtain
them. In contrast, economic goods are scarce in relation to their demand and have an opportunity cost. Unlike
free goods, they are exchangeable in the market and command a price. What do we understand by the term
price and why do people pay a price?
In common parlance, price signifies the quantity of money necessary to acquire a good or service. Price
connotes money-value i.e. the purchasing power of an article expressed in terms of money. In other words,
price expresses the value of a thing in relation to money i.e. the quantity of money for which it will be
exchanged. Value in exchange or exchange value, according to Ricardo, means command over commodities in
general, or power in exchange over purchasable commodities in general.
We need to distinguish between two important concepts namely, ‘value in use’ and ‘value in exchange’. Value
in use refers to usefulness or utility i.e the attribute which a thing may have to satisfy human needs. Value in
exchange or economic value is the amount of goods and services which we may obtained in the market in
exchange of a particular thing. It is measured by the amount someone is willing to give up in other goods and
services in order to obtain a good or service. In a market economy, the amount of currency (e.g. Dollar,
Rupees) is a universally accepted measure of economic value, because the number of units of money that a
person is willing to pay for something tells how much of all other goods and services they are willing to give up
to get that item.
In Economics, we are only concerned with exchange value. Considerations such as sentimental value mean
little in a market economy. Sentimental value is subjective and reflects an exaggerated judgment about the
worth of a commodity. For example, If a person says to his best friend that I like your car and if you give it to
me then I will be lifetime obliged to you. In this case, lifetime obligation is a sentimental value and has no
meaning as against monetary consideration.
Exchange value is determined in the market where exchange of goods and services takes place. In our day to
day life, we come across many references to markets such as oil market, wheat market, vegetable market etc.
These have connotations of a place where buyers and sellers gather to exchange goods at a price. In
Economics, markets are crucial focus of analysis, and therefore we need to understand how this term is used.
A market is a collection of buyers and sellers with the potential to trade. The actual or potential interactions of
the buyers and sellers determine the price of a product or service.
A market need not be formal or held in a particular place. Second-hand cars are often bought and sold through
newspaper advertisements. Second-hand goods may be disposed off by listing it in an online shop or by
placing a card in the local shop window. In the present high tech world, goods and services are effortlessly
bought and sold online. Online shopping has revolutionized the business world by making nearly everything
people want available by the simple click of a mouse button.
While studying about market economy, it is essential to understand how price is determined. Since this is done
in the market, we can define the market simply as all those buyers and sellers of a good or service who
influence price.
.3 MEANING AND TYPES OF MARKETS 4.3
The elements of a market are:

(i) Buyers and sellers;
(ii) A product or service;
(iii) Bargaining for a price;
(iv) Knowledge about market conditions; and
(v) One price for a product or service at a given time.
1.0.0 Classification of Market

Markets are generally classified into product markets and factor markets. Product markets are markets for
goods and services in which households buy the goods and services they want from firms. Factor markets, on
the other hand, are those in which firms buy the resources they need – land, labour, capital and
entrepreneurship- to produce goods and services. While product markets allocate goods to consumers, factor
markets allocate productive resources to producers and help ensure that those resources are used efficiently.
The prices in factor markets are known as factor prices.
In Economics, generally the classification of markets is made on the basis of
(a) Geographical Area
(b) Time
(c) Nature of transaction
(d) Regulation
(e) Volume of business
(f) Type of Competition.
On the basis of geographical area
From the marketing perspective, the geographical area in which the product sales should be undertaken has
vast implications for the firm. On the basis of geographical area covered, markets are classified into:-
Local Markets: When buyers and sellers are limited to a local area or region, the market is called a local
market. Generally, highly perishable goods and bulky articles, the transport of which over a long distance is
uneconomical’ command a local market. In this case, the extent of the market is limited to a particular locality.
For example, locally supplied services such as those of hair dressers and retailers have a narrow customer
base.
Regional Markets: Regional markets cover a wider area such as a few adjacent cities, parts of states, or
cluster of states. The size of the market is generally large and the nature of buyers may vary in their demand
characteristics. For eg. Mekhela Chador (Traditional Assamese Saree) is primarily worn by women in Assam and
adjoining areas.
National Markets: When the demand for a commodity or service is limited to the national boundaries of a
country, we say that the product has a national market. The trade policy of the government may restrict the
trading of a commodity to within the country. For example Hindi books may have national markets in India;
outside India one may not have market for Hindi books.
International markets: A commodity is said to have international market when it is exchanged internationally.
Usually, high value and small bulk commodities are demanded and traded internationally. For example Gold
and Silver are examples of commodities that have international market.
The above classification has become more or less out-dated as we find that in modern days even highly
perishable goods have international market.
On the basis of Time
Alfred Marshall conceived the ‘Time’ element in markets and on the basis of this, markets are classified into:
Very short period market: Market period or very short period refers to a period of time in which supply is fixed
and cannot be increased or decreased. Commodities like vegetables, flower, fish, eggs, fruits, milk, etc., which
are perishable and the supply of which cannot be changed in the very short period come under this category.
Since supply is fixed, very short period price is dependent on demand. An increase in demand will raise the
prices vice versa.
Short-period Market: Short period is a period which is slightly longer than the very short period. In this period,
the supply of output may be increased by increasing the employment of variable factors with the given fixed
factors and state of technology. Since supply can be moderately adjusted, the changes in the short period
prices on account of changes in demand are less compared to market period.
Long-period Market: In the long period, all factors become variable and the supply of commodities may be
changed by altering the scale of production. As such, supply may be fully adjusted to changes in demand
conditions. The interaction between long run supply and demand determines long run equilibrium price or
‘normal price’.
Very long-period or secular period is one when secular movements are recorded in certain factors over a
period of time. The period is very long. The factors include the size of the population, capital supply, supply of
raw materials etc.
On the basis of Nature of Transactions
a. Spot or cash Market: Spot transactions or spot markets refer to those markets where goods are
exchanged for money payable either immediately or within a short span of time. For example, grains sold
in the Mandi at the current prices and cash is payable immediately are thus part of Spot Market.
b. Forward or Future Market: In this market, transactions involve contracts with a promise to pay and
deliver goods at some future date. For example, purchase of foreign currency contract at future rate from
bank.
On the basis of Regulation
a. Regulated Market: In this market, transactions are statutorily regulated so as to put an end to unfair
practices. Such markets may be established for specific products or for a group of products. For
example, stock exchange.
b. Unregulated Market: It is also called a free market as there are no stipulations on the transactions.
For example. Weekly markets (Haat Bazaar).
On the basis of volume of Business

a. Wholesale Market: The wholesale market is the market where the commodities are bought and sold in
bulk or large quantities. Transactions generally take place between traders. i.e. Business to Business
(B2B).
b. Retail Market: When the commodities are sold in small quantities, it is called retail market. This is the
market for ultimate consumers. i.e. Business to Consumer (B2C).
On the basis of Competition
Based on the type of competition markets are classified into a) perfectly competitive market and b) imperfectly
competitive market.
We shall study these markets in greater detail in the following paragraphs.
1.1 TYPES OF MARKET STRUCTURES

For a consumer, a market consists of those firms from which he can buy a well-defined product; for a producer,
a market consists of those buyers to whom he can sell a single well-defined product. If a firm knows precisely
the demand curve it faces, it would know its potential revenue. If it also knows its costs, it can readily discover
the profit that would be associated with different levels of output and therefore can choose the output level that
maximizes profit. But, suppose the firm knows its own product’s costs and the market demand curve for the
product but does not know its own demand curve. In other words, it does not know its own total sales. In order
to find this, the firm needs to answer the following questions. How many competitors are there in the market
selling similar products? If one firm changes its price, will its market share change? If it reduces its price, will
other firms follow it or not? There are many other related questions that need to be answered.
Answers to questions of this type will be different in different circumstances. For example, if there is only one firm in
the market, the whole of the market demand will be satisfied by this particular firm. But, if there are two large firms in
the industry, they will share the market demand in some proportion. A firm has to be very cautious of the reactions of
the other firm to every decision it makes. But if there are, say, more than 5,000 small firms in an industry, each firm
will be less worried about the reactions of other firms to its decisions because each firm sells only a small proportion
of the market. Thus, we find that the market behaviour is greatly affected by the structure of the market. We can
conceive of more than thousand types of market structures, but we shall focus on a few theoretical market types
which mostly cover a high proportion of cases actually found in the real world. These are:
Perfect Competition: Perfect competition is characterised by many sellers selling identical products to many
buyers.
Monopolistic Competition: It differs in only one respect, namely, there are many sellers offering differentiated
products to many buyers. For example, shampoo manufacturers.
Monopoly: It is a situation where there is a single seller producing for many buyers. Its product is necessarily
extremely differentiated since there are no competing sellers producing products which are close substitutes.
For example. Indian Railways.
Oligopoly: There are a few sellers selling competing products to many buyers. For example, Telecom Industry.
Table 1 summarises the major distinguishing characteristics of these four major market forms.
Table 1 - Distinguishing Features of Major Types of Markets

Assumption Market Types
Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Number of sellers Very large Large Small numbers One
Product differentiation None Slight None to substantial Extreme
Price elasticity of demand of a firm Infinite Large Small Small
Degree of control over price None Some Some Very
considerable
Before discussing each market form in greater detail, it is worthwhile to know the concepts of total, average and
marginal revenue and the behavioural principles which apply to all market conditions.
1.2 CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE AND

MARGINAL REVENUE
Total Revenue: If a firm sells 100 units for ` 10 each, what is the amount which it realises? It realises ` 1,000
(100 x 10), which is nothing but the total revenue for the firm. Thus, we may state that total revenue or the total
expenditure incurred by the purchasers of the firm’s product refers to the amount of money which a firm
realises by selling certain units of a commodity. Symbolically, total revenue may be expressed as TR = P x Q.
Where, TR is total revenue
P is price of a commodity sold.
Q is quantity of a commodity sold.
This may be represented by the following diagrams. In figure A, when the price of the product is ` 30, the
quantity sold is 40 units. The total revenue is P x Q = ` 1200. Panel B shows the total revenue curve of a
competitive firm having a perfectly elastic demand curve. Since the firm can sell any quantity at market
determined prices, the TR curve is linear and starts from the origin.
(A) (B)
Figure 1: Total Revenue
Average Revenue: Average revenue is the revenue earned per unit of output. It is nothing but price of one unit
of output because price is always per unit of a commodity. For this reason, average revenue curve is also the
firms demand curve. Symbolically, average revenue is:
TR
AR=
Q
Where AR is average revenue
TR is the total revenue
Q is quantity of a commodity sold
P×Q
Or AR=
Q
Or AR = P
If, for example, a firm realises total revenue of ` 1,000 by the sale of 100 units, it implies that the average
revenue is ` 10 (1,000/100) or the firm has sold the commodity at a price of ` 10 per unit.
Marginal Revenue: Marginal revenue (MR) is the change in total revenue resulting from the sale of an
additional unit of the commodity. Thus, if a seller realises ` 1,000 while selling 100 units and ` 1,200 while
selling 101 units, we say that the marginal revenue is ` 200. We can say that MR is the rate of change in total
∆TR
revenue resulting from the sale of an additional unit of output. MR=
∆Q
Where MR is marginal revenue
TR is total revenue
Q is quantity of a commodity sold
∆ stands for a small change
For one unit change in output
MRn = TRn– TR n-1
Where TR is the total revenue when sales are at the rate of n units per period.
TR n-1is the total revenue when sales are at the rate of (n – 1) units per period.
In order to understand the above concepts clearly, look at Table -2. In column 1, the number of units sold of
commodity X is given. Column 2 shows the total revenue fetched by selling different units. Column 3 shows
average revenue which is nothing but price per unit. Column 4 shows marginal revenue which is addition to the
total revenue by the sale of an additional unit of output.
Table 2: Total Revenue, Average Revenue and Marginal Revenue

Units Total Revenue Average Revenue Marginal Revenue
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
8 24 3 -4
9 18 2 -6
10 10 1 -8
Note that the total revenue is maximum when 5 units of X are sold. It stays constant for one more unit and then
begins to fall. Average revenue keeps on falling showing inverse relationship between price and quantity
demanded. It represents demand function of X to the firm. Marginal revenue keeps on falling and after
becoming zero it becomes negative. Also note that TR at any particular level of output is the sum of marginal
revenues till that level of output which can be expressed as:-
TR= ∑MR
The question which arises is: why is the marginal revenue due to the third unit (` 6) not equal to price of
` 8 at which the third unit is sold. The answer is that when price is reduced for selling an additional unit, the two
units which could be sold for ` 9 before will have to be sold at the reduced price of ` 8 per unit. The total loss
on previous two units due to price fall will be equal to ` 2. Thus, for any falling average revenue (or price)
schedule, marginal revenue is always less than the price. In the case of constant average revenue (or price)
schedule, the marginal revenue is equal to average revenue (or uniform price). If TR stands for total revenue
and q stands for output, marginal revenue (MR) can be expressed as:
MR = dTR/dQ
dTR/ dQ indicates the slope of the total revenue curve.
When the demand curve of the firm is a normal downward sloping one, there is a well-defined relationship
between average revenue, marginal revenue and total revenue. This can be shown by the following figure
presenting total revenue (TR), average revenue (AR) and marginal revenue (MR) curves. The average revenue
curve in panel B is sloping downwards depicting the inverse relationship between price and quantity demanded.
MR curve lies below AR curve showing that marginal revenue declines more rapidly than average revenue.
Total revenue increases as long as marginal revenue is positive and declines (has a negative slope) when
marginal revenue is negative. Total revenue curve initially increases at a diminishing rate due to diminishing
marginal revenue and reaches maximum and then it falls. When marginal revenue becomes zero, the total
revenue is maximum and the slope of TR is zero.
Fig. 2: Total Revenue, Average Revenue and Marginal Revenue

Curves of a Firm which has downward Sloping Demand Curve
It may be noted that in all forms of imperfect competition, the average revenue curve of an individual firm
slopes downwards as in these market forms, when a firm increases the price of its product, its quantity
demanded decreases and vice versa. Under perfect competition, however, since the firms are price takers, the
average revenue (or price) curve or demand curve is perfectly elastic. Perfectly elastic average revenue curve
means that an individual firm has constant average revenue (or price). When price remains constant, marginal
revenue will be equal to average revenue and thus AR curve and MR curve will coincide and will be horizontal
curves as shown in figure 3. below.
Fig 3: Average Revenue and Marginal Revenue Curves of a Perfectly Competitive Firm
1.2.0 Relationship between AR, MR, TR and Price Elasticity of Demand

It is to be noted that marginal revenue, average revenue and price elasticity of demand are uniquely related to
one another through the formula:
e −1
MR= AR ×
e
Where e = price elasticity of demand
1−1
Thus if e = 1, MR = AR × =0
1
and if e >1, MR will be positive

and if e <1, MR will be negative
In a straight line downward falling demand curve, we know that the coefficient of price elasticity at the middle
point is equal to one. It follows that the marginal revenue corresponding to the middle point of the demand
curve (or AR curve) will be zero. On the upper portion of the demand curve, where the elasticity is more than
one, marginal revenue will be positive and on the lower portion of the demand curve where elasticity is less
than one, marginal revenue will be negative. These can be shown in diagram:
Fig.4: Relationship between AR, MR, TR and Price Elasticity of Demand

In fig. 4, DD is the AR or demand curve. At point C, elasticity is equal to one. Corresponding to C on the AR
curve, the marginal revenue is zero. Thus, MR curve is touching X-axis at N (corresponding to C on the AR
curve). At a greater quantity than ON, the elasticity of the AR curve is less than one and the marginal revenue
is negative. Negative marginal revenue means MR curve goes below the X-axis to the fourth quadrant.
Marginal revenue being negative means that total revenue will diminish if a quantity greater than ON is sold.
Total revenue will be rising up to ON output since up to this the marginal revenue remains positive. It follows
that total revenue will be maximum where elasticity is equal to one. Thus, TR is shown to be at its highest level
at ON level of output (corresponding to the point C on AR curve). Beyond ON Level of output, the TR curve has
a negative slope.
1.2.1 Behavioural principles

Principle 1- A firm should not produce at all if its total variable costs are not met.
It is a matter of common sense that a firm should produce only if it will do better by producing than by not
producing. The firm always has the option of not producing at all. If a firm’s total revenues are not enough to
make good even the total variable costs, it is better for the firm to shut down. In other words, a competitive firm
should shut down if the price is below AVC. In that case, it will minimise loss because then its total cost will be
equal to its fixed costs and it will have an operating loss equal to its fixed cost. The sunk fixed cost is irrelevant
to the shutdown decision because fixed costs are already incurred. This means that the minimum average
variable cost is equal to the shut-down price, the price at which the firm ceases production in the short run.
Shutting down is temporary and does not necessarily mean going out of business.
If price (AR) is greater than minimum AVC, but less than minimum ATC, the firm covers its variable cost and
some but not all of fixed cost. If price is equal to minimum ATC, the firm covers both fixed and variable costs
and earns normal profit or zero economic profit. If price is greater than minimum ATC, the firm not only covers
its full cost, but also earns positive economic profit or super normal profit.
Principle 2 - The firm will be making maximum profits by expanding output to the level where marginal
revenue is equal to marginal cost.
In other words, it will pay the firm to go on producing additional units of output so long as the marginal revenue
exceeds marginal cost i.e., additional units add more to revenues than to cost. At the point of equality between
marginal revenue and marginal cost, it will earn maximum profits.
The above principle can be better understood with the help of figure 5 which shows a set of hypothetical
marginal revenue and marginal cost curves. Marginal revenue curve slopes downwards and marginal cost
curve slopes upwards. They intersect each other at point E (MC= MR) which corresponds to output Q.* Up to
Q* level of output, marginal revenue is greater than marginal cost and at output level *Q they are equal. The
firm will be maximizing profits at E (or at Q* level of output). For all levels of output less than Q*, additional
units of output add more to revenue than to cost (as their MR is more than MC) and thus it will be profitable for
the firm to produce them. The firm will be foregoing profit equal to the area EFG if it stops at A. Similarly profits
will fall, if a greater output than OQ is produced as they will add more to cost than to revenues. On the units
from Qth to Bth, the firm will be incurring a loss equal to the area EHI.
Fig: 5: Equilibrium of the Firm: Maximization of Profits

To conclude, the firm will maximize profits at the point at which marginal revenue is equal to marginal cost.
SUMMARY
♦ Economic goods are scarce in relation to their demand and have an opportunity cost. Unlike free
goods, they are exchangeable in the market and command price.
♦ Price connotes money-value i.e. the purchasing power of an article expressed in terms of money.
♦ Value in exchange or exchange value, according to Ricardo, means command over commodities in
general, or power in exchange over purchasable commodities in general.
♦ Market is the whole set of arrangements for buying and selling of a commodity or service. Here buyers
and sellers bargain over a commodity for a price.
♦ The elements of a market are: buyers and sellers, a product or service, bargaining for a price,
knowledge about market conditions and one price for a product or service at a given time.
♦ Markets are generally classified into product markets and factor markets.
♦ The factors which determine the type of market are: nature of commodity, size of production and extent
of demand.
♦ Markets can be classified on the basis of area, time, nature of transaction, regulation, volume of
business and types of competition.
♦ On the basis of area: markets are classified into four i.e. local, regional, national and international.
♦ On the basis of time: markets are classified into four i.e. very short period or market period, short
period, long period and very long period or secular period.
♦ On the basis of nature of transaction: markets are classified into spot market and future market.
♦ On the basis of regulation: markets are classified into regulated and unregulated markets.
♦ On the basis of volume of business: markets are classified into wholesale and retail markets.
♦ On the basis of competition: On the basis of competition we have perfectly competitive market and
imperfect market. The imperfect market is further divided into monopoly, monopolistically competitive
market and oligopoly market.
♦ Total revenue refers to the amount of money which a firm realizes by selling certain units of a
commodity.
♦ Average revenue is the revenue earned per unit of output.
♦ Marginal revenue is the change in total revenue resulting from the sale of an additional unit of the
commodity.
♦ Marginal revenue, average revenue and price elasticity of demand are uniquely related to one another
e −1
♦ MR = AR × Where e = price elasticity of demand.
e
♦ Total revenue will be maximum where elasticity is equal to one.
♦ If a firm’s total revenues are not enough to make good even the total variable costs, it is better for the
firm to shut down. In other words, a competitive firm should shut down if the price is below AVC.
♦ At the point of equality between marginal revenue and marginal cost, a firm will earn maximum profits.
UNIT 2: DETERMINATION OF PRICES
LEARNING OUTCOMES
At the end of this unit, you should be able to:
 Explain how the prices are generally determined.
 Describe how changes in demand and supply affect prices and quantities demanded and supplied.
2.0 INTRODUCTION
Prices of goods express their exchange value. Prices are also used for expressing the value of various services
rendered by different factors of production such as land, labour, capital and organization in the form of rent,
wages, interest and profit respectively. Therefore, the concept of price, especially the process of price
determination, is of vital importance in Economics.
In this unit, we shall learn how demand and supply interact to strike a balance so that equilibrium price is
determined in a free market. A free market is one in which the forces of demand and supply are free to take
their own course and there is no intervention from outside by government or any other entity. It is to be noted
that, generally, it is the interaction between demand and supply that determines the price, but sometimes
Government intervenes and determines the price either fully or partially. For example, the Government of India
fixes the price of petrol, diesel, kerosene, coal, fertilizers, etc. which are critical inputs. It also fixes the
procurement prices of wheat, rice, sugarcane, etc. in order to protect the interests of both producers and
consumers. While determining these prices, the Government takes into account factors like cost of inputs, risks
of business, nature of the product etc.
One of the main reasons for studying the demand and supply model is that the model is particularly useful in
explaining how markets work. A comprehensive knowledge of the movements of these market forces enables
us to explain the observed changes in equilibrium prices and quantities of all types of products and factors. We
will be able to anticipate the possible market outcomes in real markets by applying the principles underlying the
interactions of demand and supply. Business firms can use the model of demand and supply to predict the
probable effects of various economic as well as non-economic factors on equilibrium prices and quantities. For
example, the market outcomes of government intervention in the form of taxation, subsidies, price ceiling and
floor prices etc. can be analysed with the help of equilibrium analysis.
2.1 DETERMINATION OF PRICES - A GENERAL VIEW

In an open competitive market, it is the interaction between demand and supply that tends to determine
equilibrium price and quantity. In the context of market analysis, the term equilibrium refers to a state of market
in which the quantity demanded of a commodity equals the quantity supplied of the commodity. In an
equilibrium state, the aggregate quantity that all firms wish to sell equals the total quantity that all buyers in the
market wish to buy and therefore, the market clears. Equilibrium price or market clearing price is the price at
which the quantity demanded of a commodity equals the quantity supplied of the commodity i.e. at this price
there is no unsold stock or no unsupplied demand.
To analyse how equilibrium price is determined in a market, we need to bring together demand for and supply
of the commodity in the market, for this we have the following schedule:
Table – 3: Determination of Price
S. No. Price (`) Demand Units Supply (Units)
1 1 60 5
2 2 35 35
3 3 20 45
4 4 15 55
5 5 10 65
When we plot the above points on a single graph with price on Y-axis and quantity demanded and supplied on
X-axis, we get a figure as shown below:
Fig. 6: Determination of Equilibrium Price

It is easy to see what will be the market price of the article. It cannot be ` 1, because at that price there would
be 60 units in demand, but only 5 units on offer. Competition among buyers would force the price up. On the
other hand, it cannot ` 5, for at that price, there would be 65 units on offer for sale but only 10 units in demand.
Competition among sellers would force the price down. At ` 2, demand and supply are equal (35 units) and the
market price will tend to settle at this figure. This is equilibrium price and quantity – the point at which price and
output will tend to stay. Once this point is reached, we will have stable equilibrium. Equilibrium is said to be
stable if any disturbance to it is self-adjusting so that the original equilibrium is restored. In other words, if the
equilibrium be disrupted, the market returns to equilibrium. It should be noted that it would be stable only if
other things are equal.
Figure 7 will demonstrate how stable equilibrium is achieved through price mechanism or market mechanism. If
the market price is above the equilibrium price, say ` 15, the market supply is greater than market demand and
there is an excess supply or surplus in the market. Competing sellers will lower prices in order to clear their
unsold stock. As we know, other things remaining constant, as price falls quantity demanded rises and quantity
supplied falls. In this process the supply-demand gap is reduced and eventually eliminated thus restoring
equilibrium.
Fig 7: Stable Equilibrium

Likewise, if the prevailing market price is below equilibrium, say ` 5 in our example, a shortage arises as
quantity demanded exceeds the quantity supplied. The shortage prompts the price to rise, as the buyers, who
are unable to obtain as much of the good as they desire, bid the price higher. The market price tends to
increase. Other things remaining the same, the price rise causes a decrease in the quantity demanded by the
buyers and an increase in the quantity supplied by the sellers and vice versa. This process will continue as long
as demand exceeds supply. The market thus achieves a state where the quantity that firms sell is equal to the
quantity that the consumers desire to buy. At equilibrium price (` 10), the supply decisions of the firms tend to
match the demand decisions of the buyers. Thus, the equilibrium is restored automatically, through the
fundamental working of the market and price movements eliminate shortage or surplus.
2.2 CHANGES IN DEMAND AND SUPPLY

The above analysis of market equilibrium was done by us under the ceteris paribus assumption. The facts of
the real world, however, are such that the determinants of demand other than price of the commodity under
consideration (like income, tastes and preferences, population, technology, prices of factors of production etc.)
always change causing shifts in demand and supply. Such shifts affect equilibrium price and quantity. The four
possible changes in demand and supply are:
(i) An increase (shift to the right) in demand;
(ii) A decrease (shift to the left) in demand;
(iii) An increase (shift to the right) in supply;
(iv) A decrease (shift to the left) in supply.
We will consider each of the above changes one by one.
(i) An increase in demand: In figure 8, the original demand curve of a normal good is DD and supply curve
is SS. At equilibrium price OP, demand and supply are equal to OQ.
Now suppose the money income of the consumer increases and the demand curve shifts to D1D1 and the
supply curve remains the same. We will see that on the new demand curve D1D1 at OP price, demand
increases to OQ2 while supply remains the same i.e. OQ and there is excess demand in the market equal to Q
Q2. Since supply is short of demand, price will go up to OP1. With the higher price, supply will also shoot up
generating an increase in the quantity supplied or an upward movement along the supply curve. Ultimately, a
new equilibrium between demand and supply will be reached. At this equilibrium point, OP1 is the price and
OQ1 is the quantity which is demanded and supplied.
Fig. 8: Increase in Demand, causing an increase in equilibrium price and quantity

Thus, we see that, with an increase in demand, there is an increase in equilibrium price, as a result of which
the quantity supplied rises. As such, the quantity sold and purchased also increases.
(ii) Decrease in Demand: The opposite will happen when demand falls as a result of a fall in income, while
the supply remains the same. The demand curve will shift to the left and become D1D1 while the supply curve
remains as it is. With the new demand curve D1D1, at original price OP, OQ2 is demanded and OQ is supplied.
As the supply exceeds demand, price will come down and quantity demanded will go up. A new equilibrium
price OP1 will be settled in the market where demand OQ1 will be equal to supply OQ1.
Fig. 9: Decrease in Demand Resulting in a Decrease in Price and Quantity Demanded

Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity demanded and
supplied.
(iii) Increase in Supply: Let us now assume that demand does not change, but there is an increase in supply
say, because of improved technology.
Fig. 10: Increase in Supply, Resulting In Decrease in Equilibrium

Price and Increase in Quantity Supplied
The supply curve SS will shift to the right and become S1S1. At the original equilibrium price OP, OQ is
demanded and OQ2 is supplied (with new supply curve). At the original price, a surplus now exists; as a result,
the equilibrium price falls and the quantity demanded rises. A new equilibrium price OP 1 will be settled in the
market where demand OQ1 will be equal to supply OQ1. Thus, as a result of an increase in supply with demand
remaining the same, the equilibrium price will go down and the quantity demanded will go up.
(iv) Decrease in Supply: Let us now assume that due to obsolete technology, there is decrease in
supply. In the figure 11, the supply curve SS will shift to the left and become S1S1. At the original
equilibrium price OP, OQ is quantity demanded and OQ 2 is quantity supplied (with new supply curve). At
the original price, a deficit now exists; as a result equilibrium price rises and the quantity demanded
decreases. A new equilibrium price OP1 will be settled in the market where demand OQ1 will be equal to
supply OQ1.
Thus as a result of decrease in supply we will find that equilibrium price will go up, but the amount sold and
purchased will go down as shown in figure 11.
Fig.11: Decrease in Supply Causing an Increase in the Equilibrium

Price and a fall in Quantity Demanded
2.3 SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

Till now, we were considering the effect of a change either in demand or in supply on the equilibrium price and
quantity sold and purchased. It sometimes happens that events shift both the demand and supply curves at the
same time. This is not unusual; in real life, supply curves and demand curves for many goods and services
typically shift quite often because of continuous change in economic environment. During a war, for example,
shortage of goods will often lead to decrease in their supply while full employment causes high total wage
payments which increase demand.
What happens when the demand and supply curves shift in the same direction? We may discuss the effect on
equilibrium price and quantity when both demand and supply increase simultaneously with the help of the
diagrams in the next page:
Fig.12: Simultaneous Change in Demand and Supply

Fig. 12 shows simultaneous change in demand and supply and its effects on the equilibrium price. In the figure,
the original demand curve DD and the supply curve SS meet at E at which OP is the equilibrium price and OQ
is the quantity bought and sold.
Fig. 12(a) shows that increase in demand is equal to increase in supply. The new demand curve D 1D1 and S1S1
meet at E1. The new equilibrium price is equal to the old equilibrium price (OP). However, equilibrium quantity
is more.
Fig. 12(b) shows that increase in demand is more than increase in supply. Hence, the new equilibrium price
OP1 is higher than the old equilibrium price OP. The opposite will happen i.e. the equilibrium price will go down
if there is a simultaneous fall in demand and supply and the fall in demand is more than the fall in supply.
Fig. 12(c) shows that supply increases in a greater proportion than demand. The new equilibrium price will be
less than the original equilibrium price. Conversely, if the fall in the supply is more than proportionate to the fall
in the demand, the equilibrium price will go up.
What is the effect on equilibrium price and quantity when both demand and supply decrease? You can check it
yourselves with the help of diagrams.
We can summarise the two possible outcomes when the supply and demand curves shift in the same direction
as follows:
 When both demand and supply increase, the equilibrium quantity increases but the change in
equilibrium price is uncertain.
 When both demand and supply decrease, the equilibrium quantity decreases but the change in
What happens when the demand and supply curves shift in opposite direction? We may discuss the effect on
equilibrium price and quantity when demand and supply curves shift in opposite direction with the help of the
diagrams given in the next page:
(a) (b)
Fig 13: Effect on Equilibrium Price and Quantity When

Demand and Supply Curves Shift in Opposite Directions
In panel (a) there is a simultaneous rightward shift of the demand curve and leftward shift of the supply curve.
Here, the increase in demand is more than the decrease in supply, therefore, the equilibrium price and
equilibrium quantity will rise. In panel (b) there is also a coincident rightward shift of the demand curve and
leftward shift of the supply curve. Here, the decrease in supply is more than the increase in demand,
consequently, the equilibrium price rises and the equilibrium quantity falls. In both cases, the equilibrium price
rises from P to P1 as the equilibrium moves from E to E1. What is the effect on quantity? In panel (a), the
increase in demand is large relative to the decrease in supply and the equilibrium quantity rises as a result. In
panel (b), the decrease in supply is large relative to the increase in demand, and the equilibrium quantity falls
as a result. That is, when demand increases and supply decreases, the actual quantity bought and sold can go
either way, depending on how much the demand and supply curves have shifted.
In general, when supply and demand shift in opposite directions, we cannot predict what the ultimate effect will
be on the quantity bought and sold. What we can say is that a curve that shifts a disproportionately greater
distance than the other curve will have a disproportionately greater effect on the quantity bought and sold.
We can summarise the two possible outcomes when the supply and demand curves shift in the opposite
directions as follows:
 When demand increases and supply decreases, the equilibrium price rises but nothing certain can be
said about the change in equilibrium quantity.
 When demand decreases and supply increases, the equilibrium price falls but nothing certain can be
ILLUSTRATION 1
D1 and S1 are the original demand and supply curves. D2, D3, S2 and S3 are possible new demand and supply
curves. Starting from initial equilibrium point (1), what point on the graph is most likely to result from each
change given in Questions 1 to 4?
SOLUTION
1. Assume X is a normal good. Holding everything else constant, assume that income rises and the price
of a factor of production also increases. What point in the figure above is most likely to be the new
equilibrium price and quantity?
2. We are analyzing the market for good Z. The price of a complement good, good Y, declines. At the
same time, there is technological advance in the production of good Z. What point the figure above is
most likely to be the new equilibrium price and quantity?
3. Heavy rains in Maharashtra during 2005 and 2006 caused havoc with the rice crop. What point in the
figure above is most likely to be the new equilibrium price and quantity?
4. Assume that consumers expect the prices of new cars to significantly increase next year. What point
in the figure above is most likely to be the new equilibrium price and quantity?
Let us try answering these questions.
1: When income of people rises, the demand curve will shift to right (becomes D2) as X is given to be a
normal good. An increase in the price of factors of production used in the production of the good under
consideration will decrease its supply and shift the supply curve to the left to S3. The new demand and
supply of X will meet at Point 2.
2: When the price of a complementary good falls, the demand for the good in question increases.
Therefore, when price of the complementary good Y falls, the demand curve for Z will move to right
and become D2 and due to technological advancement the supply of Z will increase and become S2.
The new demand and supply of Z will meet at Point 7.
3: Due to heavy rains, the supply of rice will fall and the new equilibrium point will be 3. It is assumed that
there is no change in demand.
4: If prices of cars are expected to increase in future, the demand curve will shift to right. Assuming that
the supply remains constant, the new equilibrium point will be 5.
SUMMARY
 Prices of goods express their exchange value.
 In an open competitive market, it is the interaction between demand and supply that tends to
determine equilibrium price and quantity.
 Equilibrium price or market clearing price is the price at which the quantity demanded of a commodity
equals the quantity supplied of the commodity there is no unsold stock or no unsupplied demand.
 Equilibrium is said to be stable if any disturbance to it is self-adjusting so that the original equilibrium is
restored automatically, through the fundamental working of the market. Price movements eliminate
shortage or surplus.
 If demand increases without any corresponding increase in supply, there will be increase in equilibrium
price, as a result of which the quantity sold and purchased also increases.
 If demand decreases without any change in supply, there will be decrease in the equilibrium price and
quantity demanded and supplied.
 If there is an increase in supply without any change in demand, the equilibrium price will go down and
the quantity demanded will go up.
 If there is a decrease in supply without any change in demand, the equilibrium price will go up but the
amount sold and purchased will go down.
 There can be simultaneous changes in both demand and supply and the equilibrium price will change
according to the proportionate change in demand and supply.
 When both demand and supply increase, the equilibrium quantity increases but the change in
 When both demand and supply decrease, the equilibrium quantity decreases but the change in
 When demand increases and supply decreases, the equilibrium price rises but nothing certain can be
 When demand decreases and supply increases, the equilibrium price falls but nothing certain can be
UNIT – 3: PRICE-OUTPUT DETERMINATION UNDER DIFFERENT

MARKET FORMS
LEARNING OUTCOMES
At the end of this unit, you will be able to:
♦ Describe the characteristics of different market forms namely perfect competition, monopoly,
monopolistic competition and oligopoly and cite the main differences among them.
♦ Explain how equilibrium price and quantity of output are determined both in the short run and in the
long run in different markets.
♦ Describe what happens in the long run in markets where firms are either incurring losses or are making
economic profits.
♦ Illustrate the welfare implications of each of the market forms.
The price of a commodity and the quantity exchanged per time period depend on the market demand and
supply functions and the market structure. The market structure characterises the way the sellers and buyers
interact to determine equilibrium price and quantity. The existence of different forms of market structure leads
to differences in demand and revenue functions of the firms. The market structure mostly determines a firm’s
power to fix the price of its product. The level of profit maximising price is generally different in different kinds of
markets due to differences in the nature of competition. As such, a firm has to closely watch the nature of the
market before determining its equilibrium price and output. In this unit, we shall discuss the nature of four of the
most important market structures namely, perfect competition, monopoly, monopolistic competition and
oligopoly and how these market structures operate to determine short-run and long-run equilibrium price and
quantity. We shall start our analysis with perfect competition.
3.0 PERFECT COMPETITION

3.0.0 Features
Suppose you go to a vegetable market and enquire about the price of potatoes from a shopkeeper. He says
potatoes are for ` 20 per kg. In the same way, you enquire from many shopkeepers and you get the same
answer. What do you notice? You notice the following facts:
(i) There are large number of buyers and sellers in the potatoes market.
(ii) All the shopkeepers are selling potatoes at ` 20 per kg.
(iii) Product homogeneity i.e. all the sellers are selling almost the same quality of potatoes in the sense
that you cannot judge by seeing the potatoes from which farmer’s field do they come from. Such type
of market is known as perfectly competitive market.
In general, a perfectly competitive market has the following characteristics:

(i) There are large number of buyers and sellers who compete among themselves. The number is so
large that the share of each seller in the total supply and the share of each buyer in the total demand is
too small that no buyer or seller is in a position to influence the price, demand or supply in the market.
(ii) The products supplied by all firms are identical or are homogeneous in all respects so that they are
perfect substitutes. Thus, all goods must sell at a single market price. No firm can raise the price of its
product above the price charged by other firms without losing most or all of its business. Buyers have
no preference as between different sellers and as between different units of commodity offered for
sale; also sellers are quite indifferent as to whom they sell. For example, most agricultural products,
cooking gas, and raw materials such as copper, iron, cotton, and steel sheet etc. are fairly
homogeneous. In addition, all consumers have perfect information about competing prices.
(iii) Every firm is free to enter the market or to go out of it. There are no legal or market related barriers to
entry and also no special costs that make it difficult for a new firm either to enter an industry and
produce, if it sees profit opportunity or to exit if it cannot make a profit.
If the above three conditions alone are fulfilled, such a market is called pure competition. The essential
feature of pure competition is the absence of the element of monopoly. Consequently, business
combinations of monopolistic nature are not possible. In addition to the above stated three features of
‘pure competition’; a few more conditions are attached to perfect competition. They are:
(iv) There is perfect knowledge of the market conditions on the part of buyers and sellers. Both buyers and
sellers have all information relevant to their decision to buy or sell such as the quantities of stock of
goods in the market, the nature of products and the prices at which transactions of purchase and sale
are being entered into.
(v) Perfectly competitive markets have very low transaction costs. Buyers and sellers do not have to
spend much time and money finding each other and entering into transactions.
(vi) Under prefect competition, all firms individually are price takers. The firms have to accept the price
determined by the market forces of total demand and total supply. The assumption of price taking
applies to consumers as well. When there is perfect knowledge and perfect mobility, if any seller tries
to raise his price above that charged by others, he would lose his customers.
While there are few examples of perfect competition which is regarded as a myth by many, the agricultural
products, financial instruments (stock, bonds, foreign exchange), precious metals (gold, silver, platinum)
approach the condition of perfect competition.
3.0.1 Price Determination under Perfect Competition

Equilibrium of the Industry: An industry in economic terminology consists of a large number of independent
firms. Each such unit in the industry produces a homogeneous product so that there is competition amongst
goods produced by different units. When the total output of the industry is equal to the total demand, we say
that the industry is in equilibrium; the price then prevailing is equilibrium price. A firm is said to be in equilibrium
when it is maximising its profits and has no incentive to expand or contract production.
As stated above, under competitive conditions, the equilibrium price for a given product is determined by the
interaction of the forces of demand and supply for it as is shown in figure 14 in the next page.
Fig. 14: Equilibrium of a competitive industry

In Fig. 14, OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at that price. The
equilibrium price is the price at which both demand and supply are equal and therefore, no buyer who wanted
to buy at that price goes dissatisfied and none of the sellers is dissatisfied that he could not sell his goods at
that price. It may be noticed that if the price were to be fixed at any other level, higher or lower, demand
remaining the same, there would be no equilibrium in the market. Likewise, if the quantities of goods were
greater or smaller than the demand, there would not be equilibrium in the market.
Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The output which
gives maximum profit to the firm is called equilibrium output. In the equilibrium state, the firm has no incentive
either to increase or decrease its output.
Firms in a competitive market are price-takers. This is because there are a large number of firms in the market
who are producing identical or homogeneous products. As such these firms cannot influence the price in their
individual capacities. They have to accept the price determined through the interaction of total demand and
total supply of the commodity which they produce.
This is illustrated in the following figure:
Fig. 15: The firm’s demand curve under perfect competition

The market price OP is fixed through the interaction of total demand and total supply of the industry. Firms
have to accept this price as given and as such they are price-takers rather than price-makers. They cannot
increase the price above OP individually because of the fear of losing its customers to other firms. They do not
try to sell the product below OP because they do not have any incentive for lowering it. They will try to sell as
much as they can at price OP.
As such, P-line acts as demand curve for the firm. Because it is a price taker, the demand curve D facing an
individual competitive firm is given by a horizontal line at the level of market price set by the industry. In other
words, the demand curve of each firm is perfectly (or infinitely) elastic. The firm can sell as much or as little
output as it likes along the horizontal price line. Since price is given, a competitive firm has to adjust its output
to the market price so that it earns maximum profit. Let us see in table 4 where demand and supply schedule
for the industry were as follows:
Table 4: Equilibrium price for industry
Price (` ) Demand (units) Supply (units)

1 60 5
2 35 35
3 20 45
4 15 55
5 10 65
Equilibrium price for the industry is determined through the interaction of demand and supply is ` 2 per unit.
The individual firms will accept ` 2 per unit as the price and sell different quantities at this price. Let us
consider the case of firm ‘X’. Firm X’s quantity sold, total revenue, average revenue and marginal revenue are
as given in Table 5.
Table 5: Trends in Revenue of a Competitive Firm
Price (` ) Quantity Sold Total Revenue Average Revenue Marginal Revenue

2 8 16 2 2
2 9 18 2 2
2 10 20 2 2
2 11 22 2 2
2 12 24 2 2
Firm X’s price, average revenue and marginal revenue are equal to ` 2. Thus, we see that in perfectly
competitive market a price-taking firm’s average revenue, marginal revenue and price are equal. As a result,
when the firm sells an additional unit, its total revenue increases by an amount equal to its price.
AR = MR = Price.
Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain equilibrium position, has to
satisfy two conditions as below: (Note that because competitive firms take price as fixed, this is a rule for
setting output, not price).
(i) The marginal revenue should be equal to the marginal cost. i.e. MR = MC. If MR is greater than MC,
there is always an incentive for the firm to expand its production further and gain by selling additional
units. If MR is less than MC, the firm will have to reduce output since an additional unit adds more to
cost than to revenue. Profits are maximum only at the point where MR = MC. Because the demand
curve facing a competitive firm is horizontal, so that MR = P, the general rule for profit maximization
can be simplified. A perfectly competitive firm should choose its output so that marginal cost equals
price.
(ii) The MC curve should cut MR curve from below. In other words, MC should have a positive slope.
Short-Run Profit Maximization by a Competitive Firm
We shall begin with the short-run output decision and then move on to the long run. In the short run, a firm
operates with a fixed amount of capital and must choose the levels of its variable inputs so as to maximize
profit.
Fig. 16 : Equilibrium position of a firm under perfect competition

In figure 16, DD and SS are the industry demand and supply curves which intersect at E to set the market price
as OP. The firms of perfectly competitive industry adopt OP price as given and considers P-Line as demand
(average revenue) curve which is perfectly elastic at P. As all the units are priced at the same level, MR is a
horizontal line equal to AR line. Note that MC curve cuts MR curve at two places T and R respectively. But at T,
the MC curve is cutting MR curve from above. T is not the point of equilibrium as the second condition is not
satisfied. The firm will benefit if it goes beyond T as the additional cost of producing an additional unit is falling.
At R, the MC curve is cutting MR curve from below. Hence, R is the point of equilibrium and OQ2 is the
equilibrium level of output.
3.0.2 Short run supply curve of the firm in a competitive market

One interesting thing about the MC curve of a firm in a perfectly competitive industry is that it depicts the firm’s
supply curve. This can be shown with the help of the following figure:
Fig. 17: Marginal cost and supply curves for a price-taking firm
Suppose the market price of a product is ` 2 Corresponding to it we have D1 as demand curve for the firm. At
price ` 2, the firm supplies Q1 output because here MR = MC. If the market price is ` 3, the corresponding
demand curve is D2. At ` 3, the quantity supplied is Q2. Similarly, we have demand curves D3 and D4 and
corresponding supplies are Q3 and Q4. The firm’s marginal cost curve which gives the marginal cost
corresponding to each level of output is nothing but firm’s supply curve that gives various quantities the firm will
supply at each price.
For prices below AVC, the firm will supply zero units because the firm is unable to meet even its variable cost.
For prices above AVC, the firm will equate price and marginal cost. When price is high enough to meet the
AVC, a firm will decide to continue its production. In fig. 17, at price ` 2, the AVC of the firm is covered and
therefore, the firm need not shutdown. Thus, in perfect competition, the firm’s marginal cost curve above AVC
has the identical shape of the firm’s supply curve.
3.0.3 Can a competitive firm earn profits?

In the short run, a firm will attain equilibrium position and at the same time, it may earn supernormal profits,
normal profits or losses depending upon its cost conditions. Following are the three possibilities:
Supernormal Profits: There is a difference between normal profits and supernormal profits. When the average
revenue of a firm is just equal to its average total cost, a firm earns normal profits or zero economic profits. It is
to be noted that here a normal percentage of profits for the entrepreneur for his managerial services is already
included in the cost of production. When a firm earns supernormal profits, its average revenues are more than
its average total cost. Thus, in addition to normal rate of profit, the firm earns some additional profits. The
following example will make the above concepts clear:
Suppose the cost of producing 1,000 units of a product by a firm is ` 15,000. The entrepreneur has invested
` 50,000 in the business and the normal rate of return in the market is 10 per cent. That is, the cost of self
owned factor (capital) used in the business or implicit cost is ` 5000/-. The entrepreneur would have earned
` 5,000 (10% of ` 50,000) if he had invested it elsewhere. Thus, total cost of production is ` 20,000 (` 15,000
+ ` 5,000). If the firm is selling the product at ` 20, it is earning normal profits because AR (` 20) is equal to
ATC (` 20). If the firm is selling the product at ` 22 per unit, its AR (` 22) is greater than its ATC (` 20) and it
is earning supernormal profit at the rate of ` 2 per unit.
Fig. 18: Short run equilibrium: Supernormal profits of a competitive firm
Figure 18 shows the revenue and cost curves of a firm which earns supernormal profits in the short run. MR
(marginal revenue) curve is a horizontal line and MC (marginal cost) curve is a U-shaped curve which cuts the
MR curve at E. The firm is in equilibrium at point E where marginal revenue is equal to marginal cost. OQ is the
equilibrium output for the firm. At this level of output, the average revenue or price per unit is EQ and average
total cost is BQ. The firm’s profit per unit is EB (AR-ATC). Total profits are ABEP. (EB x OQ ; OQ =AB) .
Applying the principle Total Profit = TR – TC, we find total profit by finding the difference between OPEQ and
OABQ which is equal to ABEP.
Normal profits: When a firm just meets its average total cost, it earns normal profits. Here AR = ATC.
Fig. 19: Short run equilibrium of a competitive firm: Normal profits

The figure shows that MR = MC at E. The equilibrium output is OQ. At this level of output, price or AR covers
full cost (ATC). Since AR = ATC or OP = EQ, the firm is just earning normal profits. Applying TR – TC, we find
that TR – TC = zero or there is zero economic profit.
Losses: The firm can be in an equilibrium position and still makes losses. This is the situation when the firm is
minimising losses. For all prices above the minimum point on the AVC curve, the firm will stay open and will
produce the level of output at which MR = MC. When the firm is able to meet its variable cost and a part of fixed
cost, it will try to continue production in the short run. If it recovers a part of the fixed costs, it will be beneficial
for it to continue production because fixed costs (such as costs towards plant and machinery, building etc.) are
already incurred and in such case it will be able to recover a part of them. But, if a firm is unable to meet its
average variable cost, it will be better for it to shutdown. This shutdown may be temporary. When the market
price rises, the firm resumes production.
Fig. 20: Short run equilibrium of a competitive firm: Losses
In figure 20, E is the equilibrium point and at this point AR = EQ and ATC = BQ since BQ>EQ, the firm is having
per unit loss equal to BE and the total loss is ABEP.
ILLUSTRATION 2
“Tasty Burgers” is a small kiosk selling Burgers and is a price-taker. The table below provides the data of 'Tasty
Burgers’ output and costs in Rupees.
Quantity Total Cost Fixed Cost Variable Average Average Marginal
Cost Variable Fixed Cost Cost
Cost
0 100
10 210
20 300
30 400
40 540
50 790
60 1060
Q1. If burgers sell for ` 14 each, what is Tasty Burgers’ profit maximizing level of output?
Q2. What is the total variable cost when 60 burgers are produced?
Q3. What is average fixed cost when 20 burgers are produced?
Q4. Between 10 to 20 burgers, what is the marginal cost?
SOLUTION
Let us try to solve each of these questions.
First of all it is better to fill the blanks in the Table.
Since the total cost when zero product is produced is ` 100, the total fixed cost of “Tasty Burgers” will be
` 100/-.
We fill the data now:
Quantity Total Fixed Variable Average Average Marginal Marginal
Cost Cost Cost Variable Fixed Cost Cost Cost
Cost (∆TC)
0 100 100 - - - - -
10 210 100 110 11 10.0 110 11
20 300 100 200 10 5.0 90 9
30 400 100 300 10 3.33 100 10
40 540 100 440 11 2.50 140 14
50 790 100 690 13.80 2.0 250 25
60 1060 100 960 16 1.66 270 27
Now let us answer the questions.
Ans 1: The price of Burger is ` 14. Since it is given that “Tasty Burger” is price-taker, it is a perfectly
competitive firm. In a perfectly competitive market all the products are sold at the same price, that means AR =
MR. In order to find out the profit maximizing level of output, MR should be equal to MC. Here AR = MR = ` 14.
From the table we can see that MR (14) = MC (14) when 40 burgers are produced. Therefore, the profit
maximising level of output of burgers is 40 units.
Ans 2 : The Total Variable Cost at 60 burgers is ` 960.
Ans 3: The Average Fixed Cost at 20 burgers is ` 5.
Ans 4: Between 10 to 20 burgers, the Marginal Cost is ` 9.
3.0.4 Long Run Equilibrium of a Competitive Firm

In the short run, one or more of the firm’s inputs are fixed. In the long run, firms can alter the scale of operation
or quit the industry and new firms can enter the industry. In a market with entry and exit, a firm enters when it
believes that it can earn a positive long run profit and exits when it faces the possibility of a long-run loss. Firms
are in equilibrium in the long run when they have adjusted their plant so as to produce at the minimum point of
their long run ATC curve, which is tangent to the demand curve defined by the market price. In the long run, the
firms will be earning just normal profits, which are included in the ATC. If they are making supernormal profits in
the short run, new firms will be attracted into the industry; this will lead to a fall in price (a down ward shift in the
individual demand curves) and an upward shift of the cost curves due to increase in the prices of factors as the
industry expands. These changes will continue until the ATC is tangent to the demand curve. If the firms make
losses in the short run, they will leave the industry in the long run. This will raise the price and costs may fall as
the industry contracts, until the remaining firms in the industry cover their total costs inclusive of normal rate of
profit.
In figure 21, we show how firms adjust to their long run equilibrium position. As in the short run, the firm faces a
horizontal demand curve. If the price is OP, the firm is making super-normal profits working with the plant
whose cost is denoted by SAC1. If the firm believes that the market price will remain at OP, it will have incentive
to build new capacity and it will move along its LAC. At the same time, new firms will be entering the industry
attracted by the excess profits. As the quantity supplied in the market increases, the supply curve in the market
will shift to the right and price will fall until it reaches the level of OP1 (in figure 21a) at which the firms and the
industry are in long run equilibrium.
(a) (b)
Fig. 21: Long run equilibrium of the firm in a perfectly competitive market
The condition for the long run equilibrium of the firm is that the marginal cost should be equal to the price and
the long run average cost i.e. LMC = LAC = P.
The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum possible.
At equilibrium, the short run marginal cost is equal to the long run marginal cost and the short run average cost
is equal to the long run average cost. Thus, in the long run we have,
SMC = LMC = SAC = LAC = P = MR
This implies that at the minimum point of the LAC, the corresponding (short run) plant is worked at its optimal
capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the LAC at its
minimum point and the SMC cuts the SAC at its minimum point. Thus, at the minimum point of the LAC the
above equality is achieved.
3.0.5 Long Run Equilibrium of the Industry

A long-run competitive equilibrium of a perfectly competitive industry occurs when three conditions hold:
All firms in the industry are in equilibrium i.e. all firms are maximizing profit.
No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit or
normal profit.
The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by
consumers.
Fig. 22: Long run equilibrium of a competitive industry and its firms
Figure 22 shows that in the long-run AR = MR = LAC = LMC at E1. In the long run, each firm attains the plant
size and output level at which its cost per unit is as low as possible. Since E1 is the minimum point of LAC
curve, the firm produces equilibrium output OM at the minimum (optimum) cost. A firm producing output at
optimum cost is called an optimum firm. In the long run, all firms under perfect competition are optimum firms
having optimum size and these firms charge minimum possible price which just covers their marginal cost.
Thus, in the long run, under perfect competition, the market mechanism leads to optimal allocation of
resources. The optimality is shown by the following outcomes associated with the long run equilibrium of the
industry:
(a) The output is produced at the minimum feasible cost.
(b) Consumers pay the minimum possible price which just covers the marginal cost i.e. MC = AR. (P =
MC)
(c) Plants are used to full capacity in the long run, so that there is no wastage of resources i.e. MC = AC.
(d) Firms earn only normal profits i.e. AC = AR.
(e) Firms maximize profits (i.e. MC = MR), but the level of profits will be just normal.
(f) There is optimum number of firms in the industry.
In other words, in the long run,
LAR = LMR = P = LMC = LAC and there will be optimum allocation of resources.
It should be remembered that the perfectly competitive market system is a myth. This is because the
assumptions on which this system is based are never found in the real world market conditions.
3.1 MONOPOLY
The word ‘Monopoly’ means “alone to sell”. Monopoly is a situation in which there is a single seller of a product
which has no close substitute. Pure monopoly is never found in practice. However, in public utilities such as
transport, water and electricity, we generally find a monopoly form of market.
3.1.0 Features of Monopoly Market

The following are the major features of the monopoly market:
(1) Single seller of the product: In a monopoly market, there is only one firm producing or supplying a
product. This single firm constitutes the industry and as such there is no distinction between firm and
industry in a monopolistic market. Monopoly is characterized by an absence of competition.
(2) Barriers to Entry: In a monopolistic market, there are strong barriers to entry. The barriers to entry
could be economic, institutional, legal or artificial.
(3) No close-substitutes: A monopoly firm has full control over the market supply of a product or service.
A monopolist is a price maker and not a price taker. The monopolist generally sells a product which
has no close substitutes. In such a case, the cross elasticity of demand for the monopolist’s product
and any other product is zero or very small. The price elasticity of demand for monopolist’s product is
also less than one. As a result, the monopolist faces a steep downward sloping demand curve.
(4) Market power: A monopoly firm has market power i.e. it has the ability to charge a price above
marginal cost and earn a positive profit.
While to some extent all goods are substitutes for one other, there may be essential characteristics in a good or
group of goods which give rise to gaps in the chain of substitution. If one producer can so exclude competition
that he controls the supply of a good, he can be said to be ‘monopolist’ – a single seller.
3.1.1 How do monopolies arise?

The fundamental cause of monopoly is barriers to entry; in effect other firms cannot enter the market. A few
reasons for occurrence and continuation of monopoly are:
1) Strategic control over a scarce resources, inputs or technology by a single firm limiting the access of
other firms to these resources.
2) Through developing or acquiring control over a unique product that is difficult or costly for other
companies to copy.
3) Governments granting exclusive rights to produce and sell a good or a service.
4) Patents and copyrights given by the government to protect intellectual property rights and to
encourage innovation.
5) Business combinations or cartels (illegal in most countries) where former competitors cooperate on
pricing or market share.
6) Extremely large start-up costs even to enter the market in a modest way and requirement of
extraordinarily costly and sophisticated technical know-how discourage firms from entering the market.
7) Natural monopoly arises when there are very large economies of scale. A single firm can produce the
industry’s whole output at a lower unit cost than two or more firms could. It is often wasteful (for consumers
and the economy) to have more than one such supplier in a region because of the high costs of duplicating the
infrastructure. For e.g. telephone service, natural gas supply and electrical power distribution.
8) Enormous goodwill enjoyed by a firm for a considerably long period create difficult barriers to entry.
9) Stringent legal and regulatory requirements effectively discourage entry of new firms without being
specifically prohibited.
10) Firms use various anti-competitive practices often referred to as predatory tactics, such as limit pricing
or predatory pricing intended to do away with existing or potential competition.
In real life, pure monopolies are not common because monopolies are either regulated or prohibited altogether.
But, one producer may dominate the supply of a good or group of goods. Earlier, in public utilities, e.g.
transport, water, electricity generation etc. monopolistic markets existed so as to reap the benefits of large
scale production. But these markets have been deregulated and opened to competition over a period of time. In
India, Indian Railways has monopoly in rail transportation. There is government monopoly over production of
nuclear power.
3.1.2 Monopolist’s Revenue Curves

In the absence of government intervention, a monopolist is free to set any price it desires and will usually set
the price that yields the largest possible profit. Since the monopolist firm is assumed to be the only producer of
a particular product, its demand curve is identical with the market demand curve for the product. The market
demand curve, which exhibits the total quantity of a product that buyers will offer to buy at each price, also
shows the quantity that the monopolist will be able to sell at every price that he sets. If we assume that the
monopolist sets a single price and supplies all buyers who wish to purchase at that price, we can easily find his
average revenue and marginal revenue curves.
Fig. 23: A monopolist’s demand curve and marginal revenue curve

Suppose the straight line in Fig. 23 is the market demand curve for a particular product ‘A’. Suppose M/s. X and
Co. is the only producer of the product A so that it faces the entire market demand. The firm faces a downward
sloping demand curve, because if it wants to sell more it has to reduce the price of the product.
We have tabulated hypothetical values of price and quantity in Table 6 and have computed the amounts of
average, total and marginal revenue corresponding to these levels.
Table 6 Average revenue, Total revenue and Marginal revenue for a Monopolist
Quantity Average Revenue (`) Total Revenue (`) Marginal Revenue (` )
sold (AR = P) (TR) (MR)
0 10.00 0
1 9.50 9.50 9.50
2 9.00 18.00 8.50
3 8.50 25.50 7.50
4 8.00 32.00 6.50
5 7.50 37.50 5.50
6 7.00 42.00 4.50
7 6.50 45.50 3.50
8 6.00 48.00 2.50
9 5.50 49.50 1.50
10 5.00 50.00 .50
11 4.50 49.50 (-).50
If the seller wishes to charge ` 10 he cannot sell any unit as no buyer would be willing to buy at such a high
price. Alternatively, if he wishes to sell 10 units, his price cannot be higher than ` 5. Because the seller charges
a single price for all units he sells, average revenue per unit is identical with price, and thus the market demand
curve is the average revenue curve for the monopolist.
In perfect competition, average and marginal revenue are identical, but this is not the case with monopoly since
the monopolist knows that if he wishes to increase his sales he will have to reduce the price of the product.
Consider the example given. If the seller wishes to sell 3 units, he will have to reduce the price from ` 9 to `
8.50. The third unit is sold for ` 8.50 only. This adds ` 8.50 to the firm’s revenue. But, in order to sell the 3rd
unit, the firm had to lower the price of all 3 units from ` 9 to ` 8.50. It thus receives ` .50 less on each of the 2
units it could have sold for ` 9. The marginal revenue over the interval from 2 to 3 units is thus
` 7.50 only. Again, if he wishes to sell 4 units, he will have to reduce the price from ` 8.50 to ` 8. The marginal
revenue here will be ` 6.50 only. It must reduce price to sell additional output. So the marginal revenue on its
additional unit sold is lower than the price, because it gets less revenue for previous units as well (it has to
reduce price to the same amount for all units). The relationship between AR and MR of a monopoly firm can be
stated as follows:
(i) AR and MR are both negatively by sloped (downward sloping) curves.
(ii) The slope of the MR curve is twice that of the AR curve. MR curve lies half-way between the AR curve
and the Y axis. i.e. it cuts the horizontal line between Y axis and AR into two equal parts.
(iii) AR cannot be zero, but MR can be zero or even negative.
Monopolies are mainly of two types: Simple monopoly where the monopolist charges uniform price from all
buyers For example, Indian Railways charging same fare from all AC 3Tier passengers and discriminating
monopoly where the monopolist charges different prices from different buyers of the same good or service for
eg. Dynamic fare charged by Indian Railways in specific trains. We shall look into equilibrium of a simple
monopolist.
3.1.3 Profit maximisation in a Monopolised Market: Equilibrium of the Monopoly

Firm
Firms in a perfectly competitive market are price-takers so that they are only concerned about determination of
output. But this is not the case with a monopolist. A monopolist has to determine not only his output but also
the price of his product. As under perfect competition, monopolists’ decisions are based on profit maximisation
hypothesis. Although cost conditions, i.e. AC and MC curves, in competitive and monopoly markets are
generally identical, revenue conditions differ. Since a monopolist faces a downward sloping demand curve, if he
raises the price of his product, his sales will go down. On the other hand, if he wants to increase his sales
volume, he will have to be content with lower price. A monopolist will try to reach the level of output at which
profits are maximum i.e. he will try to attain the equilibrium level of output. Since firm and industry are identical
in a monopoly setting equilibrium of the monopoly firm signifies equilibrium of the industry. We shall discuss
how a monopoly firm decides its output and price in the short run and in the long run.
Short run Equilibrium
Conditions for equilibrium: The twin conditions for equilibrium in a monopoly market are the same as that of
a firm in a competitive industry. Graphically, we can depict these conditions in figure 24.
Fig. 24: Equilibrium of a monopolist (Short run)
The figure shows that MC curve cuts MR curve at E. That means, at E, the equilibrium output is OQ. The
ordinate EQ extended to the demand curve (AR curve) gives the profit maximising equilibrium price OP. Thus
the determination of output simultaneously determines the price which a monopolist can charge.
In order to know whether the monopolist is making profits or losses in the short run, we need to introduce the average
total cost curve. The following figure shows two possibilities for a monopolist firm in the short run.
Fig. 25: Firm’s equilibrium under monopoly: Maximisation of profits

Figure 25 shows that MC cuts MR at E to give equilibrium output as OQ. At OQ, the price charged is OP. At
output level OQ, the price per unit is QA (=OP) and the cost per unit is BQ. Therefore, the economic profit per
unit given by AR – ATC is AB (AQ-BQ). The total profit is ABCP.
Can a monopolist incur losses? One of the misconceptions about a monopoly firm is that it makes profits at all
times. It is to be noted that there is no certainty that a monopolist will always earn an economic or supernormal
profit. It all depends upon his demand and cost conditions. If a monopolist faces a very low demand for his
product and the cost conditions are such that ATC >AR, he will not be making profits, rather, he will incur
losses. Figure 26 depicts this position.
Fig. 26: Equilibrium of the monopolist: Losses in the short run

In the above figure, MC cuts MR at E. Here E is the point of loss minimisation. At E, the equilibrium output is
OQ and the equilibrium price is OP. The average total cost (SATC) corresponding to OQ is QA. Cost per unit of
output i.e. QA is greater than revenue per unit which is BQ. Thus, the monopolist incurs losses to the extent of
AB per unit or total loss is ABPC. Whether the monopolist stays in business in the short run depends upon
whether he meets his average variable cost or not. If he covers his average variable cost and at least a part of
fixed cost, he will not shut down because he contributes something towards fixed costs which are already
incurred. If he is unable to meet even his average variable cost, he will shutdown.
Long Run Equilibrium: Long run is a period long enough to allow the monopolist to adjust his plant size or to use
his existing plant at any level that maximizes his profit. In the absence of competition, the monopolist need not
produce at the optimal level. He can produce at a sub-optimal scale also. In other words, he need not reach the
minimum of LAC curve; he can stop at any point on the LAC where his profits are maximum.
Fig. 27: Long run equilibrium of a monopolist

However, one thing is certain, the monopolist will not continue if he makes losses in the long run. He will
continue to make super normal profits even in the long run as entry of outside firms is blocked.
3.1.4 Price Discrimination

Consider the following examples.
The family doctor in your neighbourhood charges a higher fee from a rich patient compared to the fee charged
from a poor patient even though both are suffering from viral fever. Why?
Electricity companies sell electricity at a cheaper rate for home consumption in rural areas than for industrial
use. Why?
The above cases are examples of price discrimination. What is price discrimination? Price discrimination occurs
when a producer sells a specific commodity or service to different buyers at two or more different prices for
reasons not associated with differences in cost.
Price discrimination is a method of pricing adopted by a monopolist in order to earn abnormal profits. It refers to
the practices of charging different prices for different units of the same commodity.
Further examples of price discrimination are:
♦ Railways separate high-value or relatively small-bulk commodities which can bear higher freight
charges from other categories of goods.
♦ Some countries dump goods at low prices in foreign markets to capture them.
♦ Some universities charge higher tuition fees from evening class students than from other scholars.
♦ A lower subscription is charged from student readers in case of certain journals.

♦ Lower charges on phone calls at off peak time.
Price discrimination cannot persist under perfect competition because the seller has no influence over the
market determined price. Price discrimination requires an element of monopoly so that the seller can influence
the price of his product.
Conditions for price discrimination: Price discrimination is possible only under the following conditions:
I. The seller should have some control over the supply of his product i.e. the firm should have price-
setting power. Monopoly power in some form is necessary (not sufficient) to discriminate price.
II. The seller should be able to divide his market into two or more sub-markets.
III. The price-elasticity of the product should be different in different sub-markets. The monopolist fixes a
high price for his product for those buyers whose price elasticity of demand for the product is less than
one. This implies that, when the monopolist charges a higher price from them, they do not significantly
reduce their purchases in response to high price.
IV. It should not be possible for the buyers of low-priced market to resell the product to the buyers of high-
priced market i.e there must be no market arbitrage.
Thus, we note that a discriminating monopolist charges a higher price in a market which has a relatively
inelastic demand. The market which is highly responsive to price changes is charged less. On the whole, the
monopolist benefits from such discrimination.
A numerical example will help you understand price-discrimination more clearly.
Suppose the single monopoly price is ` 30 and the elasticities of demand in markets A and B are respectively 2
and 5. Then,
MR in market A =
= 15
MR in market B =
= 24
It is thus clear that the marginal revenues in the two markets are different when elasticities of demand at the
single price are different. Further, we see that the marginal revenue in the market in which elasticity is high is
greater than the marginal revenue in the market where elasticity is low. Therefore, it is profitable for the
monopolist to transfer some amount of the product from market A where elasticity is less and therefore
marginal revenue is low, to market B where elasticity is high and marginal revenue is large. Thus, when the
monopolist transfers one unit from A to B, the loss in revenue (` 15) will be more than compensated by gain in
revenue (` 24). On the whole, the gain in revenue will be ` 9 (24-15). It is to be noted that when some units are
transferred from A to B, the price in market A will rise and it will fall in B. This means that the monopolist is now
discriminating between markets A and B. Again, it is to be noted that there is a limit to which units of output can
be transferred from A to B. Once this limit is reached and once a point is reached when the marginal revenues
in the two markets become equal as a result of transfer of output, it will no longer be profitable to shift more
output from market A to market B. When this point of a equality is reached, the monopolist will be charging
different prices in the two markets – a higher price in market A with lower elasticity of demand and a lower price
in market B with higher elasticity of demand.
Objectives of Price discrimination:
(a) to earn maximum profit
(b) to dispose off surplus stock
(c) to enjoy economies of scale
(d) to capture foreign markets and
(e) to secure equity through pricing.
Price discrimination may take place for reasons such as differences in the nature and types of persons who buy
the products, differences in the nature of locality where the products are sold and differences in the income
level, age, size of the purchase, time of purchase.
Price discrimination may be related to the consumer surplus enjoyed by the consumers. Prof. Pigou classified
three degrees of price discrimination. Under the first degree price discrimination, the monopolist separates the
market into each individual consumer and charges them the price they are willing and able to pay and thereby
extract the entire consumer surplus. Doctors, lawyers, consultants etc., charging different fees, prices decided
under ‘bid and offer’ system, auctions, and through negotiations are examples of first degree price
discrimination.
Under the second degree price discrimination, different prices are charged for different quantities of sold. The
monopolist will take away only a part of the consumers’ surplus. The two possibilities are: a) Different
consumers pay different price if they buy different quantity. Larger quantities are available at lower unit price.
For example, a family pack of soaps or biscuits tends to cost less per kg than smaller packs.
b) Each consumer pays different price for consecutive purchases. For example, suppliers of services such as
telephone, electricity, water, etc., sometimes charge higher prices when consumption exceeds a particular limit.
Under the third degree price discrimination, price varies by attributes such as location or by customer segment.
Here the monopolist will divide the consumers into separate sub-markets and charge different prices in different
sub-markets. Examples: Dumping, charging different prices for domestic and commercial uses, lower prices in
railways for senior citizens, etc.
Equilibrium under price discrimination
Under simple monopoly, a single price is charged for the whole output; but under price discrimination the
monopolist will charge different prices in different sub-markets. First of all, the monopolist has to divide his total
market into various sub-markets on the basis of differences in elasticity of demand. For the sake of making our
analysis simple we shall explain a case where the total market is divided into two sub-markets.
In order to reach the equilibrium position, the discriminating monopolist has to make three decisions:
1) How much total output should he produce?
2) How the total output should be distributed between the two sub-markets? and
3) What prices he should charge in the two sub-markets?
The same marginal principle will guide his decision to produce a total output as that which guides a perfect
competitor or a simple monopolist. In other words, the discriminating monopolist will compare the marginal
revenue with the marginal cost of the output. But he has to find out first, the aggregate marginal revenue of the
two sub-markets taken together and compare this aggregate marginal revenue with marginal cost of the total
output. Aggregate marginal revenue curve is obtained by summing up laterally the marginal revenue curves of
the sub-markets.
In figure 28, MRa is the marginal revenue curve in sub-market A corresponding to the demand curve Da.
Similarly, MRb is the marginal revenue in sub-market B corresponding to the demand curve Db. Now, the
aggregate marginal revenue curve AMR, which has been shown in Panel (iii) of figure 28 has been derived by
adding up laterally MRa and MRb. The marginal cost curve of the monopolist is shown by the curve MC in Panel
(iii) of figure 28.
The discriminating monopolist will maximize his profits by producing the level of output at which marginal cost
curve (MC) intersects the aggregate marginal revenue curve (AMR). It is manifest from the diagram (iii) that
profit maximizing output is OM, for only at OM aggregate marginal revenue is equal to the marginal cost of the
whole output. Thus, the discriminating monopolist will decide to produce OM level of output.
Once the total output to be produced has been determined, the next task for the discriminating monopolist is to
distribute the total output between the two sub-markets. He will distribute the total output OM in such a way that
the marginal revenues in the two sub-markets are equal. The marginal revenues in the two sub-markets must
be equal if the profits are to be maximized. If he is so allocating the output into two markets that the marginal
revenues in the two are not equal, then it will pay him to transfer some amount from the sub-market in which
the marginal revenue is less to the sub-market in which the marginal revenue is greater. Only when the
marginal revenues in the two markets are equal, it will be unprofitable for him to shift any amount of the good
from one market to the other.
For the discriminating monopolist to be in equilibrium it is essential not only that the marginal revenues in the
two sub-markets should be the same but that they should also be equal to the marginal cost of the whole
output. Equality of marginal revenues in the two markets with marginal cost of the whole output ensures that
the amount sold in the two sub-markets will together be equal to the whole output OM which has been fixed by
equalizing aggregate marginal revenue with marginal cost. It will be seen from figure (iii) that at equilibrium
output OM, marginal cost is ME.
Now, the output OM has to be distributed in the two markets in such a way that the marginal revenue from them
should be equal to the marginal cost (ME) of the whole output. It is clear form the diagram (i) that OM 1 must be
sold in the sub-market A, because marginal revenue M1E1 at amount OM1 is equal to marginal cost ME.
Similarly, OM2 must be sold in sub-market B, since marginal revenue M 2E2 of amount OM2 is equal to the
marginal cost ME of the whole output. To conclude, demand and cost conditions being given, the discriminating
monopolist will produce total output OM and will sell amount OM1 in sub-market A and amount OM2 in sub-
market B. It should be noted that the total output OM will be equal to OM 1 + OM2.
Another important thing which the discriminating monopolist has to discover is what prices will be charged in
the two sub-markets. It is clear from the demand curve that amount OM 1 of the good can be sold at price OP1 in
sub-market A. Therefore, price OP1 will be set in sub-market A. Like wise, amount OM2 can be sold at price
OP2 in sub-market B. Therefore, price OP2 will be set in sub-market B. Further, it should be noted that price will
be higher in market A where the demand is less elastic than in market B where the demand is more elastic.
Thus, price OP1 is greater than the price OP2.
Fig. 28: Fixation of total output and price in the two sub-markets
by the discriminating monopolist
Price discrimination is usually resorted to by a monopolist to secure higher profit and to acquire and sustain
monopoly power. There is loss of economic welfare as the price paid is higher than marginal cost. Price
discrimination also results in reduced consumer surplus. However, there are some favourable outcomes as
well. The increase in revenue due to price discrimination will enable some firms to stay in business who
otherwise would have made a loss. By peak load pricing, firms having capacity constraints will be able to
spread its demand to off-peak times resulting in better capacity utilization and reduction in costs of production.
Many essential services (e.g. railways) cannot be profitably run unless price discrimination is followed. Some
consumers, especially, poor consumers, will benefit from lower prices as they would not have been able to
purchase the good or service if uniform high prices are charged for all consumers.
3.1.5 Economic effects of Monopoly

1) Monopoly is often criticized because it reduces aggregate economic welfare through loss of productive
and allocative efficiency.
2) Monopolists charge substantially higher prices and produce lower levels of output than would exist if
the product were produced by competitive firms.
3) Monopolists earn economic profits in the long run which are unjustifiable.
4) Monopoly prices exceed marginal costs and therefore reduces consumer surplus. There is a transfer
of income from the consumers to the monopolists. Not only that consumers pay higher prices, but they
would also not be able to substitute the good or service with a more reasonably priced alternative.
5) Monopoly restricts consumer sovereignty and consumers’ opportunities to choose what they desire.
6) Monopolists may use unjust means for creating barriers to entry to sustain their monopoly power. They
often spend huge amount of money to maintain their monopoly position. This leads increases average
total cost of producing a product.
7) A monopolist having substantial financial resources is in a powerful position to influence the political
process in order to obtain favourable legislation.
8) Very often, monopolists do not have the necessary incentive to introduce efficient innovations that
improve product quality and reduce production costs.
9) Monopolies are able to use their monopoly power to pay lower prices to their suppliers.
10) The economy is also likely to suffer from ‘X’ inefficiency, which is the loss of management efficiency
associated with markets where competition is limited or absent.
Since monopolies are exploitative and generate undesirable outcomes in the economy, a number of steps are
taken by governments to prevent the formation of monopolies and to regulate them if they are already present.
3.2 IMPERFECT COMPETITION-MONOPOLISTIC COMPETITION

Consider the market for soaps and detergents. Among the well known brands on sale are Lux, Vivel, Cinthol,
Dettol, Liril, Pears, Lifebuoy Plus, Dove etc. Is this market an example of perfect competition? Since all the
soaps are almost similar, one might think that this is an example of perfect competition. But, on a close
inspection we find that though these products are technically and functionally similar, each seller produces and
sells a product which is different from those of his competitors. For example, whereas Lux is claimed to be a
beauty soap, Liril is associated more with freshness. Dettol soap is placed as antiseptic and Dove claims to
ensure young smooth skin. The practice of product and service differentiation gives each seller a chance to
attract business to himself on some basis other than price. This is the monopolistic part of the market situation.
Thus, this market contains features of both the markets discussed earlier – monopoly and perfect competition.
In fact, this type of market is more common than pure competition or pure monopoly. The industries in
monopolistic competition include clothing, manufacturing and retail trade in large cities. There are many
hundreds of grocery shops, shoe stores, stationery shops, restaurants, repair shops, laundries, manufacturers
of women’s dresses and beauty parlours in a medium sized or large city.
3.2.0 Features of Monopolistic Competition

(i) Large number of sellers: In a monopolistically competitive market, there are large number of
independent firms who individually have a small share in the market.
(ii) Product differentiation: In a monopolistic competitive market, the products of different sellers are
differentiated on the basis of brands. Because competing products are close substitutes, demand is
relatively elastic, but not perfectly elastic as in perfect competition. Firms use size, design, colour,
shape, performance, features and distinctive packaging and promotional techniques to make their
products different. Such differentiation may be true or fancied. Brands are generally so much
advertised that a consumer starts associating the brand with a particular manufacturer and a type of
brand loyalty is developed. Product differentiation gives rise to an element of monopoly to the producer
over the competing products. Because of absence of perfect substitutability, the producer of an
individual brand can raise the price of his product knowing that he will not lose all the customers to
other brands. However, since all brands are close substitutes of one another; the seller who increases
the price of the product will lose some of his customers to his competitors. Thus, this market is a blend
of monopoly and perfect competition.
(iii) Freedom of entry and exit: Barriers to entry are comparatively low and new firms are free to enter the
market if they find profit prospects and existing firms are free to quit.
(iv) Non-price competition: In a monopolistically competitive market, firms are often in fierce competition
with other firms offering a similar product or service, and therefore try to compete on bases other than
price, for example: they indulge in aggressive advertising, product development, better distribution
arrangements, efficient after-sales service and so on. A key base of non-price competition is a
deliberate policy of product differentiation. Sellers attempt to promote their products not by cutting
prices but by incurring high expenditure on publicity and advertisement and other sales promoting
techniques. This is because price competition may result in price – wars which may throw a few firms
out of market or reduce the profit margins.
3.2.1 Price-Output Determination under Monopolistic Competition: Equilibrium of a

Firm
In a monopolistically competitive market, since the product is differentiated, each firm does not face a perfectly
elastic demand for its products. Each firm makes independent decisions about price and output. Each firm is a
price maker and is in a position to determine the price of its own product. As such, the firm is faced with a
downward sloping demand curve for its product. Generally, the less differentiated the product is from its
competitors, the more elastic this curve will be.
Fig. 29: Short run equilibrium of a firm under monopolistic competition: Supernormal profits
The firm depicted in figure 29 has a downward sloping but flat demand curve for its product. The firm is
assumed to have U-shaped short run cost curves.
Conditions for the Equilibrium of an individual firm: The conditions for price-output determination and
equilibrium of an individual firm may be stated as follows:
(i) MC = MR
(ii) MC curve must cut MR curve from below.
Figure 29 shows that MC cuts MR curve at E. At E, the equilibrium price is OP and the equilibrium output is
OM. Since per unit cost is SM, per unit supernormal profit (i.e. price - cost) is QS (or PR) and the total
supernormal profit is PQSR.
It is also possible that a monopolistically competitive firm may incur losses in the short run. This is shown in fig.
30. The figure shows that per unit cost (HN) is higher than price OT (or KN) of the product of the firm and the
loss per unit is KH (HN-KN). The total loss is GHKT.
What about long run equilibrium of the firm? If the firms in a monopolistically competitive industry earn
supernormal profits in the short run, there will be an incentive for new firms to enter the industry. As more firms
enter, profits per firm will go on decreasing as the total demand for the product will be shared among a larger
number of firms. This will happen till all supernormal profits are wiped away and all firms earn only normal
profits. Thus, in the long run all firms under monopolistic competition will earn only normal profits.
Fig. 30: Short run equilibrium of a firm under Monopolistic Competition – With losses
Fig. 31: The long-term equilibrium of a firm in monopolistic competition

Figure 31 shows the long run equilibrium of a firm in a monopolistically competitive market. The average
revenue curve touches the average cost curve at point T corresponding to quantity Q and price P. At
equilibrium (i.e. MC= MR) supernormal profits are zero, since average revenue equals average costs. All firms
are earning zero economic profits or just normal profits.
In case of persisting losses, in the long run, the loss making firms will exit from the market and this will go on till
the remaining firms make normal profits only.
It is to be noted that an individual firm which is in equilibrium in the long run, will be operating at levels at which
it does not fully realize economies of large scale production. In other words, the plants are not used to optimum
capacity. However, any attempt to produce more to secure the advantage of least cost production will be
irrational since the price reduction to sell the larger output will exceed the cost reduction made possible. If
output is increased up to R in the above figure, we find that average total cost will be greater than average
revenue. Thus, a monopolistically competitive firm which is in equilibrium in the long run is at a position where it
has excess capacity. That is, it is producing a lower quantity than its full capacity level. The firm in figure 31
could expand its output from Q to R and reduce average costs. But it does not do so because in doing so, the
firm would reduce average revenue more than it reduces average costs. It implies that, firms in monopolistic
competition are not of optimum size and there exists excess capacity (QR in our example above) of production
with each firm.
The following table presents a comparison of the three market forms we have discussed so far:
Table 7: Comparison of Perfect Competition, Monopoly and Monopolistic Competition
Perfect Competition Monopoly Monopolistic Competition
Large number of buyers and large Single seller, no difference Large number of buyers and large
number of firms in the industry between firm and industry number of firms in the industry
Homogenous products which are No close substitutes Differentiated products which are
perfect substitutes close substitutes, but not perfect
substitutes
Insignificant market share Command over the whole market Each firm is small relative to the
market
Competition among firms is Absence of competition Imperfect competition
perfect
Complete absence of monopoly High degree of monopoly power Some degree of monopoly power
prevails due to product differentiation
Free entry and exit Strong barriers to entry Free entry and exit
Price-taker Price maker Some control over price
Price is equal to marginal cost Price is higher than marginal cost Price is higher than marginal cost
Price less than other market High equilibrium price Price is high compared to perfect
forms competition
Demand curve is infinitely elastic Downward sloping and highly Downward sloping and more
inelastic demand curve elastic demand curve
MR and AR represented by the MR starts at the same point as MR starts at the same point as
same curve AR, and is twice steep when AR, and is twice steep when
compared to AR compared to AR
TR straight line positively sloping TR inverted U shaped TR inverted U shaped
through the origin
No price discrimination-same Can practice price discrimination Depends on the extent of
price for all units by selling a product at different monopoly power the firm has
prices
No supernormal profits in the long Supernormal profits both in the No supernormal profits in the long
run short run and long run run
No selling costs Generally low selling costs, only Due to severe competition, selling
for informing the consumers costs are vital to persuade buyers
Price being given, decides only Decides on both price and output Decides on both price and output
quantity of output
Product is produced at the Produced at the declining portion Produced at the declining portion
minimum average cost of average cost curve of average cost curve
Equilibrium quantity is highest Equilibrium quantity less than Equilibrium quantity less than
and produced at least cost other market forms optimal, there is excess capacity
No consumer exploitation Consumers can be exploited by Consumers are influenced
charging high prices through price and non price
competition
Efficient allocation of resources Inefficient allocation of resource Inefficient allocation of resource
No wastage of resources Wastage of resource Huge wastage of resources for
advertisements
3.3 OLIGOPOLY
We have studied price and output determination under three market forms, namely, perfect competition,
monopoly and monopolistic competition. However, in the real world economies we find that many of the
industries are oligopolistic. Oligopoly is an important form of imperfect competition. Oligopoly is often described
as ‘competition among the few’. Prof. Stigler defines oligopoly as that “situation in which a firm bases its market
policy, in part, on the expected behaviour of a few close rivals”. In other words, when there are few (two to ten)
sellers in a market selling homogeneous or differentiated products, oligopoly is said to exist. Oligopolies mostly
arise due to those factors which are responsible for the emergence of monopolies. Unlike monopoly where a
single firm enjoys absolute market power, under oligopoly a few firms exercise their power to keep possible
competitors out.
Consider the example of cold drinks industry or automobile industry. There are a handful firms manufacturing
cold drinks in India. Similarly, there are a few firms in the automobile industry in India. Airlines industry,
petroleum refining, power generation and supply in most of the parts of the country, mobile telephony and
Internet service providers are other examples of oligopolistic market. These industries exhibit some special
features which are discussed in the following paragraphs.
Types of Oligopoly:
Pure oligopoly or perfect oligopoly occurs when the product is homogeneous in nature, e.g. Aluminium
industry. This type of oligopoly tends to process raw materials or produce intermediate goods that are used as
inputs by other industries. Notable examples are petroleum, steel, and aluminium. Differentiated or imperfect
oligopoly occurs when goods sold is based on product differentiation, e.g. Talcum powder.
Open and closed oligopoly: In an open oligopoly market new firms can enter the market and compete with
the existing firms. But, in closed oligopoly entry is restricted.
Collusive and Competitive oligopoly: When few firms of the oligopoly market come to a common
understanding or act in collusion with each other either in fixing price or output or both, it is collusive oligopoly.
When there is absence of such an understanding among the firms and they compete with each other, it is
called competitive oligopoly.
Partial or full oligopoly: Oligopoly is partial when the industry is dominated by one large firm which is
considered or looked upon as the leader of the group. The dominating firm will be the price leader. In full
oligopoly, the market will be conspicuous by the absence of price leadership.
Syndicated and organized oligopoly: Syndicated oligopoly refers to that situation where the firms sell their
products through a centralized syndicate. Organized oligopoly refers to the situation where the firms organize
themselves into a central association for fixing prices, output, quotas, etc.
3.3.0 Characteristics of Oligopoly Market

The oligopolistic industry is dominated by a small number of large firms, each of which is comparatively large
relative to the total size of the market. These large firms exercise considerable control over the market. An
oligopoly market may have a large number of firms along with very large firms, but most of the market share will
be enjoyed by the few large firms and therefore they conquer and retain market control. There are strong
barriers to entry (refer barriers to entry discussed under monopoly).
Strategic Interdependence: The most important feature of oligopoly is interdependence in decision-making of
the few firms which comprise the industry. Since there are only few sellers, there will be intense competition
among them. Under oligopoly, each seller is big enough to influence the market. A firm has to necessarily
respond to its rivals’ actions, and simultaneously the rivals also respond to the firm’s actions. This is because
when the number of competitors is few, any change in price, output or product by a firm will have direct effect
on the fortunes of the rivals who will then retaliate by changing their own prices, output or advertising technique
as the case may be. It is, therefore, clear that an oligopolistic firm must consider not only the market demand
for its product, but also the reactions of other firms in the industry to any major decision it takes. An oligopoly
firm that does not consider its rivals’ behaviour or incorrectly assumes them is likely to suffer a setback in its
profits.
Importance of advertising and selling costs: A direct effect of interdependence of oligopolists is that the firms have to
employ various aggressive and defensive marketing weapons to gain greater share in the market or to maintain their
share. For this, firms have to incur a good deal of costs on advertising and other measures of sales promotion.
Therefore, there is great importance for advertising and selling costs in an oligopoly market. It is to be noted
that firms in such type of market avoid price cutting and try to compete on non-price basis because if they start
undercutting one another, a type of price-war will emerge which will drive a few of them out of the market as
customers will try to buy from the seller selling at the cheapest price.
Group behaviour: The theory of oligopoly is a theory of group behaviour, not of mass or individual behaviour and to
assume profit maximising behaviour on the oligopolists’ part may not be very valid. There is no generally accepted
theory of group behaviour. The firms may agree to pull together as a group in promotion of their common interest. The
group may or may not have a leader. If there is a firm which acts as a leader, it has to get others to follow it. These are
some of the concerns of the theory of group behaviour. But one thing is certain. Each oligopolist closely watches the
business behaviour of the other oligopolists in the industry and designs his moves on the basis of some assumptions of
how they behave or are likely to behave.
3.3.1 Price and Output Decisions in an Oligopolistic Market

Oligopoly, in fact, describes the operation of a number of large corporations in the world. The operations of
these markets are characterized by strategic behaviour of a small number of rival firms. As mentioned above,
the extent of power as well as profits depends to a great extent on how rival firms react to each other’s
decisions. If the behaviour is less competitive, that is, if the rival firms behave in a cooperative manner, firms
will enjoy market power and can charge prices above marginal cost.
An oligopolistic firm has to behave strategically when it makes a decision about its price. It has to consider
whether rival firms will keep their prices and quantities constant, when it makes changes in its price and/or
quantity. When an oligopolistic firm changes its price, its rival firms will retaliate or react and change their
prices which in turn would affect the demand of the former firm. Therefore, an oligopolistic firm cannot have
sure and determinate demand curve, since the demand curve keeps shifting as the rivals change their prices in
reaction to the price changes made by it. Now when an oligopolist does not know his demand curve, what price
and output he will fix cannot be ascertained by economic analysis. However, economists have established a
number of price-output models for oligopoly market depending upon the behaviour pattern of other firms in the
market. Different oligopoly settings give rise to different optimal strategies and diverse outcomes. Important
oligopoly models are:
(i) It is assumed by some economists that oligopolistic firms ignore their interdependence and make their
decisions independently. When interdependence is ignored, the demand curve becomes definite and
the equilibrium output is found out by equating marginal cost and marginal revenue.
(ii) Some economists assume that an oligopolist is able to predict the reaction pattern of his competitors
and on the basis of his prediction; he makes decisions relating to price and quantity. In Cournot model,
the firms’ control variable is output in contrast to price. They do not collude. In Stackelberg’s model,
the leader commits to an output before all other firms. The rest of the firms are followers and they
choose their outputs so as to maximize profits, given the leader’s output. According to Bertrand model,
price is the control variable for firms and each firm independently sets its price in order to maximize
profits.
(iii) The third approach is that oligopolists enter into agreement and try to pursue their common interests.
They jointly act as a monopoly organization and fix their prices in such a manner that their joint profits
are maximized. They will then share the profits, market or output among them as agreed. Entering into
collusion or forming a cartel is generally considered illegal because it restricts trade and creates
situations which are close to monopoly. However, in reality, we find a number of cartels operating in
the world economy who collude formally or in a tacit manner. Organisation of Petroleum Exporting
Countries (OPEC) is the best example of such type of agreement among oligopolists.
3.3.2 Price Leadership

Cartels are often formed in industries where there are a few firms, all of which are similar in size. A group of
firms that explicitly agree (collude) to coordinate their activities is called a cartel. Most cartels have only a
subset of producers. If the participating producers stick to the cartel’s agreements, the cartel will have high
market power and earn monopoly profits especially when the demand for the product is inelastic.
But it is possible that there is a dominant or a large firm surrounded by a large number of small firms. If these
firms are numerous or too unreliable, the large firm has to decide how to set its price, taking into account the
behaviour of these fringe firms. One strategy is to adopt a ‘live and let live philosophy’. Specifically, the
dominant firm accepts the presence of fringe firms and sets the price to maximize its profit, taking into account
the fringe firms’ behaviour. This is called price-leadership by dominant firm. Another type of price leadership is
by a low cost firm. Here, the price leader sets the price in such a manner that it allows some profits to the
followers also. Then there could be barometric price leadership under which an old, experienced, largest or
most respected firm acts as a leader and assesses the market conditions with regard to the demand, cost,
competition etc. and makes changes in price which are best from the view point of all the firms in the industry.
Whatever price is charged by the price leader is generally accepted by the follower firms.
Thus, we find that fixing of price under oligopoly is very tricky affair and involves a number of assumptions
regarding the behaviour of the oligopolistic group.
3.3.3 Kinked Demand Curve

It has been observed that in many oligopolistic industries prices remain sticky or inflexible for a long time. They
tend to change infrequently, even in the face of declining costs. Many explanations have been given for this
price rigidity under oligopoly and the most popular explanation is the kinked demand curve hypothesis given by
an American economist Paul A. Sweezy. Hence this is called Sweezy’s Model.
The demand curve facing an oligopolist, according to the kinked demand curve hypothesis, has a ‘kink’ at the
level of the prevailing price. It is because the segment of the demand curve above the prevailing price level is
highly elastic and the segment of the demand curve below the prevailing price level is inelastic. A kinked
demand curve dD with a kink at point P is shown in Fig. 32.
Fig. 32: Kinked Demand Curve under oligopoly

The prevailing price level is MP and the firm produces and sells output OM. Now the upper segment dP of the
demand curve dD is relatively elastic and the lower segment PD is relatively inelastic. This difference in
elasticities is due to the particular competitive reaction pattern assumed by the kinked demand curve
hypothesis. This assumed pattern is :
Each oligopolist believes that if it lowers the price below the prevailing level its competitors will follow him and
will accordingly lower prices, whereas if it raises the price above the prevailing level, its competitors will not
follow its increase in price.
This is because when an oligopolistic firm lowers the price of its product, its competitors will feel that if they do
not follow the price cut, their customers will run away and buy from the firm which has lowered the price. Thus,
in order to maintain their customers they will also lower their prices. The lower portion of the demand curve PD
is price inelastic showing that very little increase in sales can be obtained by a reduction in price by an
oligopolist. On the other hand, if a firm increases the price of its product, there will a substantial reduction in its
sales because as a result of the rise in its price, its customers will withdraw from it and go to its competitors
which will welcome the new customers and will gain in sales. These happy competitors will have therefore no
motivation to match the price rise. The oligopolist who raises its price will lose a great deal and will therefore
refrain from increasing price. This behaviour of the oligopolists explains the elastic upper portion of the demand
curve (dP) showing a large fall in sales if a producer raises his price. Briefly put, the effect of a price cut on the
quantity demanded of the product of an oligopolistic firm depends upon whether its rivals retaliate by cutting
their prices. Similarly, the effect of a price increase on the quantity demanded of the oligopolistic firm’s product
depends upon whether its rivals respond by raising their prices as well.
Each oligopolist will, thus, adhere to the prevailing price seeing no gain in changing it and a kink will be formed
at the prevailing price. Thus, rigid or sticky prices are explained by the kinked demand curve theory.
Oligopolistic firms often have a strong desire for price stability. Although costs or demand change, oligopolistic
firms are reluctant to modify the price set by it.
3.3.4 Other Important Market Forms

Other important market forms are:
Duopoly, a subset of oligopoly, is a market situation in which there are only two firms in the market.
Monopsony is a market characterized by a single buyer of a product. or service and is mostly applicable to
factor markets in which a single firm is the only buyer of a factor.
Oligopsony is a market characterized by a small number of large buyers and is mostly relevant to factor
markets.
Bilateral monopoly is a market structure in which there is only a single buyer and a single seller i.e. it is a
combination of monopoly market and a monopsony market.
SUMMARY
♦ The features of various types of market form are summarised in the table given below:
Classification of Market Forms
Form of Market Structure Number of Nature of Price Degree of
Firms product Elasticity of Control over
Demand of a price
firm
(a) Perfect competition Large number of Homogeneous Infinite None
firms
(b) Monopoly One Unique product Small Very
without close Considerable
substitute
(c) Imperfect Competition
i) Monopolistic Large number of Differentiated Large Some
Competition firms products
ii) Oligopoly Few Firms Homogeneous or Small Some
differentiated
product
Perfect Competition
 A market is said to be perfectly competitive if it has large number of buyers and sellers, homogeneous
product, free entry and exit, perfect mobility of factors of production, perfect knowledge about the
market conditions, insignificant transaction costs, no government interference and absence of
collusion.
 A firm is in equilibrium when it’s MC = MR and MC curve cuts the MR curve from below.
 In the short run, firms may be earning normal profits, supernormal profits or making losses at the
equilibrium price.
 In the long-run all the supernormal profits or losses get wiped away with entry or exit of the firms from
the industry and all firms earn only normal profit.
 in the long run, in perfect competition, the market mechanism leads to an optimal allocation of
resources.
Monopoly
 Monopoly is an extreme form of imperfect competition with a single seller of a product which has no
close substitute.
 Since the monopolist firm is the only producer of a particular product, its demand curve is identical with
the market demand curve for the product.
 Since a monopoly firm has market power it has the ability to charge a price above marginal cost and
earns a positive economic profit.
 The fundamental cause of monopoly is barriers to entry; in effect other firms cannot enter the market.
 In the long-run, the supernormal profit will be continued because entry is restricted.
 One of the important features of monopoly is price discrimination, i.e. charging different prices for the
same product from different buyers.
 Price charged will be higher in the market where the demand is less elastic and lower in the market
where the demand is more elastic.
 Under the first degree price discrimination, the monopolist separates the market into each individual
consumer and charges them the price they are willing and able to pay and thereby extract the entire
consumer surplus.
 Under the second degree price discrimination different prices are charged for different quantities of
sold.
 Under the third degree price discrimination, price varies by attributes such as location or by customer
segment.
 In the absence of competition, the monopolist need not produce at the optimal level.
 Since monopolies are exploitative and generate undesirable outcomes in the economy, a number of
steps are taken by governments to regulate and to prevent the formation of monopolies.
 In real life, pure monopolies are not common because monopolies are either regulated or prohibited
altogether.
Imperfect Competition
 Imperfect competition is an important category wherein the individual firm exercises control over the
price to a smaller or larger degree depending upon the degree of imperfection present.
Monopolistic Competition
 It refers to the market situation in which many producers produce goods which are close substitutes of
one another.
 The essential feature of monopolistic competition is the existence of large number of firms, product
differentiation, non price competition, high selling costs and freedom of entry and exit of firms.
 In monopolistic competition, the features of monopoly and perfect competition are partially present.
 Demand curve is highly elastic and a firm enjoys some control over the price.
 Firms in monopolistic competition are not of optimum size and there exists excess capacity with each
firm.
Oligopolistic Competition
 Oligopoly is also referred to as ‘competition among the few’ as a few big firms produce and compete in
this market.
 There are different types of oligopoly like pure and differentiated oligopoly, open and closed oligopoly,
collusive and competitive oligopoly, partial and full oligopoly and syndicated and organized oligopoly.
 The main characteristics of oligopoly are strategic interdependence, importance of advertising and
selling costs and group behaviour. Different oligopoly settings give rise to different optimal strategies
and diverse outcomes.
 Price-leadership can be by dominant firm, a low cost firm or it can be barometric price leadership.
 A group of firms that explicitly agree (collude) to coordinate their activities is called a cartel.
 Paul A. Sweezy propounded the kinked demand curve model of oligopoly. The price will be kept
unchanged for a long time due to fear of retaliation and price tend to be sticky and inflexible.
 Other important market forms are : Duopoly, Monopsony, Oligopsony and Bilateral monopoly.
TEST YOUR KNOWLEDGE

1. In the table below what will be equilibrium market price?
Price Demand (tonnes per annum) Supply (tonnes per annum)

(` )
1 1000 400
2 900 500
3 800 600
4 700 700
5 600 800
6 500 900
7 400 1000
8 300 1100
(a) `2
(b) `3
(c) `4
(d) `5
2. Assume that when price is ` 20, the quantity demanded is 9 units, and when price is ` 19, the quantity
demanded is 10 units. Based on this information, what is the marginal revenue resulting from an
increase in output from 9 units to 10 units.
(a) ` 20 (b) ` 19
(c) ` 10 (d) `1
3. Assume that when price is ` 20, the quantity demanded is 15 units, and when price is ` 18, the
quantity demanded is 16 units. Based on this information, what is the marginal revenue resulting from
an increase in output from 15 units to 16 units?
(a) ` 18 (b) ` 16
(c) −` 12 (d) ` 28
4. Suppose a firm is producing a level of output such that MR > MC, what should be firm do to maximize
its profits?
(a) The firm should do nothing. (b) The firm should hire less labour.
(c) The firm should increase price. (d) The firm should increase output.
5. Marginal Revenue is equal to:
(a) The change in price divided by the change in output.
(b) The change in quantity divided by the change in price.
(c) The change in P x Q due to a one unit change in output.
(d) Price, but only if the firm is a price searcher.
6. Suppose that a sole proprietorship is earning total revenues of ` 1,00,000 and is incurring explicit
costs of ` 75,000. If the owner could work for another company for ` 30,000 a year, we would
conclude that :
(a) The firm is incurring an economic loss.
(b) Implicit costs are ` 25,000.
(c) The total economic costs are ` 1,00,000.
(d) The individual is earning an economic profit of ` 25,000.
7. Which of the following is not an essential condition of pure competition?
(a) Large number of buyers and sellers (b) Homogeneous product
(c) Freedom of entry (d) Absence of transport cost
8. What is the shape of the demand curve faced by a firm under perfect competition?
(a) Horizontal (b) Vertical
(c) Positively sloped (d) Negatively sloped
9. Which is the first order condition for the profit of a firm to be maximum?
(a) AC = MR (b) MC = MR
(c) MR = AR (d) AC = AR
10. Which of the following is not a characteristic of a “price-taker”?
(a) TR = P x Q (b) AR = Price
(c) Negatively – sloped demand curve (d) Marginal Revenue = Price
11. Which of the following statements is false?

(a) Economic costs include the opportunity costs of the resources owned by the firm.
(b) Accounting costs include only explicit costs.
(c) Economic profit will always be less than accounting profit if resources owned and used by the
firm have any opportunity costs.
(d) Accounting profit is equal to total revenue less implicit costs.
12. With a given supply curve, a decrease in demand causes
(a) an overall decrease in price but an increase in equilibrium quantity.
(b) an overall increase in price but a decrease in equilibrium quantity.
(c) an overall decrease in price and a decrease in equilibrium quantity.
(d) no change in overall price but a reduction in equilibrium quantity.
13. It is assumed in economic theory that
(a) decision making within the firm is usually undertaken by managers, but never by the owners.
(b) the ultimate goal of the firm is to maximise profits, regardless of firm size or type of business
organisation.
(c) as the firm’s size increases, so do its goals.
(d) the basic decision making unit of any firm is its owners.
14. Assume that consumers’ incomes and the number of sellers in the market for good A
both decrease. Based upon this information, we can conclude, with certainty, that the equilibrium:
(a) price will increase. (b) price will decrease.
(c) quantity will increase. (d) quantity will decrease.
15. If supply increases in a greater proportion than demand
(a) The new equilibrium price and quantity will be greater than the original equilibrium price and
quantity.
(b) The new equilibrium price will be greater than the original equilibrium price but equilibrium
quantity will be higher.
(c) The new equilibrium price and quantity will be lower than the original equilibrium price and
quantity.
(d) The new equilibrium price will be lower than the original equilibrium and the new equilibrium
quantity will be higher.
16. Assume that in the market for good Z there is a simultaneous increase in demand and the quantity
supplied. The result will be :
(a) an increase in equilibrium price and quantity.
(b) a decrease in equilibrium price and quantity.
(c) an increase in equilibrium quantity and uncertain effect on equilibrium price.

(d) a decrease in equilibrium price and increase in equilibrium quantity.
17. Suppose the technology for producing personal computers improves and, at the same time, individuals
discover new uses for personal computers so that there is greater utilisation of personal computers.
Which of the following will happen to equilibrium price and equilibrium quantity?
(a) Price will increase; quantity cannot be determined.
(b) Price will decrease; quantity cannot be determined.
(c) Quantity will increase; price cannot be determined.
(d) Quantity will decrease; price cannot be determined.
18. Which of the following is not a condition of perfect competition?
(a) A large number of firms.
(b) Perfect mobility of factors.
(c) Informative advertising to ensure that consumers have good information.
(d) Freedom of entry and exit into and out of the market.
19. Which of the following is not a characteristic of a perfectly competitive market?
(a) Large number of firms in the industry.
(b) Outputs of the firms are perfect substitutes for one another.
(c) Firms face downward-sloping demand curves.
(d) Resources are very mobile.
20. Which of the following is not a characteristic of monopolistic competition?
(a) Ease of entry into the industry. (b) Product differentiation.
(c) A relatively large number of sellers. (d) A homogeneous product.
21. Monopoly may arise in a product market because
(a) A significantly important resource for the production of the commodity is owned by a single
firm.
(b) The government has given the firm patent right to produce the commodity.
(c) The costs of production and economies of scale makes production by a single producer more
efficient.
(d) All the above.
22. Oligopolistic industries are characterized by:
(a) a few dominant firms and substantial barriers to entry.
(b) a few large firms and no entry barriers.
(c) a large number of small firms and no entry barriers.

(d) one dominant firm and low entry barriers.
23. Price-taking firms, i.e., firms that operate in a perfectly competitive market, are said to be “small”
relative to the market. Which of the following best describes this smallness?
(a) The individual firm must have fewer than 10 employees.
(b) The individual firm faces a downward-sloping demand curve.
(c) The individual firm has assets of less than ` 20 lakhs.
(d) The individual firm is unable to affect market price through its output decisions.
24. For a price-taking firm :
(a) marginal revenue is less than price.
(b) marginal revenue is equal to price.
(c) marginal revenue is greater than price.
(d) the relationship between marginal revenue and price is indeterminate.
25. Monopolistic competition differs from perfect competition primarily because
(a) in monopolistic competition, firms can differentiate their products.
(b) in perfect competition, firms can differentiate their products.
(c) in monopolistic competition, entry into the industry is blocked.
(d) in monopolistic competition, there are relatively few barriers to entry.
26. The long-run equilibrium outcomes in monopolistic competition and perfect competition are similar,
because in both market structures
(a) the efficient output level will be produced in the long run.
(b) firms will be producing at minimum average cost.
(c) firms will only earn a normal profit.
(d) firms realise all economies of scale.
27. Which of the following is the distinguishing characteristic of oligopolies?
(a) A standardized product
(b) The goal of profit maximization
(c) The interdependence among firms
(d) Downward-sloping demand curves faced by firms.
28. In which form of the market structure is the degree of control over the price of its product by a firm very
large?
(a) Monopoly (b) Imperfect Competition
(c) Oligopoly (d) Perfect competition

29. Average revenue curve is also known as:
(a) Profit Curve (b) Demand Curve
(c) Average Cost Curve (d) Indifference Curve
30. Under which of the following forms of market structure does a firm have no control over the price of its
product?
(a) Monopoly (b) Monopolistic competition
(c) Oligopoly (d) Perfect competition
31. Discriminating monopoly implies that the monopolist charges different prices for his commodity:
(a) from different groups of consumers (b) for different uses
(c) at different places (d) any of the above.
32. Price discrimination will be profitable only if the elasticity of demand in different sub-markets is:
(a) uniform (b) different
(c) less (d) zero
33. In the context of oligopoly, the kinked demand hypothesis is designed to explain
(a) Price and output determination (b) Price rigidity
(c) Price leadership (d) Collusion among rivals.
34. The firm in a perfectly competitive market is a price-taker. This designation as a price-taker is based
on the assumption that
(a) the firm has some, but not complete, control over its product price.
(b) there are so many buyers and sellers in the market that any individual firm cannot affect the
market.
(c) each firm produces a homogeneous product.
(d) there is easy entry into or exit from the market place.
35. Suppose that the demand curve for the XYZ Co. slopes downward and to the right. We can conclude
that
(a) the firm operates in a perfectly competitive market.
(b) the firm can sell all that it wants to at the established market price.
(c) the XYZ Co. is not a price-taker in the market because it must lower price to sell additional
units of output.
(d) the XYZ Co. will not be able to maximise profits because price and revenue are subject to
change.
36. If firms in the toothpaste industry have the following market shares, which market structure would best
describe the industry?
Market share (% of market)
Toothpaste 18.7
Dentipaste 14.3
Shinibright 11.6
I can’t believe its not toothpaste 9.4
Brighter than white 8.8
Pastystuff 7.4
Others 29.8
(a) Perfect competition. (b) Monopolistic competition.
(c) Oligopoly. (d) Monopoly.
37. The kinked demand curve model of oligopoly assumes that
(a) the response (of consumers) to a price increase is less than the response to a price decrease.
(b) the response (of consumers) to a price increase is more than the response to a price
decrease.
(c) the elasticity of demand is constant regardless of whether price increases or decreases.
(d) the elasticity of demand is perfectly elastic if price increases and perfectly inelastic if price
decreases.
38. A firm encounters its “shutdown point” when:
(a) average total cost equals price at the profit-maximising level of output.
(b) average variable cost equals price at the profit-maximising level of output.
(c) average fixed cost equals price at the profit-maximising level of output.
(d) marginal cost equals price at the profit-maximising level of output.
39. Suppose that, at the profit-maximizing level of output, a firm finds that market price is less than
average total cost, but greater than average variable cost. Which of the following statements is
correct?
(a) The firm should shutdown in order to minimise its losses.
(b) The firm should raise its price enough to cover its losses.
(c) The firm should move its resources to another industry.
(d) The firm should continue to operate in the short run in order to minimize its losses.
40. When price is less than average variable cost at the profit-maximising level of output, a firm should:
(a) produce where marginal revenue equals marginal cost if it is operating in the short run.
(b) produce where marginal revenue equals marginal cost if it is operating is the long run.
(c) shutdown, since it will lose nothing in that case.

(d) shutdown, since it cannot even cover its variable costs if it stays in business.
41. A purely competitive firm’s supply schedule in the short run is determined by
(a) its average revenue. (b) its marginal revenue.
(c) its marginal utility for money curve. (d) its marginal cost curve.
42. One characteristic not typical of oligopolistic industry is
(a) horizontal demand curve. (b) too much importance to non-price
competition.
(c) price leadership. (d) a small number of firms in the industry.
43. The structure of the toothpaste industry in India is best described as
(a) perfectly competitive. (b) monopolistic.
(c) monopolistically competitive. (d) oligopolistic.
44. The structure of the cold drink industry in India is best described as
(a) perfectly competitive. (b) monopolistic.
(c) monopolistically competitive. (d) oligopolistic.
(a) Even a monopolistic firm can have losses.
(b) Firms in a perfectly competitive market are price takers.
(c) It is always beneficial for a firm in a perfectly competitive market to discriminate prices.
(d) Kinked demand curve is related to an oligopolistic market.
46. Under perfect competition, in the long run, there will be no ________________ .
(a) normal profits (b) supernormal profits.
(c) production (d) costs.
47. When ________________________________ , we know that the firms are earning just normal profits.
(a) AC = AR (b) MC = MR
(c) MC = AC (d) AR = MR
48. When ________________________________, we know that the firms under perfect competition must
be producing at the minimum point of the average cost curve and so there will be productive efficiency.
(a) AC = AR (b) MC = AC
(c) MC = MR (d) AR = MR
49. When ______________________________, there will be allocative efficiency meaning thereby that
the cost of the last unit is exactly equal to the price consumers are willing to pay for it and so that the
right goods are being sold to the right people at the right price.
(a) MC = MR (b) MC = AC
(c) MC = AR (d) AR = MR
50. Agricultural goods markets depict characteristics close to
(a) perfect competition. (b) oligopoly.
(c) monopoly. (d) monopolistic competition.
51. Which of the following is not a characteristic of a competitive market?
(a) There are many buyers and sellers in the market.
(b) The goods offered for sales are largely the same.
(c) Firms generate small but positive supernormal profits in the long run.
(d) Firms can freely enter or exit the market.
52. Which of the following markets would most closely satisfy the requirements for a perfectly competitive
market?
(a) Electricity (b) Cable television
(c) Cola (d) Milk
53. Which of the following statements is accurate regarding a perfectly competitive firm?
(a) Demand curve is downward sloping
(b) The demand curve always lies above the marginal revenue curve
(c) Average revenue need not be equal to price
(d) Price is given and is determined by the equilibrium in the entire market
54. The market for hand tools (such as hammers and screwdrivers) is dominated by Draper, Stanley, and
Craftsman. This market is best described as
(a) Monopolistically competitive (b) a monopoly
(c) an oligopoly (d) perfectly competitive
55. A market structure in which many firms sell products that are similar but not identical is known as
(a) monopolistic competition (b) monopoly
(c) perfect competition (d) oligopoly
56. When an oligopolist individually chooses its level of production to maximize its profits, it charges a
price that is
(a) more than the price charged by either monopoly or a competitive market
(b) less than the price charged by either monopoly or a competitive market
(c) more than the price charged by a monopoly and less than the price charged by a competitive
market
(d) less than the price charged by a monopoly and more than the price charged by a competitive
market.
57. In the long-run equilibrium of a competitive market, firms operate at
(a) the intersection of the marginal cost and marginal revenue
(b) their efficient scale
(c) zero economic profit
(d) all of these answers are correct
58. Which of the following is not a characteristic of a monopolistically competitive market?
(a) Free entry and exit (b) Abnormal profits in the long run
(c) Many sellers (d) Differentiated products
59. In a very short period market:
(a) the supply is fixed (b) the demand is fixed
(c) demand and supply are fixed (d) none of the above
60. Time element was conceived by
(a) Adam Smith (b) Alfred Marshall
(c) Pigou (d) Lionel Robinson
61. Total revenue =
(a) price × quantity (b) price × income
(c) income × quantity (d) none of the above
62. Average revenue is the revenue earned
(a) per unit of input (b) per unit of output
(c) different units of input (d) different units of output
63. AR can be symbolically written as:
(a) MR / Q (b) Price × quantity
(c) TR / Q (d) none of the above
64. AR is also known as:
(a) price (b) income
(c) revenue (d) none of the above
65. Marginal revenue can be defined as the change in total revenue resulting from the:
(a) purchase of an additional unit of a commodity
(b) sales of an additional unit of a commodity

(c) sale of subsequent units of a product
66. When e > 1 then MR is
(a) zero (b) negative
(c) positive (d) one
67. When e = 1 then MR is
(a) positive (b) zero
(c) one (d) negative
68. When e < 1 then MR is
(a) negative (b) zero
(c) positive (d) one
69. In Economics, the term ‘market’ refers to a:
(a) place where buyer and seller bargain a product or service for a price
(b) place where buyer does not bargain
(c) place where seller does not bargain
70. Under perfect competition a firm is the ___________
(a) price-maker and not price-taker (b) price-taker and not price-maker
(c) neither price-maker nor price-taker (d) none of the above
71. A Monopolist is a
(a) price-maker (b) price-taker
(c) price-adjuster (d) none of the above
72. Price discrimination is one of the features of ___________
(a) monopolistic competition (b) monopoly
(c) perfect competition (d) oligopoly
73. Under monopoly, the degree of control over price is:
(a) none (b) some
(c) very considerable (d) none of the above
74. Generally, perishable goods like butter, eggs, milk, vegetables etc., will have
(a) regional market (b) local market
(c) national market (d) none of the above

75. At price P1, the firm in the figure would produce
(a) Zero output (b) Q 3.

(c) Q 5. (d) Q 6.
76. Secular period is also known as
(a) very short period (b) short period
(c) very long period (d) long period
77. Stock exchange market is an example of
(a) unregulated market (b) regulated market
(c) spot market (d) none of the above
78. The market for the ultimate consumers is known as
(a) whole sale market (b) regulated market
(c) unregulated market (d) retail market
79. The condition for pure competition is
(a) large number of buyer and seller, free entry and exist
(b) homogeneous product
(c) both (a) and (b)
(d) large number of buyer and seller, homogeneous product, perfect knowledge about the product
80. Pure oligopoly is based on the ________________ products
(a) differentiated (b) homogeneous
(c) unrelated (d) none of the above
81. In oligopoly, when the industry is dominated by one large firm which is considered as leader of the
group, Then it is called:
(a) full oligopoly (b) collusive oligopoly
(c) partial oligopoly (d) syndicated oligopoly

82. When the products are sold through a centralized body, oligopoly is known as
(a) organized oligopoly (b) partial oligopoly
(c) competitive oligopoly (d) syndicated oligopoly
83. When the monopolist divides the consumers into separate sub markets and charges different prices in
different sub-markets it is known as
(a) first degree of price discrimination (b) second degree of price discrimination
(c) third degree of price discrimination (d) none of the above.
84. Under _________________ the monopolist will fix a price which will take away the entire consumers’
surplus.
(a) second degree of price discrimination (b) first degree of price discrimination
(c) third degree of price discrimination (d) none of the above.
85. Price discrimination is related to
(a) time (b) size of the purchase
(c) income (d) any of the above
86. The firm and the industry are one and the same in _______________
(a) Perfect competition (b) Monopolistic competition
(c) Duopoly (d) Monopoly
87. The demand curve of a monopoly firm will be __________________
(a) Upward sloping (b) Downward sloping
(c) Horizontal (d) Vertical
88. If the average cost is higher than the average revenue then the firm incurs _________________
(a) Normal profit (b) Abnormal profit
(c) Loss (d) No profit, no loss
(a) Price rigidity is an important feature of monopoly.
(b) Selling costs are possible under perfect competition.
(c) Under perfect competition factors of production do not move freely as there are legal
restrictions.
(d) An industry consists of many firms.

(a) Under monopoly there is no difference between a firm and an industry.
(b) A monopolist may restrict the output and raise the price.
(c) Commodities offered for sale under a perfect competition will be heterogeneous.
(d) Product differentiation is peculiar to monopolistic competition.
91. For market the essential condition is –
(a) A particular geographical place (b) Control of the government
(c) Close contact between buyers and sellers (d) None of these
92. Assume that when Price is ₹10, the quantity demanded is 5 units and when Price is ₹12 the quantity
demanded is 4 units .Based on this information, what is the Marginal Revenue resulting from increase
in output from 4 units to 5 units.
(a) ₹5 (b) ₹4
(c) ₹2 (d) ₹3
93. Average revenue is equal to.
(a) The change in P & Q due to a one unit change in output.
(b) Nothing but price of one unit of output.
(c) The change in quantity divided by change in price.
(d) Graphically it denotes the firm’s supply curve.
94. Example of a commodity said to have an International Market.
(a) Perishable Goods.
(b) High Value and Small Bulk Commodities.
(c) Product whose trading is restricted by government.
(d) Bulky Articles.
95. Stock Exchange is example of ________ Market:
(a) Regulated Market (b) Spot Market
(c) Forward Market (d) Retail Market
96 Conditions for equilibrium of a firm are:
(a) MR = MC
(b) MC should cut MR from below.
(c) MR = AR and MC should cut MR from below.
(d) MR = MC and MC should have a positive slope.

97 Natural Monopoly arises when
(a) There is enormous goodwill enjoyed by a firm.
(b) There are stringent legal and regulatory requirement.
(c) There are very large Economies of Scale.
(d) There are Business Combinations and Cartels.
98 Price Discrimination cannot persist under the following market form:
(a) Perfect Competition (b) Monopoly
(c) Monopolistic (d) Oligopoly
99. Sweezy’s Model explains the concept of price rigidity relating to following market form:
(a) Oligopoly Market (b) Perfect Competition Market
(c) Monopoly Market (d) Monopolistic Market
100. Combination of Monopoly Market and Monopsony Market is called as:
(a) Duopoly Market (b) Oligopoly Market
(c) Bilateral Monopoly Market (d) Monopolistic Market
101. Price varies by attributes such as location or by Customer Segment is __________ degree of Price
Discrimination.
(a) First (b) Second
(c) Third (d) Fourth
Answers
1. (c) 2. (c) 3. (c) 4. (d) 5. (c) 6. (a)
7. (d) 8. (a) 9. (b) 10. (c) 11. (d) 12. (c)
13. (b) 14. (d) 15. (d) 16. (c) 17. (c) 18. (c)
19. (c) 20. (d) 21. (d) 22. (a) 23. (d) 24. (b)
25. (a) 26. (c) 27. (c) 28. (a) 29. (b) 30. (d)
31. (d) 32. (b) 33. (b) 34. (b) 35. (c) 36. (c)
37. (b) 38. (b) 39. (d) 40. (d) 41. (d) 42. (a)
43. (c) 44. (d) 45. (c) 46. (b) 47. (a) 48. (b)
49 (c) 50. (a) 51. (c). 52. (d) 53. (d) 54. (c)
55. (a) 56. (d) 57. (d) 58. (b) 59. (a) 60. (b)
61. (a) 62. (b) 63. (c) 64. (a) 65. (b) 66. (c)
67. (b) 68. (a) 69. (a) 70. (b) 71. (a) 72. (b)
73. (c) 74. (b) 75. (a) 76. (c) 77. (b) 78. (d)
79. (c) 80. (b) 81. (c) 82. (d) 83. (c) 84 (b)
85. (d) 86. (d) 87. (b) 88. (c) 89. (d) 90. (c)
91. (c) 92 (c) 93 (b) 94 (b) 95 (a) 96 (d)
97 (c) 98 (a) 99 (a) 100 (c) 101 (c)
CHAPTER
5
BUSINESS CYCLES
LEARNING OUTCOMES
At the end of this Chapter, you should be able to:
♦ Explain the Meaning of Business Cycles.
♦ Describe the Different Phases of Business Cycles.
♦ Explain the Features of Business Cycles.
♦ Explain the General Causes behind these Cycles.
♦ Elucidate the relevance of Business Cycles in Business Decision Making.
CHAPTER OVERVIEW
BUSINESS CYCLES
Meaning Phases Features Causes Relevance in Business

Decision Making
▪ Expansion Internal External

▪ Peak ▪ War
▪ Contraction ▪ Fluctunations in Effective
Demand ▪ Post War
▪ Trough Reconstruction
▪ Fluctunations in Investment
Variations in Government ▪ Technology
Spending Shocks
▪ Macro Economic Policies ▪ Natural Factors
▪ Money Supply ▪ Population Growth
▪ Psychological Factors
5.0 INTRODUCTION
Consider the following:
1. During 1920s, UK saw rapid growth in Gross Domestic Product (GDP), production levels and living
standards. The growth was fuelled by new technologies and production processes such as the
assembly line. The economic growth also caused an unprecedented rise in stock market values.
2. China’s recent economic slowdown and financial mayhem are fostering a cycle of decline and
panic across much of the world, as countries of nearly every continent see escalating risks of
prolonged slumps, political disruption and financial losses.
What are these? These are examples of business cycles. The first example shows that the UK economy was
going through boom during 1920s while the second example of the recent slowdown in China indicates the
beginning of a recessionary phase.
We have seen in chapter 1 that Economics is concerned with fluctuations in economic activities. The economic
history of nearly all countries point towards the fact that they have gone through fluctuations in economic
activities i.e. there have been periods of prosperity alternating with periods of economic downturns. These
rhythmic fluctuations in aggregate economic activity that an economy experiences over a period of time are
called business cycles or trade cycles. A trade cycle is composed of periods of good trade characterised by
rising prices and low unemployment percentage, altering with periods of bad trade characterised by falling
prices and high unemployment percentages. In other words, business cycle refers to alternate expansion and
contraction of overall business activity as manifested in fluctuations in measures of aggregate economic
activity, such as, gross national product, employment and income.
A noteworthy characteristic of these economic fluctuations is that they are recurrent and occur periodically.
That is, they occur again and again but not always at regular intervals, nor are they of the same length. It has
been observed that some business cycles have been long, lasting for several years while others have been
short ending in two to three years.
5.1. PHASES OF BUSINESS CYCLE

We have seen above that business cycles or the periodic booms and slumps in economic activities reflect the
upward and downward movements in economic variables. A typical business cycle has four distinct phases.
These are:
1. Expansion (also called Boom or Upswing)
2. Peak or boom or Prosperity
3. Contraction (also called Downswing or Recession)
4. Trough or Depression
The four phases of business cycle are shown in Figure 1. The broken line (marked ‘trend’) represents the
steady growth line or the growth of the economy when there are no business cycles. The figure starts with
‘trough’ when the overall economic activities i.e. production and employment, are at the lowest level. As
.3 BUSINESS CYCLES 5.3
production and employment expand, the economy revives, and it moves into the expansion path. However,
since expansion cannot go on indefinitely, after reaching the ‘peak’, the economy starts contracting. The
contraction or downturn continues till it reaches the lowest turning point i.e. ‘trough’. However, after remaining
at this point for some time, the economy revives again and a new cycle starts.
Figure 1 Phases of Business Cycle

 Expansion: The expansion phase is characterised by increase in national output, employment,
aggregate demand, capital and consumer expenditure, sales, profits, rising stock prices and bank
credit. This state continues till there is full employment of resources and production is at its maximum
possible level using the available productive resources. Involuntary unemployment is almost zero and
whatever unemployment is there is either frictional (i.e. due to change of jobs, or suspended work due
to strikes or due to imperfect mobility of labour) or structural (i.e. unemployment caused due to
structural changes in the economy). Prices and costs also tend to rise faster. Good amounts of net
investment occur, and demand for all types of goods and services rises. There is altogether increasing
prosperity and people enjoy high standard of living due to high levels of consumer spending, business
confidence, production, factor incomes, profits and investment. The growth rate eventually slows down
and reaches its peak.
 Peak: The term peak refers to the top or the highest point of the business cycle. In the later stages of
expansion, inputs are difficult to find as they are short of their demand and therefore input prices
increase. Output prices also rise rapidly leading to increased cost of living and greater strain on fixed
income earners. Consumers begin to review their consumption expenditure on housing, durable goods
etc. Actual demand stagnates. This is the end of expansion and it occurs when economic growth has
reached a point where it will stabilize for a short time and then move in the reverse direction.
 Contraction: The economy cannot continue to grow endlessly. As mentioned above, once peak is
reached, increase in demand is halted and starts decreasing in certain sectors. During contraction,
there is fall in the levels of investment and employment. Producers do not instantaneously recognise
the pulse of the economy and continue anticipating higher levels of demand, and therefore, maintain
their existing levels of investment and production. The consequence is a discrepancy or mismatch
between demand and supply. Supply far exceeds demand. Initially, this happens only in few sectors
and at a slow pace, but rapidly spreads to all sectors. Producers being aware of the fact that they have
indulged in excessive investment and over production, respond by holding back future investment
plans, cancellation and stoppage of orders for equipments and all types of inputs including labour. This
in turn generates a chain of reactions in the input markets and producers of capital goods and raw
materials in turn respond by cancelling and curtailing their orders. This is the turning point and the
beginning of recession.
Decrease in input demand pulls input prices down; incomes of wage and interest earners gradually
decline resulting in decreased demand for goods and services. Producers lower their prices in order to
dispose off their inventories and for meeting their financial obligations. Consumers, in their turn, expect
further decreases in prices and postpone their purchases. With reduced consumer spending,
aggregate demand falls, generally causing fall in prices. The discrepancy between demand and supply
gets widened further. This process gathers speed and recession becomes severe. Investments start
declining; production and employment decline resulting in further decline in incomes, demand and
consumption of both capital goods and consumer goods. Business firms become pessimistic about the
future state of the economy and there is a fall in profit expectations which induces them to reduce
investments. Bank credit shrinks as borrowings for investment declines, investor confidence is at its
lowest, stock prices fall and unemployment increases despite fall in wage rates. The process of
recession is complete and the severe contraction in the economic activities pushes the economy into
the phase of depression.
 Trough and Depression: Depression is the severe form of recession and is characterized by
extremely sluggish economic activities. During this phase of the business cycle, growth rate becomes
negative and the level of national income and expenditure declines rapidly. Demand for products and
services decreases, prices are at their lowest and decline rapidly forcing firms to shutdown several
production facilities. Since companies are unable to sustain their work force, there is mounting
unemployment which leaves the consumers with very little disposable income. A typical feature of
depression is the fall in the interest rate. With lower rate of interest, people’s demand for holding liquid
money (i.e. in cash) increases. Despite lower interest rates, the demand for credit declines because
investors' confidence has fallen. Often, it also happens that the availability of credit also falls due to
possible banking or financial crisis. Industries, especially capital and consumer durable goods industry,
suffer from excess capacity. Large number of bankruptcies and liquidation significantly reduce the
magnitude of trade and commerce. At the depth of depression, all economic activities touch the bottom
and the phase of trough is reached. It is a very agonizing period causing lots of distress for all. The
great depression of 1929-33 is still cited for the enormous misery and human sufferings it caused.
Recovery: The economy cannot continue to contract endlessly. It reaches the lowest level of
economic activity called trough and then starts recovering. Trough generally lasts for some time and
marks the end of pessimism and the beginning of optimism. This reverses the process. The process of
reversal is initially felt in the labour market. Pervasive unemployment forces the workers to accept
wages lower than the prevailing rates. The producers anticipate lower costs and better business
environment. A time comes when business confidence takes off and gets better, consequently they
start to invest again and to build stocks; the banking system starts expanding credit; technological
advancements require fresh investments into new types of machines and capital goods; employment
increases, aggregate demand picks up and prices gradually rise. Besides, price mechanism acts as a
self-correcting process in a free enterprise economy. The spurring of investment causes recovery of
the economy. This acts as a turning point from depression to expansion. As investment rises,
production increases, employment improves, income improves and consumers begin to increase their
expenditure. Increased spending causes increased aggregate demand and in order to fulfil the demand
more goods and services are produced. Employment of labour increases, unemployment falls and
expansion takes place in the economic activity.
It is to be reemphasized that no economy follows a perfectly timed cycle and that the business cycles
are anything but regular. They vary in intensity and length. There is no set pattern which they follow.
Some cycles may have longer periods of boom, others may have longer period of depression.
It is very difficult to predict the turning points of business cycles. Economists use changes in a variety of
activities to measure the business cycle and to predict where the economy is headed towards. These are called
indicators. The types of indicators are shown in the chart -
Economic Indicators
Coincident or concurrent
Leading Indicators Lagging Indicators
Indicators
e.g. Changes in Stock

e.g. Unemployment,
Price, New orders for e.g. GDP, Inflation,
Corporate profit, labour
capital and consumer Indusrial Production
cost per unit of output
goods
A leading indicator is a measurable economic factor that changes before the economy starts to follow a
particular pattern or trend. In other words, those variables that change before the real output changes are
called ‘Leading indicators’. Leading indicators often change prior to large economic adjustments. For example,
changes in stock prices, profit margins and profits, indices such as housing, interest rates and prices are
generally seen as precursors of upturns or downturns. Similarly, value of new orders for consumer goods, new
orders for plant and equipment, building permits for private houses, fraction of companies reporting slower
deliveries, index of consumer confidence and money growth rate are also used for tracking and forecasting
changes in business cycles. Leading indicators, though widely used to predict changes in the economy, are not
always accurate. Even experts disagree on the timing of these so-called leading indicators. It may be weeks or
months after a stock market crash before the economy begins to show signs of receding. Nevertheless, it may
never happen.
Lagging indicators reflect the economy’s historical performance and changes in these indicators are observable
only after an economic trend or pattern has already occurred. In other words, variables that change after the
real output changes are called ‘Lagging indicators’. If leading indicators signal the onset of business cycles,
lagging indicators confirm these trends. Lagging indicators consist of measures that change after an economy
has entered a period of fluctuation. Some examples of lagging indicators are unemployment, corporate profits,
labour cost per unit of output, interest rates, the consumer price index and commercial lending activity.
A third type of indicator is coincident indicator. Coincident economic indicators, also called concurrent
indicators, coincide or occur simultaneously with the business-cycle movements. Since they coincide fairly
closely with changes in the cycle of economic activity, they describe the current state of the business cycle. In
other words, these indicators give information about the rate of change of the expansion or contraction of an
economy more or less at the same point of time it happens. A few examples of coincident indicators are Gross
Domestic Product, industrial production, inflation, personal income, retail sales and financial market trends
such as stock market prices.
Examples of Business Cycles
Great Depression of 1930: The world economy suffered the longest, deepest, and the most widespread
depression of the 20th century during 1930s. It started in the US and became worldwide. The global GDP fell by
around 15% between 1929 and 1932. Production, employment and income fell. As far as the causes of Great
Depression are concerned, there is difference of opinion amongst economists. While British economist John
Maynard Keynes regarded lower aggregate expenditures in the economy to be the cause of massive decline in
income and employment, monetarists opined that the Great Depression was caused by the banking crisis and
low money supply. Many other economists blamed deflation, over-indebtedness, lower profits and pessimism to
be the main causes of Great Depression. Whatever may be the cause of the depression, it caused wide spread
distress in the world as production, employment, income and expenditure fell. The economies of the world began
recovering in 1933. Increased money supply, huge international inflow of gold, increased governments’ spending
due to World War II etc., were some of the factors which helped economies slowly come out of recession and
enter the phase of expansion and upturn.
Information Technology bubble burst of 2000: Information Technology (IT) bubble or Dot.Com bubble roughly
covered the period 1997-2000. During this period, many new Internet–based companies (commonly referred as
dot-com companies) were started. The low interest rates in 1998–99 encouraged the start-up internet companies
to borrow from the markets. Due to rapid growth of internet and seeing vast scope in this area, venture
capitalists invested huge amount in these companies. Due to over-optimism in the market, investors were less
cautious. There was a great rise in their stock prices and in general, it was noticed, that companies could cause
their stock prices to increase by simply adding an "e-" prefix to their name or a ".com" to the end. These
companies offered their services or end products for free with the expectation that they could build enough brand
awareness to charge profitable rates for their services later. As a result, these companies saw high growth and a
type of bubble developed. The "growth over profits" mentality led some companies to engage in lavish internal
spending, such as elaborate business facilities. These companies could not sustain long. The collapse of the
bubble took place during 1999–2001. Many dot-com companies ran out of capital and were acquired or
liquidated. Nearly half of the dot –com companies were either shut down or were taken over by other companies.
Stock markets crashed and slowly the economies began feeling the downturn in their economic activities.
Recent Example of Business Cycle: Global Economic Crisis (2008-09): The recent global economic crisis
owes its origin to US financial markets. Following Information Technology bubble burst of 2000, the US economy
went into recession. In order to take the economy out of recession, the US Federal Reserve (the Central Bank of
US) reduced the rate of interest. This led to large liquidity or money supply with the banks. With lower interest
rates, credit became cheaper and the households, even with low creditworthiness, began to buy houses in
increasing numbers. Increased demand for houses led to increased prices for them. The rising prices of housing
led both households and banks to believe that prices would continue to rise. Excess liquidity with banks and
availability of new financial instruments led banks to lend without checking the creditworthiness of borrowers.
Loans were given even to sub-prime households and also to those persons who had no income or assets.
Houses were built in excess during the boom period and due to their oversupply in the market, house prices
began to decline in 2006. Housing bubble got burst in the second half of 2007. With fall in prices of houses which
were held as mortgage, the sub - prime households started defaulting on a large scale in paying off their
instalments. This caused huge losses to the banks. Losses in banks and other financial institutions had a chain
effect and soon the whole US economy and the world economy at large felt its impact.
5.2 FEATURES OF BUSINESS CYCLES

Different business cycles differ in duration and intensity. But there are certain features which they commonly
exhibit:
(a) Business cycles occur periodically although they do not exhibit the same regularity. The duration of
these cycles vary. The intensity of fluctuations also varies.
(b) Business cycles have distinct phases of expansion, peak, contraction and trough. These phases
seldom display smoothness and regularity. The length of each phase is also not definite.
(c) Business cycles generally originate in free market economies. They are pervasive as well.
Disturbances in one or more sectors get easily transmitted to all other sectors.
(d) Although all sectors are adversely affected by business cycles, some sectors such as capital goods
industries, durable consumer goods industry etc, are disproportionately affected. Moreover, compared
to agricultural sector, the industrials sector is more prone to the adverse effects of trade cycles.
(e) Business cycles are exceedingly complex phenomena; they do not have uniform characteristics and
causes. They are caused by varying factors. Therefore, it is difficult to make an accurate prediction of
trade cycles before their occurrence.
(f) Repercussions of business cycles get simultaneously felt on nearly all economic variables viz. output,
employment, investment, consumption, interest, trade and price levels.
(g) Business cycles are contagious and are international in character. They begin in one country and
mostly spread to other countries through trade relations. For example, the great depression of 1930s in
the USA and Great Britain affected almost all the countries, especially the capitalist countries of the
world.
(h) Business cycles have serious consequences on the well-being of the society.
5.3 CAUSES OF BUSINESS CYCLES

Business Cycles may occur due to external causes or internal causes or a combination of both. The 2001
recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recessions
followed a period of unprecedented speculation in the U.S. housing market.
• Fluctuations in Effective Demand

• Fluctuations in Investment
• Variations in government spending
Internal Causes • Macroeconomic policies
• Money Supply
• Psychological factors
• War
• Post War Reconstruction
• Technology shock
External Causes • Natural Factors
• Population growth
Internal Causes: The Internal causes or endogenous factors which may lead to boom or bust are:
Fluctuations in Effective Demand: According to Keynes, fluctuations in economic activities are due to
fluctuations in aggregate effective demand (Effective demand refers to the willingness and ability of consumers
to purchase goods at different prices). In a free market economy, where maximization of profits is the aim of
businesses, a higher level of aggregate demand will induce businessmen to produce more. As a result, there
will be more output, income and employment. However, if aggregate demand outstrips aggregate supply, it
causes inflation. As against this, if the aggregate demand is low, there will be lesser output, income and
employment. Investors sell stocks, and buy safe-haven investments that traditionally do not lose value, such as
bonds, gold and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying
anything but necessities. That causes a downward spiral. The bust cycle eventually stops on its own when
prices are so low that those investors that still have cash start buying again. However, this can take a long
time, and even lead to a depression.
The difference between exports and imports is the net foreign demand for goods and services. This is a
component of the aggregate demand in the economy, and therefore variations in exports and imports can lead
to business fluctuations as well. Thus, increase in aggregate effective demand causes conditions of expansion
or boom and decrease in aggregate effective demand causes conditions of recession or depression. (You will
study about these concepts in detail at Intermediate level in Economics for Finance).
Fluctuations in Investment: According to some economists, fluctuations in investments are the prime cause
of business cycles. Investment spending is considered to be the most volatile component of the aggregate
demand. Investments fluctuate quite often because of changes in the profit expectations of entrepreneurs. New
inventions may cause entrepreneurs to increase investments in projects which are cost-efficient or more profit
inducing. Or investment may rise when the rate of interest is low in the economy. Increases in investment shift
the aggregate demand to the right, leading to an economic expansion. Decreases in investment have the
opposite effect.
Variations in government spending: Fluctuations in government spending with its impact on aggregate
economic activity result in business fluctuations. Government spending, especially during and after wars, has
destabilizing effects on the economy.
Macroeconomic policies: Macroeconomic policies (monetary and fiscal policies) also cause business cycles.
Expansionary policies, such as increased government spending and/or tax cuts, are the most common method
of boosting aggregate demand. This results in booms. Similarly, softening of interest rates, often motivated by
political motives, leads to inflationary effects and decline in unemployment rates. Anti-inflationary measures,
such as reduction in government spending, increase in taxes and interest rates cause a downward pressure on
the aggregate demand and the economy slows down. At times, such slowdowns may be drastic, showing
negative growth rates and may ultimately end up in recession.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes in
supply of money may cause business fluctuation in an economy. An increase in the supply of money causes
expansion in aggregate demand and in economic activities. However, excessive increase of credit and money
also set off inflation in the economy. Capital is easily available, and therefore consumers and businesses alike
can borrow at low rates. This stimulates more demand, creating a virtuous circle of prosperity. On the other
hand, decrease in the supply of money may reverse the process and initiate recession in the economy.
Psychological factors: According to Pigou, modern business activities are based on the anticipations of
business community and are affected by waves of optimism or pessimism. Business fluctuations are the
outcome of these psychological states of mind of businessmen. If entrepreneurs are optimistic about future
market conditions, they make investments, and as a result, the expansionary phase may begin. The opposite
happens when entrepreneurs are pessimistic about future market conditions. Investors tend to restrict their
investments. With reduced investments, employment, income and consumption also take a downturn and the
economy faces contraction in economic activities.
According to Schumpeter’s innovation theory, trade cycles occur as a result of innovations which take place in
the system from time to time. The cobweb theory propounded by Nicholas Kaldor holds that business cycles
result from the fact that present prices substantially influence the production at some future date. The present
fluctuations in prices may become responsible for fluctuations in output and employment at some subsequent
period.
External Causes: The External causes or exogenous factors which may lead to boom or bust are:
Wars: During war times, production of war goods, like weapons and arms etc., increases and most of the
resources of the country are diverted for their production. This affects the production of other goods - capital
and consumer goods. Fall in production causes fall in income, profits and employment. This creates contraction
in economic activity and may trigger downturn in business cycle.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges etc. are
built and economic activity begins to pick up. All these activities push up effective demand due to which output,
employment and income go up.
Technology shocks: Growing technology enables production of new and better products and services. These
products generally require huge investments for new technology adoption. This leads to expansion of
employment, income and profits etc. and give a boost to the economy. For example, due to the advent of
mobile phones, the telecom industry underwent a boom and there was expansion of production, employment,
income and profits.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause instability in the
economies, especially those economies which are mainly agrarian. In the years when there are draughts or
excessive floods, agricultural output is badly affected. With reduced agricultural output, incomes of farmers fall
and therefore they reduce their demand for industrial goods. Reduced production of food products also pushes
up their prices and thus reduces the income available for buying industrial goods. Reduced demand for
industrial products may cause industrial recession.
Population growth: If the growth rate of population is higher than the rate of economic growth, there will be
lesser savings in the economy. Fewer saving will reduce investment and as a result, income and employment
will also be less. With lesser employment and income, the effective demand will be less, and overall, there will
be slowdown in economic activities.
Economies of nearly all nations are interconnected through trade. Therefore, depending on the amount of
bilateral trade, business fluctuations that occur in one part of the world get easily transmitted to other parts.
Changes in laws related to taxes, trade regulations, government expenditure, transfer of capital and production
to other countries, shifts in tastes and preferences of consumers are also potential sources of disruption in the
economy.
5.4 RELEVANCE OF BUSINESS CYCLES IN BUSINESS DECISION

MAKING
Business cycles affect all aspects of an economy. Understanding the business cycle is important for
businesses of all types as they affect the demand for their products and in turn their profits which ultimately
determines whether a business is successful or not. Knowledge regarding business cycles and their inherent
characteristics is important for a businessman to frame appropriate policies. For example, the period of
prosperity opens up new and superior opportunities for investment, employment and production and thereby
promotes business. In contrast, a period of recession or depression reduces business opportunities and profits.
A profit maximising firm has to consider the nature of the economic environment while making business
decisions, especially those related to forward planning.
Business cycles have tremendous influence on business decisions. The stage of the business cycle is crucial
while making managerial decisions regarding expansion or down-sizing. Businesses have to advantageously
respond to the need to alter production levels relative to demand. Different phases of the cycle require
fluctuating levels of input use, especially labour input. Firms should exercise the capability to expand or
rationalize production operations so as to suit the stage of the business cycle. Business managers need to
work effectively to arrive at sound strategic decisions in complex times across the whole business cycle,
managing through boom, downturn, recession and recovery.
Economy-wide trends can have significant impact on all types businesses. However, it should be kept in mind
that business cycles do not affect all sectors uniformly. Some businesses are more vulnerable to changes in
the business cycle than others. Businesses whose fortunes are closely linked to the rate of economic growth
are referred to as "cyclical" businesses. These include fashion retailers, electrical goods, house-builders,
restaurants, advertising, overseas tour operators, construction and other infrastructure firms. During a boom,
such businesses see a strong demand for their products but during a slump, they usually suffer a sharp drop in
demand. It may also happen that some businesses actually benefit from an economic down turn. This happens
when their products are perceived by customers as representing good value for money, or a cheaper
alternative compared to more expensive products.
Overcoming the effects of economic downturns and recessions is one of the major challenges of sustaining a
business in the long-term. The phase of the business cycle is important for a new business to decide on entry
into the market. The stage of business cycle is also an important determinant of the success of a new product
launch. Surviving the sluggish business cycles require businesses to plan and set policies with respect to
product, prices and promotion.
In general, economic forecasts are not perfectly reliable. Neither, of course, are the hunches and intuitions of
entrepreneurs. Understanding what phase of the business cycle an economy is in and what implications the
current economic conditions have for their current and future business activity, helps businesses to better
anticipate the market and to respond with greater alertness. However, taken together and applied carefully,
economic forecasts can help business firms to prepare for changes in the direction of the economy either prior
to or soon after these changes occur.
SUMMARY
 The rhythmic fluctuations in aggregate economic activity that an economy experiences over a period of
time are called business cycles or trade cycles and are manifested in fluctuations in measures of
aggregate economic activity such as gross national product, employment and income.
 A typical business cycle has four distinct phases namely,
 Expansion (also called boom or upswing) characterized by increase in national output and all
other economic variables.
 Peak of boom or prosperity refers to the top or the highest point of the business cycle.
 Contraction (also called downs-wing or recession) when there is fall in the levels of
investment, employment.
 Trough or depression occurs when the process of recession is complete and there is severe
contraction in the economic activities.
 Economists use changes in a variety of activities to measure the business cycle and to predict where
the economy is headed towards. These are called indicators.
 A leading indicator is a measurable economic factor that changes before the economy starts to follow a
particular pattern or trend. i.e. they change before the real output changes.
 Variables that change after real output changes are called ‘Lagging indicators’.
 Coincident economic indicators, also called concurrent indicators, coincide or occur simultaneously
with the business-cycle movements.
 According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate effective
demand.
 According to some economists, fluctuations in investments are the prime cause of business cycles.
Investment spending is considered to be the most volatile component of the aggregate demand.
 Fluctuations in government spending with its impact on aggregate economic activity result in business
fluctuations.
 Macroeconomic policies, (monetary and fiscal policies) also cause business cycles.
 According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes in the
supply of money may cause business fluctuation in an economy.
 According to Pigou, modern business activities are based on the anticipations of business community
and are affected by waves of optimism or pessimism.
 According to Schumpeter, trade cycles occur as a result of innovations which take place in the system
from time to time.
 Understanding what phase of the business cycle an economy is in and what implications the current
economic conditions have for their current and future business activity, helps businesses to better
anticipate the market and to respond with greater alertness.
TEST YOUR KNOWLEDGE

1. The term business cycle refers to
(a) the ups and downs in production of commodities
(b) the fluctuating levels of economic activity over a period of time
(c) decline in economic activities over prolonged period of time
(d) increasing unemployment rate and diminishing rate of savings
2. A significant decline in general economic activity extending over a period of time is
(a) business cycle (b) contraction phase
(c) recession (d) recovery
3. The trough of a business cycle occurs when _____ hits its lowest point.
(a) inflation in the economy (b) the money supply
(c) aggregate economic activity (d) the unemployment rate
4. The lowest point in the business cycle is referred to as the
(a) Expansion. (b) Boom.
(c) Peak. (d) Trough.
5. A leading indicator is
(a) a variable that tends to move along with the level of economic activity
(b) a variable that tends to move in advance of aggregate economic activity
(c) a variable that tends to move consequent on the level of aggregate economic activity
6. A variable that tends to move later than aggregate economic activity is called
(a) a leading variable. (b) a coincident variable.
(c) a lagging variable. (d) a cyclical variable.
7. Industries that are extremely sensitive to the business cycle are the
(a) Durable goods and service sectors.
(b) Non-durable goods and service sectors.
(c) Capital goods and non-durable goods sectors.
(d) Capital goods and durable goods sectors.
8. A decrease in government spending would cause
(a) the aggregate demand curve to shift to the right.
(b) the aggregate demand curve to shift to the left.
(c) a movement down and to the right along the aggregate demand curve.
(d) a movement up and to the left along the aggregate demand curve.
9. Which of the following does not occur during an expansion?
(a) Consumer purchases of all types of goods tend to increase.
(b) Employment increases as demand for labour rises.
(c) Business profits and business confidence tend to increase
10. Which of the following best describes a typical business cycle?
(a) Economic expansions are followed by economic contractions.
(b) Inflation is followed by rising income and unemployment.
(c) Economic expansions are followed by economic growth and development.
(d) Stagflation is followed by inflationary economic growth.
11. During recession, the unemployment rate ___________ and output ___________.
(a) Rises; falls (b) Rises; rises
(c) Falls; rises (d) Falls; falls
12. The four phases of the business cycle are

(a) expansion, peak, contraction and trough (b) contraction, expansion, trough and boom
(c) expansion contraction, peak, and trough (d) peak, depression, bust, and boom
13. Leading economic indicators
(a) are used to forecast probable shifts in economic policies
(b) are generally used to forecast economic fluctuations
(c) are indicators of stock prices existing in an economy
(d) are indicators of probable recession and depression
14. When aggregate economic activity is declining, the economy is said to be in
(a) Contraction. (b) an expansion.
(c) a trough. (d) a turning point.
15. Peaks and troughs of the business cycle are known collectively as
(a) Volatility. (b) Turning points.
(c) Equilibrium points. (d) Real business cycle events.
16. The most probable outcome of an increase in the money supply is
(a) interest rates to rise, investment spending to rise, and aggregate demand to rise
(b) interest rates to rise, investment spending to fall, and aggregate demand to fall
(c) interest rates to fall, investment spending to rise, and aggregate demand to rise
(d) interest rates to fall, investment spending to fall, and aggregate demand to fall
17. Which of the following is not a characteristic of business cycles?
(a) Business cycles have serious consequences on the well-being of the society.
(b) Business cycles occur periodically, although they do not exhibit the same regularity.
(c) Business cycles have uniform characteristics and causes.
(d) Business cycles are contagious and unpredictable.
18. Economic recession shares all of these characteristics except.
(a) Fall in the levels of investment, employment
(b) Incomes of wage and interest earners gradually decline resulting in decreased demand for
goods and services
(c) Investor confidence is adversely affected and new investments may not be forthcoming
(d) Increase in the price of inputs due to increased demand for inputs
19. The different phases of a business cycle

(a) do not have the same length and severity
(b) expansion phase always last more than ten years
(c) last many years and are difficult to get over in short periods
20. Which of the following is not an example of coincident indicator?
(a) Industrial production (b) inflation
(c) Retail sales (d) New orders for plant and equipment
21. According to ________________ trade cycles occur due to onset of innovations.
(a) Hawtrey (b) Adam Smith
(c) J M Keynes (d) Schumpeter
22. Economic indicators are –
(a) A one stroke solution to check the phase of economy
(b) Indicators showing the movement of economy
(c) Some activities which predict the direction of economy
(d) Just an illusion
23. Which economic indicator is required to predict the turning point of business cycle?
(a) Leading indicator
(b) Lagging indicator
(c) Coincident
24. Business cycle generally originate in free market economies, what is a free market economy?
(a) The economy where government is in possession of major assets
(b) The economy where private firms control major assets
(c) The economy where decisions of productions are taken by public sector undertakings
(d) The economy where price is controlled by government.
(a) The business cycle largely affects the agricultural sector
(b) The business cycle largely affects small employees
(c) The business cycle generally affects all sectors of economy but business sector in particular.
(d) The business cycle affects low wages workers
26. According to Keynes, fluctuations in Economic activities are due to-.

(a) Fluctuation in aggregate effective demand.
(b) Innovations
(c) Changes in money supply
(d) Fluctuation in agricultural output
27. Which of the following is the cause of business cycles?
(a) Fluctuations in aggregate effective demand
(b) Fluctuations in investments
(c) Fluctuations in government spending
Answers
1. (b) 2. (b) 3. (c) 4. (d) 5. (b) 6. (c)
7. (d) 8. (b) 9. (d) 10. (a) 11. (a) 12. (a)
13. (b) 14. (a) 15. (b) 16. (c) 17. (c) 18. (d)
19. (a) 20. (d) 21. (d) 22. (c) 23. (d) 24. (b)
25. (c) 26. (a) 27. (d)
GLOSSARY
1. Economics:- It the branch of knowledge which is concerned with production, consumption and transfer
of wealth.
2. Business Economics:- The use of economic analysis to make business decisions involving the best
use of an organization’s scarce resources.
3. Micro economics:- It is basically the study of behavior of different individuals and organizations within
an economic system. Here the focus is on a small number of group of units rather than all the units
combined.
4. Macro economics:- It is the study of the overall economic phenomena of the economy as a whole,
rather than its individual parts. Accordingly, in Macro Economics, we study the behavior of the large
economic aggregates.
5. Positive Economics:- It is the branch of economics that concerns the description and explanation of
economic phenomena. It focuses on facts and cause and effect relationships.
6. Normative Economics:- It is that part of economics that expresses value judgements about economic
fairness or what the outcome of the economy or goals of public policy ought to be.
7. Economic System:- An economic system refers to the sum total of arrangements for the production
and distribution of goods and services in a society. It includes various individuals and economic systems.
8. Capitalist Economy:- An economic system in which all means of production are owned and controlled
by private individuals for profit.
9. Socialist Economy:- An economic system where the resources are allocated according to the
commands of a central planning authority and market forces have no role to play in the allocation of
resources.
10. Mixed Economy:- An economic system which depends on both markets and governments for allocation
of resources. The aim is to include the best features of both Capitalist and Socialist Economy.
11. Demand:- The various quantities of a given commodity or service which the consumers would buy in
one market during a given period of time, at various prices, or at various incomes, or at various prices
of related goods.
12. Market demand:-It is defined as the sum of individual demands for a product at a price per unit of time.
ii BUSINESS ECONOMICS
13. Elasticity of demand:- It is defined as the responsiveness of the quantity demanded of a good to
changes in one of the variables on which demand depends. More precisely, elasticity of demand is the
percentage change in quantity demanded divided by the percentage change in one of the variables on
which demand depends.
14. Inferior goods:- Inferior goods are those goods whose quantity demanded decreases with the increase
in money income.
15. Price elasticity:- It expresses the response of quantity demanded of a good to a change in its price,
given the consumer’s income, his tastes and prices of all other goods.
16. Income Elasticity:- It is the degree of responsiveness of quantity demanded of a good to changes in
the income of consumers.
17. Cross Demand:- It refers to the quantities of a commodity or service which will be purchased with
reference to changes in price, not of that particular commodity, but of other inter-related commodities,
other things remaining the same.
18. Cross Elasticity:- A change in the demand for one good in response to a change in the price of another
good represents cross elasticity of demand of the former good for the latter good.
19. Advertisement Elasticity:- Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in firm’s spending or advertising. The advertising
elasticity of demand measures the percentage change in demand that occurs given a one percent
change in advertisement expenditure.
20. Demand forecasting:- It is the art and science of predicting the probable demand for a product or a
service at some future date on the basis of certain past behaviou patterns of some related events and
the prevailing trends in the present.
21. Producers goods:- Producers goods are those goods which are used for the production of other goods-
either consumer goods or producer goods themselves.
22. Consumer goods:- Those goods which are used for final consumption.
23. Utility:- Utility is the anticipated satisfaction by the consumer, and satisfaction is the actual satisfaction
derived.
24. Total utility:- It is the sum of utility derived from different units of a commodity consumed by a consumer.
25. Marginal utility:- It is the addition made to total utility by the consumption of an additional unit of a
commodity.
26. Consumer surplus:- Is is defined as the excess of price that the the consumer is ready to pay from
which he actually pays.
27. Indifference curve:- It is a curve which represents all those combinations of two goods which give same
satisfaction to the consumer.
28. Indifference map:- A collection of many indifference curves where each curve represents a certain
level of satisfaction. In short, a set of indifference curve is called indifference map.
.iii GLOSSARY iii
29. Supply:- It refers to the amount of a good or service that the producers are willing and able to offer to
the market at various prices during a given period of time.
30. Elasticity of Supply:- It is defined as the responsiveness of the quantity supplied of a good to a change
in its price.
31. Equilibrium price:- The price at which the wishes of both the buyers and sellers are satisfied. At this
price, the amount that buyers want to buy and sellers want to sell are equal.
32. Production:- It is the organized activity of transforming resources into finished products in the form of
goods and services.
33. Land:- The term “land” is used in a special sense in economics. It does not mean soil or earth’s surface
alone, but refers to all free gifts of nature.
34. Labour:- The term labour means any mental or physical exertion directed to produce goods and
services.
35. Capital:- Capital is that part of wealth of an individual which is used for further production of wealth.
Capital is a stock concept which yields a periodical income which is a flow concept.
36. Entrepreneur:- A factor which mobilizes all other factor of production like land, labour, capital, and
combines them in the right proportion, initiates the process of production and bears the risk involved in
it.
37. Average product:- Average product is the total product per unit of the variable factor.
38. Marginal product:- Iit is the change in total product per unit change in the quantity of variable factor.
39. Isoquant:- An isoquant represents all those combinations of inputs which are capable of producing the
same level of output.
40. Cost analysis:- The study of behavior of cost in relation to one or more production criteria, namely, size
of output, scale of operations, prices of the factor of production and other relaveant economic variables.
41. Accounting costs:- Accounting costs relate to those costs which involve cash payments by the
entrepreneur of the firm. These are explicit cost and are the expenses already incurred by the firm.
42. Economic cost:- The cost which takes into account the explicit as well as the implicit cost is known as
Economic cost.
43. Social cost:- Social cost refers to the total cost borne by the society on account of a business activity
and includes private cost and external cost.
44. Fixed cost:- The costs which do not vary with the level of output upto a certain level of activity are
known as fixed cost.
45. Variable cost:- These costs are a function of output and hence vary with the production.
46. Marginal cost:- Marginal cost is the addition made to the total cost by production of an additional unit
of output.
47. Market:- Amarket is a collection of buyers and sellers with a potential to trade. The actual or potential
interactions of the buyers and sellers determine the price of a product or service.
iv BUSINESS ECONOMICS
48. Perfect competition:- It is a type of market which is characterized by many sellers selling identical
products to many buyers.
49. Monopoly:-It is a situation where there is a single seller and many buyers. The product sold does not
have any close substitutes.
50. Monopolistic competition:- This type of market is characterized by many sellers selling differentiated
products to many buyers.
51. Oligopoly:-There a few sellers selling competing products to many buyers.
52. Average revenue:- It is the revenue earned per unit of output. It is nothing but the price of one unit of
output.
53. Marginal revenue:- It is the change in total revenue resulting from the sale of an additional unit of the
commodity.
54. Price discrimination:- It is a method of pricing adopted by a monopolist to earn abnormal profits. It
refers to the practice of charging different prices for different units of the same commodity.
55. Cartel:- Cartel refers to a group of firms that explicitly agree to coordinate their activities.
56. Business Cycle:- The rhythmic fluctuations in aggregate economic activity that an economy
experiences over a period of time are called business cycles or trade cycles. A typical business cycle
has four distinct phases namely Expansion, Boom, Contraction, Trough.
ADDITIONAL QUESTIONS
QUESTIONS FOR PRACTICE
1. Which of the following is/are limitation(s) of the wealth definitions of economics given by classical
economists?
(A) By considering the problem of production distribution & exchange of wealth, they focused
attention on important issues with which economics is concerned.
(B) By restricting the definition of wealth to material wealth & the neglect of immaterial services,
they narrowed down the scope of economics.
(C) Both (A) and (B)
(D) None of these
2. According to which of the following definitions, economics studies human behavior regarding how he
satisfied his wants with scare resources?
(A) Robbin’s definition
(B) Marshall’s definition
(C) J.B. Say’s definition
(D) Adam Smith’s definition
3. Which of the following falls within the domain of Normative Economics?
(A) How national income between different individuals is distributed?
(B) What actual wage rate is determined under monopsony in labour market?
(C) What wage should be paid to the labourers so that they should not be exploited?
(D) None of these
4. ______________________ is concerned with welfare proposition.
(A) Normative Economics
(B) Positive Economics
A-2 BUSINESS ECONOMICS

(D) None of these
5. Which of the following is/are correct about micro economics?
(A) Micro economics studies the economy in its totality.
(B) In micro economics we make a microscopic study of the economy.
(C) Micro economics deals with the division of total output among industries and firms & the
allocation of resources among competing uses.
(D) Both (B) and (C)
6. “If Americans today, for example were to content to live at the level of the Indian middle class people,
all their wants would be fully satisfied with their available resources and capacity to produce.”
On the basis of the above statement, which of the following conclusion can be made?
(A) The possession of goods and services by USA has enormously increased to exceed their
wants.
(B) The affluent and developed countries of USA and Western Europe face the problem of
scarcity even today as their present wants remain a head of their increased resources and
capacity to produce.
(C) The affluent and developed countries are not facing the problem of scarcity.
(D) None of these
7. If there is no central planning authority to make the fundamental economic decisions and thus to
allocate productive resources, how can then free enterprise or capitalist economy solve its central
problems?
(A) Through the power of God
(B) On the basis of decision taken by industrial groups.
(C) The free market economy uses the impersonal forces of the market to solve its central
problems
(D) None of these
8. The industrialization and economic development of the USA, Great Britain and other Western
European countries have taken place under the condition of _______________________.
(A) Socialism and planned structure
(B) Capitalism and laissez faire
(C) Mixed economic structure
(D) None of these
.3 ADDITIONAL QUESTIONS A-3
9. The greater the inequalities in the distribution of money incomes, the __________________ the
inequalities in the distribution of national output.
(A) greater
(B) lesser
(C) (A) or (B)
(D) None of these
10. “A wise individual or a society likes to provide for its growth of productive capacity.” This requires that
a part of its resources should be devoted to the production of ______________________.
(A) Consumer goods
(B) Capital goods
(C) Defense goods
(D) None of these
11. In the beginning the name of economics was ___________________________.
(A) Economics of wealth
(B) Political economy
(C) Welfare economics
(D) None of these
12. The word economics has been derived from a _____________________ word.
(A) French
(B) Latin
(C) Greek
(D) German
13. Economics is mainly concerned with
(A) the achievement of economic development
(B) the achievement and use of material requirements to satisfy human wants
(C) the exploring more resources to satisfy human wants
(D) the limiting human wants with respect to given resources
14. Business economics is a field in __________________ which uses economic theory and quantitative
methods to analyze business enterprises.
(A) Welfare Economics
(B) Development Economics
(C) Applied economics

(D) None of these
15. Business economics is based on micro economics in two categories _______________ and
________________.
(A) Positive, Normative
(B) Qualitative, Quantitative
(D) None of these
16. Economics is a branch of ___________________ focused on the production, distribution and
consumption of goods and services.
(A) Natural science
(B) Physical science
(C) Social science
(D) None of these
17. “Generally a business manager is concerned with problems of his own business units. He does not
study the economic problems of an economy as a whole.”
State whether the above statement is___________
(A) True
(B) False
(C) Partly True
(D) Partly False
18. Business economics is _______________________ in its approach.
(A) Idealistic
(B) Pragmatic
(D) None of these
19. “A business manager must know the external forces working over his business environment.”
State whether the above statement is___________
(A) True
(B) False
(C) Partly True
(D) Partly False
20. The scope of business economics includes ______________________.

(A) Demand analysis
(B) Cost analysis
(C) Inventory management
(D) All of these
21. A socialist economy is a system of production where goods and services are
produced________________.
(A) to generate profit
(B) directly for use
(D) None of these
22. Which one of the following statements is correct regarding socialist economy?
(A) Production is planned or coordinated and suffers from the business cycle
(B) Production suffers from the business cycle
(C) Production is planned and does not suffers from business cycle
(D) None of these
23. Which of the following is not a merit of socialist economy?
(A) It provides equal access to health care and education
(B) Workers are no longer exploited because they own the means of production
(C) Profits are not spread equitably among all workers according to their individual contributions.
(D) Natural resources are preserved for the good of the whole.
24. Which of the following is/are the merit(s) of mixed economic system?
(A) Entrepreneurs able to make profit
(B) Progressive taxes to reduce inequality
(C) Government’s provision of public goods
(D) All of the above
25. Capital intensive technique of production is used in _____________________.
(A) Developed Economy
(B) Underdeveloped Economy
(C) Labour surplus economy
(D) Capital surplus economy
26. The desire for a commodity by a person depends upon the ________________ he expects to obtain
from it.
(A) Utility
(B) Pleasure
(C) Taste
(D) None of these
27. People know utility of goods by means of ______________________.
(A) price
(B) introspection
(C) demand
(D) desire
28. Being _____________________ utility varies with different persons.
(A) absolute
(B) objective
(C) subjective
(D) None of these
29. An important generalization about demand is described by __________________________.
(A) Law of demand
(B) Factors affecting demand
(C) Quantity demanded
(D) None of these
30. Successful business firms spend considerable time, energy and efforts in analyzing the _________ for
their products.
(A) Supply
(B) Price
(C) Demand
(D) None of these
31. By way of an optimal choice, a consumer tends to
(A) save money
(B) purchase large quantity
(C) maximize satisfaction
(D) maximize satisfaction subject to constraints like tastes and preferences.
32. The economist’s concept of demand is _____________ as desire or need or choice or preference or
order.
(A) the same thing
(B) not the same thing
(C) (A) or (B)
(D) None of these
33. The demand for labour in response to the wage rate is __________ whereas the demand for same
labour in response to the price of electronic goods where labour enters as an input is_____________.
(A) Derived Demand, Direct Demand
(B) Direct Demand, Derived Demand
(C) Individual Demand, Market Demand
(D) Company Demand, Industry Demand
34. In the below figure, if DD is the demand curve and R is a given point on it then the area of shaded
portion OP1RQ1 is _____________
(A) Total Revenue (TR)

(B) Marginal Revenue (MR)
(C) Total Cost (TC)
(D) None of these
35. Which of the following groups of goods have inelastic demand?
(A) Salt, Smart Phone and Branded Lipstick
(B) School Uniform, Branded Goggles and Smart Phone
(C) Salt, School Uniform and Medicine
(D) Medicine, Branded Sports Shoes and Diamond ring
36. If the price of a commodity raised by 12% and Ed is (-) 0.63, the expenditure made on the commodity
by a consumer will _____________
(A) Decrease
(B) Increase
(C) Remain same
(D) Can’t Say
37. A consumer’s preferences are monotonic if and only if between two bundles, the consumer prefers the
bundle which has _______________________
(A) more of one of the goods
(B) less of at least one of the goods
(C) more of at least one of the goods and less of the other good.
(D) more of at least one of the goods and no less of the other good.
38. During lockdown due to COVID-19, a consumer finds the vegetable vendors selling vegetables in the
street have raised the prices of vegetables than usual prices. She will buy ____________ vegetables
than/as her usual demand showing the demand of vegetables is ____________.
(A) more, inelastic demand
(B) less, elastic demand
(C) same, inelastic demand
(D) same, elastic demand
39. Which of the following is incorrect regarding indifference curve approach of consumer’s behavior?
(A) Indifference curve analysis assumes utility is merely orderable and not quantitative.
(B) Consumer is capable of comparing the different levels of utilities or satisfactions from different
commodities.
(C) Consumer can say by how much one level of satisfaction is higher or lower than other.
(D) None of these

40. According to ordinal approach of consumer’s behavior-
(A) Consumer is able to indicate the exact amounts of utilities that he derives from commodity or
any combinations of them.
(B) Utility being psychological feeling is not quantifiable.
(C) The consumer is capable of simply comparing the different levels of satisfaction.
41. At saturation point of TU curve , the slope of TU curve is_________________________
(A) 1
(B) Infinity
(C) Zero
(D) Positive
42. Luxuries are goods that are
(A) Enjoyable and essential
(B) Enjoyable but not essential
(C) Essential but not enjoyable
(D) Neither enjoyable nor essential
43. Commodities such as prescribed medicines and salt have __________________ and ___________
hence, have an ___________________ demand.
(A) Several substitutes, elastic
(B) Several substitutes, inelastic
(C) No close substitutes, inelastic
(D) No close substitutes, elastic
44. Let slope of demand curve is (-) 0.6, calculate elasticity of demand when initial price is $ 30 per unit
and initial quantity is 100 units of the commodity.
(A) 0.5
(B) 5.55
(C) (-) 0.5
(D) (-) 0.18
1500
45. Let QX = , the elasticity of demand of the good X when its price falls from $ 8 to $ 2 per unit, will be-
PX
(A) greater than one

(B) less than one
(C) equal to one
(D) can’t say
46. Budget line or price line is downward sloping because _________________________________.
(A) There is inverse relationship between the price and demand of a commodity.
(B) If a consumer wants to buy more of one good, he has to buy less of other good at given
money income.
(C) If a consumer wants to buy more of one goods, he has to buy less of other goods as his
money income falls.
(D) None of these
47. While drawing budget line of a consumer consuming Nachos chips and Pepsi, if the quantity of Nachos
taken on Y-axis and quantity of Pepsi on X-axis. The slope of budget line will be-
PP
(A)
PN
PN
(B)
PP
M
(C)
PN
M
(D)
PP
[Where, Pp – Price of Pepsi, PN - Price of Nachos & M – Money income of consumer]
48. If there is decrease in quantity supplied of a commodity, there will be-
(A) Upward movement on same supply curve
(B) Rightward shift in supply curve
(C) Downward movement on same supply curve
(D) Leftward shift in supply curve
49. Relationship between slope of supply curve and elasticity of supply can be defined as -
(A) Product of slope of supply curve and ratio of quantity supply to price
(B) Elasticity of supply is equal to the slope of supply curve.
(C) Product of reciprocal of supply curve and ratio of price to quantity supplied
(D) Elasticity of supply is equal to reciprocal of slope of supply curve.
50. A new technique of production reduces the marginal cost of producing paper. How will this affect the
supply curve of writing material like notebook, register & notepad etc?
(A) Upward movement on same supply curve
(B) Downward movement on same supply curve
(C) Leftward shift in supply curve
(D) Rightward shift in supply curve
51. Supply and stock are _________________________
(A) same things
(B) different
(C) having no comparison
52. Elasticity of demand and supply are ___________________ concepts.

(A) Relative
(B) Absolute
(D) Neither (A) and (B)
53. Law of demand is a qualitative concept where as price elasticity of demand is _____________.
(A) also qualitative concept
(B) Quantitative concept
(C) Quantitative and qualitative concept
(D) Neither qualitative nor quantitative concept
54. Which of the following statements is correct regarding indifference curve?
(A) Two ICs may not intersect each other.
(B) Two ICs may intersect each other
(C) Two ICs are always parallel to each other
(D) None of these
55. The most crucial determinant of demand for an item is __________________________.
(A) Income of consumer
(B) Prices of other related goods
(C) Taste and preference of consumer
(D) It’s own price
56. The price of a piece of jewellery rises, the demand for it may also rise as consumers attach a
______________ to owning and displaying expensive items.
(A) money value
(B) use value
(C) snob value
(D) None of these
57. With reference to Arc elasticity measures the responsiveness of demand _____________ on the
demand curve.
(A) at one given point
(B) at intercepts on X-axis & Y-axis
(C) between two points
(D) Any of the above
58.
In the above figure, DD1 is the demand curve of a commodity. There are two points on the demand
curve i.e., A and B with (P, Q) as (10, 2) & (8, 3) respectively. If the initial point is A OR initial point is
B, the price elasticity of demand will be -
(A) same in both cases by point method of price elasticity of demand
(B) different in both cases by Arc method of price elasticity of demand
(C) same in both cases by Arc method & different by point method of price elasticity of demand
(D) None of these
59. Goods X and Y being independent goods, the cross price elasticity of demand (ignoring the sign)
between them will be-
(A) 1 (unit elastic)
(B) less than 1
(C) greater than 1
(D) Zero
60. Match the following
LIST-I LIST- II
a. Cardinal approach 1. Marginal utility
b. Ordinal approach 2. Alfred Marshall
c. Hicks & Allen approach 3. J.R.Hicks
d. Consumer’s Surplus 4. Indifference Curve
5. Revealed preference theory
Codes: a b c d
(A) 1 2 3 4
(B) 1 5 4 2
(C) 1 3 4 2
(D) 1 3 2 4
61. Condition of equilibrium using utility analysis of demand can be expressed as

(A) MUX/PX = QX
(B) PX QX = MUM
(C) MUX/PX = MUY/PY = MUM
(D) MUX = MUM
62. Law of diminishing marginal rate of substitution is associated with
(A) Marshall
(B) Hicks
(C) Slutsky
(D) Keynes
63. According to principle of diminishing marginal rate of substitution-
a. One commodity must be decreased while other is increased
b. Commodity which is increased has higher marginal significance
c. Commodity which is decreased has higher marginal significance
d. Neither qualitative nor quantitative concept
Of these statements:
(A) Only a is correct
(B) Both a and b are correct
(C) Both a and c are correct
(D) All are correct
64. Which of the following statements is correct regarding property of indifference curve?
(A) Two ICs may intersect each other.
(B) Two ICs may not intersect each other
(C) Two ICs are always parallel to each other
(D) Two ICs may be parallel to each other
65. MU curve will be below X-axis when
(A) MU is zero
(B) TU is falling
(C) MU is negative
66. Match the following

List I
(a) for a given 10% change in price demand changes by zero per cent.
(b) for a given 10% change in price demand changes by 5%
(c) for a given 10% change in price demand changes by 10%.
(d) for a given 10% change in price demand changes by 20%.
List II
1. e>1 2. e = 1 3. e<1 4. e = 0
Codes: a b c d
(A) 3 1 2 4
(B) 4 3 2 1
(C) 1 2 3 4
(D) 2 3 1 4
67. A falling MU curve illustrates
(A) The principle of diminishing marginal utility
(B) The principle of diminishing marginal rate of substitution
(C) The principle of equi-marginal utility
(D) Any of the above
68. In the following diagram, consumer’s surplus is shown by-
(A) OPEQ
(B) ODEQ
(C) PDE
(D) None of these
69. In the following diagram, when the price of the commodity decreases from P1 to P2, the gain in
consumer’s surplus is equal to-
(A) AP1B
(B) AP2C
(C) P1P2CB
(D) BSC
70. ‘Ceteris Paribus’ clause in Law of demand does not mean-
(A) The price of the commodity does not change
(B) The price of substitutes does not change
(C) The income of consumer does not change
(D) The price of complementary goods does not change
71. Assertion (A): In the short run, a producer operates in only II stage of Law of Diminishing Returns
Where average product of variable factor is declining.
Reason (R): In stage I and stage III the marginal product of the fixed and the variable factors
respectively are negative.
(A) (A) is true and (R) is false
(B) Both (A) and (R) are true & (R) is the correct explanation of (A)
(C) Both (A) and (R) are true & (R) is not the correct explanation of (A)
(D) (A) is false and (R) is true
72. In the long run which factor of production is fixed?
(A) Labour
(B) Capital
(C) Building
(D) None of these
73. Cost incurred which has ‘no relevance’ to future planning is called_
(A) Marginal Cost
(B) Sunk Cost
(C) Book Cost
(D) Average Cost
74. Law of diminishing returns to scale is relevant to_
(A) Short period
(B) Long period
(C) Market period
(D) None of these
75. The Cobb-Douglas homogeneous production function given as: Q = L1/2 k1/2 exhibits-
(A) Constant returns to scale
(B) Decreasing returns to scale
(C) Increasing returns to scale
(D) All of the above at various level of output
76. In second stage of the Law of Variable Proportion-
(A) MP diminishes & AP increases
(B) AP diminishes but MP increases
(C) Both MP& AP diminish
(D) Both MP& AP increase
77. If all inputs are increased in the same proportion, then it is the case of
1. Short run production function
2. Long run production function
3. Law of Variable Proportion
4. Law of Returns to Scale
(A) 1 & 2 only
(B) 2 & 3 only
(C) 1 & 4 only
(D) 2 & 4 only
78.
Iso-Quants shown in the above figure exhibits

1. Perfect substitutability of factors
2. Perfect complementarily of factors
3. Fixed proportion production function
4. Variable proportion production function
(A) 1 & 2 only
(B) 1 & 3 only
(C) 3 & 4 only
(D) 2 & 3 only
79. Match List I with List II and choose the correct answer using the codes given below.
LIST-I LIST- II
a. MP is larger than AP I. AP is at its maximum
b. MP is equal to AP II. AP is falling
c. MP is smaller than AP III. AP is rising
Codes: a b c
(A) I II III
(B) III I II
(C) II III I
(D) III II I
80. Match the following and choose the correct answer using the codes given below.
Average Cost Marginal Cost
a. AC horizontal I. MC will rise at a greater rate
b. AC rises II. MC falls but at a higher rate
c. AC falls III. MC falls at higher rate & then rises at higher rate
d. AC falls first & then rises IV. MC will coincide with it

Codes: a b c d
(A) IV II I III
(B) IV I II III
(C) I II III IV
(D) II III IV I
81. Diminishing returns are due to ________________ and increasing returns are due to ___________
(A) Internal diseconomies, Internal economies
(B) Internal economies, Internal diseconomies
(C) External diseconomies, Internal economies
(D) Internal diseconomies, external economies
82. Cobb-Douglas function
When, P = Actual output
L = Labour
C = Capital
b = No. of units of labour
k = Exponent of labour
j = Exponent of capital
is represented as-
(A) P = b Lj C k
(B) P = b L1/j C1/k
(C) P = b Lk C j
(D) P = 1/ b Lk C j
83. Assertion (A): An iso-cost line is a straight line.
Reason (R): The market rate of exchange between the two inputs is constant.
(A) (A) is true and (R) is false
(B) Both (A) and (R) are true & (R) is the correct explanation of (A)
(C) Both (A) and (R) are true & (R) is not the correct explanation of (A)
(D) (A) is false and (R) is true
84. Marginal cost is less than the Average Cost when Average Cost falls with
(A) an increase in output
(B) a decrease in output

(C) constant output
(D) None of these
85. “Returns to Scale” refers to the effect on total output of changes in
(A) a factor
(B) various inputs separately
(C) all the inputs simultaneously
(D) None of these
86. Consider the following statements about the relationship between cost and production-
1. When AP rises, AVC falls
2. When AP reaches at maximum, AVC is minimum
3. When AP falls, AVC rises
Which of the above statements is correct?
(A) 1&2
(B) 3 only
(C) 1, 2 & 3
(D) 2&3
87. Which one of the following is not a national objective of an enterprise?
(A) To provide fair deal to the employees at different levels.
(B) To remove inequality of opportunities & provide fair opportunity to all to work and to progress.
(C) To produce according to national priorities.
(D) To help the country become self reliant & avoid dependence on other nations.
88. An enterprise has social objectives as-
(A). It has to make profit from the society.
(B) It lives in society & it cannot grow unless it meets the needs of the society.
(C) It has a separate legal identity.
(D) None of these
89. Human objectives of an enterprise are-
(A) To provide fair deal to the employees at different levels.
(B) To develop new skills and abilities and provide a work climate in which they will grow mature.
(C) Only (A)

(D) Both (A) and (B)
90. Which of the following is not a problem of an enterprise?
(A) Problem relating to location & size.
(B) Problem of making huge profit.
(C) Problem relating to finance.
(D) Problem relating to organizational structure.
91. After identifying the market, the enterprise has to make decision regarding 4 Ps. Which one of the
following is not one of these 4 Ps.
(A) Promotion
(B) Place
(C) People
(D) Product
92. Which one of the following is not an assumption of law of variable proportion?
(A) Technology of production remains unchanged.
(B) Only physical inputs & output are considered.
(C) All units of variable factors are different.
(D) The must be some inputs whose quantity is kept fixed.
93. The schedule given below representing the combinations of two variable inputs (Labour & Capital) for
two Isoquants of output 100 and 200 respectively.
IQ1 IQ2
Combinations Output Capital Labour Output Capital Labour
I 100 90 10 200 85 5
II 100 60 20 200 70 10
III 100 40 30 200 60 15
IV 100 30 40 200 55 20
On the basis of above schedule, which of the following statement is true?
(A) IQ1 & IQ2 are parallel to each other.
(B) IQ1 & IQ2 are non parallel & intersecting to each other.
(C) IQ1 & IQ2 are neither parallel nor intersecting each other.
(D) Can’t say
94. Isoquant word is made up of two words i.e., Iso & Quant. Where quant means quantity or output then
Iso means-
(A) Maximum
(B) Equal
(C) Minimum
(D) None of these
95. Isoquant curve is convex to the origin due to diminishing MRTS. If X-axis is labour (L) axis & Y-axis is
Capital (K) axis then MRTS = ?
∆L
(A)
∆K
∆K
(B)
∆L
1
(C)
∆K
(D) (A) and (B)
96. Which one of the following cost curve is rectangular hyperbola in shape?
(A) TFC
(B) MC
(C) AFC
(D) AVC
97. The areas of all rectangles formed by drawing perpendiculars on both axis from different points on
AFC curve are___________
(A) same
(B) different
(C) (A) or (B)
(D) can’t be determined
98. The area of a rectangle formed by drawing perpendiculars on both axis from a point on AFC curve is
equal to___________
(A) Total cost
(B) Marginal cost
(C) Average cost
(D) Total fixed cost
99. Which of the following is not a formula for marginal cost?

(A) MCN = TCN – TCN-1
∆ TC
(B) MC =
∆Q
(C) MCN = TVCN – TVCN-1
(D) MCN = TFCN – TFCN-1
100. Which of the following is incorrect formula?
(A) TC = AC × Q
(B) ∑ MC = TC
(C) ∑ MC = TVC
(D) ∑ MC + TFC = TC
101. If the price of a product is Rs.20/unit and its price elasticity of demand is (-) 0.25. Its MR will be
`______
(A) 60
(B) 100
(C) - 60
(D) None of these
102. If the price of a product is Rs.10/unit and its price elasticity of demand is (-) 2.5. Its MR will be `_____
(A) 10
(B) 6
(C) - 10
(D) 4
103. If the price elasticity of demand of a product is (-) 3, what should be the price of the product for its MR
to be ` 20?
(A) ` 10/unit
(B) ` 20/unit
(C) ` 30/unit
(D) ` 40/unit
104. If a product has elastic demand, its marginal revenue (MR) will be ______________. (Given that the
price of the product is Rs.5/unit).
(A) Positive
(B) Zero
(C) Negative
(D) can’t be determined
105. Which of the following is an implication of the imposition of price ceiling below the equilibrium price?
(A) Shortages in the market
(B) Problem of allocation of limited supplies among large number of consumer.
(C) Black marketing
106. In the perfect competition at short run, the firm is a price _____________ and can sell _________
amount of output at the on going market price.
(A) Taker, any
(B) Taker, a definite
(C) Maker, any
(D) None of the above
107. The size of a monopolist’s plant and the degree of utilization of any given plant size depend entirely on
the ______________________.
(A) Factor price
(B) Price of good
(C) Market demand
(D) Market supply
108. Monopoly equilibrium can be reached when _______________________.
(A) Marginal cost is rising
(B) Marginal cost is remaining constant
(C) Marginal cost is falling
(D) None of these
109. Consider the following:
1. Large number of buyers and sellers
2. Firms produce differentiated products
3. Free entry & exit of firms
4. Perfect knowledge about technology
Which of the above are the characteristics of monopolistic competition?
(A) 1&3
(B) 2& 3
(C) 2, 3 & 4
(D) 1, 2, 3 & 4
110. The kinked demand curve theory explains that even when the demand conditions _____________ the
price ______________.
(A) Change, changes
(B) Change, remains stable
(C) Remain stable, changes
(D) Remain stable, falls
111. Which of the following is true at equilibrium in monopolistic competition?
(A) Price is greater than marginal cost
(B) Price is greater than marginal revenue
(D) Price is equal to marginal revenue
112. Marginal revenue along with marginal cost helps to determine
(A) Profit maximizing output
(B) Profit/unit
(C) Price/unit
(D) Total revenue
113. Imperfect competition arises when
(A) There is imperfect rivalry among competitors
(B) There are unexplainable imperfections in the market
(C) Competition does not exist
(D) Product variation, ignorance of consumers and distance & transportation costs lead to
Imperfection in the competitive market which operates on certain assumptions.
114. Monopolistic competition has features of
(A) Monopoly but not competition
(B) Monopoly and competition with features of competition predominating
(C) Monopoly and competition with features of monopoly predominating
115. For a competitive firm, long period normal price will
(A) Equal AC and MC of production
(B) Equal MC of production only
(C) Equal TC of production only

(D) None of these
116. If a monopolist could perfectly discriminate them which of the following statements would be true?
(A) Every increment of the goods would be priced separately so as to capture the entire consumer
surplus.
(B) Every increment of the goods would be priced evenly.
(C) Every increment of the goods would be priced higher than the previous one.
(D) Every increment of the goods would be priced lower than the previous one.
117. Which of the following is an essential condition for price discrimination?
Choose the correct answer using the codes given below:
1. Existence of two or more than two markets
2. Full control over the supply
3. Communication between buyers in different sectors of the monopolist’s market
4. Existence of different elasticity of demand in different markets.
5. No possibility of reselling a commodity at a higher price in another market.
Code:
(A) 1, 2, 3 & 4
(B) 2, 3, 4 & 5
(C) 3, 4 & 5
(D) 1, 2, 4 & 5
List I List II
a. Perfect competition I. Differentiated product
b. Imperfect competition II. Homogeneous or differentiated products
c. Oligopoly III. Homogenous product
d. Monopoly IV. Sharply differentiated products
Codes: a b c d
(A) I II III IV
(B) III I II IV
(C) IV III II I
(D) I IV III II
119. Marginal cost is equal to marginal revenue, average cost is equal to average revenue, average
revenue is equal to marginal revenue and average cost is equal to marginal cost.
This is the condition of-
1. Long period equilibrium for a firm under oligopoly
2. Short period equilibrium for a firm under oligopoly
3. Long period equilibrium
4. Long period equilibrium for a firm under perfect competition
5. Short period equilibrium for a firm under perfect competition
(A) 1 & 5 only
(B) 3 & 4 only
(C) 3 & 1 only
(D) 2 only
120. At a particular price level, there are no forces tending to move it either up or down means
1. The firm is in equilibrium
2. The price in equilibrium
3. The equilibrium price of the firm
4. The equilibrium price & quantity of the firm
(A) 1 & 4 only
(B) 1, 2 & 4 only
(C) 3 & 1 only
(D) 4 only
121. Which of the following is not correct?
1. Monopoly form of market organization may be the result of increasing returns to scale
2. Monopoly form of market organization may be the result of patent or govt. decision
3. Monopoly form of market or organization may be the result of control over the supply of raw
materials
4. Monopoly form of market or organization may be the result of control over the demand of raw
materials
(A) 1 only
(B) 2 only
(C) 1 & 3 only
(D) 4 only
122. Which of the following assumptions is correct in connection with oligopoly?

1. If an oligopolist increases his price his rivals will follow.
2. If an oligopolist increases his price his rivals will not follow.
3. If an oligopolist increases his price his rivals will lower their prices.
4. If an oligopolist decreases his price his rivals will not react.
(A) 1 only
(B) 2 only
(C) 1 & 3 only
(D) 4 only
123. Price is
List I List II
i. Highest a. Monopoly
ii. Second highest b. Oligopoly
iii. Third highest c. Monopolist Competition
iv. Fourth highest d. Perfect Competition
Codes:
(A) i-d, ii-c, iii-b, iv-a
(B) i-a, ii-b, iii-c, iv-d
(C) i-d, ii-a, iii-c, iv-b
(D) i-a, ii-c, iii-b, iv-d
124. Demand curve is
List I List II
i. Horizontal a. Monopoly
ii. Kinked b. Oligopoly
iii. Downward sloping c. Monopolist Competition
Codes:
(A) i-c, ii-a, iii-b
(B) i-c, ii-b, iii-a
(C) i-a, ii-b, iii-c
(D) i-b, ii-a, iii-c
125. An industry comprised of a very large number of sellers producing a standardized product is known as
(A) Monopolistic competition
(B) Oligopoly
(C) Pure monopoly
(D) Pure competition
126. The demand curve confronted by an individual purely competitive firm is-
(A) Relatively elastic i.e., the elasticity coefficient is greater than unity.
(B) Perfectly elastic.
(C) Relatively inelastic i.e., the elasticity coefficient is less than unity.
(D) Perfectly inelastic
127. For a purely competitive firm total revenue
(A) is price times quantity sold.
(B) increases by a constant absolute amount as output expands.
(C) graphs as a straight upsloping line from the origin.
(D) has all of the above characteristics.
128. A purely competitive seller’s average revenue curve coincides with
(A) its marginal revenue curve only
(B) its demand curve only
(C) both its demand & marginal revenue curves
(D) Neither demand nor marginal revenue curve.
129. A firm reaches a break-even point (normal profit position) where,
(A) Marginal revenue curve cuts the horizontal axis.
(B) Marginal cost curve intersects the average variable cost curve.
(C) Total revenue equals total variable cost.
(D) Total revenue and total cost are equal.
130. When a firm is maximizing profit i it will necessarily be
(A) Maximizing profit per unit of output.
(B) Maximizing the difference between total revenue and total cost.
(C) Minimizing total cost
(D) Maximizing total revenue
131. For an imperfectly competitive firm

(A) Total revenue curve is straight upsloping line because a firm’s sales are independent of
product price.
(B) The marginal revenue curve lies above the demand curve because any reduction in price
applies to all units sold.
(C) The marginal revenue curve lies below the demand curve because any reduction in price
applies to all units sold.
(D) Marginal revenue curve lies below the demand curve because any reduction in price applies
to only extra unit sold.
132. With respect to the pure monopolist’s demand curve it can be said that
(A) The stronger the barrier to entry, the more elastic is the monopolist’s demand curve.
(B) Price exceeds marginal revenue at all outputs greater than 1.
(C) Demand is perfectly inelastic.
(D) Marginal revenue equals price at all outputs.
133. Because the monopolist’s demand curve is down sloping
(A) Marginal revenue equals price.
(B) Price must be lowered to sell more output.
(C) The elasticity coefficient will increase as price lowered.
(D) Its supply curve will also be downsloping.
134. The monopolistically competitive seller’s demand curve will become more elastic, the
(A) more significant the barriers to entering the industry.
(B) greater the degree of product differentiation.
(C) larger the number of competitors.
(D) smaller the number of competitors.
135. The kinked demand curve model of oligopoly is useful in explaining
(A) the way that collusion works.
(B) why oligopolistic price and output are extremely sensitive to changes in marginal cost.
(C) why oligopolistic prices might change only infrequently.
(D) the process by which oligopolists merge with one other.
136. The government and industry try to predict the business cycle by using indicators. These are:
(A) Variable that can explain the growth of production capacity.
(B) Variables that precede the actual movements in expenditure and production.
(C) The expenditure categories of consumption, investment and exports.

(D) Domestic and foreign indications relating to the business cycle and the tendency.
137. During an upturn in the business cycle the negative output gap does not become much more negative
than it was. This is because of the fact that:
(A) Capacity increases because of the rise in investment.
(B) Expenditure decreases because of the rise in the interest rate.
(C) The government lowers the taxes during an upturn.
(D) Labour productivity decreases during upturn.
138. Business cycle emerge in ____________.
(A) Socialist economy
(B) Free market economy
(C) Mixed economic system
39. According to British economist J. M. Keynes _______________ was the main cause of massive
decline in income and employment during Great Depression of 1930.
(A) Lower aggregate expenditure in the economy.
(B) Banking crises and low money supply.
(C) Overdebtness.
(D) Lower profits & pessimism
List I List II
a. Leading indicator I. Industrial production
b. Lagging indicator II. Changes in stock price
c. Coincident indicator III. Corporate profit
Codes: a b c
(A) I II III
(B) II III I
(C) III II I
(D) I III II
141. ______________ sector is more prone to the adverse effects of the business cycle.
(A) Agriculture
(B) Service
(C) Industrial
(D) Can’t say
142. Trade/Business cycles occur due to
List I List II
i. Changes in money supply a. Monopoly
ii. Innovations take place in the system b. Oligopoly
iii. Waves of optimism or pessimism c. Monopolist Competition
iv. Fluctuations in aggregate effective demand d. Perfect Competition
Codes:
(A) i-d, ii-c, iii-b, iv-a
(B) i-a, ii-b, iii-c, iv-d
(C) i-d, ii-a, iii-c, iv-b
(D) i-c, ii-a, iii-d, iv-b
143. Cyclical business refers to
(A) The business where demand fluctuates seasonally.
(B) The business which keep on changing their product.
(C) The business whose fortunes are closely related to the rate of economic growth.
144. Which of the following statements is correct regarding business cycles?
(A) Business cycles always affect all sectors uniformly.
(B) Business cycles may affect all sectors uniformly.
(C) Business cycles do not affect all sectors uniformly.
(D) None of these
145. Suppose in an economy the population growth rate remained 6% during last 5 years while the
economic growth rate during the same period was just 3%.
What will be the consequences of it? Select the right option from the options given below.
(A) Lesser savings→ Lower investment→ Low income & employment→ Low effective demand
→ Overall slowdown in economic activities
(B) More consumption expenditure→ more demand→ more production→ more employment &
income → Overall boom in economic activities
(C) Increase in labour supply→ Lower wage rate→ Low income → Low savings & investments
→ Low production→ Overall slowdown in economic activities
146. Post war reconstruction
(A) will push the economy to slow down because of excess external debts.
(B) will cause pickup in economic activities as the reconstruction pushes up effective demand &
in turn employment and income.
(C) can cause boom or recession depending upon the policies for reconstruction adopted by govt.
(D) None of these
147. Cost of living increases when business cycle is ___________________
(A) at peak
(B) contracting
(C) expanding
(D). at lowest point
148. During business cycles the opposite of a trough is _____________.
(A) an inflation
(B) a hyperinflation
(C) a trend
(D) a peak
149. In order to influence spending on the goods and services in the short run, monetary policy is directed
at directly influencing ___________________________.
(A) Unemployment rate
(B) Inflation rate
(C) Interest rate
(D) Economic growth rate
150. An important indicator of a nation’s well being is _____________
(A) Gross Domestic Product (GDP)
(B) Gross National Product (GNP)
(C) Gross National Income (GNI)
(D) Growth rate of GDP or GNP
ANSWER KEY
1. (B) 2. (A) 3. (C) 4. (A) 5. (D) 6. (B)
7. (C) 8. (B) 9. (A) 10. (B) 11. (B) 12. (C)
13. (B) 14. (C) 15. (A) 16. (C) 17. (A) 18. (B)
19. (A) 20. (D) 21. (B) 22. (C) 23. (C) 24. (D)
25. (D) 26. (A) 27. (B) 28. (C) 29. (A) 30. (C)
31. (D) 32. (B) 33. (B) 34. (A) 35. (C) 36. (B)
37. (D) 38. (C) 39. (C) 40. (D) 41. (C) 42. (B)
43. (C) 44. (C) 45. (C) 46. (B) 47. (A) 48. (C)
49. (C) 50. (D) 51. (B) 52. (A) 53. (C) 54. (D)
55. (D) 56. (C) 57. (C) 58. (C) 59. (D) 60. (C)
61 (C) 62 (B) 63 (C) 64 (D) 65 (D) 66 (B)
67 (A) 68 (C) 69 (C) 70 (A) 71 (B) 72 (D)
73 (B) 74 (B) 75 (A) 76 (C) 77 (D) 78 (D)
79 (B) 80 (B) 81 (A) 82 (C) 83 (B) 84 (A)
85 (C) 86 (A) 87 (A) 88 (B) 89 (D) 90 (B)
91 (C) 92 (C) 93 (A) 94 (B) 95 (D) 96 (C)
97 (A) 98 (D) 99 (D) 100 (B) 101 (C) 102 (B)
103 (C) 104 (A) 105 (D) 106 (A) 107 (C) 108 (A)
109 (D) 110 (B) 111 (C) 112 (A) 113 (D) 114 (B)
115 (A) 116 (A) 117 (D) 118 (B) 119 (B) 120 (D)
121 (D) 122 (B) 123 (D) 124 (A) 125 (D) 126 (B)
127 (D) 128 (C) 129 (D) 130 (B) 131 (C) 132 (B)
133 (B) 134 (C) 135 (C) 136 (D) 137 (A) 138 (B)
139 (A) 140 (B) 141 (C) 142 (D) 143 (C) 144 (C)
145 (A) 146 (B) 147 (C) 148 (D) 149 (C) 150 (A)
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THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

© THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

Edition : September, 2021

Price (All Modules) : `

Published by : The Publication Department on behalf of The Institute of Chartered

: Typeset and designed at Board of Studies.

Suggestions for further improvements are heartily welcomed.

PAPER – 4: BUSINESS ECONOMICS AND BUSINESS AND COMMERCIAL KNOWLEDGE

1. Introduction to Business Economics

PART – II : BUSINESS AND COMMERCIAL KNOWLEDGE (40 MARKS)

Chapter 1 – Nature & Scope of Business Economics ..................................................................... 1.1 – 1.24

1.1 Definitions of Business Economics .................................................................................................. 1.5

1.2 Nature of Business Economics ........................................................................................................ 1.5

1.3 Scope of Business Economics ........................................................................................................ 1.8

Summary ...................................................................................................................................... 1.10

2.2 Socialist Economy ....................................................................................................................... 1.16

Summary ...................................................................................................................................... 1.19

Test Your Knowledge Questions ................................................................................................... 1.19

Chapter 2 – Theory of Demand and Supply

1.1 What Determines Demand .............................................................................................................. 2.3

1.2 Demand Function ........................................................................................................................... 2.6

1.3 Law of Demand ............................................................................................................................ 2.7

1.4 Expansion and Contraction of Demand .......................................................................................... 2.13

1.5 Elasticity of Demand ..................................................................................................................... 2.17

1.6 Income Elasticity of Demand ......................................................................................................... 2.30

1.7 Cross- Price Elasticity of Demand ................................................................................................. 2.33

1.8 Advertisement Elasticity ................................................................................................................ 2.36

1.9 Demand Forecasting ..................................................................................................................... 2.37

Summary ...................................................................................................................................... 2.45

2.1. Classification of Wants………………………………………………………………………………………….2.48

2.2 What is Utility? .......................................................................................................................... 2.48

2.3 Marginal Utility Analysis ................................................................................................................ 2.49

2.4 Consumer Surplus ........................................................................................................................ 2.55

2.5 Indifference Curve Analysis........................................................................................................... 2.59

Summary ...................................................................................................................................... 2.69

Unit III: Supply ......................................................................................................................................... 2.70

3.1. Determinants of Supply ................................................................................................................. 2.70

3.5 Elasticity of Supply ....................................................................................................................... 2.75

Summary ...................................................................................................................................... 2.82

Chapter 3 – Theory of Production and Cost

1.1 Factors of Production ..................................................................................................................... 3.4

1.3 Production Optimisation ................................................................................................................ 3.23

Unit II: Theory of Cost ............................................................................................................................ 3.28

2.1. Cost Function ............................................................................................................................... 3.30

2.2 Short Run Total Costs................................................................................................................... 3.31

2.3 Long Run Average Cost Curve ...................................................................................................... 3.36

2.4 Economies & Diseconomies of Scale ............................................................................................ 3.38

Summary ...................................................................................................................................... 3.41

Test Your Knowledge Questions ................................................................................................... 3.43

Chapter 4 – Price Determination in Different Markets

1.1 Types of Market Structures ............................................................................................................. 4.5

Summary ...................................................................................................................................... 4.12

Unit II: Determination of Prices .............................................................................................................. 4.13

2.2 Changes in Demand and Supply ................................................................................................... 4.15

Summary ...................................................................................................................................... 4.21

3.1. Monopoly...................................................................................................................................... 4.32

3.2 Imperfect Competition- Monopolistic Competition ......................................................................... 4.42

Summary ...................................................................................................................................... 4.51

Chapter 5 – Business Cycles