F.y.b.a. economics - eng (rev)

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F.Y.B.A. Paper – I

Economic Theory (Micro Economics-I)

SECTION – I

Module 1 : Introduction
Meaning, nature, scope, significance and limitations of micro
economics. Ceteris Paribus – use and significance. Concept and
types of equilibrium : stable, unstable, static and dynamic
equilibrium – partial equilibrium and general equilibrium, positive
economics and normative economics, managerial economics.
Basic concepts – wealth, welfare and scarcity. Basic tools of
economics analysis (equations and functions, graphs and
diagrams, slope and intercepts)

Module 2 : Consumers Behaviour and Demand
Marishallian Approach : Equi-marginal utility, Law of demand –
Determinants of demand. Elasticity of demand and its
measurement. Price – Income – Cross and Promotional elasticity of
demand. Consumer’s Surplus.

Hicksian Approach : Indifference curves – properties of Indifference
Curve, Consumer’s Equilibrium, Price effect, Income effect and
substitution effect – Derivation of demand from Price Consumption
Curve (PCC) – Giffen’s paradox.
Samuelson Approach : Revealed Preference Theory.

Module 3 : Production and Cost Analysis
Concept of production function : short run and long run – Cobb –
Douglass production function. isoquants – iso-cost line – producer’s
equilibrium. Law of variable proportion and Law of returns to scale
– Economies of scale – Economies of scope.

Concepts of costs : Money and real cost, Opportunity cost, Social
cost, Private cost – Derivation of short run and long run cost
curves– Learning curve.

SECTION –II

Module 4 : Theory of Firm :
Concepts of revenue : Total Revenue, Average Revenue and
Marginal Revenue – Relationship between TR, AR and MR under
perfect and imperfect competition – AR, MR and elasticity.
Objectives of a Firm – Analysis of Equilibrium of a firm : TC-TR
Approach – MC-MR Approach – Break-Even Analysis.

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Module 5 : Market Structure :
Perfect Competition : Features – Short – run Equilibrium of the Firm
and Industry – Long Run Equilibrium of the Firm and Industry.
Monopoly : Features – Short-run Equilibrium of the Monopolist
under Different Cost Conditions and Long-run Equilibrium of the
Monopolist – Discrimination Monopoly : Equilibrium under
Discriminating Monopoly – Dumping.

Monopolistic Competition : Features, Equilibrium in the Short-run
and Long-run – Wastages under Monopolistic Competition –
Oligopoly : Features of Oligopoly.

Module 6 : Pricing Methods and Capital Budgeting :
Pricing Methods : Marginal Cost Pricing – Full Cost Pricing – Multi
product pricing – Limit Pricing : Bain’s Model.

Meaning and importance of Capital Budgeting : Methods of Capital
Budgeting : Pay Back Period [PBP] – Net Present Value [NPV].

Reference :

1. Ahuja H. L. (2005), Advanced Economic Theory, S Chand and
Company, New Delhi.
2. Dwivedi, D N. (2003), Micro Economics : Theory and
Applications; Pearson Education (Singapore) Pvt. Ltd, Delhi.
3. Koustsoyiannis, A. (1980) Modern Economics, the Macmillan
Press Ltd. London.
4. Lipsey and Chrystal (2004), Economics, Oxford University
Press.
5. Masfield, E. (1997), Micro Economics, W. W. Norton and
Company, New York.
6. Mankiw, N. G. (2002), Principles of Economics, Thomson Asia
Pte. Ltd., Singapore.
7. Mehta P.L. (2006), Managerial Economics Analysis, Problems
and Cases, Sultan Chand & Sons, New Delhi.
8. Samuelson P.A. & Nordhaus W. D. (1998), Economics, Tata
McGraw Hill, New Delhi.
9. Salvatore, D. (2003), Micro Economics, Oxford University Press.
10. Stonier A. W. & Hague D. C. (2004), A Textbook of Economic
Theory, Pearson Education, Delhi.
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1
Module 1

INTRODUCTION TO MICROECONOMICS

Unit Structure :

1.0 Objectives
1.1 Introduction
1.2 Meaning and Nature of Micro Economics
1.3 Scope of Micro Economics
1.4 Usefulness of Microeconomics
1.5 Limitations of Microeconomics
1.6 Macro Economics
1.6.1 Distinguish between Micro and Macro Economics
1.7 Questions

1.0 OBJECTIVES

After having studied this unit, you should be able

 To Understand the fundamentals of Micro Economics
 To Know the nature of micro Economics
 To Study the concept of Macro economics
 To understand difference between Micro & Macro economics

1.1 INTRODUCTION

Economics is about economizing; that is, about choice
among alternative uses of scarce resources. Choices are made by
millions of individuals, businesses, and government units.
Economics examines how these choices add up to an economic
system, and how this system operates. (L.G. Reynolds) Scarcity is
central to economic theory. Economic analysis is fundamentally
about the maximization of something (leisure time, wealth, health,
happiness—all commonly reduced to the concept of utility) subject
to constraints. These constraints—or scarcity—inevitably define a
tradeoff. For example, one can have more money by working
harder, but less time (there are only so many hours in a day, so

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time is scarce). One can have more apples only at the expense of,
say, fewer grapes (you only have so much land on which to grow
food—land is scarce). Adam Smith considered, for example, the
trade-off between time, or convenience, and money. He discussed
how a person could live near town, and pay more for rent of his
home, or live farther away and pay less, “paying the difference out
of his convenience”.

Economics as a subject came into being with the publication
of very popular book in 1776, “An Enquiry into the Nature and
Causes of Wealth of Nations”, written by Prof. Adam Smith. At that
time it was called Political economy, which remained operational at
least up to the middle part of the 19th century. It is since then that
the economists developed tools and principles using inductive and
deductive reasoning. In fact, the ‘Wealth of Nations’ is a landmark
in the history of economic thought that separated economics from
other social sciences.

The word ‘Economics’ was derived from the Greek words
‘Oikos’ (a house) and ‘Nemein’ (to manage), which meant
managing a household, using the limited money or resources a
household has.

Let us explain a few important definitions frequently referred
to in the economic theory. In other words, economics is not a
science of wealth but a science of man primarily. It may be called
as the science which studies human welfare. Economics is
concerned with those activities, which relates to wealth not for its
own sake, but for the sake of human welfare that it promotes.
According to Cannan, “The aim of political economy is the
explanation of the general causes on which the material welfare of
human beings depends.” Marshall in his book, “Principles of
Economics”, published in 1890, describes economics as, “the study
of mankind in the ordinary business of life; it examines that part of
the individual and social action which is most closely connected
with the attainment and with the use of the material requisites of
well being”.

On examining the Marshall’s definition, we find that he has
put emphasis on the following four points:

(a) Economics is not only the study of wealth but also the study of
human beings. Wealth is required for promoting human welfare.

(b) Economics deals with ordinary men who are influenced by all
natural instincts such as love, affection and fellow feelings and not
merely motivated by the desire of acquiring maximum wealth for its
own sake. Wealth in itself is meaningless unless it is utilized for
obtaining material things of life.

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(c) Economics is a social science. It does not study isolated
individuals but all individuals living in a society. Its aim is to
contribute solutions to many social problems.

(d) Economics only studies ‘material requisites of well being’. That
is, it studies the causes of material gain or welfare. It ignores non-
material aspects of human life.

This definition has also been criticized on the ground that it
only confines its study to the material welfare. Non-material aspects
of human life are not taken into consideration. Further, as Robbins
said the science of economics studies several activities, that hardly
promotes welfare.

The activities of producing intoxicants, for instance, do not
promote welfare; but it is an economic activity.

1.2 MEANING AND NATURE OF MICRO
ECONOMICS

Microeconomics (from Greek prefix micro- meaning "small"
+ "economics") is a branch of economics that studies the behavior
of individual households and firms in making decisions on the
allocation of limited resources. Typically, it applies to markets
where goods or services are bought and sold. Microeconomics
examines how these decisions and behaviors affect the supply and
demand for goods and services, which determines prices, and how
prices, in turn, determine the quantity supplied and quantity
demanded of goods and services.

This is in contrast to macroeconomics, which involves the
"sum total of economic activity, dealing with the issues
of growth, inflation and unemployment." Microeconomics also deals
with the effects of national economic policies (such as
changing taxation levels) on the aforementioned aspects of the
economy. Particularly in the wake of the Lucas critique, much of
modern macroeconomic theory has been built upon 'micro
foundations' — i.e. based upon basic assumptions about micro-
level behavior.

One of the goals of microeconomics is to analyze
market mechanisms that establish relative prices amongst goods
and services and allocation of limited resources amongst many
alternative uses. Microeconomics analyzes market failure, where
markets fail to produce efficient results, and describes the
theoretical conditions needed for perfect competition. Significant
fields of study in microeconomics include general equilibrium,
markets under asymmetric information, choice under uncertainty

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and economic applications of game theory. Also considered is
the elasticity of products within the market system.

Applied microeconomics includes a range of specialized
areas of study, many of which draw on methods from other
fields. Industrial organization examines topics such as the entry and
exit of firms, innovation, and the role of trademarks. Labour
economics examines wages, employment, and labor market
dynamics. Public economics examines the design of government
tax and expenditure policies and economic effects of these policies
(e.g., social insurance programs). Political economy examines the
role of political institutions in determining policy outcomes. Health
economics examines the organization of health care systems,
including the role of the health care workforce and health insurance
programs. Urban economics, which examines the challenges faced
by cities, such as sprawl, air and water pollution, traffic congestion,
and poverty, draws on the fields of urban geography and
sociology. Financial economics examines topics such as the
structure of optimal portfolios, the rate of return to capital,
econometric analysis of security returns, and corporate financial
behavior. Law and economics applies microeconomic principles to
the selection and enforcement of competing legal regimes and their
relative efficiencies. Economic history examines the evolution of the
economy and economic institutions, using methods and techniques
from the fields of economics, history, geography, sociology,
psychology, and political science.

The term ‘Micro’ and ‘Macro’ economics have been coined
by Prof. Ragnar Frisch of Oslo University during 1920’s. The word
micro means a millionth part. In Greek mickros means small.

Thus microeconomics deals with a small part of the whole
economy. For example, if we study the price of a particular
commodity instead of studying the general price level in the
economy, we actually are studying microeconomics. Precisely,
microeconomics studies the behaviour of individual units of an
economy such as consumers, firms, and industry etc. Therefore, it
is the study of a particular unit rather than all units combined
together. Microeconomics is called Price theory, which explains the
composition, or allocation of total production.

In short, microeconomics is the study of the economic
behaviour of individual consumers, firms, and industries and the
distribution of production and income among them. It considers
individuals both as suppliers of labour and capital and as the
ultimate consumers of the final product. On the other hand, it
analyses firms both as suppliers of products and as consumers of
labour and capital.

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1.3 SCOPE OF MICRO ECONOMICS

Microeconomics seeks to analyze the market form or other
types of mechanisms that establish relative prices amongst goods
and services and/or allocates society’s resources amongst their
many alternative uses. In microeconomics, we study the following:

1. Theory of product pricing, which includes-
(a) Theory of consumer behaviour.
(b) Theory of production and costs.

2. Theory of factor pricing, which constitutes-
(a) Theory of wages.
(b) Theory of rent.
(c) Theory of interest.
(d) Theory of profits.

3. Theory of economic welfare.
Microeconomics has occupied a very important place in the
study of economic theory. In fact, it is the stepping–stone to
economic theory. It has both theoretical and practical implications.

1.4 USEFULNESS OF MICROECONOMICS

1. Determination of demand pattern: The study of
microeconomics has several uses. It determines the pattern of
demand in the economy, i.e., the amounts of the demand for the
different goods and services in the economy, because the total
demand for a good or service is the sum total of the demands of all
the individuals. Thus, by determining the demand patterns of every
individual or family, microeconomics determines the demand
pattern in the country as a whole.

2. Determination of the pattern of supply: In a similar way, the
pattern of supply in the country as a whole, can be obtained from
the amounts of goods and services produced by the firms in the
economy. Microeconomics, therefore, determines the pattern of
supply as well.

3. Pricing: Probably the most important economic question is the
one of price determination. The prices of the various goods and
services determine the pattern of resource allocation in the
economy. The prices, in turn, are determined by the interaction of
the forces of demand and supply of the goods and services. By
determining demand and supply, microeconomics helps us in
understanding the process of price determination and, hence, the
process of determination of resource allocation in a society.

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4. Policies for improvement of resource allocation: As is well-
known, economic development stresses the need for improving the
pattern of resource allocation in the country. Development polices,
therefore, can be formulated only if we understand how the pattern
of resource allocation is determined. For instance, if we want to
analyse how a tax or a subsidy will affect the use of the scarce
resources in the economy, we have to know how these will affect
their prices. By explaining prices and, hence, the pattern of
resource allocation, microeconomics helps us to formulate
appropriate development policies for an underdeveloped economy.

5. Solution to the problems of micro-units: Finally, it goes
without saying that, since the study of microeconomics starts with
the individual consumers and producers, policies for the correction
of any wrong decisions at the micro-level are also facilitated by
microeconomics. For example, if a firm has to know exactly what it
should do in order to run efficiently, it has to know the optimal
quantities of outputs produced and of inputs purchased. Only then
can any deviation from these optimal levels be corrected. In this
sense, microeconomics helps the formulation of policies at the
micro-level. In every society, the economic problems faced by
different economic agents (such as individual consumers,
producers, etc.) can be analysed with the help of microeconomic
theories. This shows that economics is a social science which aims
at analysing the economic behavior of individuals in a social
environment.

1.5 LIMITATIONS OF MICROECONOMICS

However, microeconomics has its limitations as well:

1. Monetary and fiscal policies: Although total demand and total
supply in the economy is the sum of individual demands and
individual supplies respectively, the total economic picture of the
country cannot always be understood in this simplistic way. There
are many factors affecting the total economic system, which are
outside the scope microeconomics. For example, the role of
monetary and fiscal policies in the determination of the economic
variables cannot be analysed completely without going beyond
microeconomics.

2. Income determination: Microeconomics also does not tell us
anything about how the income of a country (i.e., national income)
is determined.

3. Business cycles: A related point is that, it does not analyse the
causes of fluctuations in national income. The ups-and-downs of
national income over time are known as business cycles.

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Microeconomics does not help us in understanding as to why these
cycles occur and what the remedies are.
4. Unemployment: One of the main economic problems faced by
an economy like India is the problem of unemployment. This, again,
is one of the areas on which microeconomics does not shed much
light. Because, if we are to find a solution to the unemployment
problem, we must first understand the causes of this problem. For
that, in turn, we must understand how the total employment level in
the economy is determined. This is difficult to understand from
within the confines of microeconomics.
Check your progress :
1. What is the subject matter of microeconomics?
2. What are the limitations of microeconomics?

1.6 MACRO-ECONOMICS

In Macro-economics, we are essentially concerned with the
economic system as a whole. Macro-economics concerns itself with
those aggregates which relate to the whole of the economy.
According to Kenneth Boulding, “Macro-economics deals not with
individual quantities but wit aggregates o f these quantity, not with
individual incomes but with national income, not with individual
prices but general price-level, not with individual output but with the
national output”. We are here concerned with the aggregates and
averages of the entire economy such as National Income, output,
employment, total consumption, saving, investment, aggregate
demand, aggregate supply and the general level of prices. It also
refers to the study of trade cycles and business fluctuations, and
the theory of economic growth. The hyper-inflation after the World
War I and the Great Depression of the 1930s’ were chiefly
responsible for the development of Macro-economic approach.
1.6.1 DISTINCTION BETWEEN MICRO AND
MACROECONOMICS
1. The dimensional difference Micro-economics, as seen earlier
deals with the analysis of individual behaviour, whereas in macro-
economics we are concerned with the study the economy as a
whole.

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Thus in Micro-economics we analyse the behaviour of an
individual consumer or an individual producer, pricing of product or
a factor whereas in Macro-economics we analyse the National
output, general level of price etc.
2. The Methodological difference The methodology applied in the
study of micro-economics is more ‘individualistic’ in nature;
whereas in the study of macro-economics it is more ‘aggregative’ in
nature. For instance in Micro-economics we apply the technique of
‘slicing’. Whereas in Macro-economics we resort to the technique of
‘lumping’.

3. Fields of Enquiry : Micro-economics is basically concerned with
the theory of product and factor-pricing.

Whereas Macro-economics is primarily concerned with
National Income, problems of growth and economic stability.

4. Derivation of Economic functions : The distinction between
micro and macro-economics is based on how the economic
functions are derived; if from aggregative data, we have macro-
economic function and if the function has been built up from a
careful study of individual units, then we have microeconomic
function. Thus micro-economics is concerned with the micro
variables such as individual demand, individual supply, price of a
particular commodity or factor etc. Whereas Macro economics is
concerned with macro variables; general price level, national
output, aggregate saving, investments and the level of employment
for the economy as a whole.

Micro Economics Macro Economics
1 Unit of Study: Individual Aggregate
2 Method: Slicing Lumping
3 Subject Matter : Study of Study of National Income,
product arid factor pricing general level of prices, trade
etc. cycle
4 Basis : Based on Based on Interdependence
independence
5 Core of study: Price Income Theory
Theory
6 Advocated by : Alfred John Maynard Keynes
Marshall
7 Vision : Worms eye view : Birds eye view Forest as a
study of a tree whole
8 Approach: Individualistic Aggregative
9 Quality of Analysis : Difficult and complicated.
Simple and easy

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Complementarity of two approaches:
However, these two approaches cannot be insulated from
each other in water-tight compartments. The two approaches are
essentially complementary in nature. Ignoring one and
concentrating attention on the other alone may often lead not only
to inadequate or wrong explanation but also to inappropriate or
even disastrous remedial measures. The two approaches are,
therefore, not in any way mutually exclusive and as such must be
properly integrated to secure fruitful results. To quote Paul
Samuelson; “There is really no opposition between Micro and
Macro-economics. Both are absolutely vital. You are less than half
educated if you understand the one while being ignorant of the
other”. Modern economic analysis is a combination of micro and
macro approaches. Economics is both theoretical and empirical in
nature. Micro and Macro-economics are complementary.

1.7 QUESTIONS

1. Explain the concept and meaning of Micro Economics.?
2. Explain the Nature & Scope of Micro Economics ?
3. Explain the Concept of Macro Economics and Distinguish
between Micro and Macro Economics?

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2

BASIC CONCEPTS IN MICROECONOMICS

Unit Structure :

2.0 Objectives
2.1 Introduction
2.2 Meaning of Ceteris Paribus
2.3 Concept of Partial Equilibrium
2.4 Concept of General Equilibrium
2.5 Positive Economics
2.6 Normative Economics
2.7 Summary
2.8 Questions

2.0 OBJECTIVES


 To Understand the assumption of Ceteris paribus in Micro
Economics
 To Know the nature of Partial & General Equilibrium
 To Study the concept of Positive & Normative economics.

2.1 INTRODUCTION

Ceteris paribus or caeteris paribus is a Latin phrase,
literally translated as "with other things the same," or "all other
things being equal or held constant." It is an example of
an ablative absolute and is commonly rendered in English as "all
other things being equal." A prediction, or a statement
about causal or logical connections between two states of affairs, is
qualified by ceteris paribus in order to acknowledge, and to rule out,
the possibility of other factors that could override the relationship
between the antecedent and the consequent.

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2.2 CONCEPT OF CETERIS PARIBUS
A ceteris paribus assumption is often fundamental to
the predictive purpose of scientific inquiry. In order to formulate
scientific laws, it is usually necessary to rule out factors which
interfere with examining a specific causal relationship. Under
scientific experiments, the ceteris paribus assumption is realized
when a scientist controls for all of the independent variables other
than the one under study, so that the effect of a single independent
variable on the dependent variable can be isolated. By holding all
the other relevant factors constant, a scientist is able to focus on
the unique effects of a given factor in a complex causal situation.

Such assumptions are also relevant to the
descriptive purpose of modeling a theory. In such circumstances,
analysts such as physicists, economists, and behavioral
psychologists apply simplifying assumptions in order to devise or
explain an analytical framework that does not necessarily prove
cause and effect but is still useful for describing fundamental
concepts within a realm of inquiry.

In Economics this phrase is used quite often to assume all
other factors to remain the same, while analysing the relationship
between any two variables. This assumption eliminates the
influence of other factors which may negativate the efforts to
establish a scientific statement regarding the behaviour of
economic variables. e.g. If we try to establish the relationship
between demand and price, there may be other variables which
may also influence demand besides price. The influence of the
other factors may invalidate the hypotheses that quantity
demanded of a commodity is inversely related to its price. If rise in
price takes place along with an increase in income or a change in
fashion, then the effect of price change may not be the same. A
change in fashion may in fact raise the demand, despite the rise in
price. Thus, we try to eliminate the disturbing influences of other
variables by assuming them to remain constant.

2.2.1 Merits of ‘Ceteris Paribus’
i) This assumption helps us in making predictions about the
future.
ii) The assumption makes the analysis simple and easy.
iii) It is applicable to solution of practical problems in the real
world.
iv) Such an assumption is very useful in analysis of behaviour of a
firm or a consumer or a factor of production.
v) It is easy to collect data when the field of inquiry is restricted by
this assumption.

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2.2.2 Limitations of ‘Ceteris Paribus’

i) Ceteris Paribus neglects the interdependence between the forces
and makes the analysis over-simplified.
ii) The assumption makes the analysis unrealistic. In the real world
‘Other things never remain constant.’ Everything is always
changing.
iii) This assumption makes the principles and theories restrictive in
nature. Therefore the analysis has limited applicability.
iv) The analysis is made static and less relevant to real world
situation.
v) Ceteris Paribus’ makes the explanation incomplete because it
analyses the functional relation between a few selected
variables and neglects others.

However, once we understand the functional relation and
sequences between different variables and events with the ‘Ceteris
Paribus’ we can gradually release the forces one by one and
analyse more and more complicated realities. ‘Ceteris Paribus’ is
therefore a tool for model building.

‘Ceteris Paribus’ is an assumption which we are compelled
to make due to complexities in the real world. It is necessary for the
sake of convenience. The limitations of human intelligence and
capacity compel us to make this assumption. Moreover, without this
assumption we cannot make a detailed study of economic events
and economic relations and sequences.

Without ‘Ceteris Paribus’ condition we may not be able to
isolate causal relationships between the variables that we intend to
study and arrive at logical conclusions. However, in reality there are
large number of variables interacting simultaneously at a given
time. If our analysis has to be accurate we may have to examine
two variables at a time which makes it inevitable to assume other
variables to remain constant.

Moreover, as a social science we deal with human behavior
which is subject to variations. At no cost we can expect people to
behave in the same manner at all time. This does not imply any sort
of irrationality on the part of people. Likewise assuming ceteris
paribus condition does not reduce the validity of the theory. If any
conclusion regarding human behaviour is drawn with ‘ceteris
paribus’ condition it does not invalidate its practicality. In fact, even
scientists take the help of ceteris paribus condition. e.g. when
gravitational force is calculated, the scientist would make
allowances for air and wind force to be at a constant rate. Thus
ceteris-paribus is not peculiar to Economic analysis alone.

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2.3 PARTIAL AND GENERAL EQUILIBRIUM

2.3.1 Meaning and Definitions of Equilibrium
Concept of equilibrium, which forms the basis of various
theories in different economic activities, is borrowed from Physics.
Unlike its meaning in Physics i.e. an absence of activity, m
economic sense it implies absence of tendency or urge to change.
It thus means a state of balance.

“Equilibrium is a position from which there is no tendency to
‘move”. - Prof. Stigler
“Equilibrium denotes absence of change in the movement
and not the absence of movement itself’. - Prof. J.K. Mehta

“A market or an economy or any other group of persons and
firms is in equilibrium, when none of its members feels impelled to
change his behaviour”. — Scitovsky

All the above definitions bring home the point that
equilibrium in economic sense implies a position of rest. It does not
imply absence of movement but suggests absence of change in the
movement. Number of examples of equilibrium can be mentioned
e.g. a firm is in equilibrium when it is maximising its profits; the
consumer is in equilibrium when he maximises his level of
satisfaction, within given constraints of his income and prices.

2.3.2 Types of Equilibrium
1. Stable — Unstable - Neutral Equilibrium
2. Static and Dynamic Equilibrium
3. Single and Multiple Equilibrium
4. Short Term and Long Term Equilibrium
5. Partial and General Equilibrium.

All these varieties are important in their own ways. However
the concepts of Partial and General Equilibrium are of particular
significance. Hence we shall concentrate on them here,.

2.3.3 PARTIAL EQUILIBRIUM
Partial Equilibrium analyses the position of rest i.e.
equilibrium of an individual unit such as a consumer, a firm, an
industry etc. It is thus a microeconomic concept. In order to analyze
the position of equilibrium of an individual unit, it becomes
necessary to assume that all other variables are constant. Thus if
we intend to establish the conditions of equilibrium of an individual
consumer, we have to ignore (assume to be constant) other forces
that affect the behaviour of the said individual. Hence we ignore the
changes in tastes and preferences of consumers, prices of other
goods etc. while discussing the individual equilibrium.

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“A partial equilibrium is one which is based on only restricted
range of data, a standard example is price of a single product;
the prices of all other products being held fixed during the
analysis’. It assumes ‘Ceteris Paribus’. Prof. Stigler

In short Partial Equilibrium implies:
• Equilibrium of an individual or a single unit
• It isolates an individual unit from others
• It ignores the independence and hence is based on independence
of individual units.
• It excludes other variables and relies on a restricted data.
• It assumes, ’Other things remaining the same’.

Subject Matter of Partial Equilibrium:
As mentioned above partial equilibrium explains how an
individual consumption or production unit attains the position of
equilibrium. Naturally, it deals with issues such as the following:

Equilibrium of Consumer : On the basis of income, prices and
preferences of individual it determines the manner in which a
consumer derives maximum satisfaction i.e. equilibrium.

Equilibrium of a firm : This implies determination of level of output
that yields maximum profit. It reached when MR = MC. The position
is arrived at on the basis of cost behaviour, prices, technique of
production etc.

Industry Equilibrium : It occurs when number of firms in the
industry remains constant i.e. there is neither entry nor exit of firms.
This happens when all firms enjoy only normal profit i.e. AR = AC.

Factor Market : An individual factor reaches the position of
equilibrium when it receives highest possible reward. Since the
alternative reward is less he sticks to that employment.

2.3.4 Assumptions of Partial Equilibrium:
The Partial equilibrium isolates an individual unit from other
influences. Naturally, it has to make a variety of assumptions many
of which may be quite unrealistic.

Following are assumed to exist.
1. Constancy of price of the product and income, habits etc. of
consumer.
2. Prices of other goods are constant. For a firm prices and
availability of resources is given and constant.
3. Perfect factor mobility.
4. Existence of perfect competition etc.

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2.3.5 Limitations of Partial Equilibrium
1. Narrow approach.
2. Limited applicability due to restrictive assumptions.
3. Neglect of interdependence among unit.
4. Inadequate
5. Inability to explain interdependence among units.

2.3.6 Significance of Partial Equilibrium

Although Partial equilibrium approach is exposed to number
of limitations. Yet it has a considerable practical and theoretical
significance.

1. Explanation of determination in product and factor prices.
2. Analysis of change in individual unit.
3. Explanation of consequences of change in behaviour of single
unit
4. Description of effect of policy changes.
5. Help in solving economic problem.
6. Simplification of important issues.
7. Foundation of understanding interdependence.
8. Assistance in general equilibrium analysis.

2.4 GENERAL EQUILIBRIUM

“Theory of general equilibrium is the theory of inter
relationship among all parts of economy.”‘ - Prof. Stigler

Above definition is self explanatory and fully reveals the
meaning and nature of general equilibrium. It is obvious that this
approach concentrates on the entire economy i.e. whole as against
partial equilibrium analysis which deals with ‘a part’ or an individual
unit. It is a macro approach undertaking extensive and
comprehensive study of the different variables, their interrelations
and inter-dependence, etc. It primarily tries to arrive at equilibrium
of the entire system. A general equilibrium occurs when every
individual unit attains equilibrium simultaneously. Thus what
general equilibrium does is to bring out the link between different
individual units in a system.

2.4.1 Subject Matter of General Equilibrium:
Since general equilibrium deals with the whole economy it
has to explain how total demand and total supply are brought into
equality both in the factor and product markets. This implies an in
depth study of the factors forming total demand (Buyers) and total
supply (Sellers) in both product as well as factor markets. The state
of general equilibrium will be reached when the decisions of buyers
and sellers regarding demand and supply in product and factor

18

markets are in harmony.. Taking into account all these facts we can
mention the subject matter of general equilibrium in the following
manner.

Total Demand for product : Tastes, preferences, prices of
complimentary and substitute products income i.e. rewards in factor
market, etc.

Total Supply of product : Cost of different products, upon the
reward of factors and their quantity prices of commodities in the
product market, of production etc.

Total Demand for factor: Input productivity, the rewards of
factors, quality and quantity of different factors of production etc.

Total Supply of factor : Rewards, availability, willingness to work,
size and composition of population policy implications etc.

It is obvious that since general equilibrium approach deals
with entire system in the context of equilibrium in product and factor
markets, it has to properly analyze the interdependence among all
the four aspects mentioned above. Study of consequences of
change in one of the constituents on the different macro variables is
also to be made.

It can be observed that in any market the general equilibrium
occurs at equality between total demand and total supply. In the
product market the consumers are on demand side and the firms
on the supply. In the factor market these roles are reversed. Two
sets of conditions have to be fulfilled to achieve general equilibrium.

1. Subjective factors : Maximization of gains (satisfaction/profits)
by each individual unit.

2. Objective factors : Demand — Supply equality in all markets.

Walras points out that : “General equilibrium occurs through
the mutual interdependence between different markets and their
constituents”. In his opinion, the trade in perfectly competitive
market is similar to auction. The prices are raised when demand
exceeds supply and lowered in the opposite situation. Raising and
lowering continues till demand and supply become equal when we
have the position of equilibrium.

2.4.2 Assumptions of General Equilibrium
Following are the basic assumptions of general equilibrium
analysis.
1. Existence of perfect competition in product and factor
markets.

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2. Perfect factor mobility
3. Identical cost conditions for all firms.
4. Homogeneity of productive resources.
5. Given and constant state of technology
6. Full employment of resources.
7. Constant Returns to scale.

Not all assumptions are true but are essential as they provide the
framework for general equilibrium analysis.

2.4.3 Limitations of General Equilibrium

1. Unrealistic Assumptions of this approach weaken its
importance. The assumptions like perfect competition, full
employment, perfect mobility etc. can hardly be experienced in
practice.

2. Neglect of changing conditions is yet another defect of this
approach. It assumes the constancy of most of the variables which
in reality are frequently changing. Such a static model cannot
effectively analyse the real dynamic scenerio. It is aptly remarked,
“Since the given Wairasian conditions are continuously changing,
the movement towards general equilibrium is ever thwarted and its
attainment has ever remained wishful ideal’.

3. Limited Validity is the fate of Walrasian general equilibrium
model. They are applicable only when conditions are fulfilled i.e.
assumptions are valid. This is true only in restricted situations. The
validity depends upon proper solutions to various simultaneous
equations.

2.4.4 Significance of General Equilibrium

The general equilibrium model of Walras has great utility in
enhancing our understanding of the functioning of the whole system
and in solving various problems faced by the entire economy. It
rightly reveals the fact of inter-dependence between individual units
and highlights the dangers in isolating them. The practical
importance of this approach can be explained with reference to
following

1. It provides a wide and comprehensive explanation of the
inevitable mutual interdependence in a free enterprise economy.
2. This approach provides a thorough explanation of the functioning
of the entire economy.
3. General equilibrium analysis simplifies the market complexities
by revealing the inter-relations between individual units.

20

4. The approach clearly explains the role and functions of the
market mechanism and reveals how economic decisions are
arrived at.
5. The Input-Output analysis of Prof. Leontif is developed on the
basis of general equilibrium analysis.
6. The Walrasian model provides the starting point for almost all
economic theories. In almost every field of economic enquiry
such as money, trade, welfare etc. the approach proves very
useful.

In brief General equilibrium model of Prof. Walras is useful in
understanding the real issues of the economy as a whole.

Thus Partial Equilibrium approach is based on the
assumption, ‘other things remaining the same”. i.e. ‘ceteris paribus’:
whereas the General Equilibrium approach assumes ‘everything
depends on everything else”. Both the approaches, as we have
seen, have their respective limitations and significance.

1. What do you understand by Ceteris Paribus assumption?
2. Distinguish between Partial Equilibrium approach and
General Equilibrium Approach.

2.5 POSITIVE ECONOMICS

Positive economics is the study of what and why an
economy operates as it does. It is also known as Descriptive
economics and is based on facts which can be subjected
to scientific analysis in order for them to be accepted.

It is based on factual information and uses statistical data,
and scientific formula in determining how an economy should be. It
deals with the relationship between cause and effect and can be
tested.

Positive economic statements are always based on what is
actually going on in the economy and they can either be accepted
or rejected depending on the facts presented.

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2.6 NORMATIVE ECONOMICS

Normative economics is the study of how the economy
should be. It is also known as Policy economics wherein normative
statements like opinions and judgments are used. It determines the
ideal economy by discussion of ideas and judgments.

In normative economics, people state their opinions and
judgments without considering the facts. They make distinctions
between good and bad policies and the right and wrong courses of
action by using their judgments.

Normative economic statements cannot be tested and
proved right or wrong through direct experience or observation
because they are based on an individual’s opinion.

Although these two are distinct from each other, they
complement each other because one must first know about
economic facts before he can pass judgment or opinion on whether
an economic policy is good or bad.

2.7 SUMMARY

1. Positive economics deals with what is while normative
economics deals with what should be.
2. Positive economics deals with facts while normative economics
deals with opinions on what a desirable economy should be.
3. Positive economics is also called descriptive economics while
normative economics is called policy economics.
4. Positive economic statements can be tested using scientific
methods while normative economics cannot be tested.

2.8 QUESTIONS

1. Explain the concept of ‘ Ceteris Paribus’ in detail. Mention its
assumption and importance in economics.
2. What do you mean by Partial Equilibrium? What is the subject
matter of partial equilibrium?
3. Explain the importance of Partial equilibrium?
4. Explain the concept of General equilibrium? Discuss its
assumptions & limitations?
5. Explain the importance of General equilibrium?
6. Distinguish between Positive and Normative economics.



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3
MANAGERIAL ECONOMICS & BASIC
TOOLS OF ECONOMIC ANALYSIS

Unit Structure :

3.0 Objectives
3.1 Introduction
3.2 Meaning of Managerial Economics
3.3 Scope of managerial economics
3.4 Importance of managerial economics
3.5 Stages of Developing Economics as a Subject
3.6 Basic tools of economic analysis
3.7 Questions

3.0 OBJECTIVES


 To Understand the concept of Managerial Economics
 To Know the nature & scope of managerial economics
 To Study the Importance of managerial economics
 To Study the basic tools of economic analysis

3.1 INTRODUCTION

The discipline of managerial economics deals with aspects
of economics and tools of analysis, which are employed by
business enterprises for decision-making. Business and industrial
enterprises have to undertake varied decisions that entail
managerial issues and decisions. Decision-making can be
delineated as a process where a particular course of action is
chosen from a number of alternatives. This demands an unclouded
perception of the technical and environmental conditions, which are
integral to decision making. The decision maker must possess a
thorough knowledge of aspects of economic theory and its tools of
analysis. The basic concepts of decision-making theory have been
culled from microeconomic theory and have been furnished with
new tools of analysis. Statistical methods, for example, are pivotal

23

in estimating current and future demand for products. The methods
of operations research and programming proffer scientific criteria
for maximising profit, minimising cost and determining a viable
combination of products. 4 Decision-making theory and game
theory, which recognise the conditions of uncertainty and imperfect
knowledge under which business managers operate, have
contributed to systematic methods of assessing investment
opportunities.

Almost any business decision can be analysed with
managerial economics techniques. However, the most frequent
applications of these techniques are as follows:

• Risk analysis: Various models are used to quantify risk and
asymmetric information and to employ them in decision rules to
manage risk.

• Production analysis: Microeconomic techniques are used to
analyse production efficiency, optimum factor allocation, costs and
economies of scale. They are also utilised to estimate the firm's
cost function.

• Pricing analysis: Microeconomic techniques are employed to
examine various pricing decisions. This involves transfer pricing,
joint product pricing, price discrimination, price elasticity estimations
and choice of the optimal pricing method.

• Capital budgeting: Investment theory is used to scrutinise a
firm's capital purchasing decisions.

3.2 MEANING OF MANAGERIAL ECONOMICS

Managerial economics, used synonymously with business
economics, is a branch of economics that deals with the application
of microeconomic analysis to decision-making techniques of
businesses and management units. It acts as the via media
between economic theory and pragmatic economics. Managerial
economics bridges the gap between 'theoria' and 'pracis'. The
tenets of managerial economics have been derived from
quantitative techniques such as regression analysis, correlation and
Lagrangian calculus (linear). An omniscient and unifying theme
found in managerial economics is the attempt to achieve optimal
results from business decisions, while taking into account the firm's
objectives, constraints imposed by scarcity and so on. A paradigm
of such optmisation is the use of operations research and
programming.

24

Managerial economics is thereby a study of application of
managerial skills in economics. It helps in anticipating, determining
and resolving potential problems or obstacles. These problems may
pertain to costs, prices, forecasting future market, human resource
management, profits and so on.

3.2.1 DEFINITIONS OF MANAGERIAL ECONOMICS
McGutgan and Moyer: “Managerial economics is the
application of economic theory and methodology to decision-
making problems faced by both public and private
institutions”.

McNair and Meriam: “Managerial economics consists of the use of
economic modes of thought to analyse business situations”.

Spencer and Siegelman: Managerial economics is “the
integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning
by management”.

Haynes, Mote and Paul: “Managerial economics refers to
those aspects of economics and its tools of analysis most relevant
to the firm’s decision-making process”.

By definition, therefore, its scope does not extend to
macroeconomic theory and the economics of public policy, an
understanding of which is also essential for the manager.

Managerial economics studies the application of the
principles, techniques and concepts of economics to managerial
problems of business and industrial enterprises. The term is used
interchangeably with business economics, microeconomics,
economics of enterprise, applied economics, managerial analysis
and so on. Managerial economics lies at the junction of economics
and business management and traverses the hiatus between the
two disciplines.

3.2.2 CHARACTERISTICS OF MANAGERIAL ECONOMICS

1. Microeconomics: It studies the problems and principles of an
individual business firm or an individual industry. It aids the
management in forecasting and evaluating the trends of the market.

2. Normative economics: It is concerned with varied corrective
measures that a management undertakes under various
circumstances. It deals with goal determination, goal development
and achievement of these goals. Future planning, policy-making,
decision-making and optimal utilisation of available resources,
come under the banner of managerial economics.

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3. Pragmatic: Managerial economics is pragmatic. In pure micro-
economic theory, analysis is performed, based on certain
exceptions, which are far from reality. However, in managerial
economics, managerial issues are resolved daily and difficult issues
of economic theory are kept at bay.
4. Uses theory of firm: Managerial economics employs economic
concepts and principles, which are known as the theory of Firm or
'Economics of the Firm'. Thus, its scope is narrower than that of
pure economic theory.
5. Takes the help of macroeconomics: Managerial economics
incorporates certain aspects of macroeconomic theory. These are
essential to comprehending the circumstances and environments
that envelop the working conditions of an individual firm or an
industry. Knowledge of macroeconomic issues such as business
cycles, taxation policies, industrial policy of the government, price
and distribution policies, wage policies and antimonopoly policies
and so on, is integral to the successful functioning of a business
enterprise.
6. Aims at helping the management: Managerial economics
aims at supporting the management in taking corrective decisions
and charting plans and policies for future.
7. A scientific art: Science is a system of rules and principles
engendered for attaining given ends. Scientific methods have been
credited as the optimal path to achieving one's goals. Managerial
economics has been is also called a scientific art because it helps
the management in the best and efficient utilisation of scarce
economic resources. It considers production costs, demand, price,
profit, risk etc. It assists the management in singling out the most
feasible alternative. Managerial economics facilitates good and
result oriented decisions under conditions of uncertainty.
8. Prescriptive rather than descriptive: Managerial economics is
a normative and applied discipline. It suggests the application of
economic principles with regard to policy formulation, decision-
making and future planning. It not only describes the goals of an
organisation but also prescribes the means of achieving these
goals.

3.3 SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics includes following subjects:
1. Theory of demand
2. Theory of production
3. Theory of exchange or price theory
4. Theory of profit
5. Theory of capital and investment

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3.4 IMPORTANCE OF MANAGERIAL ECONOMICS

Business and industrial enterprises aim at earning maximum
proceeds. In order to achieve this objective, a managerial executive
has to take recourse in decision-making, which is the process of
selecting a specified course of action from a number of alternatives.
A sound decision requires fair knowledge of the aspects of
economic theory and the tools of economic analysis, which are
directly involved in the process of decision-making. Since
managerial economics is concerned with such aspects and tools of
analysis, it is pertinent to the decision-making process.

Spencer and Siegelman have described the importance of
managerial economics in a business and industrial enterprise as
follows:

1. Accommodating traditional theoretical concepts to the
actual business behaviour and conditions: Managerial
economics amalgamates tools, techniques, models and theories of
traditional economics with actual business practices and with the
environment in which a firm has to operate. According to Edwin
Mansfield, “Managerial Economics attempts to bridge the gap
between purely analytical problems that intrigue many economic
theories and the problems of policies that management must face”.

2. Estimating economic relationships: Managerial economics
estimates economic relationships between different business
factors such as income, elasticity of demand, cost volume, profit
analysis etc.

3. Predicting relevant economic quantities: Managerial
economics assists the management in predicting various economic
quantities such as cost, profit, demand, capital, production, price
etc. As a business manager has to function in an environment of
uncertainty, it is imperative to anticipate the future working
environment in terms of the said quantities.

4. Understanding significant external forces: The management
has to identify all the important factors that influence a firm. These
factors can broadly be divided into two categories. Managerial
economics plays an important role by assisting management in
understanding these factors.

• External factors: A firm cannot exercise any control over these
factors. The plans, policies and programmes of the firm should be
formulated in the light of these factors. Significant external factors
impinging on the decision-making process of a firm are economic
system of the country, business cycles, fluctuations in national

27

income and national production, industrial policy of the government,
trade and fiscal policy of the government, taxation policy, licensing
policy, trends in foreign trade of the country, general industrial
relation in the country and so on.

• Internal factors: These factors fall under the control of a firm.
These factors are associated with business operation. Knowledge
of these factors aids the management in making sound business
decisions.

5. Basis of business policies: Managerial economics is the
founding principle of business policies. Business policies are
prepared based on studies and findings of managerial economics,
which cautions the management against potential upheavals in
national as well as international economy.

Thus, managerial economics is helpful to the management in
its decision-making process.

1. What are the characteristics of managerial economics?
2. Name the subjects included in managerial economics.

3.5 STAGES OF DEVELOPING ECONOMICS AS A
SUBJECT

Economics as a subject has developed in the following stages :
1. Wealth concept
2. Welfare concept
3. Scarcity concept
4. Development concept

3.5.1. Wealth Concept
During the eighteenth and the early part of nineteenth
century, classical economists, such as Adam Smith, J.B. Say and
Walkar defined Economics as the science of wealth. Adam Smith
systematised the concept in the form the book which was entitled
as ‘‘An enquiry into the nature and cause of the wealth of nations.’’
These economists stated that Economics is related to and
concerned with wealth.

28

Excessive emphasis on wealth enabled the businessmen
and industrialists to amass wealth by any means, whether fair or
foul. Social reformers like Thomas, Carlyle, John Ruskin, Charles
Dickens and William Morris reacted sharply to the wealth concept
of Economics. They branded Economics as a dismal science,
gospel of Mammon and science of bread and butter etc. Wealth
concept of Economics was bitterly criticized, because it assumed
wealth as an end of human activities. If it is accepted in life, there
will be no place for love, affection, sympathy and patriotism.
Absence of these values will make our real life a hell.

3.5.2 Welfare Concept
According to this concept, Economics is not the science of
wealth but it is concerned with human welfare. It studies and
emphasizes wealth as a means of satisfying human wants, not as
an end of human activities. Marshall was the pioneer of welfare
thought. According to him, ‘‘Political Economy or Economics is the
study of mankind in the ordinary business of life..... Thus it is on the
one side a study of wealth and on the other, and more important
side a part of the study of man.’’ The important features of this
welfare concept are as under :

(i) Economics is the science of human welfare.
(ii) Economics is the study of mankind in the ordinary business of
life.
(iii) Economics is a social science.
(iv) Economics is the study of only economic activities.

Welfare concept was also criticized by the pioneers of
‘Scarcity Concept’. According to these economists, it will be an
injustice to the subject, if it is restricted to ordinary business of life,
concerned with economic activities and related to human welfare
only.

3.5.3 Scarcity Concept
The profounder of this concept was ‘Lionel Robbins’.
According to him, ‘‘Economics is the science, which studies human
behaviour as a relationship between ends and scarce means which
have alternative uses.’’ The important features of this concept are :

(i) Economics is a positive science.
(ii) Economics is the study of human behaviour.
(iii)Our wants are unlimited.
(iv) Our resources are limited/scarce.
(v) Resources can be put to alternative uses.
According to this approach certain universal truth are
regarded as the basis of economic problems. Every individual and
economy has unlimited wants and scarce means to satisfy these
wants. Inability to satisfy unlimited wants with limited resources

29

creates the problems of choice making i.e., fixing priority of wants
to be satisfied. As resources can be put to alternative uses, we will
have to take decision as to which specific want should be satisfied
with particular means. In this way, choice making or decision
making is the means of tackling all these economic problems.

3.5.4 Development Concept
Scarcity concept explains the presence of economic
problems. It is concerned with the positive aspect of the subject.
Modern economists feel that economist should also suggest, how
the scarce means should be further increased to satisfy more wants
and attain good living. The profounder of this concept is Professor
Samuelson, who presented the growth-oriented definition of
Economics. According to him, ‘‘Economics is the study of how man
and society choose, with or without the use of money to employ
scarce productive resources, which could have alternative uses, to
produce various commodities over time and distribute them for
consumption now and in the future among various people and
groups of society. The important features of this concept may be
summarized as under :

(i) Problem of choice making arises due to unlimited wants and
scarce means. We have to decide which wants are to be satisfied
and which of them are to be deferred.

(ii) Wants have tendency to increase in the modern dynamic
economic system, so the available resources should be judiciously
used. Best possible efforts should also be made to increase the
resources, so that increasing wants can be satisfied.

(iii) Economics is not concerned with the identification of economic
problems but it should also suggest ways and means to solve the
problems of unemployment, production, inflation etc.

(iv) Economists should also suggest how the resources of the
economy should be distributed among various individuals and
groups.

(v) Economists should also point out the plus and minus points of
different economic systems.

3.6 BASIC TOOLS OF ECONOMICS ANALYSIS

Economic theories are formulated to explain different
phenomenon. They try to explain the relationship between two or
more variables. While formulating theories a number of tools are
used by experts in this field. The tools of economic analysis are
found in the realm of Mathematics. Mathematics is being profusely

30

used in modern economic analysis. Mathematics is regarded as
the second language for the students of economics. Geometry is
being increasingly resorted to in order to provide pictorial
presentation of economic behavior. Diagrams and Graphs provide
visual impact and help to grasp and learn economics with interest
and ease. A Chinese proverb says “A picture is worth a thousand
words”.

Modern economists have turned to Calculus, Matrix, Algebra
and Derivatives to use them as fundamental tools to express
complicated aspects of economic theories and models more
precisely and accurately. All these applications of mathematics are
significant as a tools and techniques to impart conciseness,
precision and rigour to economic analysis.

In brief, get acquainted with the terms such as Variables,
Ceteris Paribus, Functions, Equations, Identities, Graphs and
Diagrams, Lines and Curves, Slopes, Limits and Derivatives, Time
Series and so on. These are the basic tools of economic analysis.

3.6.1 VARIABLES
Variables play an important role in economic theories and
models. A variable is a magnitude of interest can be defined and
measured. In other words a variable is something whose magnitude
can change. It assumes different values at different times or places.
Variables that are used in economics are income, expenditure,
saving, interest, profit, investment, consumption, imports, exports,
cost and so on. It is represented by a symbol.
Variables can be endogenous and exogenous. An
endogenous variable is a variable that is explained within a theory.
An exogenous variable influences endogenous variables, but the
exogenous variable itself is determined by factors outside the
theory.

3.6.2 CETERIS PARIBUS
Ceteris paribus is a Latin phrase meanings, “all other things
remaining the same” or all relevant factors being equal. In
Economics the term “Ceteris Paribus” is used quite often to assume
all other factors to remain the same, while analyzing the
relationship between any two variables.
Ceteris Paribus is an assumption which we are compelled to
make due to complexities in the reality. It is necessary for the sake
of convenience. The limitations of human intelligence and capacity
compel us to make this assumption. Besides, without the
assumption we cannot reach on economic relations, sequences
and conclusions. In fact, there are large number of variables
interacting simultaneously at a given time. If our analysis has to be

31

accurate we may have to examine two variables at a time which
makes it inevitable to assume other variables to remain unchanged.

For instance, if we try to establish the relationship between
demand and price, there may be other variables which may also
influence demand besides price. The influence of other factors may
invalidate the hypothesis that quantity demanded of a commodity is
inversely related to its price. If rise in price takes place along with
an increasing in income or a change technology, then the effect of
price change may not be the same. However, we try to eliminate
the interrupting influences of other variables by assuming them to
remain unchanged.

The assumption of Ceteris Paribus thus eliminates the
influence of other factors which may get in the way of establishing a
scientific statement regarding the behavior of economic variables.
Ceteris Paribus is an assumption which we are compelled to make
due to complexities in the reality. It is necessary for the sake of
convenience. The limitations of human intelligence and capacity
compel us to make this assumption. Besides, without the
assumption we cannot reach on economic relations, sequences
and conclusions. In fact, there are large number of variables
interacting simultaneously at a given time. If our analysis has to be
accurate we may have to examine two variables at a time which
makes it inevitable to assume other variables to remain unchanged.

3.6.3 FUNCTION
A 'function' explains the relationship between two or more
economic variables. A simple technical term is used to analyze and
symbolizes a relationship between variables. It is called a function.
It indicates how the value of dependent variable depends on the
value of independent or other variables. It also explains how the
value of one variable can be found by specifying the value of other
variable.

For instance, economist generally links demand for good
depends upon its price. It is expressed as D = f (P). Where D =
Demand, P = Price and f = Functional relationship.

Functions are classifieds into two type namely explicit
function and implicit function. Explicit function is one in which the
value of one variable depends on the other in a definite form. For
instance, the relationships between demand and price Implicit
function is one in which the variables are interdependent.

3.6.4 EQUATIONS
Economic theory is a verbal expression of the functional
relationships between economic variables. When the verbal
expressions are transformed into algebraic form we get Equations.

32

The term equation is a statement of equality of two expressions or
variables. The two expressions of an equation are called the sides
of the equation. Equations are used to calculate the value of an
unknown variable. An equation specifies the relationship between
the dependent and independent variables. Each equation is a
concise statement of a particular relation.

For example, the functional relationship between
consumption (C) and income (Y) can take different forms. The most
simple equation; C = a (Y) states that consumption (C) is related to
income (Y). It says nothing about the form that this relation takes.

Here ‘a’ is constant and it has a value greater than zero but
less than one (0<a<1). Thus the equation shows that C is a
constant proportion of income. For instance, if ‘a’ is 1/2then the
consumer would always spend 50% of the income on consumption.
The equation shows that if income is zero, consumption will also be
zero.

C = a + b Y is yet another form of consumption function. Here value
of a is positive and b is 0<b<1.

3.6.5 IDENTITIES
An identity explains an equilibrium condition or a definitional
condition. A definitional identity explains that two alternative
expressions have exactly the same meaning. For example, total
profit is defined as the excess of total revenue over total cost, and
we can denote as:
π ≡ TR - TC

Where π is total profit, TR is total revenue and TC is total cost.
Similarly, saving is defined as the difference between income and
consumption expenditure and we can say;
S≡ Y-C
You are required to note that an identity is denoted by a three - bar
sign (≡).

The distinction between an identity and an equation is very
subtle and important. An identity is a relation that is true for all
values of the variables; no values can be found that will contradict
it. For instance, (x + y)2 = x2 + 2xy + y2 is an expression which is
true for any numerical value of x and y. Identities are statements
that are compatible with any state of the universe. In case of
National Income accounting we have an important identity between
National Income (Y) ≡ National Output (O) ≡ National
Expenditure (E)
Hence; Y ≡ O ≡ E
Identities are mere “truisms”, they cannot form the basis of any
theory.

33

3.6.6 GRAPHS AND DIAGRAMS
A graph or a diagram presents the relationship between two
or more sets of data or variables that are related to one another.
Graph is most commonly used tool in modern economics. Graph
depicts the functional relationship between two or more economic
variables. The use of graph provides a better understanding of the
economic generalizations. Graph presents a visual picture of an
abstract idea. Also it is useful for accuracy and precision.

Graph can be drawn only two dimensional figures on a plain
paper. It represents the values of only two variables at a time. The
common method of constructing a graph or a diagram is
described below:

A graph has a horizontal line termed as X axis and a vertical
line termed as Y axis. The point of intersection between X and Y
axis is termed as 'origin' point.

The surface is divided into four parts, each part is called a
quadrant. The four quadrants are numbered in anticlockwise
direction as depicts in following diagram.

Fig. 3.1

The first quadrant depicts the positive values of both X and
Y. It is called positive quadrant. Generally, economic theories are
deals with the positive quadrants.

At times the terms “Graph” and “Diagram” are used
interchangeably. Diagrams, like graphs, are pictorial presentations.
Diagrams may be in the form of figures such as explaining the
circular flow of national income. Graphs are quite meticulous

34

whereas diagrams can be based on abstraction. For instance, Pie
diagram is a best example of a diagram that indicates through
slicing the percentage- wise composition of a phenomenon, such
as how much percentage of national income is generated from
which sector of the economy.

3.6.7 LINES AND CURVES
The functional relationship between the variables may be
linear or non-linear. A line or a curve is nothing but the locus of
various points. A line depicts the relationship between the
variables. For example, the relationship between consumption and
income as shown in the following diagram:

Fig. 3.2

Line CC1 is a straight line and has a positive slope. It depicts that
aggregate consumption is positively related to aggregate
disposable income. It explains that, an increase in disposable
income will promote to an increase in consumption. Many
economists try to set up the relationship between economic
variables in different ways. One of the most popular and easy
method is through curves. A non linear function of graph is depicted
in terms of curve. Let us consider the following curves.

35

Fig. 3.3

In the following diagram,DD1 is a smooth downward sloping
non linear demand curve. It explains the relationship between
quantity demanded of good X at various prices. Moreover, SS1 is
an upward sloping supply curve. It is also a non-linear curve and
shows relationship between quantity supplied of good X at various
prices.

3.6.8 SLOPE
Slope is an important term in modern economic analysis.
The slope indicates change in one variable due to a change in
other variable. Slope is defined as the amount of change in the
variable measured on the vertical or Y axis per unit change in the
variable measured on the horizontal or X axis. It is expressed
as ∆Y/∆X, where delta (∆) stands for a change in the variable. The
slope of a curve is an exact numerical measure of the relationship
between the change in the variable Y to change the variable X.

Slope is also popularly termed as ‘the rise over the run’.
Here rise is the vertical distance while run is the horizontal
distance. The measurement of slope can be shown as follows:

36

Fig. 3.4

In both the diagrams (A) and (B) slope = vertical
distance/horizontal distance. i. e. CD / BC. However, in diagram
(A), slope is negative as the relationship between X and Y is
inverse. Here units of Y decrease with increase in the units of X. In
Diagram (B) the curve is slopping upwards, indicating a positive
relationship between X and Y. Here units of Y increase with
increase in the units of X.

If the curve is non-linear, then its slope changes at various
points. Slope on a non-linear curve is measured at a given point by
drawing a tangent at the given point and is then measured as the
vertical distance/horizontal distance. This is shown in the following
diagram with a non-linear curve. We measure slope at point 'a' by
drawing a tangent at point 'a'. Y1X1 is the tangent drawn at point 'a'.
Slope of the curve at point 'a' is given as 0Y1/0X1

Fig. 3.5

37

The main properties of slope are:
i) It can be numerically measured.
ii) In case of a straight line, the slope is constant through out the
curve.
iii) In case of a non-linear curve, the slope changes through out the
curve.
iv) The nature of the relationship between two variables can be
indicated with the help of slope. If the slope is negative then it
indicates inverse relationship between the two variables and if
the slope is positive, it indicates direct relationship.

3.6.9 Slope of Linear Functions
The concept of slope is important in economics because it is
used to measure the rate at which changes are taking place.
Economists often look at how things change and about how one
item changes in response to a change in another item.

It may show for example how demand changes when price
changes or how consumption changes when income changes or
how quickly sales are growing.

Slope measures the rate of change in the dependent
variable as the independent variable changes. The greater the
slope the steeper the line.

Consider the linear function:
y = a + bx
b is the slope of the line. Slope means that a unit change in x, the
independent variable will result in a change in y by the amount of b.
slope = change in y/change in x = rise/run

Slope shows both steepness and direction.
With positive slope the line moves upward when going from left to
right. With negative slope the line moves down when going from
left to right.

If two linear functions have the same slope they are parallel.

Slopes of linear functions
The slope of a linear function is the same no matter where
on the line it is measured. (This is not true for non-linear functions.)

38

Fig. 3.6

An example of the use of slope in economics
Demand might be represented by a linear demand function such as
Q(d) = a - bP
Q(d) represents the demand for a good
P represents the price of that good.

Economists might consider how sensitive demand is to a change in
price.

This is a typical downward sloping demand
curve which says that demand declines as
price rises.

This is a special case of a horizontal
demand curve which says at any price
above P* demand drops to zero. An
example might be a competitor's product
which is considered just as good.

39

This is a special case of a vertical demand
curve which says that regardless of the price
quantity demanded is the same. An example
might be medicine as long as the price does
not exceed what the consumer can afford.

Supply might be represented by a linear supply function such as
Q(s) = a + bP
Q(s) represents the supply for a good
P represents the price of that good.

Economists might consider how sensitive supply is to a change in
price.

This is a typical upward sloping supply curve which says that
supply rises as price rises

An example of the use of slope in economics
The demand for a breakfast cereal can be represented by
the following equation where p is the price per box in dollars:
d = 12,000 - 1,500 p

This means that for every increase of $1 in the price per box,
demand decreases by 1,500 boxes.

Calculating the slope of a linear function
Slope measures the rate of change in the dependent
variable as the independent variable changes. Mathematicians and
economists often use the Greek capital letter D or  as the symbol
for change. Slope shows the change in y or the change on the
vertical axis versus the change in x or the change on the horizontal
axis. It can be measured as the ratio of any two values of y versus
any two values of x.

Fig. 3.8

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Example 1
Find the slope of the line segment connecting the following points:
(1,1) and (2,4)
x1 = 1 y1 = 1
x2 = 2 y2 = 4

Example 2
(-1,-2) and (1,6)
x1 = -1 y1 = -2
x2 = 1 y2 = 6

Example 3
(-1,3) and (8,0)
x1 = -1 y1 = 3
x2 = 8 y2 = 0

3.7 QUESTIONS

1. What do you mean by Managerial Economics? Explain the
characteristics of managerial economics?
2. What are the practical significance of managerial economics?
3. Explain the various concepts in managerial economics?
4. Describe the various basic tools in economics?









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4
Module 2

CONSUMER BEHAVIOUR AND DEMAND

Unit Structure :

4.0 Objectives
4.0 Marshaallian Utility Analysis
4.2 Law of Equi-marginal utility
4.3 Elasticity of Demand and its Measurement
4.4 Determinants of Demand
4.5 Consumer’s Surplus
4.6 Summary
4.7 Questions

4.0 OBJECTIVES

 To understand the various laws of demand.
 To understand the different determinants of demand.
 To understand the different concepts of elasticity of demand,
its measurement and its practical use.
 To understand the concept of consumer’s surplus and its
uses.

4.1 MARSHALLIAN UTILITY ANALYSIS

Alfred Marshall introduced a system of defining and
measuring utility objectively. This is known as the cardinal
approach to utility. According to Marshall, ‘utility is the want
satisfying ability of a good’. Thus, when a consumer uses a good,
he derives utility. Further, it is possible to measure utility objectively
and so, we can clearly find out the satisfaction derived by the
consumption of a given commodity. Following are the main features
of the cardinal utility analysis:

a. Objective measurement of Utility: A consumer expresses the
utility derived from the use of a good in absolute numbers. Like,

42

consumption of good A gives 10 units of utility, B gives 12 units, C
gives 15 units and so on. Marshall argued that money can be used
a measure of utility. The price that a consumer is willing to pay
rather than go without buying a good is the marginal utility of that
good and hence money is the measuring rod of utility.

b. Independent Utilities: According to cardinal utility approach, the
utility that a consumer derives from a good is a function of the
quantity of that good only. In other words, utility of a good is not
linked to the quantities of other goods that the consumer
consumes. Thus, the total utility that a consumer derives from the
use of a given basket of goods is nothing else but the total of
individual utilities. Therefore, utility is “additive”.

c. Constant Marginal Utility of Money: An important assumption
of cardinal utility analysis is the assumption that the marginal utility
of money is constant. Since the marginal utility of money is
constant, it can measure the utility. This is because, for any
consumer money spent on any particular commodity will be a small
portion of his/her total expenditure. We can ignore any change in
real income due to a change in the price of any one particular
commodity.

d. Method of Introspection: The Marshallian utility analysis is
based on observing one’s own experiences and then extending the
logic to the behaviour of the consumer. The law of diminishing
marginal utility is based on this particular observation.

4.2 LAW OF EQUI-MARGINAL UTILITY

A) Law of Equi-marginal Utility:

An important step in the cardinal utility analysis is the law of
equi-marginal utility. Marshall uses this law to explain the
consumer’s equilibrium when he/she purchases more than one
commodity. For equilibrium,

MUA/PA = MUB/PB = MUm
Let the income of the consumer be Rs. 100 and the consumer
buys to goods, A and B. The prices of which are given as: Rs. 20
and Rs. 10 respectively. If the marginal utilities of these two goods
are given, we can derive the consumer equilibrium as under:

43

Units Marginal Utility of A Marginal Utility of B
1 120 90
2 100 80
3 80 70
4 40 60
5 20 50
6 15 40
7 18 30
8 20 20
9 21 10

From the above table if we compare the ratios of the marginal
utilities and the prices, we see that when the consumer buys 3 units
of A and 4 units of B, the ratios are equal (4 each) hence at this
point, (80/20) = (40/10) = 4 or MUA/PA = MUB/PB = MUm. The
consumer spends Rs. 60 on A and Rs. 40 on B. Thus, the law of
equi-marginal utility allows us to explain the consumer’s equilibrium
when he is purchasing more than one good.

B) Law of Demand and the Derivation of the Demand Curve:
Using the principle of additive utility, Marshall derived the law
of demand and the demand curve. Assuming that the income of the
consumer, his preferences and the price of one good remain the
same, we can derive that as the price of a good falls, the demand
for it will increase. When the price of good A falls, other things
being the same, the MUA/PA will be greater than MUB/PB and MUm.
In such a case, marginal utility of A must be reduced. Therefore,
the consumer has to buy more units of the good whose price has
decreased. The proportionality rule requires that as the price of a
goods falls, the quantity demanded of that good has to increase. In
figure 4.1 we show the derivation of the demand curve.

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Figure 4.1

The upper plane (Panel A) shows the equilibrium of the
consumer. Given his money income, OX is the marginal utility of
money, MUm. As the price of A falls, the MUA/PA will shift from
MUA/PA1 to MUA/PA2 and to MUA/PA3. The consumer will increase
his purchase of good A to maintain a constant marginal utility of
money. The lower panel (Panel B) shows the derivation of the
demand curve. As the price of A falls from P1 to P2 and to P3, the
consumer increases his purchases from qA1 to qA2 and qA3. Thus, a
fall in the price of a good, results in larger demand, ceteris paribus.

C) Limitations of Cardinal Utility Analysis:
Following are some of the limitations of the Marshall’s
cardinal approach to utility:

1. As utility is a psychological concept and hence subjective, it is
not possible to measure utility objectively in quantitative terms. A
consumer can only say whether the satisfaction derived from the
consumption of different goods gave more or less satisfaction and
will never be able to quantify the utility.

2. Marshall assumed that the utility is independent of the utility of
other goods consumed. However, given the money income, utility
of any one goods is linked to the utility of other goods that are used
by the consumers. Moreover, some goods are complementary
while others are substitutes. Hence, the utility derived from any one
good is invariably linked to the utility of other goods consumed.

3. The assumption of constant marginal utility of money is also not
valid. As the consumer spends money on one good, the money left
with him/her reduces. Therefore, the marginal utility of the
remaining money income increases instead of remaining constant.
Further, as the price of a good changes the real income of the
consumer also changes. With the change in real income, the
marginal utility of money also changes. This would have an effect

45

on the demand for the good that is being studied as well as on the
demand for other goods as well. Therefore, the assumption of
constant marginal utility of money is both conceptually and
practically untenable. If the marginal utility of money changes we
cannot use it to measure utility objectively.

4. The Marshallian analysis cannot explain the Giffen’s paradox.
This is a case when the price of a product falls the consumer
purchases more units of the cheaper good.

5. The cardinal utility analysis can be used only in case of a single
commodity. If there are more than one good, the consumer can
substitute his purchase of one good with that of another. In case of
more than one good the assumption of constant marginal utility of
money would be incompatible with utility analysis.

6. The most important limitation of cardinal utility analysis is its
failure to distinguish between the income and substitution effects of
a price change. When the price of a good changes, the real income
of the consumer changes. At the same time, the relative price of the
other good also changes. As a result, the consumer will change
his/her purchases of both the goods. This situation cannot be
explained using the case of single good.

Check your progress:
1. What is utility?
2. What is the law of Equi-marginal utility?

4.3 ELASTICITY OF DEMAND AND ITS
MEASUREMENT

Elasticity of demand refers to the rate of change in demand
when one of its determinants changes. Generally, since price is
considered to be the most important determinant of demand, we
use the concept of price elasticity of demand. Price elasticity of
demand is defined as ‘the proportionate change in quantity
demanded for a given proportionate change in its price’.
Alternatively, ‘it is the percentage change in quantity demanded for
a percentage change in the price of a commodity’. Symbolically:

46

q p
ep   where, p and q are price and quantity demanded
p q
respectively and ∆is the proportionate change. Elasticity of demand
helps us to see how a given change in the price of a good causes
the changes in its demand. Since we postulate a negative
relationship between the two, the elasticity has a negative sign.

Measurement of Elasticity of Demand:
We can measure the elasticity of demand using any one of
the following methods. A particular method is selected depending
upon the given situation.

II.I.E. a) Total Outlay Method: In this method we compare the total
expenditure or outlay of the consumer on a given commodity to
arrive at the elasticity of demand for that good.

If the demand for a good is elastic (ep >1), a decrease in the
price will result in demand increasing more than proportionately and
hence the total outlay on the good will increase. If the elasticity is
less than one, as price falls, the outlay on the good also falls. When
the elasticity is equal to one, the total outlay on the product remains
the same. Figure 4.2 shows the outlay method of estimating the
elasticity of demand.

Figure 4.2

In the above diagram we measure quantity demanded on the
x-axis and the price on the y-axis. DD is the demand curve. As the
price falls from OP1 to OP2, the quantity demanded increases from
OQ1 to OQ2. The total outlay in the first case is OP1AQ1. OP2BQ2 is
the outlay after the change in the price. Since elasticity is given as:
q p qp
ep   we can see that >1. Therefore, in the above case,
p q pq
using the outlay method, the elasticity of demand is greater than
one.

47

II.I.E. b) Point Method of Elasticity of Demand: In this case we take
a point on the given demand curve and measure the elasticity.

Figure 4.3

Figure 4.3 shows the use of point method of measuring elasticity. In
this figure, x-axis shows the quantity and y-axis shows the price.
DD! is the demand curve. We can see that the original price is OP
and original quantity is OQ, elasticity at point A will be equal to
q p 1 p p
ep   =  (slope is equal to ). Therefore, elasticity
p q slope q q
at A is equal to
1 OP PA OP OP
ep     
PD OQ PD OQ PD
PA
Further, in the above diagram, in a right-angled triangle ODD! PA is
OP AD! lower segment
parallel to OD!. Therefore, ep    . This
PD AD upper segment
method is also called ‘the vertical axis formula’ and is a popular
method of estimating the elasticity.

c) Arc Elasticity: This method is used to measure the elasticity of
demand along a non-linear demand curve. The method is
essentially the same as that of the point method. If we have a
demand curve, we then measure the elasticity at different points on
the demand curve. But on a non-linear demand curve the elasticity
of demand varies from point to point. Figure 4.4 shows the arc
method of measuring the elasticity.

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Figure 4.4

In the above figure, x-axis measures the quantity demanded and y-
axis measures the price. DD0 is the demand curve. To measure the
elasticity of demand at point E we draw a parallel to the demand
curve AA1. Then applying the point method, the elasticity of
EA1
demand at E is given as: . Now to measure the elasticity at
EA
point E1, we draw another parallel to the demand curve, BB1. The
E1B1
elasticity at E1 is therefore, . We can also see that in the
E1B
above case, the elasticity of demand at E is greater than at E1.
II.I.E. d) Mid-point Method: This method is used when there are
large changes in the prices and/or the quantities. We can see this
with the help of a numerical example. Let us say the price
increased from Rs. 250 to Rs. 400 and the quantity demanded fell
from 150 units to 125 units. In this case the price decreased by 60
percent and the quantity demanded fell by 16.7 percent. The
60
elasticity of demand would be measured as ep   3.59 . If we
16.7
reverse the direction of change in the price, that is price falls from
Rs. 400 to Rs. 250, the quantity demanded would increase from
125 units to 150 units. The percentage change in price would be
37.5 and for quantity it would be 20 percent. This will give us an
elasticity of 0.53. We see that for the same absolute changes in the
quantity and price we would obtain different elasticities. To solve
this problem the mid-point method is used. We write elasticity of
demand as:
q1  q 2 p1  p 2 q  p 2  p1 
ep   
q1  q 2  p 2  p1  p   q 2  q1  where, q1 and p1 are the
 
 
 
2  2 
original quantity and price, q2 and p2 are the new quantity and
price after the change in price.

49

Using the above formula, the elasticity of demand in the above
example would be:
125  150 400  250
ep    0.39 .
 125  150   400  250 
   
 2   2 

1. How will you define the elasticity of demand?
2. State the methods of measurement of elasticity of demand.

4.4 DETERMINANTS OF DEMAND

Let us now examine the various determinants of demand for
a particular good. Economists agree that while the demand for a
product is affected by a number of variables, it is possible to identify
the most important of them. Following are the determinants of
demand for a given product or good.

a) Price of the Good: Price of the given good is the most important
determinant of its demand. The economic theory postulates a
negative relationship between the price of a good and its demand.

b) Income of the Consumer: Income of the consumer has a positive
effect on the demand for a good. As income increases, the
consumer would prefer to buy larger units of a given good. Only in
case of Giffen goods, we see a negative relationship between the
income and the demand for a good.

c) Prices of Other Goods: the relationship between the demand for
a good and the prices of other goods is postulated in the following
manner: i) In case of substitutes, the relationship is positive. That
is, if we have two goods A and B, the demand for A is positively
related to the price of B and vice versa if they are substitutes. ii) In
case of complementaries, the relationship is negative. That is, if the
price of A increases, the demand for B decreases. iii) In case of
unrelated goods, the relationship is zero. In other words, changes
in the price of A will not cause any changes in the demand for B.

50

d) Tastes and Preferences: Demand for a good depends upon the
consumer’s preference for that good. If consumer prefers to buy
more units, the demand will be higher for at a given price.

e) Size of the Population: Demand for an given good is determined
by the number of consumers in the market. Larger the number of
consumers, higher would be the demand for a given good.

f) Expected Prices: It is important to note that not only the current
price, but the expected future price will also determine the demand
for a given good. If the consumer expects the future price to fall,
he/she would prefer to postpone the purchase of the good and wait
for the price to fall. Similarly, if the future price is expected to rise,
the consumer would buy larger units presently.

g) Advertising: It is possible to influence the demand for a product
by advertising about it in different media like new papers, radio and
TV. As a firm advertises its products, consumers will be attracted to
it and demand would increase.

Demand Function:
A demand function is a mathematical expression of the
determinants of demand for a product. We write this symbolically
as,
Di = f (Pi,Y,Pr,T,N,Pe,A)
where Di = Demand for a given good, i,
Pi = price of the given good,
Y = income of the consumer,
P r = prices of related goods,
T = tastes and preferences of the consumer,
N = number of consumers
Pe = expected price of the good,
A = advertising.

While estimating the above equation, we test whether the
observed relationship is according to the theory or not.

Concepts of Elasticity of Demand:
Economic theory uses different concepts of elasticity. In
other words, these are the relationship between the changes in the
determinants and demand and the corresponding changes in the
demand for a given good. We shall examine each of these
concepts.

1. Income elasticity: This refers to the ‘proportionate change in
quantity demanded for a given proportionate change in the income
of the consumer. Symbolically,
proportionate change in income y y
  
proportionate change in the quantity demanded q q

51

y and q are income and quantity demanded. ε is the income
elasticity of demand. The value of ε indicates the nature of the
product. For normal goods it is positive, indicating that as the
income of the consumer increases, he/she will increase the
purchase of the good and vice versa for a Giffen good.

2. Cross Elasticity: Indicates, as noted earlier, the relationship
between two goods. It is defined as the proportionate change in the
demand for X for a given change in the price of Y. Thus, we have:
proportionate change in quantity demanded of X X Py
  
proportionate change in the price of Y Py X
where, ∆X is change in the quantity of good X, ∆Py is the change in
price of Y, X is the original quantity of X and Py is the original price
of Y. If ξ>1 the two goods are substitutes. If it is less than one, they
are complementariness and unrelated if ξ is zero.

3. Promotional Elasticity: In modern capitalist economies,
advertising plays an important part of the strategy to increase sales.
The promotional elasticity studies the impact of advertising on the
quantity demanded. Symbolically we have,
proportionate change in quantity demanded Q A
 
proportionate change in adverti sin g exp enditure A Q
A firm will be successful in its efforts to improve sales only
when η >1.

4.5 CONSUMER’S SURPLUS

Marshall introduced the concept of consumer’s surplus to
explain the welfare aspects of pricing. It is defined as ‘the excess of
price which a consumer would be willing to pay rather than go
without a thing over that which he actually does pay is the
economic measure of this surplus satisfaction’. Since the amount of
money which the consumer is willing to pay indicates his utility, we
can use the price the consumer is ready to pay as a measure of his
surplus. Thus, we have:

Consumer’s Surplus = Σ Marginal Utility – Total Outlay. We can
show the consumer’s surplus with the help of an example.

Units of the Good 1 2 3 4 5 6 7 8 9 10
Price 30 28 25 22 19 15 12 10 8 5
Marginal Utility 50 45 40 30 20 15 8 0 -5 -10

In the above table we see that as the price falls the marginal utility
also declines. At a price of 8, the marginal utility is zero and turns
negative. At a price of 15, the marginal utility equals the price and

52

the consumer buys six units of the good. The consumer’s surplus
would be: 200 – 90 = 110.

The following figure explains the concept of consumer’s surplus.

Figure 4.5

In the above figure, x-axis shows the quantity demanded and
y-axis shows the price. DD is the demand curve. When the price is
OP, the consumer buys OQ units. The consumer is willing to pay
ODAQ and he pays only OPAQ. Therefore, ∆PDA is the
consumer’s surplus.
Merits and Demerits of Consumer’s Surplus:
1. Governments use extensive use of the concept of consumer’s in
pricing public utilities, educational and health facilities. It highlights
the significance of value-in-use rather than the value-in-exchange.

2. Firms use this concept to fix their prices. They will fix the prices
in such that a way that they can squeeze the maximum consumer’s
surplus without forcing the consumer to give up buying the product.
3. As we often see, some of the residential areas are provided with
special and exclusive access to amenities. This will add to the
consumer’s surplus of the residents of these localities. Though they
may carry higher prices, the utility of these services is higher than
the prices.
4. The concept of consumer’s surplus helps us to understand the
adverse effects of indirect taxes. Economic theory recommends the
use of direct taxes since they do not cause a direct loss of
consumer’s surplus.
5. The concept of consumer’s surplus is based on the cardinal
utility and hence all the limitations of that analysis are applicable to
this. Since utility cannot be objectively measured, we cannot talk of
measurable utility derived from the consumption of a given
commodity.

53

6. The assumption that different units of the given good provide
different amounts of satisfaction is central to this concept. However,
in reality the consumer may derive the same marginal utility from
each additional unit of the good consumed by him/her. In such a
situation it may not be possible to measure the consumer’s surplus.
7. This concept is based on the assumption that the consumer has
control on the price. However, in reality the consumer often may not
have the ability to influence the price and he/she has to buy the
given good. In such a case, we can never measure the consumer’s
surplus.
Despite its many limitations, this concept has important
implications for policy and is often used in determination of prices.
The drug pricing policy in India is one example where the
government uses this concept to protect the interests of the
consumers.


1. What is a demand function?
2. How Consumer surplus can be measured

4.6 SUMMARY

1. Cardinal utility is the measurement of utility in an objective
manner.
2. Marshall assumes the consumer of the income, tastes and
preferences and income of the consumer to be constant to
explain cardinal utility.
3. Law of equi-marginal utility requires the marginal utility of money
to be constant.
4. Law of demand states that the demand for a product is inversely
related to its price, other things being the same.
5. Cardinal utility cannot explain Giffen’s paradox.
6. In outlay method we compare the change in the consumer’s
spending on the good before and after the change in the price.

54

7. Point method measures the elasticity of demand at a particular
price.
8. Arc elasticity is useful when the demand curve is not a straight
line.
9. Mid-point method is useful when the changes in demand and
price are large.
10. Elasticity of demand measures the relationship between
changes in the price and demand of a given good.
11. Income elasticity depends upon the nature of the good.
12. Cross elasticity helps us to understand the relation between any
two goods.
13. Consumer’s surplus is the relationship between the price and
utility of a good.

4.7 QUESTIONS

1. Explain the concept of cardinal utility analysis. What are its main
limitations?
2. Explain the law of equi-marginal utility.
3. Derive the demand curve using the law of demand.
4. Explain the different determinants of demand.
5. Explain the concepts of price, income, cross and promotional
elasticity of demand.
6. Explain the concept of consumer’s surplus and its uses.




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5

INDIFFERENCE CURVE ANALYSIS

Unit Structure :

5.0 Objectives
5.1 Introduction
5.1.1 Scale of Preferences
5.1.2 Indifference Curve
5.1.3 Properties of Indifference Curves
5.1.4 Budget Line of Price Line
5.1.5 Consumer’s Equilibrium
5.2 A Income, Substitution and Price effects
5.2.1 Income Effect
5.2.2 Substitution Effect
5.2.3 Price Effect
5.3 Breaking-up of the Price Effect
5.3.1 Price Effect of a Normal Good
5.3.2 Price Effect of a Giffen Good
5.4 Derivation of the Demand Curve
5.5 The Revealed Preference Theory
5.6 Summary
5.7 Questions

5.0 OBJECTIVES

1. To understand the concept of indifference curves
2. To understand the derivation of consumer’s equilibrium
3. To understand different effects of changes in prices and income
4. To understand the derivation of the demand curve
5. To understand the concept of revealed preference

5.1 INTRODUCTION: INDIFFERENCE CURVE ANALYSIS

Sir John Hicks introduced the concept of indifference curve
analysis to explain the consumer behaviour. The starting point of

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the indifference curve analysis is the understanding that it is not
possible to objectively measure utility. Since utility depends on the
thinking of the consumer, we can only say whether the utility of the
consumer is more or less. No precise measurement of utility is
possible. This is known as the ‘ordinal utility analysis’. This analysis
is based on the premise that unlike in the Marshallian analysis, the
consumer in real life purchases two or more goods at any given
time. The indifference curves help to understand the consumer’s
equilibrium in a situation where it is not possible to objectively
measure utility. Hicks developed a few concepts to facilitate the
analysis. We shall now examine them.

5.1.1 Scale of Preferences:
A scale of preferences is a mental construct where the
consumer ranks the different combinations of two goods that give
equal level of satisfaction. The following table shows the concept of
a scale of preference.

Combination Units of Good Units of Marginal Rate of
X Good Y Substitution (MRS)
1 25 50 --
2 27 43 -7
3 29 37 -6
4 31 32 -5
5 33 28 -4

In the above table we show five different combinations of the
two goods X and Y that give equal level of satisfaction. As the
consumer moves from combination 1 to 2, he gets two extra units
of good X and is ready to give up seven units of good Y. As he
moves on to combination 3, he gets another two additional units of
X, but is ready to give up only seven units of Y. As he moves to
combination 4 he is willing to give up five units of good Y to get two
additional units of good X. In the last combination, he is willing to
sacrifice only four units of good Y to obtain two additional units of X.
In other words, when a consumer is offered equal increases in one
of the two goods, he would prefer to sacrifice lesser and lesser
units of the other good. The rate at which the consumer prefers to
substitute one good for another is known as the marginal rate of
substitution. In order to keep the level of satisfaction at the same
level, we have to have a situation where the consumer gives up
lesser additional units of one good. This is because as the units of
one good available increase the marginal utility of the other good
increases and so the consumer would not be willing to sacrifice
more units of this good. Therefore, the marginal rate of substitution
is also the ratio of the marginal utilities of the two goods.
M arg inal utility of Good X X
Symbolically MRSX,Y = 
M arg inal utility of Good Y Y

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5.1.2 Indifference Curve:
An indifference curve is a graphic representation of the scale
of preferences. Therefore, it is also the graphic representation of
the ratios of the marginal utilities of the two goods. Following the
diminishing marginal utility, the indifference curve is a downward
sloping, curve that is convex to the origin. Figure 5.1 shows an
indifference curve. We see that as the consumer moves from
combination A to B to C, his level of satisfaction remains the same
as indicated by the given indifference curve, IC0.

Figure 5.1

In the above diagram x-axis measures the units of good X
and y-axis measures the units of Y. IC0 is the indifference curve. A,
B, and C are the various points on the indifference curve each
indicating the same level of satisfaction.

5.1.3 Properties of Indifference Curves:
Let us now examine the properties of indifference curves.

Figure 5.2

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1. An Indifference Curve is Convex to the origin:
Since an indifference curve indicates the diminishing
marginal rate of substitution between the two goods, it is convex to
the origin. If it is concave to the origin as in figure 5.2 a), it indicates
increasing marginal rate of substitution. That is the consumer will
be ready to give up more and more units of one commodity in order
to get equal increases in the other good. Since this is contrary to
the law of diminishing marginal rate of substitution, an indifference
curve cannot be concave to the origin. At the same time, an
indifference curve cannot be a straight line as in figure 5.2 b). This
is because in this case the marginal rate of substitution remains the
same along the indifference curve. This is contrary to the
assumption of diminishing marginal utility. Therefore, an
indifference curve is convex to the origin.

2. Two Indifference Curves cannot intersect:
This property implies that when two indifference curves
intersect each other at that point the level of satisfaction is same
along the two indifference curves. In figure 5.3 we explain this
property.

Figure 5.3
At point E the two indifference curves IC1 and IC2 intersect.
At this point the level of satisfaction on the two indifference curves
is the same (consumer gets Ox units of X and Oy units of Y). If we
move to another point say A on IC1, the consumer has Ox1 units of
X and Oy1 units of Y. But at this point on IC2 the consumer has Oy1
units of Y and Ox2 units of X. Point to be noted is the level of
satisfaction at point A and B and E are the same following the
definition that an indifference curve indicates the same level of
satisfaction. Thus, no two indifference curves can intersect each
other.

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3. Higher indifference curve indicates higher level of
satisfaction:
Since a higher indifference curve is away from the origin, it
indicates larger units of both the goods which in turn indicate higher
levels of satisfaction. Therefore, higher indifference curve indicates
higher level of satisfaction. We show this in figure 5.4.

Figure 5.4

In the above figure, as the consumer moves from point A to
B to C along the different indifference curves, he/she obtains larger
amounts of both X and Y. Therefore, higher the indifference curve,
higher will be the level satisfaction.

5.1.4 Budget Line or Price Line:
This is the graphical representation of the various
combinations of two goods that an individual consumer can buy
with his given income at the given prices of the two goods. For
example, if the income of the consumer is 100 and price of X and Y
are 5 and 10 respectively the consumer can buy 20 units of X or 10
units of Y or any combination of in between. The budget line
indicates all these combinations. Therefore, the slope of the budget
line is the ratio of the prices of the two goods. Figure 5.5 shows the
budget line.

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Figure 5.5

In the above figure AB is the Budget line. The consumer can
buy OA units of good Y or OB units of good X. If the income of the
consumer increases and/or the prices of the goods fall the
consumer can buy larger units of the two goods. The budget line
will in that case shift outwards (A1B1). Conversely if the income falls
and/or prices increase, the budget line shifts inwards (A2B2) and the
consumer will be able to buy lesser units.

5.1.5 Consumer’s Equilibrium
Using the concepts of indifference curves and the budget
line J.R. Hicks derived the consumer’s equilibrium within the ordinal
utility framework. We make certain simplifying assumptions to
arrive at the consumer’s equilibrium:

1. The consumer is rational and tries to maximize the utility or
satisfaction.
2. The income of the consumer is given and remains the same.
3. The prices of the two goods X and Y are given and remain the
same.

Given the above assumptions, we say that the consumer
maximizes his/her satisfaction when the following conditions are
met:

a. The price ratio is equal to the marginal rate of substitution.
b. At that point the indifference curve is convex to the origin.
The first condition is known as the necessary condition and is
X P X
given as MRS X ,Y   where MRSX,Y is the marginal
Y PY
rate of substitution between X and Y, PX, and PY are the price of
X and Y respectively. This condition is known as ‘the tangency
solution’. The second condition indicates that at the point of
tangency the indifference curve is convex to the origin. We can

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X P X
write this as: MRS 
 . This condition implies that
X ,Y
Y PY
at the point of tangency the diminishing marginal rate of
substitution is in operation. As we have seen in the properties of
indifference curves, without this assumption it is not possible to
arrive at the concept of same level of satisfaction along the
indifference curve. Figure 5.6 shows the consumer’s
equilibrium.

Figure 5.6

In the above figure x-axis shows units of good X and y-axis
shows units of good Y. AB is the budget line. At point E and E1 the
budget line is tangent to the indifference curves IC0 and IC1. At E

the MRSX,Y = P X
. It satisfies the necessary condition. But at this
P Y
point the indifference curve is concave to the origin and indicates a
positive marginal rate of substitution which is incompatible with the
assumption of equal level of satisfaction. Therefore, point E is not
the equilibrium point. Only at point E1 the condition of diminishing
marginal rate of substitution is satisfied at this point. Or at E1:
X P X
  .
Y PY

1. Ordinal utility measures utility objectively. Explain
2. What is a scale of preferences?

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5.2 INCOME, SUBSTITUTION AND PRICE EFFECTS

The most important contribution of the indifference curve
analysis is in terms of its ability to distinguish between the income
and the substitution effects. When the income of a consumer
changes his/her demand will change. The changes in demand due
to changes in income it is called ‘income effect’. The real income of
the consumer also changes when the price of a good changes,
other things being the same. This change in the real income causes
changes in the demand. This is the ‘income effect’ of a price
change. At the same time, the psychology of a consumer is to
substitute the costlier good with the cheaper one. That is he/she will
buy more of the cheaper good. This is the ‘substitution effect’. We
will examine each of them.

5.2.1 Income Effect:
As noted above, if the prices of the two goods X and Y are
the same, if the money income of the consumer changes, he can
buy more of the two goods. In this case, his budget line will shift
outwards. This we have seen earlier while explaining the concept of
budget line. The income effect can be positive or negative. Positive
income effect implies that when the income of the consumer
increases, he tends to buy more of a particular good. This happens
in the case of normal goods. Negative income effect is seen when
the consumer buys lesser of the good when his/her income
increases. This happens in case of inferior goods and Giffen goods.
The income effect is based on the assumptions that the consumer
is rational and the prices of the two goods are given. Hicks
introduced the concept of the Income Consumption Curve (ICC) to
explain the nature of effect of a change in income on the demand
for a good. The ICC starts from the origin since demand is zero
when there is no income. Figure 5.7 shows the impact of a change
in income on the demand for different goods.

Figure 5.7 (a)

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Figure 5.7 (b)

In Figure 5.7 (a) we show the changes in consumer’s equilibrium
when his income increases. A0B0 is the initial budget line. The
consumer is in equilibrium at E0. As his income increases, his
budget line shifts from A0B0 to A1B1 and further to A2B2. As his
income increases, the consumer moves to E0 to E1 to E2. In this
process, his purchase of good X decreases and that of Y increases.
So good X is inferior and this is reflected in the slope of ICC which
moves away from good X. Figure 5.7 (b) shows the changes in the
consumer’s equilibrium when good X is normal and good Y is
inferior. A0B0 is the initial budget line. The consumer is in
equilibrium at E0. As his income increases, his budget line shifts
from A0B0 to A1B1 and further to A2B2. As his income increases, the
consumer moves to E0 to E1 to E2. In this process, he purchases
more units of good X and lesser units of good Y. Therefore, good X
is normal and good Y is inferior. The ICC in this case moves away
from good Y. Figure 5.8 shows the different possible combinations
of ICC depending upon the nature of the two goods.

Figure 5.8

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In the above figure the three ICCs show the nature of each of the
two goods.

5.2.2 Substitution Effect:
Hicks explained the substitution effect in terms of changes in
the money income of the consumer. Thus, when the price of one
good changes the money income of the consumer is also changed
in such a way that the consumer has the same level of satisfaction.
This is known as ‘compensating variation’. It is defined as ‘the
amount by which the money income of the consumer is changed so
that the consumer is neither better off nor worse off than before’.
That is, the consumer remains on the same indifference curve.
Figure 3.9 shows the substitution effect.

Figure 5.9

In the above figure A0B0 is the original price line. The
consumer is in equilibrium at E. He purchases Oy0 units of Y and
Ox0 units of X. As the price of X falls while that of Y remains the
same, the budget line shifts to A0B1. Using the compensating
variation, the new budget line is P0P1. This line is parallel to the
budget line A0B1 indicating that the relative prices are the same. At
point E1 the indifference curve IC is tangent to the budget line. The
consumer now purchases Ox1 units of X and Oy1 units of Y. The
consumer would always prefer to buy more of the cheaper good.
The substitution effect is always positive.

5.2.3 Price Effect:
The price effect shows the behaviour of the consumer to
changes in the price of one good while his money income, tastes
and preferences and prices of other goods remain the same. When
the price of a good falls, other things being the same, the consumer
would move be able to buy more of the good and vice versa when
the price increases. Figure 5.10 explains the price effect.

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Figure 5.10

In the above diagram x-axis shows good X and y-axis shows
good Y. We assume that the price of good Y and the money
income of the consumer remain the same. AB0 is the original price
line. The consumer is in equilibrium at E. He purchases Ox0 units of
X and Ex0 units of Y. As the price of X falls, the price line shifts to
AB1. As a result the consumer moves from point E to E1 and he
purchases more units of X (x0x1). Further as the price of X falls, he
moves on to E2 and purchases Ox2 units of X. the movement from
E to E1 to E2 is traced along the Price Consumption Curve (PCC).
PCC is ‘the locus of all equilibrium points when the price of one
good and the money income of the consumer remain the same and
only the price of the other good changes’. Figure 5.11 shows the
possible slopes of the PCC.

Figure 5.11

In the above figure PCC1 shows changes in consumer
equilibrium when both the goods are normal and the price of one
good changes while the price of the other good and income are the

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same. PCC2 shows the changes in consumer equilibrium when
good X is a Giffen good and good Y is normal. The consumer will
buy lesser units of X when the price of X falls. PCC3 shows the
case when good X is neutral and good Y is normal. In this case
when the price of X falls the consumer will continue to buy the
same units. PCC4 shows the case when good Y is neutral and good
X is normal. PCC5 shows the case when good Y is a Giffen good
and good X is a normal good.

5.3 BREAKING-UP OF THE PRICE EFFECT

We can show that the price effect is a total of the income
and substitution effects. We assume that the consumer is rational,
his/her income of is given, price of Y remains the same, price of X
falls. We shall examine the price effect of a normal good first and
then examine the price effect of a Giffen good.

5.3.1 Price Effect of a Normal Good:
In case of a normal good a fall in the price results in a rise in
the demand and a rise in the price causes the demand to fall.
Figure 5.12 shows the price effect of a normal good.

Figure 5.12

In the above figure x-axis shows good X and y-axis shows
good Y. A0B0 is the original price line. The consumer is in
equilibrium at point E where the price line is tangent to the
indifference curve IC1. He/she purchases Ox0 units of good X. As
the price of X falls, the budget line shifts to A0B1. The consumer
moves to point E1 on indifference curve IC2. The consumer buys
Ox2 units of X. By the principle of compensating variation, if we
reduce the income of the consumer to retain him at the original
level of satisfaction, the budget line will shift downwards to A1B2.

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The consumer reaches equilibrium at E2 and buys Ox1 units of X.
The movement from E to E1 is the total price effect (change in
demand due to a change in the price of the good, x0x2). Of this,
movement from E to E2 is the substitution effect (x0x1) and
movement from E2 to E1 is the income effect (x1x2). Thus price
effect = income effect + substitution effect
x0x2 = x1x2 + x0x1

5.3.2 Price Effect of a Giffen Good:
In case of a Giffen good a fall in the price results in a rise in
demand and a rise in price causes the demand to fall. Figure 5.13
explains the price effect of a Giffen good.

Figure 5.13

shows units of good Y. A0B0 is the original price line and the
consumer is in equilibrium at E on IC0 and purchases Ox0 units of
X. As the price of X falls, the budget line shifts to A0B1 and the
consumer moves to E1 on IC1. The units of X purchased reduces to
Ox1. If we compensate for the fall in price of X, the budget line will
shift to A1B2 and the consumer moves to E2 on the original
indifference curve. Movement from E to E1 is the price effect.
Movement from E to E2 is due to the substitution effect while
movement from x2 to x1 is due to the negative income effect. Thus,
in case of Giffen goods the negative income effect outweighs the
positive substitution effect and the consumer will buy lesser units of
the good whose price has fallen.

Thus price effect = income effect + substitution effect
-x0x1 = x1x2 - x0x2

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The following table shows the break-up of price effect of different
goods depending upon their nature:

Nature of the Price Income Substitution
Good effect Effect Effect
1. Normal Goods Positive Positive Positive
2. Inferior Good Positive Negative Positive
3. Giffen Good Negative Negative Positive

5.4 DERIVATION OF THE DEMAND CURVE

The most important use of the indifference curve analysis is
to derive the consumer demand curve. We show this with the help
of the following figure. We assume that the consumer is rational, his
money income and price of Y remain the same and only the price of
X falls.

Figure 5.14

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In the above the upper panel shows the price effect of the
fall in price of good of X while the money income of the consumer
remains the same. He moves from point E to E1 to E2 as the price
of X falls and his budget line shifts from AB0 to AB1 to AB2. PCC is
the price consumption curve. The lower panel shows the various
quantities purchased and the corresponding prices. As the price
falls from P0 to P1 and to P2, the consumer increases his purchases
from OA to OB to OC. Thus, we see the inverse relationship
between the price and the quantity demanded, ‘other things being
the same’.

Check your Progress:

1. Write notes on :
a) Income effect b) Substitution effect c) Price effect

5.5 THE REVEALED PREFERENCE THEORY

One of the most important developments in the area of
consumer’s choice is “the revealed preference theory”. This
approach was developed by P. A. Samuelson to overcome the
shortcomings of both the Marshallian and Hicksian approaches.
This approach is based on the ‘observed behaviour of the
consumer’ and not on ‘contemplations based on psychological
constructs’. Thus, Samuelson observed ‘choice reveals preference’.
When a consumer chooses a particular good or a combination of
goods, he/she revealed the preference for that over all other
available alternatives. In other words, the consumer is not
indifferent to the choices available. This approach is also known as
the ‘behaviourist ordinalist approach’ since it is based on the actual
behaviour of the individual consumer. Following are the main
arguments of the revealed preference theory. When the consumer
chooses a particular combination of goods, for him all others are
‘revealed inferior’, that is he rejected all other combinations from his
choice. Figure 5.15 shows this.

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Figure 5.15

In the above figure given the price line y0x0 the consumer
chooses combination A. Combination B is ‘revealed inferior’ since it
lies below the budget line. Combination C is ‘revealed superior’
since it falls outside the budget line and is not within the reach of
the consumer. Hence, given the price-income situation, A is the
optimum combination. The revealed preference theory is based on
certain assumptions. They are: 1) the income of the consumer is
given. 2) There is consistency in the choice of the consumer.
Varian defines this as ‘if combination A is directly revealed
preferred to another combination B, then in any other situation, the
combination B cannot be revealed preferred to combination A by
the consumer when combination A is available’. This is also known
as the weak axiom of revealed preference (WARP). 3) The
revealed choices are transitive. This implies that if the consumer
chooses combination A over B and C over B, then transitivity
condition requires that he chooses A over C: If A>B and B>C, then
A>C. Given the above, Samuelson states the “Fundamental
Theorem of Consumer Theory” as under: ‘any good (simple or
composite) that is known always to rise in demand when money
income alone rises must definitely shrink in demand when its price
alone rises’. We prove this theorem with the help of two figures.

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a) Price Rises:
The following figure explains the effect of a price rise on the
consumer’s demand.

Figure 5.16
shows units of good Y. AB is the original price line and point E is
consumer’s choice. If the price of X rises, the budget line will shift
inwards to AB1. That means on the new price line the consumer
cannot buy combination E. If we compensate the consumer by
giving extra money income that would enable him/her to buy the
original combination, the budget line will shift to A1B2. The
consumer will not choose a point on EB2 portion of the new budget
line since he will have lesser units than before. So the choice of the
consumer will be within the A1E portion of the budget line after
compensation. In this portion of the price line he/she is buying
lesser units of X than before. Thus, the Fundamental Theorem is
validated.

b) Price Falls:
We show the effect of a fall in the price in figure 3.17.

Figure 5.17

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In this case the consumer is having AB as the original price
line and he chooses combination E. As the price of X falls, the
budget line shifts to AB1. At this stage, if we take away the
additional income, the new budget line would be A1B2. On this
budget line the consumer will not choose in the A1E portion since it
implies he has lesser units of X than before. Therefore, he will
choose in the area BEB2 which indicates that he is purchasing more
units of X than before the change in the price. Thus, the theorem is
proved that when price falls and income increases demand for that
good also increases.

Appraisal of the Revealed Preference Theory:
1. As noted earlier, the revealed preference theory is based on
actual observed behaviour of the consumer. It does not involve
psychological constructs like the indifference between different
combinations.

2. It provides a scientific basis for explaining the consumer
behaviour by focusing on the consumer’s reactions.

3. The theory is concerned only with positive income effect. It
cannot explain the Giffen’s paradox.

4. It has been observed that though the consumers are consistent
in their choices, they will be indifferent to certain combinations.

1. What do you understand by ‘choice reveals preference’?
2. What is meaning of ‘consistency in choice’?
3. What is ‘transitivity’ in consumer choice?

5.6 SUMMARY

1. An indifference curve is a graphic representation of the scale
of preferences.
2. An indifference curve shows equal level of satisfaction at all
points.
3. Marginal rate of substitution is the rate at which the consumer
substitutes one good for another.

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4. A concave indifference curve shows the same level of
satisfaction.
5. Price line shows the amounts of two goods that an individual
can buy with the given income.
6. Budget line and indifference curve are tangent at the point of
equilibrium.
7. Income effect measures changes in consumer’s equilibrium
due to changes in income.
8. Substitution effect is always positive.
9. Compensating variation helps the consumer to maintain the
same level of satisfaction.
10. Price effect shows the changes in consumer’s equilibrium
when the price of one good changes.
11. Price effect is the total of income and substitution effects.
12. For a Giffen good the price effect is negative because the
negative income effect is stronger than the positive
substitution effect.
13. Fundamental Theorem of Consumption Theory explains the
effect of changes in price on the demand.

5.7 QUESTIONS

1. Explain the concept of utility. What are the features of cardinal
utility analysis?
2. Explain the law of equi-marginal utility. What are its limitations?
3. Explain the derivation of the law of demand in the cardinal utility
analysis.
4. Explain the properties of indifference curves.
5. Examine the necessary and sufficient conditions for consumer’s
equilibrium.
6. Explain the income effect and substitution effect.
7. Show that the price effect is the total of income and substitution
effects.
8. Explain the price effect of a Giffen good.
9. Derive the demand curve with the help of the PCC.
10. What do you understand by revealed preference? Explain the
law of demand with the help of revealed preference theory.



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6

Module 3
THEORY OF PRODUCTION

Unit Structure :

6.0 Objectives
6.1 Concept of Production and Production Function
6.2 Short-run Production Function or the Law of variable
Proportions
6.3 Long-run Production Function or the Laws of Returns to
Scale
6.4 Cobb-Douglas Production Function
6.5 Producer’s Equilibrium
6.5.1 The concept of an iso-quant
6.5.2 Iso-cost Line or Budget Line
6.6 Economies of Scale
6.7 Economies of Scope
6.8 Summary
6.9 Questions

6.0 OBJECTIVES

 To understand the concept of production and production
function
 To understand the nature of short-run and long-run production
functions
 To understand the concept of Cobb-Douglas production
function
 To understand the concept of producer’s equilibrium
 To understand the laws of production
 To understand the concepts of economies of scale and scope

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6.1 CONCEPT OF PRODUCTION AND PRODUCTION
FUNCTION

Production in economics refers to the process of
transforming inputs into output or creation of value. Thus by
production we mean not only goods put also services. Economics
deals with the efficient use of inputs or factors of production to
produce goods and services. The concept of production function is
central to the theory of production. Production function is defined as
“the technological relation which connects factor inputs and
outputs”. It helps us to understand the relationship between the use
of inputs and the resulting output. ‘The production function is
related to a particular period of time. It expresses a flow of inputs
resulting in a flow of output in a specified time’. The production
function is written as under:
Q = f (L, K, R, S, λ, ν)
(1)
Q = physical output, L = units of labour, K = units of capital, R = raw
materials, S = land input,
ν = returns to scale, λ = efficiency parameter. We shall now
examine the short-run and long-run production functions.

6.2 SHORT-RUN PRODUCTION FUNCTION OR THE
LAW OF VARIABLE PROPORTIONS

In the short-run certain factors of production like the capital
stock, plant and equipment, land are held constant and the variable
factor land is changed to bring about changes in the output. We
write such a production functions as under:
(2)

This is the short-run production function. Here capital and
land inputs are held constant, while units of labour are variable.
Thus, it is also described as the law of variable proportions.
Marshall defined the ‘law of variable proportions as “if, given the
state of arts, successive units of a variable input are combined with
a fixed input (or fixed inputs), the returns, after a point, will be less
than proportionate”. G. J. Stigler defined this law as “as equal
increments of one input are added, the inputs of other productive
services being held constant, beyond a certain point the resulting
increments of product will decrease, i.e., the products will diminish”.
P. A. Samuelson defined “increases 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
additions of extra inputs will become less and less”. J. M. Cassels
stated the law as “if, with the same methods of production,
successive physical units of an input are added to a constant

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physical quantity of another input (or fixed combinations of other
inputs), the total physical output obtained would vary in magnitude
through three distinct phases”. The law of variable proportions is
based on the following assumptions:

1. The state of technology is given.
2. Factors of production are clearly classified as fixed and variable.
Labor is the variable factor, and capital and land are fixed inputs
(as given in (2) above).
3. It is possible to combine the factors of production is variable
proportions. The production function is not of fixed proportions
type.
4. Both inputs are required to produce the given output.
5. There are constant returns to scale.

Following Cassels definition we can delineate the three phases of
change in the output due to changes in variable input(s) as under:

Phase I: During this phase the total product would be increasing.
There would be two stages in this increase. In the first stage there
would be an absolute increase in the output, i.e., the marginal
product of the variable input would be increasing. In the second, the
marginal product would be increasing at a decreasing rate. The
marginal product would be greater than the average product of the
variable input. During this phase, the relative rate of increase in the
output would be greater than the relative rate of increase in the
variable input. At the end of this phase, the two rates would be the
same. At this point the marginal product equals the average
product of the variable input. This point represents the extensive
margin of production. Elasticity of output is used to explain the
choice of a rational producer. It is defined as:
dQ dv dQ v M arg inal Pr oduct of v
ev  Q  v  dv  Q  Average Pr oduct of v
ev = elasticity of output of variable input, v. dQ = the change in
output, Q = output, dv = the change in variable input, v = units of
variable input. In this phase the elasticity of output is greater than 1.
Phase II: In the phase, though the total product is still increasing, it
would be at a decreasing absolute rate that is the marginal product
of the variable input would be decreasing. The relative increase in
output would be less than the relative increase in the quantity of the
input. The marginal product would be less than the average product
of the variable input. At the end of this phase, the total product
reaches its maximum, i.e., the marginal product is zero. This point
is known as the intensive margin of production. In this phase the
elasticity of output is less than one.

Phase III: in this phase the total product starts decreasing as the
marginal product of the variable input is negative. This is the
‘uneconomic’ or ‘irrational’ zone of production. The elasticity of

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output would be less than one or negative in this phase. Table 4.1
shows the law with the help of a numerical example.

Table 6.1: Law of Variable Proportions:

Units of Total Average Marginal Output
Variable Product Product Product Elasticity of
Input (TP) (AP) (MP) Labour
(Labour)
1 10 10 - -
2 25 12.5 15 1.2
3 45 15 20 1.33
4 63 15.75 18 1.14
5 73 14.6 10 0.68
6 79 13.17 6 0.45
7 79 11.29 0 0
8 74 9.25 -5 -0.54

Figure 6.1 shows the law of variable proportions.

Figure 6.1

In the above figure TP is the total product curve. This curve
increases at increasing rate in the OA portion indicating the
increasing returns. In this phase both the MP and AP rare rising
with MP reaching its maximum and then declining. At the end of
this phase MP equals AP at its maximum and continues to decline.
This is at point A. Phase II is shown in the AB portion of the total
product curve. In the AB portion of the TP curve, the output would
be increasing at a decreasing rate since the MP is falling while the
AP also continues to decline. At point B, the TP curve reaches its
maximum and the MP cuts through the x-axis at point E. The marks
the end of phase II. After point B the total product is falling and the
marginal product turns negative. This is the uneconomic zone.

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6.3 LONG-RUN PRODUCTION FUNCTION OR THE
LAWS OF RETURNS TO SCALE

Long-run refers to a period where the firm can alter all its
inputs. In other words, there are no fixed inputs in the long-run.
Therefore, the returns to scale studies the impact of proportionate
change in all inputs on the resulting changes in the output. It is
important to note that the returns to scale occur not only in case of
different production functions, but they do occur even when the
production function is the same. We write the returns to scale as:
Pr oportionat e change in output
r .
Pr oportionat e change in all inputs
We can write the returns to scale as:
hQ = f (λK, λL) (3)

The different possibilities are:
1) if h = λ the production function exhibits constant returns to
scale.
2) If h >λ the production function exhibits increasing returns.
3) If h<λ the production function exhibits decreasing returns.
Like the variable proportions, there are three distinct returns to
scale. They are as under:

A) Increasing Returns to Scale:
In the initial stages of production, as a firm increases all its
inputs in equal proportions, the resulting output will be increasing at
an increasing rate. This is the phase of increasing returns to scale.
Following are some of the causes of the increasing returns to scale:

i) According to Joan Robinson, Lerner and Kinght, some of the
inputs like machinery are indivisible. Therefore, when output
increases from a small scale to a large scale, these factors are
utilized better resulting in increasing returns.

ii) Chamberlin did not agree with the views on indivisibilities. He
argued that as the level of output increases, it becomes
increasingly possible to introduce specialization and this allows
increasing returns even if the factors are perfectly divisible. This is
the case with some sophisticated machinery which can be
effectively used only when the production is large.

iii) At times, inputs can be more efficiently used when the output is
large enough. For example, some of the latest locomotives can pull
up to 45 wagons and are less efficient when the number of wagons
is less than this.

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B) Constant Returns to Scale:
In this case a proportionate increase in inputs will result in an
equally proportionate increase in the output. For example if all the
inputs are doubled, the output will also be double. This type of
production function is called ‘production function of first degree’.
According to E. A. G. Robinson, a firm might be able to utilize its
resources better. He argues that the technical, financial, marketing,
and ‘forces of risk and fluctuations’ are responsible for firms
experiencing constant returns to scale.

C) Decreasing Returns to Scale:
When a firm expands beyond a particular scale it starts
experiencing that the increase in output is less than the
proportionate change in its inputs- this is the decreasing returns to
scale. These occur because the firm will find it difficult to co-
ordinate the production activities when the size is too large.

The concept of returns to scale is explained with the help of
the ‘expansion path’. In Figure 4.2 x-axis shows labour input and y-
axis shows capital input. OR is the expansion path. This line shows
us the returns to scale when the firm uses the same production
process and still experiences the returns to scale.

Figure 6.2

In the above figure A, B and C indicate increasing returns to
scale (output increasing more than the increase in inputs). As
inputs are increased, output increases more than proportionately.
Points D, and E, indicate constant returns (output increasing in the
same proportion as inputs). Points F and G indicate decreasing
returns since a given proportionate change in output requires more
than proportionate change in the inputs.

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1. What do you understand by production function?
2. Distinguish between short run and long run production function.

6.4 COBB-DOUGLAS PRODUCTION FUNCTION

One of the most frequently estimated production functions is
the Cobb-Douglas production function. This studies the behaviour
of output in the entire manufacturing sector of an economy. It
considers output as depending upon the quantities of labour and
capital units at a given state of technology. This function is based
on the observation that the wage bill is constant proportion of the
national income. Formally, the Cobb-Douglas production function is
written as under:
Q = ALαKβ (4)

Q is manufacturing output, L is quantity of labour employed, K is
quantity of capital employed, A a constant is the efficiency
parameter, α and β are the elasticity of output with respect to labour
and capital. It is based on the implicit assumption that both capital
and labour units are required to produce output. The isoquant
based on this function will be convex to the origin with the marginal
product of capital decreasing as K increases and increasing as L
increases. If we assume α+β = 1, the function indicates constant
returns to scale (in formal terms the production function is said to
be ‘linearly homogeneous in capital and labour inputs’).

The Cobb-Douglas production function is most widely used
both with time-series and cross-section data of industrial sectors.
The function is estimated with the condition that α+β = 1 as well as
without this condition. There is uniformity of findings in both the
specifications. It returned fairly accurate estimates with the values
of α at 0.75 and β at 0.25. The exponents are found to be fairly
stable over time and nor different industrial sectors of the economy.
Further, the values of co-efficient were fairly close to the shares of
labour and capital in the national income. However, the Cobb-
Douglas production function is criticised for ignoring the changes in
the quality of capital assets and their utilization. It does not
consider the changes in the working hours of labour which has

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welfare implications. It is not possible to obtain an aggregate Cobb-
Douglas production function by aggregating the micro production
functions. Thought the estimates give results similar to the ones
based on the conditions of perfect competition and constant returns
to scale it is well known that they are not real life conditions. Capital
and labour are not perfect substitutes and the function neglects the
inter-industry differences in production functions. It is argued that
the Cobb-Douglas production function comes to the constant
returns to scale via a priori reasoning. Though the function contains
the term on technological conditions, it fails to estimate the role of
technical progress in output growth. It is shown that the function
actually estimates the changes in factor shares when there are no
large variations in the factor prices between industries.

6.5 PRODUCER’S EQUILIBRIUM

The concept of producer’s equilibrium is analogous to the
consumer’s equilibrium. Producer’s equilibrium refers to the
situation where the producer maximizes his/her output for a given
set of inputs or produces a given output with the minimum possible
inputs. Thus, it is also known as the ‘least cost combination’. It is
based on the concepts of a) iso-quant and b) factor price line. We
shall now examine each of them.

6.5.1 The concept of an iso-quant :
The concept of an iso-quant was introduced by Edgeworth.
This concept shows the various combinations of two inputs that
give the same level of output. Each iso-quant shows a particular
level of output measured in physical terms. An iso-quant measures
the physical output that can be obtained by combining the two
inputs in various proportions. For example, Q = (5K, 3L) and Q =
(3K, 6L) indicates that to produce a given level of output, Q, we can
use 5 units of capital and 3 units of capital or alternatively 3 units of
capital and 6 units of labour. In other words, the two factors are
considered to be perfect substitutes and each unit of factor is
homogeneous. Figure 4.3 a) shows such a production function. The
production function can be of fixed proportions or of variable
proportions. In case of fixed proportions, it is not possible to
combine the factor inputs in any other way except one. This
production function will be L-shaped. Figure 4.3 b) shows this
function. The Marginal Rate of Technical Substitution (MRTS)
shows the factor combinations. In case of variable proportions
production function, it is less than one and in case of fixed
proportions production function it is zero.

An iso-quant never touches either of the two axes. This is
because, when the iso-quant touches one of the axes, it indicates
that at that point it is possible to produce the given output with only

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one factor. Since this contrary to the assumption that both the
factors are required to produce a given level of output, an iso-quant
cannot touch either of the axes. Figure 4.4 a) and b) shows this. In
case of the former, the iso-quant touches y-axis indicating that at
point E, no labour units are required to produce the given level of
output. In the later case it indicates that output can be produced
without any units of capital at point R. Both cases are ruled out.

Further, two iso-quants do not intersect. This is shown in
Figure in 4.5. At the point A, both the iso-quants intersect. At this
stage the two different levels of output (100 and 120 units) can be
produced using the same combination of inputs. This is inconsistent
with the property of each iso-quant measuring a particular level of
output.

6.5.2 Iso-cost Line or Budget Line :

This is analogous to the price line of the indifference curve.
In this case, we measure the different units of the two inputs that
can be obtained by the producer for a given outlay. The slope of the
iso-cost line is the ratio of the prices of the two factors. Given the
factor prices, outlay and a family of iso-quants, we can determine
the equilibrium of the producer or the optimum output that can be
produced. Figure 6.6 shows the producer’s equilibrium.

Figure 6.6

At point E the slope of the iso-quant equals the slope of the iso-cost
line (AB) at this point the MRTSK,L equals the ratio of factor prices:
MPL  MPK  MPL  w (5)
w r MPK r

Therefore at E the firm produces maximum output with
minimum cost (using ol units of labour and ok units of capital). At
any other point, the ratios of marginal products and factors will not
be the same (as at points C and D). The following example explains
the producer’s equilibrium.

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Let the production function be Q = 50L0.75K0.25; Capital
employed is 150 units; price of output is Rs. 150; wage rate is Rs.
50, and cost of capital is Rs. 60. MPL = 25L-0.75 K0.25; and
MPK = 25L0.75K-0.25;
-0.75 0.25
MP L
25L K K w
Therefore, = 0.75 0.25
(6)
MP K 25L K L r

Or
(7)

L=
(8)
L = 180
(9)
Q = 50 × (1500.75) ×(1800.25) = 7849.47
TR = 7849.47×150 = 1,177,420.40
TC = 9000 + 9000 = 18,000
Total Profit = 1177420.47 – 18000 = 1,168,420.47

Given the data, by producing 7849.47 units of output by
employing 150 units of capital and 180 units of labour the firm
makes a total profit of 1,168,420.47. This combination of factors is
‘the least cost’ or ‘profit maximising’ output.


1. Explain the following concepts :
a) Iso quant curve b) Iso cost line

6.6 ECONOMIES OF SCALE

As the output increases, the average cost of production of a
firm declines up to a point. As the firm changes its input
proportions, the returns to scale concept is not applicable.
Economies to scale refer to the situation when the firm doubles its
output for less than twice the cost. Beyond a particular level of
output, the cost increases more than the output. In such a case the
firm is said to be experiencing diseconomies of scale. The returns
to scale reflect in the ‘U’-shaped long-run average cost curve. In the

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initial stages the firm experiences economies of scale resulting in a
fall in the average cost. As the firm continues to increase its scale,
it will start experiencing diseconomies which result in increasing
average cost. Economies of scale are measured in terms of cost-
output elasticity, EC. It is defined as the percentage change in the
cost of production resulting from a 1-percent increase in output. We
have:
EC = (∆C/C)/(∆Q/Q) or (∆C/∆Q)/(Q/C) = MC/AC (10)

We can see that the economies of scale are given by the ratio of
marginal to average cost of production. When the marginal cost is
falling the firm will enjoy economies of scale and when the marginal
cost is increasing the firm will experience diseconomies. We
examine the various economies and diseconomies of scale in turn.

A) Economies of Scale:
1. As the scale of operations increase, the firm may be able to
introduce specialisation that helps to improve labour efficiency. The
firm can vary the combination of inputs that allow better
management of production process.

2. Large firms enjoy the benefit of discounts and suppliers’ credit
which are not available at lower levels of output. Large firms will
have easy access to banks and financial institutions that will reduce
the cost of credit.

3. Large firms can afford research and development (R&D) that
helps them to introduce new processes and products that are more
cost-effective.

4. Large scale production allows the use of by-products.

5. Since there are indivisibilities in the use of capital equipment,
large firms will be able to realize them better than when the scale is
small.

6. Large firms will be able to diversify in to new areas of production
and thus enjoy risk-diversification.

7. Large scale production allows the advantage of hiring specialists
to supervise the operations. The production, procurement and
marketing can be assigned to trained managers which will improve
the efficiency of the firm ad reduce the costs.

B) Diseconomies of Scale:
It is important to note that there is an optimum scale beyond
which an expansion in size results in output increasing lower than
the cost. The main reasons for this are as under:

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1. Supervision of operations becomes difficult beyond a particular
scale. Co-ordinating the activities of different departments becomes
difficult and inter-departmental rivalries are common in large firms.

2. In large firms the personal element in operations is lost. This can
result in alienation and indifference to work.

3. Large firms will inevitably depend on external markets for their
sales. This makes them open to the vagaries of the economic and
political uncertainties in other countries.

6.7 ECONOMIES OF SCOPE

The concept of economies of scope was introduced by J. C.
Panzar and R. D. Wiling. It was further developed by E. E. Bailey
and A. F. Friedlaender. This concept explains the economies that a
firm can enjoy when it is producing two are more goods that are
related. For example, a poultry farm can sell eggs as well. Similarly,
an automobile company, which is producing cars, can also produce
mini-trucks using the same machinery. In both cases, a firm enjoy
cost advantages when it produces two or more products since the
firm is making joint use of inputs or production, marketing and
administrative facilities. Also, in some cases, the production of one
product provides an automatic or unavoidable by-product(s) that
can be used for the production of another product. This can be
explained with the help of the following example. Let us say a firm
is producing trucks and tractors. Even if the plants are not located
at the same place, the firm can make use of management
resources. The managers of the firm must choose who much of
each product is to be produced. Figure 6.7 explains the concept of
economies of scope:

Figure 6.7

In the above diagram, O1 is the product transformation curve
of the firm producing trucks and cars. When the firm is experiencing

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constant returns to scale, when inputs are increased, the
transformation curve shifts parallel to O2. In such a case, joint
production will help a single company to produce more of both the
products with the same resources than would two plants producing
each product separately. This is possible because of the joint use
of inputs. A single management is often able to schedule and
organize production and to handle accounting and financial aspects
better than when separate managements are operating. If, on the
other hand, the firm faces a straight line transformation curve, there
will be no gains (or losses).

Economies of scope are present when the joint output of a
single firm is greater than the output that could be achieved by two
different firms each producing a single product. The firm will face
diseconomies of scope when the joint output is less than that which
could be achieved by separate firms. It is important to note that, a
firm enjoying economies to scope may as well be experiencing
diseconomies to scale. This happens when producing, from our
above example, producing cars and trucks together is cheaper than
producing both cars and trucks separately. It is also possible to
enjoy increasing returns to scale and diseconomies of scope when
different plants are administered separately.

The following formula gives the degree of economies of
scope (SC):
SC = C(Q1) + C(Q2) – C(Q1Q2)
(11)
C(Q1Q2)
where, C(Q1) = the cost of producing output of the first product,
C(Q2) = the cost of producing output of the second product,
C(Q1Q2) = the joint cost of producing both outputs.

When the firms is enjoying economies of scope, SC>0, if it is facing
diseconomies of scale, SC<0.

6.8 SUMMARY

1. Production refers to the creation of utility.
2. In short-run certain factors of production remain constant.
3. In long-run all factors of production are variable.
4. Variable proportions are changes in output due to changes in
the variable factor.
5. Returns to scale are due to proportionate change in all the
factors of production.
6. Increasing returns to scale are due to factor indivisibilities and
improvements in efficiency.

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7. Cobb-Douglas production function allows for estimation of
output given the factor inputs and technology.
8. Cobb-Douglas production function shows that industrial sector
experiences constant returns.
9. Isoquant shows the level of output that can be produced using
a given set of inputs.
10. Isoquant can be convex to the origin or L-shaped.
11. Iso-cost line shows the ratio of factor prices.
12. Minimum cost of production ensures profit maximisation.
13. Economies to scale arise due to better use of inputs.
14. Diseconomies are due to managerial inefficiencies.
15. Economies of scope involve changes in production processes.

6.9 SUGGESTED QUESTIONS

1. Explain the concept of production function.
2. How do you distinguish between short-run and long-run
production functions?
3. What do you understand by ‘returns to factor’? Explain the law
of variable proportions.
4. Write a note on returns to scale.
5. Explain the main features of Cobb-Douglas production function.
6. What is least cost combination? Discuss the conditions for
producer’s equilibrium.
7. Explain the various economies of scale.
8. Write a note on economies of scope.






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7
THEORY OF COSTS

Unit Structure :

7.0 Objectives
7.1 Concepts of Costs of Production
7.2 Short Run Costs
7.3 Learning Curve
7.4 Summary
7.5 Questions

7.0 OBJECTIVES

 To understand the concepts of costs of production
 To understand the nature of short-run and long-run costs of
production
 To understand the concept of learning curve

7.1 CONCEPTS OF COSTS OF PRODUCTION

Cost of production refers to the resources- financial or real
required to produce a given quantity of output. This concept is
central to economics since resources are scarce, and they have
alternative uses, a firm has to ensure a proper use of its available
resources. The idea of cost is different in economics from the daily
use of the term. We shall now examine the different concepts of
costs used in economics.

1. Money Costs: They refer to the money spent on procuring the
various factors of production that are required to obtain a given
output. For example, the wages paid to labour, the cost of raw
materials, rent on premises, and so on. This cost is considered for
pricing decisions.

2. Real Costs: This refers to the sacrifices, physical and mental
privations that the entrepreneur and labour undergo in the process
of production. Marshall considered them to be important. However,
given the nature of these costs, they are subjective and hence not
easy to measure.

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3. Implicit Costs: They refer to the imputed value of factors of
production that are owned by the entrepreneur and are used in
production. There is no money payment for them. A popular
example for this is the capital invested by the producer. If the lends
his funds instead of using them for production, he would earn
interest. The interest sacrificed is the implicit cost of the capital. An
important component of implicit cost is the ‘normal profit’. This
refers to the minimum profit that the entrepreneur must obtain to
continue in production. This is the salary he will earn as a manager
instead of being an entrepreneur. Similarly the time spent by the
family members in the production process is also an implicit cost. It
is to be noted that they are only imputed.

4. Explicit Costs: These are the payments made in cash to the
various factors of production. These are also known as ‘accounting
costs’ since they are the once considered in the balance sheets of
the firms.

5. Economic Costs: These refer to the total cost of production
measured as in terms of the resources expended. Thus, economic
costs are inclusive of explicit and implicit costs. Thus the economic
cost of production is higher than the accounting cost of production.
We write: Economic Cost = Implicit Cost + Explicit Cost.

6. Opportunity Cost: As noted above, the resources being scarce
it is important to note that if they are employed for one use, they are
not available for another. Economics focuses on this aspect of cost
of production. Heberler defined opportunity cost as ‘the next best
use sacrificed’. We can see it both at the micro and macro level. If a
household spends more income on food, it will have lesser income
for other purposes. At the macro level, if the government decides to
spend more on defence, it will have lesser money for education or
family welfare. It is this opportunity cost that must be minimised by
employing the resources in a thoughtful way.

7. Private Costs: These refer to the cost of a product to an
individual producer. The money spent on inputs is one example for
this. The private cost is paid by the user of the particular factor and
thus is inclusive.

8. Social Costs: These are the costs that the society or economy
as a whole has to bear for the particular use of resources. For
example, using a private car may be convenient for an individual
but the pollution caused by this is a social cost- the consequences
of a particular resource use will have to be borne by the entire
society. Industrial pollution is an important social cost. In recent
years, the cost-benefit analysis techniques are developed to assess
the social cost of production and consumption as well.

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Check your Progress :

1. What is money cost of production?
2. Distinguish between Implicit cost and Explicit cost.

7.2 SHORT-RUN COSTS

In the short-run certain inputs remain the same and certain
inputs can be changed according to the needs of the firm. The firm
holds its fixed inputs as constant and uses the changes in the
variable costs to bring about changes in the output. Following are
the different concepts of short-run costs of production.

1. Fixed Costs or Sunk Costs: These are the costs incurred on
fixed factors of production. They remain the same irrespective of
the level of production. Plant and equipment, permanent staff,
interest liabilities are some of the fixed costs. According to
Marshall, firms do not pay much attention to these costs while
considering production decisions in the short-run.

2. Variable Costs or Prime Costs: These are the costs incurred
on the variable factors of production. Thus, they change with the
level of production. Expenditure on labour, fuel and electricity, raw
materials and transport costs are some of the important variable
costs.

3. Total Cost of Production: This refers to the total of fixed and
variable costs. We write: TC = TFC + TVC. Where TC is the total
cost of production; TFC is the total fixed cost and TVC is the total
variable cost.

3. Average Cost: This is the cost of production per unit of output.
Thus AC = TC/Q = (TFC+TVC)/Q
4. Average Fixed Cost: This is the fixed cost per unit of output. AFC
= TFC/Q.
5. Average Variable Cost: This is the variable cost per unit of
output: AVC = TVC/Q

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6. Marginal Cost: This is the additional cost per unit of output. MC =
∂TC/∂Q or alternatively,
MC = TCn – TCn-1. In other words, marginal cost is change in the
cost when the firm increases its output by one extra unit. The
following table shows the relationship between different concepts of
short-run costs.

Table III.1 Short-run Costs:

Output Fixed Variable Total Average Average Average Marginal
Cost Cost Cost Fixed Variable Cost Cost
(TFC) (TVC) (TC) Cost Cost (AC) (MC)
(AFC) (AVC)

10 100 75 175 10.0 7.5 17.5 --
20 100 100 200 5.0 5.0 10.0 25
30 100 145 245 3.3 2.1 8.2 45
40 100 205 305 2.5 5.25 7.6 60
50 100 275 375 2.0 5.5 7.5 70
60 100 380 480 1.7 6.3 8 105
70 100 490 590 1.4 7 8.4 110
80 100 600 700 1.3 7.5 8.8 110
90 100 735 835 1.1 8.2 9.2 135
100 100 890 990 1.0 8.9 9.9 155

From the above table we can infer the relationship between
the various short-run cost curves. The total fixed cost remains the
same at all levels of output. The total variable cost increases with
the increase in the level of output. Since the total cost is the total of
these two, it also keeps increasing as the level of output increases.
Figure III.1 shows the relationship between these three costs.

Figure 7.1

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In the above figure x-axis shows the level of output and y-
axis shows the cost. TFC is the total fixed cost. TVC is the total
variable cost. TC is the total cost. The vertical distance between
TVC and TC measures the fixed cost.

We can show the behaviour of the average and marginal
costs of production also. Figure III.2 shows this relationship.

Figure 7.2

In the above figure x-axis shows the level of output and y-
axis shows the different costs. AFC is the average fixed cost. As
the level of output increases, this keeps falling but never reaches
zero since there is fixed cost at all levels of output. AVC is the
average variable cost. It decreases initially as production increases
and starts increasing after a certain level of production. It moves
asymptotically towards AC, but never touches it (since AFC>0 at all
levels of production). AC the average cost of production. AC starts
increasing after the AVC. This is because; part of the increase in
AVC is offset by the falling AFC. The MC curve falls faster than the
AVC and AC and intersects both the curves from below at their
minimum point. MC increases faster than the AVC and AC after
their minimum points.

III.2.1 C Long-Run Costs:
The long-run is a series of short-run. In the long-run the firm
can change all its factors of production in any given way. Hence in
the long-run all factors are variable and there are no fixed factors of
production. The firm can alter the way in which its combines its
inputs. It can also decide on the size of the plant. We can explain
this with the help of an illustration. In Figure III.3 we show the cost
and size of a firm.

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Figure 7.3

If the firm expects to produce say, Q1 of output, it should
operate on its SAC1 which corresponds to this output. It is planning
to sell Q2 of output it should have a plant size corresponding to
SAC2. If on the other hand it is planning to sell Q3 of output, its plant
size should be corresponding to SAC3. The different sizes of the
plants that correspond to different levels of production give us the
long-run average cost curve (LAC). Thus, LAC is the envelope of
the short-run average cost curves. Due to the economies and
diseconomies of scale, the minimum points on the SACs will not lie
on the LAC. The minimum point of only one SAC will be the same
as of the minimum point of the LAC and this particular size was
termed as “the optimum firm” by E. A. G. Robinson. As noted above
the long-run average cost curve reflects the economies and
diseconomies of scale. When the firm is experiencing the
economies of scale, its costs will be decreasing and hence the
average cost will be declining. As the firm reaches the most
efficient size, the average cost reaches its minimum. Beyond this
level of output the cost of production increases due to
diseconomies of scale. If the firm selects a size that is too small it
will find it difficult to keep the cost low. Therefore, the firm would
prefer to have a larger size.

The long-run marginal cost curve (LMC) is not the envelope
of the short-run marginal cost curves (SMC). This is because the
SMC applies to a particular plant while the LMC applies to all
possible plant sizes. Each point on the LMC is the SMC associated
with the most cost-efficient pant. SMC1 therefore, intersects LMC at
the output level Q1 at which the SAC1 is tangent to the LAC.

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1. Distinguish between Fixed Cost and Variable Cost

7.3 LEARNING CURVE

The concept of learning curve was based on the experience
in aircraft maintenance. It is also known as improvement/progress
curve or learning-by-doing. It is based on the experience that each
time the task is repeated; decreasing amounts of labour input is
required. It was developed by W. Z. Hirsch to explain the process
through which firms enjoy falling long-run average cost, though
there may not be increasing returns to scale. This is possible when
workers and managers with experience, are able to absorb new
technological information. This happens due to the following
reasons: 1) workers often taken longer to accomplish a given task
the first few times they do it. As they become more adept, their
speed increases. 2) Managers learn to schedule the production
process more effectively, from the flow of materials to the
organisation of the manufacturing itself. 3) Engineers, with
experience, will be able to produce designs that save costs without
increasing defects. 4) Over the time, the suppliers will be able to
provide materials at lower costs and pass on this advantage to the
firm. The learning curve shows the reduction in labour units
required to produce the cumulative output. The learning curve is
based on the following relationship:

L = A + BN-β (1).
where, N = cumulative units of output produced,
L = labour input per unit of output,
A, B are constants, with A showing the minimum labour input
per unit of output after all learning has taken place. In the equation,
when β is positive, as output gets larger and larger, L becomes
arbitrarily close to A, so that A represents the minimum labour per
unit of output after all learning has taken place.

Alternatively, the learning curve can be shown as a liner
function, i.e., as output increases, the labour input requirement
decreases at a uniform rate. In such a case, the learning curve will
be:

95

Y = a Xb (2).
where, Y = man hour per unit of output,
X = units of output,
a = intercept, theoretical labour requirement for the first unit
of output,
b = slope of the curve/ the rate of reduction in labour
requirement.

Figure 7.4 shows the learning curve:

Figure 7.4

In the above figure LC is the learning curve. It shows that as
the production increases the cost falls as lesser labour hours are
required to produce equivalent increases in output. This is because
as managers and workers become more experienced and more
effective at using the available plant and machinery, they will be
able to turn out larger output. The learning curve shows the extent
to which hours of labour needed per unit of output fall as the
cumulative output increases. Learning curve helps to predict the
labour requirement when output is doubled. The following table
explains the concept of learning.

Cumulative Per-Unit Labour Total Labour Learning
Output (N) Requirement Requirement Percentage
for each 10 units of
Output (L)
10 1.00 10.0 --
20 0.80 18.0 (10.0+8.0) 80
30 0.70 25.0 (18.0+7.0) 38.9
40 0.64 31.4 (25.0+6.4) 25.6
50 0.60 37.4 (31.4+6.0) 19.1
60 0.56 43.0 (37.4+5.6) 14.9

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It can be seen from the above table that the percentage of
learning, or the additional labour input required to double the output
goes on increasing, i.e., learning curve is downward sloping.

Learning curve is used in forecasting the future labour
requirements. It is also used in measuring the improved proficiency
of the operator as output is increased in estimating reductions in
manufacturing losses. It is also used in stabilizing the designs and
increasing the lots sizes. It is used in improving the special tooling
needed for production and shifting from manual to automation as
additional production is required.

It is important to distinguish learning effects from the returns
to scale. Returns to scale implies, producing larger quantities for a
given increase in inputs. Whereas, learning curve results in
lowering of the average cost curve itself. Figure III.5 helps to
understand the two.

Figure 7.5

In the above diagram, x-axis shows the output and y-axis
shows the cost (per unit of output). The movement from A to B on
AC1 (initial average cost) indicates economies to scale and
movement from A to C depicts the learning effects which result in
the average cost curve from AC1 to AC2. The learning curve
concept is useful when the firm has to calculate the cost of
producing a new product. If a firm is enjoying learning effects, the
total labour requirement for producing larger quantities of output
increases in smaller increments. Therefore, this concept is useful
for a firm deciding whether it would be profitable to enter an
industry or not.

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7.4 SUMMARY

1. Real cost refers to the sacrifices made in the process of
production.
2. Implicit costs measure the imputed value of inputs owned by
the entrepreneur and used in production.
3. Economic costs are broader than the accounting costs.
4. Total Fixed Cost remains the same at all levels of output.
5. AFC never becomes zero.
6. MC is ‘U’-shaped.
7. MC intersects AC and AVC at their minimum points.
8. In long-run all factors of production are variable.
9. LAC is a locus of all the short-run average cost curves.
10. LMC shows the most efficient output of each size of the firm
11. Learning curve shows the fall in labour requirement as output
increases.
12. Learning curve causes the AC to shift downwards.
13. Firms need information on learning effects to plan long-run
output.

7.5 QUESTIONS

1. Explain the concepts of money costs and real costs of
production.
2. Distinguish between social costs and private costs.
3. The economic concept of costs is broader than the accounting
costs.
4. The short-run cost curves are ‘U’-shaped.
5. Explain the derivation of the long-run average cost curve.
6. Explain the concept of learning curve.





98

8
Module 4

THEORY OF FIRM

Unit Structure :

8.0 Objectives
8.1 Concepts of Revenue
8.2 The relationship between TR, AR and MR under Perfect
Competition
8.3 The relationship between TR, AR and MR under Monopoly
8.4 Relationship between AR and MR curves
8.5 Objectives of a firm
8.5.1 Profit Maximization
8.5.2 Sales Maximization
8.5.3 Satisfaction Maximization
8.5.4 Growth Maximization
8.6 Questions

8.0 OBJECTIVES

 To study various concepts of revenue
 To study the relationship between TR, AR and MR under
perfect competition
 To study the relationship between TR, AR and MR under
monopoly
 To understand different objectives of a firm

8.1 CONCEPTS OF REVENUE

The term revenue refers to the sales receipts obtained by a
seller or a firm by selling certain amount of a commodity. There are
three concepts of revenue used in economics.

99

A firm’s revenue is classified as under-

1. Total Revenue: - “Total revenue refers to the total amount of
sales receipts received by a seller or a firm by selling certain
amount of a commodity over a period of time.” The total revenue is
obtained by multiplying the total quantity of a commodity sold by the
price. Therefore, symbolically expressed as TR = Q × P.

Where, TR= total revenue, Q = total quantity of a commodity
sold and P = price per unit of a commodity.

Total revenue depends upon two important factors i.e. total
quantity of a commodity sold and price per unit of a commodity. For
example, a firm sells 10 units of a commodity at a price of 10 per
unit. Thus 10 × 10 = 100 is the total revenue. TR of a firm initially
goes on increasing up to a certain limit then after it starts falling.

2. Average Revenue: - “It refers to the price or revenue per unit of
a commodity sold.” It can be obtained by dividing the TR by the
total number of units of a commodity sold (Q). It can be
symbolically expressed as AR = TR / Q.

Where, AR stands for Average Revenue. With the example,
100 / 10 = 10 is the average revenue.

3. Marginal Revenue – It may be defined as, “Net addition made to
the total revenue by selling one more additional unit of a commodity
is called as marginal revenue.” In other words net increase in total
revenue is called as marginal revenue. It can be symbolically
expressed as MR = ΔTR / ΔQ. Where MR stands for Marginal
Revenue, ΔTR = change in total revenue and ΔQ = change in total
quantity of a commodity sold.

For e.g. a seller obtains the total revenue of 90 from the
sell of 9 units at price of 10 per unit. If he increases his sales by
one more additional unit (9 to10) his total revenue increases from
90 to 100 the net change in TR or MR = 10.

The relationship between TR, AR and MR are different under
different market condition.

8.2 THE RELATIONSHIP BETWEEN TR, AR AND MR
UNDER PERFECT COMPETITION

Under perfect competition an individual firm can not
influence a given market price. So a firm is a price- taker. Hence,
the price remains constant as more and more units are sold.
Therefore, an addition made to the total revenue by selling every

100

additional unit of a commodity will always be equal to the given
market price. Hence the marginal revenue of a firm is always equal
to its average revenue.

Firms Demand Curve:
Under the condition of perfect competition, a firm’s demand
curve is perfectly elastic i.e. horizontal to ‘X’ axis at the height of the
given market price. So the average revenue of a firm is the same
as the price, whatever be the quantity sold. Hence a perfectly
elastic demand curve i.e. average revenue curve is also called as
marginal revenue curve. This is shown in the following figure.

An Industry’s Demand Curve:
Under perfect competition an industry can sell more and
more units of a commodity only at a lower price. Hence, the
demand curve slopes downward from left to right towards ‘X’ axis.
This is shown in the following figure.

Y Industry Y
Firm
S
D
S

P P D D
Price
AR=M

S DD
O S

Quantity M X O Quantity X

Figure 8.1 Figure 8.
2
The downward sloping demand curve DD is the demand
curve of an industry as shown in the above figure 8.1 and the
horizontal DD curve is a firm’s demand curve shows that demand
for a commodity is perfectly elastic at the given market price OP as
shown in the figure No. 8.2.

The market price is determined by the total demand for and
total supply of the commodity in the market as a whole. This is
shown in figure 8.1. The demand curve slopes downward it shows
that the market demand for a commodity increases when its price is
reduced and vice-versa.

101

The relationship between TR, AR and MR under perfect
competition:

Let us assume that the price per unit of a commodity is 10.
Hence the AR is constant. The relationship between TR, AR and
MR is shown in the following table.

Revenue Schedule of a firm

No. of units Price TR AR MR
ofa commodity Q×P TR / Q ΔTR / ΔQ
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
7 10 70 10 10

The above table shows that TR increases at a constant rate
as more and more units are sold. It also shows that the MR of a
firm is always equal to AR or price under perfect competition. We
can show graphically the TR, AR and MR in the following figure.
Y
TR

D D
Price,
TR,
AR=M
AT &
R
45U
O
Quantit X
y
Figure 8.3

In this figure TR is the total revenue slopes upward to the
right. The horizontal DD curve is the AR as well as MR curve. This
is because the MR curve coincides with the AR curve. It is parallel
to the ‘X’ axis.

102

8.3 THE RELATIONSHIP BETWEEN TR, AR AND MR
UNDER MONOPOLY

Under monopoly the demand curve of a firm for its product
slopes downward from left to right. It shows that, such a monopoly
firm can sell more only at a lower price. Hence, its total revenue
increases at diminishing rate.

A monopoly firm can influence the price. It is a price-maker.
A monopolist can charge a high price only by reducing his market
supply. A monopolist can fix a high price of his product and sell
whatever amount of his product i.e. demanded by consumers.

A monopolist can sell more only by reducing the price of his
product. The price is also called AR. So as price is reduced to sell
more the AR falls.

When the AR or price declines the MR also falls. So the net
addition made to the TR will be less than the price of AR. Hence,
TR of a monopoly firm increases at a diminishing rate. For
example, suppose a monopoly firm sells 3 units of a commodity at
8 per unit. Its total revenue will be 24. If now it wants to sell 4th
unit it will have to reduce the price to say 7 with this price its total
revenue will be 28. Hence, the MR will be only 4 which is less
than the price 7. This is shown in the following table.

Revenue Schedule of a Firm under Monopoly

No. of units of Price TR AR MR
a commodity Q×P TR / Q ΔTR / ΔQ
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2

It can be seen in the above table that as more and more
units of a commodity are sold the TR increases at a diminishing
rate. It also shows that as price is reduced the MR is less than AR.
With the fall in MR the gape between AR and MR goes on
widening. This is because in order to sell one more unit of a
commodity the price per unit will have to be reduced.

103

Y
30
Pric
e
AR, T
MR A

O
6 Quantity X
M
Figure 8 .4

When the demand curve AR is sloping downward towards
‘X’ axis the MR curve also slopes downward and is always below
the AR curve. The gap between AR and MR curve goes on
widening as the price is reduced. This is shown in the figure.

8.4 RELATIONSHIP BETWEEN AR AND MR CURVES

There is some geometrical relationship between AR and MR
curves. The important ones are as follows.
 Under Perfect Competition: - MR is always equal to AR from an
individual firm’s point of view. In this case the AR curve is
horizontal to the ‘X’ axis and the MR curve coincides with AR
curve.
Y

AR=M
R

O X
Quantity

Figure 8.5

 Under Monopoly: - The AR curve has a negative slope. Hence,
MR curve lies below it. MR curve can cut the ‘X’ axis and enter
the negative quadrant. So MR can be zero or negative, but the
AR curve can not intersect the ‘X’ axis and enter the negative
quadrant. This is because price or AR can never be zero or
negative. See figure No. 6

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Y Y A

Price, F
AR & B
MR C

E
+ A A
O O
- X Q M X
M
Output
Figure 8.6 Figure 8.7

 AR is a straight line or liner demand curve sloping downward
under monopoly: - MR curve is also a straight line sloping
downward from left to right. See figure No. 7. The MR curve is
below the AR curve it shows that under monopoly MR is less
than price or AR. In such a situation MR curve is exactly half a
way between AR curve and ‘Y’ axis. This is because the MR
falls twice than the fall in price at each level of output.
At OC price OQ amount is demanded thus we get F point on
AR curve. The line CF is drawn. The MR curve cuts the line CF at
point B. CF is the distance between ‘Y’ axis and AR curve. To
prove this we have to prove that CB = BF. It can be prove that
triangle ACB and EFB are equal in area and are also similar. So CB
= BF. This indicates that point B is exactly in the middle of the line
CF since MR curve passes through the point B which lies exactly
half a way between AR curve and Y axis.

 If the AR curve is convex: - The MR curve which is below the
AR curve is close to the Y axis i.e. the MR curve is less than
half way between the Y axis and AR curve. This is shown in the
figure No.8.

105

Y 

A 
Pric N
eAR P
,MR Y M

E MR AR

O Q X

Figure 8.8

Quantity
Y

A
N
P
M

E

M A

O Q X

Figure 8.9

In the above diagram the distance between Y axis and MR
curve is less than half way between the Y axis and AR curve i.e.
PM is less than MN or the triangle APM is smaller than the triangle
EMN.
 If AR curve is concave: - The MR curve which is below the AR
curve is closer to AR curve i.e. MR curve is more than half way
between the Y axis and AR curve. This is shown in the above
figure No. 9.
In the diagram the distance between Y axis and MR curve is
more than the distance between MR curve and AR curve i.e. PM is
more than MN or the triangle APM is larger than EMN.

106

8.5 OBJECTIVES OF A FIRM

In order to achieve various objectives firm undertakes
production. Maximization of profit is one of the important objectives
of a firm. But in real practice it is not the only objective of a firm. In
reality modern firms may have different objectives such as sales
maximization, maximization of satisfaction, growth maximization
etc. Some of the important objectives of a modern firm are as
follows.

8.5.1 Profit Maximization:

The traditional objective of a firm is to maximize profit. The
price and output of a firm under perfect competition are determined
with the sole objective of profit maximization. Profits depend on the
cost and revenue of the firm. Profit is the excess of total revenue
over total cost. Firm aims at maximizing the difference between
revenue and cost. Maximum profits refer to pure profits which are
surplus above the average cost of production. But normal profit is a
necessary payment for an entrepreneur to stay in the business.

When profits are above normal profits they are called as
supernormal profits and when profits fall below normal profits, they
are called subnormal profits. Firm has to fulfill two conditions for
profit maximization. They are
(1) MR of a firm must be equal to its MC and
(2) MC curve of a firm must cut MR curve from below.

The equilibrium or profit maximization of a firm can be
explained with the help of total revenue and total cost curves. The
firm maximizes its profit at that level of output where the difference
between TR and TC is maximum.

Y TC
TR
B

Profit, Break-even C
Revenue Point
& cost
A Profits
Losses D

X
Output Q1 Q Q2

Figure 8.10

107

In the above diagram X axis represent level of output and Y
axis profit, revenue and cost. It is clear form the above diagram that
till OQ1 level of output TC remains more than TR. Hence initially
firm has to bear a loss. At point A TC becomes equal to TR. This
point is called as break-even point. Beyond point A TR increases
more than TC with an increase in the level of output. At OQ level of
output the difference between TR and TC is maximum. Therefore,
firm enjoys maximum profits shown by the shaded area i.e. CD.

8.5.2 Sales Maximization:

This objective is introduced by Prof. Baumol. According to him
revenue or sales maximization rather than profit maximization is
more consistent with the actual behavior of the firms. Sales
maximization means revenue maximization by the firm. The firm
maximizes its sales subject to minimum profit constraint. Following
fig. explains Boumol’s sales maximization objective.

Y R1 R2 TC

TR, TC TR
& TP A

M P Minimum profit
E

O Q Q1 Q2 X
Output TP

Figure 8.11

The above figure shows how a firm maximizes its sales with
minimum profit. OQ is profit maximizing output. At that level profits
are high at AQ. MP is minimum profit constraint. Sales
maximization output is OQ1 at which total revenue TR is maximum
at RQ. When MP is the minimum profit line, OQ2 is not the
consistent level of output. At this level profit EQ2 is less than
minimum profit. In reality, the objective is sales maximization with
minimum profit. Hence OQ1 is the maximum sales output.

However, the critics point out that it is difficult to combine sales
maximization objective with profit. In spite of this short coming,
maximization of sales is an important objective which is pursued by
firms.

108

8.5.3 Satisfaction Maximization:

According to economist, ‘Scitovskey and Haggins, the objective
of satisfaction maximization of a firm has greater significance than
profit maximization.’ An entrepreneur wants to maximize
satisfaction. But as income increases, he prefers leisure to more
work. The top management tries to attain a satisfactory level of
production, a satisfactory share of the market, a satisfactory level of
profit, and so on. The following fig. 03 explains the objective of
satisfaction maximization.

In the Fig. 03 output & leisure are measured on X axis and
profits on Y axis. IC1 and IC2 show entrepreneur’s scale of
preference between profit and leisure. MN is the net profit (income)
curve, i.e. the difference between TR and TC.

At point N, output is zero. Leisure is also measured on the same
axis starting form O toward X. As we move left side form N to L no
doubt output increases but leisure decreases.

Y

Profit R1
R

IC2

IC1
O M L Q N X
Leisure & Output

Figure 8.12

It is clear form the figure that maximum satisfaction is at R when
IC2 is tangential to net profit curve MN and the output is NQ. This
output is less than the profit maximization output NL. The profit RQ
at NQ output level are also less than the maximum profits R1L at
output NL.

Thus the producer maximizes his satisfaction at RQ level of
profit because he enjoys OQ leisure.

8.5.4 Growth Maximization:

Prof. Penrose considered growth maximization rather than profit
maximization to be a primary goal of managers of modern firms. A
systematic growth maximizing theory of a firm was developed by
Prof. Morris. According to him, the managers of a large firm aim at

109

promoting the growth and security of his business firm. Incentives
are provided to the manager to expand the size of the firm. For
achieving this objective he may expand new market through the
creation of new products and new demands. Morris introduced a
steady- state growth model. Under this managers chose constant
rate of growth. This helps its sales, profit assets etc. to grow.

Robin Marris presents a growth maximizing model of the firm
considering two basic relationship linking profitability and growth.
1. The supply growth relationship i.e. g = f (p) and
2. The demand –growth relationship i.e. p = h (g)
Here, p denotes profitability
g denotes growth
f and h denotes functional relationship.

Y
R S Supply-Growth Curve
B Q

Profitability
(g)

O Growth rate (g) A D X

Figure 8.13
The supply growth relationship is positive as shown by the OS
curve. There is a positive e relationship between profitability and
growth.

OD is the demand growth curve. It shows positive relationship
between the initial stage and higher rates of growth. The two curves
intersect each other at point Q. The firm will therefore operate at
the growth rate OA and profitability rate OB.

8.6 QUESTIONS

1. Explain the different concepts of Revenue.
2. Discuss the relationship between TR, AR & MR under perfect
competition.
3. Discuss the relationship between TR, AR & MR under
monopoly.
4. What are the different objectives of a firm?



110

9

BREAK-EVEN ANALYSIS AND
EQUILIBRIUM OF A FIRM

Unit Structure :

9.0 Objectives
9.1 Introduction of Break-Evan analysis
9.2 Analysis of Equilibrium of a firm
9.3 Conditions of Equilibrium of a firm : Marginal cost and
Marginal Revenue Approach
9.3.1 Conditions for the equilibrium or profit
maximization of a firm under perfect competition
9.3.2 Conditions for the equilibrium or profit
maximization of a firm under monopoly
9.4 Questions

9.0 OBJECTIVES

 To study the meaning and the concept of break-even
analysis.
 To study the conditions of equilibrium of a firm.

9.1 INTRODUCTION OF BREAK-EVEN ANALYSIS

The break-even analysis (BEA) has considerable
significance for economic research, business decision-making,
company management, investment analysis and public policy.

The break even analysis is an important technique to
explain the relationship between cost, revenue and profits at the
varying levels of output or sales.

The maximization of profit is one of the traditional
objectives of a firm. Maximum profit and minimum cost can not be
achieved at the same time. Similarly, profit maximization output can
not be known in advance. If it is known it can not be achieved at the
beginning. Thus often in practice the firms start their production

111

even experiencing a loss so as to earn the anticipated profit in the
future. In the process of production firm has to incur cost in the form
of fixed cost even before the production starts. Even when output is
zero total fixed cost is there. But when no unit of output is sold then
total revenue is zero. Thus in the initial stage of production cost
remains higher than the revenue. Therefore, a firm has to bear a
loss. But as more and more units of output are sold total revenue
starts increasing and it reaches to the point where total revenue will
cover total cost i.e. TR = TC.

Break-even point is the point at which the total revenue is
exactly equal to the total cost. In other words, the Break-even point
is defined as, ‘the point where the level of output is so reached that
TR = TC and hence the net income is equal to zero. Hence break-
even point is no-profit-no-loss zone.

Break-even point may be calculated either in the terms of
units of output which is called as break-even volume or in the terms
of total rupee sales. We can explain the break-even point concept
with the help of the following diagram.

Y TR TC

Revenue TVC
& cost E

A TFC

O Q output X

Figure 9.1

In the diagram X axis represents level of output and Y axis
represent revenue & cost. TFC is the total fixed cost curve which is
an intercept on Y axis at point ‘A’. TVC is the total variable cost, TC
is the total cost which is the sum of TFC & TVC and TR is the total
revenue which starts from origin and slopes positively upward from
left to right shows that TR increases with an increase in sales. Till
OQ output the total cost is more than total revenue and therefore
the area AOE indicates the area of losses. But as output increases
to OQ level, TR = TC at point E. If the output is increased beyond
the OQ level TR increases much faster than TC and hence total
profit goes on increasing. Thus the point ‘E’ is called as Break-
even point.

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 BEP in terms of total number of units of output/ break even
volume –
Algebraically, the break even volume is measured by the
following formula.

Total Fixed Cost
Break-even volume = ------------------------------
Price – Variable Cost

Let us explain with the help of following example.
Suppose the FC of a firm is 7,000.
Variable cost per unit of output is 15/-.
Price per unit is 50/-.
We can find out the break even level of output with the help of
above formula.
7,000
BEV = --------------
50 – 15

7,000
= ---------
35
= 200 units
 BEP in terms of total rupee sales-
Total sales value or Total Revenue = P × Q
= 50× 200
= 10,000.
Total Cost = FC + VC
TFC = 7,000
TVC = VC per unit × Total number
of units of output.
= 15 × 200
= 3,000
TFC + TVC = TC
7,000 + 3,000 = 10,000
TR - TC = Net income is equal to
zero.
TR 10,000 – TC 10,000 = 0
Hence, total profit is zero and thus 200 units is the break-even
level output.

Assumptions- Break-even analysis is based on the following
assumptions.
1. The cost function and revenue function are linear.
2. The total cost is divided into fixed and variable costs.
3. The selling price is fixed.
4. The volume of sales and production are identical.
5. Prices of factors are remaining constant.
6. Productivity and efficiency remains unchanged.

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Limitations- Break-even analysis has following limitations.
1. Break-even analysis is based on certain assumptions
which are assumed to be constant. This implies a static
in nature. It is not applicable to the dynamic situation.
2. Break-even analysis is unrealistic because it is based on
many assumptions. Linear cost and revenue functions
are true only for a limited range of output.
3. It fails to explain the impact of technological change,
better management, division of labour, improved
productivity and other factors which influence profits.
4. It assumes horizontal demand curve with the constant
price. It is possible only in case of perfect competition.
But it is not true in case of monopoly.
5. The scope of break even analysis is limited to the short
run only.
6. The break even analysis does not consider elements of
uncertainty due to tax structure.

Usefulness of BEA-
1. BEA is useful for decision-making in regards to pricing, cost
control, product- mix, channels of distribution etc.
2. It is a useful tool of managerial planning.
3. It can be used for determining the safety margin.
4. It provides a microscopic view of the profit structure of the firm.
5. It is useful for determining the quantity of output and level of
sales of a firm.
6. We can compare the profit margin of different firms with the
help of BEA.
7. BEA is useful to understand the relationship between firm’s
cost, revenue, production, loss and profit.

9.2 ANALYSIS OF EQUILIBRIUM OF A FIRM

Introduction -

A firm is said to be in equilibrium when it has no tendency
either to increase or to decrease its output. In this chapter we shall
explain general conditions for the equilibrium of the firm under all
types of market.
There are two approaches regarding the equilibrium or
profit maximization of a firm firstly, is total revenue and total cost
approach and secondly, marginal revenue and marginal cost
approach.

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Conditions of Equilibrium of a Firm: Total Revenue and Total
Cost Approach-

The firm is in equilibrium when it maximizes its total
profits (π). Total profit is the difference between total revenue (TR)
and total cost (TC). Symbolically,
π = TR – TC
Max. π = Max. the positive difference (TR- TC).

Graphically, maximization of total profits is illustrated in
the following diagram.

Y Fig. 2 TC
TR
B

TR, TC, Break-even
profit Point
& loss
A Profits

Losses

O Q
XA XB
Π

π=0 π=0
O Q
Losses XA Xπ m XB Losses

Output π

Figure 9.2
Where,
TR = Total revenue curve is a straight positively slopping
line from the origin increasing in the same
proportion as sales. It shows that the firm is a price-
taker and can sell any amount of output at the going
market price
TC = Total cost curve which is inverse- S shaped starting
from the level of fixed cost, reflecting the law of
variable proportions.

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π = Total profit curve. It is obtained by subtracting TC
form TR at each level of output.
Xπm = Output showing maximum profit. At this level of
output, the vertical distance between TR and
TC curves is maximum. In other words, both TR and
TC curves have same slope at this output level.
Points A & B = At these points TR = TC and the firm break even
i.e. profit is zero.
Losses = The firm incurs losses from origin till XA level of
output and beyond XB level of output because TC
is mote than TR. It is shown by shaded areas.

9.3 CONDITIONS OF EQUILIBRIUM OF A FIRM:
MARGINAL COST AND MARGINAL REVENUE
APPROACH-

9.3.1 Conditions for the equilibrium or profit maximization of a
firm under perfect competition-

A firm is in equilibrium when its MR is equal to MC. This
approach is called as MR-MC equality approach. A firm attains
equilibrium i.e. it maximizes its profit and minimizes its losses when
its MR is equal to its MC.

So long as MR is greater than MC, the residual profits
would be less than maximum. In such a situation, every additional
unit of output will add to the total revenue of the firm than to its total
cost. Hence, the total profit would go on rising or losses would go
on falling, with an increase in its output and sale. When MR is equal
to MC no more units will be produced.

If the output is increased beyond this point, MC will be
greater than MR i.e. it would add more to the total cost of the firm
than to its total revenue. In such a case its residual profits will be
less than maximum or its losses would rise. When MR is equal to
MC the difference between TR and TC would be maximum. Hence,
a firm will be in equilibrium when MR is equal to MC.

Under the condition of prefect competition the demand
curve of a firm is perfectly elastic i.e. horizontal straight line to the
‘X’ axis at the height of the given market price. Hence, under
perfect competition the price or AR is always equal to MR. A
perfectly elastic demand curve is called as AR as well as MR curve.

There are two conditions for the equilibrium or profit
maximization of a firm.

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1. MR of a firm must be equal to its MC.

2. MC curve must cut MR curve from below not from above.
The conditions for the equilibrium or profit maximization of a
firm under perfect competition can be explained with the help
of following diagram.

Y
MC > MR MC
Price, AR MR > MC
MR, MC E1
& profit A R T P H AR= MR

E

O M Q1 Q Q2 X
Units of output

Figure 9.3

In the diagram the horizontal line AH is the demand curve. It
represents AR and MR. Suppose that MC is the marginal cost
curve. It intersects the MR curve from above at point ‘R’ and from
below at point ‘P’. When MC curve intersect MR curve from above
at point ‘R’ MR is equal to MC with an output of OM units. But
point ‘R’ is not point of stable equilibrium. This is because by
increasing the output beyond OM units it can add more to its TR
than to its TC. So its residual profit will increase.

It is only at point ‘E’ where the MC curve intersects the
MR curve from below that the firm attains a stable equilibrium. This
is because the last unit produced ads to the TR which is equal to
the cost of producing that unit. Here, the firm gets maximum profits.

So at the output of OQ units MR is equal to MC and MC
curve rises and intersects the MR curve from below at point ‘P’. The
output of OQ units is a profit maximization output. The area REP is
the maximum profit area.

If it produces less than OQ units, say OQ1 units MC will
be less than MR. So the profit will increase by an area of TEP when
the output is increased up to OQ units. On the other hand any
output beyond OQ units say OQ2 units, will reduce profits by an
area of ‘PHE’ for MC is greater than MR. Hence, the profits will
increase until the output is contracted to OQ unit. At point ‘E’ there

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is a stable equilibrium. This is because at point ‘P’ MR is equal to
MC and MC curve intersect the MR curve from below OQ is the
equilibrium output. Prof. Samuelson calls the point ‘P’ as the best
profit point.

9.3.2 Conditions for the equilibrium or profit maximization of a
firm under monopoly-

A monopoly firm will also be in equilibrium when it
maximizes its profits or minimizes its losses. A monopoly firm is in
equilibrium when MR is equal to MC. This approach is called as
MR- MC equality approach.

A firm is in equilibrium when MR is equal to MC. When MR is
equal to MC, the firm would enjoy maximum total profit. Here the
difference between TR and TC is maximum. This is shown in the
following figure.

Y

R
P1 MC
Price, P2
revenue Profit Loss
& cost A P B

MR

O H N1 M Q X
Units of output

Figure 9.4

In this figure MR is marginal revenue curve slopes
downward from left to right. MC is the marginal cost curve falls in
the beginning and then rises. At first, the MC curve intersects the
MR curve from above at point ‘R’ when MR is equal to MC. It would
produce OH units. But it can not maximize its profit at this point.
This point ‘R’ is the breakdown point. When the output is increased
beyond OH units MC becomes less than MR and there are residual
profits. It would increase its output until the MC curve intersects the
MR curve from below at point ‘P’ where MR is equal to MC and the
monopoly firm attains equilibrium and enjoys maximum profits. OM
is the equilibrium output.

It shows that up to the OM units of output MR is more
than MC and thus, each unit provides profit.

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If it produces less than OM units say ON1, MR is greater
than MC by AP1. This is because while MC is AN, MR is P1N. So
the profit would be less than maximum. The profits can still be
increased. They are increased by expanding the production so long
as MR is greater than MC but with OM unit MR is equal to MC and
profits are increased by PAP1 Here the total profits are maximized.
RAP is the maximum profit area. Thus, with output OM it would
maximize its profits.

IF the output is increased beyond OM units MC is greater
than MR, so its profit would be reduced, if OQ units are produced
the MC is P2Q while MR is BQ. Thus, the net loss is BP2 and the
total loss is PBP2. So the output must be decrease until the output
OM is reached at which MR is equal to MC. Hence, the equality
between MR and MC is a necessary condition for the equilibrium of
a monopoly firm, but it is not sufficient condition. The sufficient
condition is that the MC curve must intersect the MR curve form
below, at point ‘P’ where the stable equilibrium is attained.

9.4 QUESTIONS

1. Explain fully the concept of Break-even analysis.
2. Explain the condition of Total Revenue and Total Cost
approach to attain equilibrium of a firm.
3. Discuss the profit maximization condition of a firm under perfect
competition.
4. Discuss conditions for the equilibrium of a firm under monopoly

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10
Module 5

PERFECT COMPETITION
Unit Structure :

10.0 Objectives
10.1 Introduction of perfect competition
10.2 Equilibrium
10.3 Equilibrium of a firm in the short run and long run
10.3.1 Short run equilibrium of a firm
10.3.2 Long run equilibrium of a firm
10.4 Equilibrium of an industry
10.4.1 Short run equilibrium
10.4.2 Long run equilibrium
10.5 Questions

10.0 OBJECTIVES

 To study the features of perfect competition.
 To study the meaning and determination of equilibrium price
under perfect competition.
 To study how a firm attains an equilibrium in the short run
and long run under perfect competition.
 To study the short run and long run equilibrium of an industry
under perfect competition.

10.1 INTRODUCTION OF PERFECT COMPETITION

A firm is an individual production unit which produces
particular type of a commodity. Under perfect competition the term
industry refers to a group of firms which produce a homogeneous
or identical product. So all firms producing a particular identical
commodity are together called industry.

Perfect competition is one type of market structure. Perfect
competition may be defined as, ‘that market situation, in which

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there are large number of firms producing homogeneous product,
there is free entry and free exit, perfect knowledge on the part of
buyer, perfect mobility of factors of production and no transportation
cost at all.’

Features: -
The main features of perfect competition are as follows.

1 Large number of buyers and sellers: There are so many buyers
and sellers that no individual buyer or seller can influence the price
of a commodity in the market. Any change in output supplied by a
single firm will not affect the total output of an industry. A producer
can sell whatever output he produces at the given price. So a firm
is a price taker. Similarly, no individual buyer can influence the
price of the commodity by his decision to vary the amount that he
would like to buy.

2 Homogenous product: Firms in the market produce
homogeneous products. Homogeneity of a product implies that one
unit of the product is a perfect substitute for another. The products
are identical in quality, shape, size, colour, design, packing etc.
There cross elasticity is infinity. Since the products are identical
buyers make no difference between sellers.

3 Free entry and free exit: Industry is characterized by freedom of
free entry and exit of firms, In a perfectly competitive market, there
are no barriers to movement in and out of an industry.

4. Perfect knowledge: All buyers and sellers have a complete
knowledge of the market conditions; viz; prevailing market prices,
quality of the product sold, availability of factors of production etc.
Information is free and costless. Under there conditions there are
no uncertainty about future development in the market. Advertising
has no role to play in the perfectly competitive market.

5. Perfect mobility of factors of production: The factors of
production can move easily from one firm to another. Workers can
move between jobs and between places.

6. Absence of transportation cost: All goods are produced locally.
Therefore, transportation costs are zero.

As already mentioned above when the first three
assumptions are satisfied, there exists pure competition.

The competition becomes perfect when three additional
assumptions are satisfied.

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10.2 EQUILIBRIUM

Equilibrium literally means a state of balance or a state of
rest or position of no change. In economics, the term equilibrium
means the state in which there is no tendency on the part of
consumers and producers to change.

It may be defined as, ‘when two opposite forces balanced
each other on a particular object, that object is said to be in a state
of equilibrium.’ Two factors determining equilibrium price- are
demand and supply.

Thus, equilibrium price is the price at which demand and
supply are equal to each other. At this price, there are no incentives
to change.

Determination of Equilibrium Price:
Equilibrium price is determined by the equality between
demand and supply. At this price, Quantity demanded = Quantity
supplied.

Prof. Marshall compared demand and supply to the two
blades of a pair of scissors. It shows that it is not blade that cuts the
cloth. Both the blades together, do it. Similarly, it is not demand or
supply alone that determines the price of a commodity. Together
through interaction they determine the equilibrium price of a
commodity.

The process of determination of equilibrium price can be
explained under three heads.

1 Demand- A commodity is demanded because it has utility and
satisfies human want. The law of demand states that there is an
inverse relationship between price and quantity demanded of a
commodity. Higher the price, lower is the demand and vice versa.
The aim of the consumer is to maximize his satisfaction.

2. Supply- The law of supply states that there is a direct relationship
between the price and quantity supplied of a commodity. More the
price, more will be the supply and vice versa. The aim of the
producer is to maximize profits.

3. Equilibrium between demand and supply- The forces of demand
and supply determine the price of a commodity. There is a conflict
in the aim of producers and consumers. Producers want to sell the
goods at the highest price to maximize profit and consumer want to
buy the goods at the lowest price to maximize satisfaction.

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Equilibrium price will be determined where quantity
demanded is equal to quantity supplied. This is called market price.
A demand and supply schedule and curve will show the
determination of equilibrium price.

Price ` (per k.g.) Demand (k.g./month) Supply (k.g./month)
10 1 5
9 2 4
8 3 3
7 4 2
6 5 1

Table No. 10.1 Demand- supply schedule of Salt

Y
10 D S

9
Price 8 E DD = SS

7

6 S D

0 1 2 3 4 5 X

Demand and Supply

Figure No. 10.1 Equilibrium Price

In the above table demand and supply of salt at different
prices are shown. Equilibrium price is fixed at 3 where quantity
demanded and the quantity supplied are equal i.e. equal to 3 units.

In Fig. 01 quantity demanded and supplied are measured on
the X axis and price on the Y axis. DD is the downward sloping
demand curve and SS is the upward sloping supply curve. Both
these curves intersect each other at point ‘E’ which is the
equilibrium point and it implies that at price of 6, demand is 3
units and supply is also 3 units. Thus equilibrium price is 6.

Effects of Changes in Demand and Supply on Equilibrium
Price:-
Equilibrium price is derived by that point where quantity
demanded is equal to quantity supplied. Therefore, if either demand

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changes or supply changes or both change, equilibrium price and
output will change. The effect of changes in demand and supply on
equilibrium price and output can be explained as follows.

Changes in Demand: -
Changes in demand take place due to changes in prices of
related goods, income, fashion, tastes and habits of the consumers
etc. When demand changes, demand curve shifts. Due to changes
or shifts in demand curve, supply curve remaining the same, there
is a change in the equilibrium price and output. Demand may (a)
increase or (b) decrease.

(a) Increase in demand: - When demand of a commodity
increases, while supply remains constant, equilibrium price will
increase. At the same time, quantity sold and purchased will also
increase. This is shown in Fig. No. 02

Y D1 Y D S
D S D1

P1 E1 P E
Price
P E P1 E1

D1 S
D
S
D1
D
S D
O Q Q1 X O Q1 Q
X

Demand & supply Demand & supply

Figure No.10. 2 Increase in Demand Figure No. 10.3 Decrease in Demand

In the original situation, the DD and SS curves intersect at
point E at this equilibrium point the equilibrium price is OP and
output is OQ. While supply remain constant, if the demand
increases the demand curve shifts from DD to D1D1. The new
equilibrium is established at point E1. The equilibrium price goes up
from OP to OP1 and output from OQ to OQ1. Therefore, when
demand curve shifts upwards, equilibrium price and output
increases.

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(b) Decrease in demand: If the demand of a commodity
decreases, while supply remains constant, the equilibrium price and
output will fall. This is shown in the Fig. No. 3.

In Fig. 3 quantity demanded and supplied are shown on the X
axis and price of commodity on the Y axis. DD is the original
demand curve. SS is the original supply curve, E is the equilibrium
point. Decrease in demand is shown by downward shift of DD curve
to D1D1. New demand curve intersects the supply curve at point E1.
Equilibrium price falls from OP to OP1 and output falls from OQ to
OQ1. Therefore, when demand curve shifts downwards both
equilibrium price and output falls.

Changes in Supply: -
Like demand, supply of a commodity also changes. Changes
in supply take place due to chages in the cost of production,
production techniques, etc. Due to changes in supply, supply curve
shifts. It may (a) Increase of (b) Decrease.

Y Y
S1
D S D
Price S1
S

P E P1 E1

P1 E1 P E

S S1 D
S1 D S

O Q Q1 X O Q1 Q
X
Demand & supply Demand &
supply
Fig. No. 10.4 Increase in Supply Fig. No.10 5 Decrease in
Supply

(a) Increase in Supply: - If the supply of a commodity increases,
while demand remains constant, equilibrium price will fall. This is
shown in Fig. 4. In the figure, quantity demanded and supplied is
shown on the X axis and price on Y axis. DD is the original demand
curve. SS is the original supply curve. E is the original equilibrium
point. SS increase to S1S1. New supply curve cuts demand curve
DD at point E1, which is the new equilibrium point. At this
equilibrium point, price falls from OP to OP1 and quantity demanded

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and supplied rises from OQ to OQ1. Thus, if supply increases, while
demand is constant, equilibrium price will decrease and quantity
supplied will increase.

(b) Decrease in Supply: - If the supply of a commodity decreases,
while demand remain constant, equilibrium price will increase. It is
shown in Fig. 5. In the figure, quantity demanded and supplied are
shown on the X axis and price of a commodity on the Y axis. DD is
the original demand curve. SS is the original supply curve. E is the
original equilibrium point. Supply decreases to S1S1. New supply
curve cuts the demand curve DD at E1, which is the new
equilibrium point. Equilibrium price has gone up form OP to OP1
and the quantity supplied decreased from OQ to OQ1. Thus, if
supply decreases, while demand remains constant, equilibrium
price will rise and output will fall.

10.3 EQUILIBRIUM OF A FIRM IN THE SHORT RUN
AND ONG RUN

Under perfect competition a firm has to fulfill two conditions
for the short run and long run equilibrium of a firm.
1. MR is equal to MC.
2. MC curve should cut MR curve from below.

For the purpose of the study equilibrium of a firm or price-
output determination by a firm can be studied under two heads-
short run equilibrium and long run equilibrium. Let us first study the
short run equilibrium.

10.3.1 Short run equilibrium of a firm :

A short run equilibrium of a firm under homogenous and
heterogynous cost conditions is reached as under. There are three
possibilities of short run equilibrium of a firm.

1. Excess profit 2. Normal profit and 3. Loss.
2.
A firm has to fulfill two conditions for the short run equilibrium
of a firm. We can explain the above three possibilities and two
conditions with the help of following figure.

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SRMC
Y P1 AC
M1 AR1= MR1
H S E
M P AR= MR

N P2 AR2= MR2
Price,
revenue
& cost

O Q2 Q Q1 X
Units of output

Figure No. 10.6

In the above diagram ‘X’ axis represent units of output and
‘Y’ axis represent price, revenue and cost. There are horizontal AR
and MR curves. ‘SMRC’ curve intersects MR curve at three points
P, P1 and P2. OQ commodities are produced at OM price. OQ1
commodities are produced at OM1 price and OQ2 commodities are
produced at ON price.

* At point ‘P’- SRMC = MR & AR = AC.
At this point AR = AC, so at this equilibrium point OQ
commodities are produced at OM price. Hence, the firm is in short
run equilibrium and enjoys only normal profit.

* At point ‘P1’- MR = MC and AR > AC.
The excess profit and loss is determined by the difference
between AR and AC. At this equilibrium point OQ1 commodities are
produced at OM1 price. Hence, some firms in the industry enjoy
excess profit shown by the area ‘M1P1EH’.

* At point ‘P2’ – MR = MC and AR < AC.
At this equilibrium point OQ2 commodities are produced at
ON price. Hence firm would suffer a loss at a price which is less
than AC shown by the area ‘MSP2N’.

In short there are three possibilities depending upon AR and
AC.

10.3.2 Long run equilibrium of a firm :

In the long run the equilibrium of a firm under homogenous
and heterogeneous cost condition is explained as under.

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In the long run all the factors of production can be changed.
In the short run some loss making firms would leave the industry in
the long run. The excess profit is divided among the firms in a same
proportion. Hence, in the long run no one firm would enjoy excess
profit or suffer a loss.

The long run equilibrium of a firm is attained by the equality
between MR = MC and AR = AC. This is explained with the help of
the following diagram.

Y LRMC
LRAC
Price,
AR & E
MR P AR= MR

O Q X
Units of output

Figure10. 7

In the above diagram ‘X’ axis represent units of output and
‘Y’ axis represent price, revenue and cost. LRMC curve intersect
AR = MR curve at point ‘E’ from below. This equilibrium point
shows that both the AR = AC and MR = MC. This equilibrium point
also shows that no one firm would earn excess profit or suffer a
loss. Here each and every firm in the long run enjoys only normal
profit. Hence the firm will be in a stable equilibrium.

10.4 EQUILIBRIUM OF AN INDUSTRY

Industry simply means a group of firms producing a
particular type of a commodity.
The equilibrium of an industry in the short run and in the long run
can be explained as follows.

10.4.1 Short run equilibrium :

An industry which consists of large number of firms
producing identical product is to be in equilibrium. Under perfect
competition in order to attain an equilibrium three conditions must
be fulfilled by the industry. The conditions are-

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1. Every firm must be in equilibrium i.e. MR of every firm must be
equal to its MC. The MC curve of every firm must cut its MR
curve from below.
2. Industry as a whole must be in equilibrium i.e. the AR of every
firm should be equal to its AC. However, in the short run
industry may not be in a stable equilibrium because, the AR of
every firm may not necessarily be equal to its AC.
3. The short run sub normal price in the industry is in equilibrium,
when the short run demand and short run industry’s supply are
equal.

10.4.2 Long run equilibrium :

In the long run an industry would be in a stable equilibrium
when every firm enjoys only normal profit. In the long run an
industry has to fulfill three conditions. They are-

1. MR of every firm must be equal to its MC. The MC curve of
every firm must cut its MR curve from below.

2. The AR of every firm must be equal to its AC.
When AR = AC the number of firms in the long run industry
would remain constant and the industry would attain a stable
equilibrium.

In the case the AR is more of less than AC the industry would
not be in a stable equilibrium. When AR is greater than AC the
existing firms would enjoy excess profit. This would induce new
firms to enter the industry. The output would increase and the price
would come down until it is equal to AC. On the other hand, when
AR is less than AC some existing firms would suffer losses. This
would force some of them to leave the industry. Hence the output
would decrease and the price would rise until it becomes equal to
AC.

When AR is equal to AC the industry as well as every firm will be
in a stable equilibrium. In such a situation the number of firms in the
industry and its output would remain constant.

3. The long run normal price in the industry is in equilibrium when
the long run demand and long run industry’s supply are equal.

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10.5 QUESTIONS

1. Explain the features of perfect competition.
2. Discuss how equilibrium price is determined under perfect
competition.
3. Explain how a firm under perfect competition attains an
equilibrium in the short run.
4. How a firm under perfect competition attains an equilibrium in
the long run. Discuss
5. Describe the equilibrium condition of the industry in the short run
and long run under perfect competition.

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11

MONOPOLY MARKET

Unit Structure :

11.0 Objectives
11.1 Introduction of monopoly
11.2 Types of Monopoly
11.3 Equilibrium of a firm
11.4 Discriminating Monopoly
11.4.1 Types / Methods of price discrimination
11.5 Equilibrium under discriminating monopoly
11.6 Dumping
11.6.1 Equilibrium under the conditions of dumping
11.7 Questions

11.0 OBJECTIVES

 To study the meaning and types of monopoly.
 To study the equilibrium of a monopoly firm in the short run and
long run.
 To understand the meaning of discriminating monopoly and
conditions essential for price discrimination.
 To study the equilibrium of a monopoly firm under discriminating
monopoly.
 To study the equilibrium of a monopoly firm under conditions of
dumping.

11.1 INTRODUCTION OF MONOPOLY

The term ‘Monopoly’ consist of two words ‘Mono’ and ‘poly’.
Mono means single, poly means seller. Thus, when there is only
one seller of a commodity in the market can be called as monopoly
market. There is various definition of ‘monopoly’ given by various

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economists. Prof. Lerner defines it as, ‘any seller who is confronted
with a falling demand curve for his product.’

The Monopoly refers to, ‘that market situation in which there
is only one firm (seller) in the market, that has a control over the
supply of a commodity and which has no close substitutes for its
product in the market.’

It is to be noted here that in practice we rarely come across
the pure monopoly (single seller) except in case of government
monopolies. When we refer to monopoly, normally we have ‘lesser
degree of competition’ in our mind rather than complete absence of
competition.

Features of Monopoly-
The above definitions help us in determining certain broad
features of monopoly market.

1. Single Seller – There is only one producer/firm/seller of the
product in the market. Obviously, he has complete control over
the supply of the commodity.
2. Absence of perfect substitutes – In a monopoly market the
product of a monopolist does not have perfect or close
substitutes.
3. Price Maker – A monopolist is a price maker and not a price
taker. It means that monopolist himself is in a position to decide
the price. He does not have to accept the price in the market.
4. Profit Maximization – Unlike a competitor seller, the monopolist
necessarily aims at earning maximum profits. As Marshall puts it
the price setting by a monopolist is not just for covering the cost
of production but is essentially for earning maximum net
revenues.
5. Firm and Industry – As pointed out earlier in a monopoly
market, there is no distinction between a firm and an industry.
The monopolist firm is itself the industry.
6. Falling Demand Curve – As Prof. Lerner points out that a
monopolist is always confronted by a falling demand curve
which means that he gets a fairly inelastic demand curve for his
product.
Thus, a market characterized by all the above features is a
monopoly market.

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11.2 TYPES OF MONOPOLY

Monopoly may be classified into various types. These types
of monopoly are based on various criteria. The main types can be
described in the following manner.

1. Pure monopoly and Imperfect monopoly: The classification of
monopoly into pure and imperfect is based on degree of
competition in the market. Pure monopoly is said to exist when
there is no competition at all in the market. It is possible only if
there are no substitutes for the monopolist’s product. On the
other hand, imperfect monopoly implies a market where the
monopolist may have a few substitutes though the substitutes
may not be absolute or perfect substitutes.
2. Private and Public Monopolies: This classification is made on
the basis of the ownership of monopoly firm. Private monopoly
refers to a monopoly firm owned by a private individual. Public
monopoly, on the other hand is a firm owned, managed and
controlled by Govt. There are certain types of activity which are
exclusively meant for public undertaking. Indian Railway or Post
can be cited as examples of such public monopolies.
3. Natural, legal, technological and joint monopolies: This
classification is based on the sources of getting monopoly
power by firms.
Natural monopolies refer to a situation where, by advantageous
location, age-old reputation etc. the firm derives a monopoly
power.
Legal monopolies arise out of legal sanctions for patents trade-
marks etc. The other firms are forbidden to make use of patents
and trademarks already given to certain firms.
Technological monopolies refer to the monopoly power gained
by certain firms because of their technological expertise.
Joint monopolies are enjoyed by certain firms who come
together with a definite objective and form combinations like
cartels, trusts etc.
4. Simple Monopoly and Discriminating Monopoly: Such a
classification is made on the basis of the pricing policies
adopted by the monopoly firms. Simple monopoly has a uniform
price policy for all customers while the discriminating monopoly
firms charges different prices from different customers for the
same product.

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11.3 EQUILIBRIUM OF A FIRM

In order to understand the price output determination or
equilibrium of a firm in a monopoly market in the short run and in
the long run we shall make some basic assumptions.
1. Monopoly of a seller.
2. Perfect competition among the buyer.
3. No close substitutes.
4. Profit maximization.
With the above assumption we shall now first deal with the short
run equilibrium of a firm under monopoly.

11.3.1 SHORT RUN EQUILIBRIUM

It may be recalled here that in the monopoly market AR and
MR differs from each other. This is on account of price variations. It
should also be noted here that for a monopoly firm AR curve
represents the demand curve. The AR curve also denotes the price
under any market situation as AR is equal to price. The equilibrium
condition is equality of MR and MC. The monopoly price may be
greater than, equal to or less than AC which may lead to excess
profits, no profit no loss and loss respectively. This means there
are three possibilities in the short run equilibrium. The figure No.
11.1, 11.2, and 11.3 will make it clear.

Y Y

MC MC

P R AC P R

C T AC
Price E E
Revenue
& cost
MR AR MR AR

O Q X O Q X
Unit of output Unit of output
MR = MC & AR > AC MR = MC & AR = AC


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Y
MC

C T AC

P R
Price,
revenue
& cost E

MR AR

O Q X
Units of output
MR = MC & AC > AR

Figure No.11. 3

The above figure No. 11.1 shows that X axis represent
units of output and Y axis represent price, revenue and cost. MC is
the marginal cost curve which intersects MR curve at point ‘E’. At
this equilibrium point AR average revenue is more than AC average
cost. At point ‘E’ OQ units are produced and sold at OP price. The
average cost of OQ units of output is OC which is less than
average revenue or price OP. The average revenue curve AR lies
above the AC average cost curve. This enables the monopolist to
earn excess profits shown be the area PRTC.

The figure No. 11.2 shows that MC curve intersects MR
curve at point ‘E’. Point ‘E’ is the equilibrium point. At this
equilibrium level AC average cost curve is tangent to AR average
revenue curve. This shows that at point ‘E’ not only MR = MC but
also AR = AC, OQ units are produced at OP price. The average
cost of OQ units is equal to average revenue or price OP. Hence at
this output the monopolist is able to earn only normal profit i.e. no
loss no profit.
The above figure No. 11.3 shows that at point ‘E’ the
monopoly firm attains equilibrium. At this equilibrium point the
average cost curve AC lies above the AR average revenue curve
which shows that average cost is greater than average revenue. At
point ‘E’ OQ units are produced and sold at OP price. The average
cost at OQ units is OC which is more than the average revenue or
price OP. Hence, firm has to bear a loss shown by the area PCTR.

The long run equilibrium of the monopoly firm is attained
at point ‘E’ where LMR and LMC curves intersects each other. In
the long run the firm can change the variable as well as fixed

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factors of production. The monopolist will try to maximize profits to
the extent possible.
In the long run the monopolist will earn supernormal or
excess profits. In any case he will not earn normal profit or bear the
losses. The following figure shows the condition of excess profit
earning and long run equilibrium.

Y
LMC

P R LAC

C T
Price,
revenue E
& cost
LMR LAR

O Q X
Units of output
MR = MC & AR > AC

Figure No. 11.4

The above figure No. 11.4 shows that units of output is
measured on X axis and price, revenue and cost are measured on
Y axis. LMC is the marginal cost curve which intersects LMR curve
at point ‘E’. At this equilibrium point AR average revenue is more
than LAC average cost. At point ‘E’ OQ units are produced and sold
at OP price. The average cost of OQ units of output is OC which is
less than average revenue or price OP. The average revenue curve
AR lies above the AC average cost curve. This enables the
monopolist to earn excess profit shown be the area PRTC. It should
be remembered that the elasticity of demand decides the price. If
the demand is elastic lower price will be set and if the demand is
more inelastic the price would be higher.

11.4 DISCRIMINATING MONOPOLY

Discriminating monopoly is one of the important features
of the monopoly market. When a monopoly firm charges different
prices from different customer for the same product at the same
time is known as price discrimination. A monopoly under which this
type of price discrimination is practiced is known as Discriminating
Monopoly. In actual practice when we use the term ‘Price
Discrimination’, we refer to discrimination between groups of buyers
rather than discrimination between units of a homogeneous
product.

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Essential Conditions for Price Discrimination –
There are three basic conditions which must be fulfilled for
Price discrimination. The conditions are as follows.
1. Monopoly Firm: Price discrimination is possible only for a
monopoly firm. It means that a firm under perfect competition
can not go for price discrimination, obviously as the customer
may go to seller other than the discriminating one.
2. Two or more markets: The monopolist should have two or more
markets for the same commodity with different elasticities of
demand at a monopoly price. This enables the monopolist to
charge higher price in the market having more inelastic demand
and relatively lower price in the market having lesser inelastic
demand for his product. This condition of different elasticities of
demand in different markets is the most important condition
because; if the elasticities are equal/ same the monopolist can
not increase his profits simply by distribution of his total output
in different markets.
3. No possibility of resale: This condition is also important since,
the possibility of resale of the commodity would deny the
possibility of discrimination. If a consumer is in a position to
purchase the commodity from the market where the price is low
and resell it in the market where the price is higher, the
monopolist will not be able to continue with the price
discrimination. The two market should be totally separated form
each other, other wise the exchange of goods would take place
between the customers. Thus there should be no
communication between the customers of the two different
markets. The markets for services can be easily separated from
each other. The doctor can therefore charge different fees from
different patients for the same type of services.
Thus, if the above conditions are fulfilled the monopolist is
able to follow the policy of price discrimination.

11.4.1 Types/ Methods of price discrimination :

There are various types or methods of price discrimination
which are determined on the basis of the strategy or the policy
adopted by the monopolist. Following are the main methods or
types.
1. Discrimination according to markets: The monopolist may
discriminate between the whole sale and retail market. Thus a
commodity may be sold at a lower price in the wholesale
market and at a higher price in the retail market.
2. Discrimination according to income: Discrimination can also be
made on the basis of incomes of various customers. The

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financial consultant may charge higher fees from a big
businessman while lower fees from a small businessman.
3. Discrimination according to time: The time when a commodity
or service is bought may also constitute the basis for price
discrimination. The rickshaw service hired during the night
hours costs more fare. Doctors may charge higher fees for the
night visits.
4. Discrimination according to national boundaries: A monopolist
may charge higher price in the protected domestic market but a
lower price across the national boundary. This in other words
called as ‘dumping’.
5. Discrimination according to utility: Sometimes, different prices
are charged from different customers according to the utilities
conferred on them. Discrimination in first class and second
class fares by railways is an example of this kind. The
passenger travelling by first class gets more comforts for which
he pays more.
6. Discrimination according to places: The place where the
commodity is sold is also responsible for price discrimination.
The set of ‘playing cards’ sold at railway station shop may cost
more than elsewhere.
7. Discrimination according to uses: Sometimes the monopolist
may charge different price for the same service or commodity if
used for different purposes. The electricity charges for
example, are more for domestic use than for industrial use.
The above mentioned types or methods are the major types
of price discrimination.

11.5 EQUILIBRIUM UNDER DISCRIMINATING
MONOPOLY

The equilibrium under discriminating monopoly is also governed
by the same principle of MR = MC. However, since the monopolist
will have two or more markets with different elasticities of demand,
he will have to be in equilibrium in each market separately as well
as in all the markets jointly. The supply of his product will have to
be distributed accordingly.

The monopolist will be able to charge higher price and will
bring less number of units in the market where the demand for his
product is more inelastic but he will charge lower price and bring
more units in the market where the demand is less inelastic. This
will be clear from the following diagram.

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Market 1 Market 2 Market 3

Y Y Y

A MC

P1
P2
R1 R2 R
E
AR2
CMR

B
MR1 AR1 MR2
O Q1 X O Q2 X O Q
X

Equilibrium under the conditions of dumping
Figure 11.5

In the above diagram fig. 11.5 represent market (1) with
more inelastic demand, market (2) with less inelastic demand and
the combined situation for the firm in fig. (3). It can be seen that
OP1 price is charged in market ‘1’ while OP2 price is charged in
market ‘2’. The CMR in fig. ‘3’ is combined marginal revenue curve
of the two markets derived by adding the MR curves in the two
markets sideways. Thus, by maintaining the same level of MR in
two markets, the monopolist distributes the total output (OQ in fig.
3) in the two markets as OQ1 and OQ2. It can be seen that, he
brings less output where the price is higher and more output is
brought where the price is lower. By doing so, he can maximize his
profits. The total profits earned by him are shown by the shaded
area ARB in fig. ‘3’.

Thus, price discrimination helps the monopolist in
maximizing his profits.

11.6 DUMPING

Selling a product at a higher price at home and at a lower
price in the foreign countries is called as dumping. In other word,
‘selling goods abroad at a lower price than that of the domestic
price is called dumping.’

According to Haberler, ‘the sale of good abroad at a price
which is lower than the selling price of the same good at the same
time and in the same circumstance at home taking account of

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differences in transport costs is called as dumping.’ Dumping is a
special type of price discrimination. It may be persistent or
temporary.

Motives for dumping:
1. To remove rivals in foreign markets.
2. To dispose of surplus output.
3. To take the advantage of falling cost conditions.
4. To create new demand
5. Differences in the price elasticities of demand.

11.6.1 Equilibrium under the conditions of dumping:
We can explain the equilibrium of a firm under the conditions
of dumping based on the following assumptions.

1. The monopolist sells his product in the home market and in
foreign markets.
2. He attempts to maximize his profits.
3. There are many buyers on the demand side.
4. He is a monopolist at home and a competitor in foreign
countries.
5. It should not be possible for foreign buyers to re-sell the good in
the domestic market of the exporting country.
6. In the home market, the demand for his product is relatively
inelastic and in foreign markets, it is perfectly elastic.

The conditions for the maximization of his total profits are as
follows.

i) Profits are maximized when MR in both the markets are
equal.
ii) The marginal revenue in each market is equal to the marginal
cost of the total output.

This can be explained with the help of the following diagram.
In figure No.8 ARH is a downward sloping demand curve at home
and MRH curve is the corresponding downward sloping marginal
revenue curve at home.

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Y MC

B
P
Price
A E R ARW = MRw

T
MRH ARH

O N Q X
Units of output
Figure No. 11.6

Since, the monopolist is a competitor in the foreign market;
we shall assume that the demand curve for his product in foreign
countries is perfectly elastic under the condition of perfect
competion.

Hence, he faces a horizontal demand curve represented by
ARW in the foreign market. Since it is horizontal, the marginal
revenue, MRW coincides with the ARW. Hence, ARW = MRW.

BE is the MR curve in the home market and ERD is the MR
curve in the foreign market. When both are added, we get the
combined marginal revenue curve BERD at point ‘R’ at which CMR
= MC. Here firm attains equilibrium. The equilibrium output is OQ.
The output is distributed in the two markets- the home market and
the foreign market in such a way that the marginal revenues are
equal in each market, and the marginal revenue in each market is
equated to marginal cost of the entire output. In the home market
MRH curve at point E where MRH = MC. So ON amount is sold in
the home market at PN price and remaining output NQ is sold in
the foreign market at OA or RQ price because in the foreign market
MRW = MC. IT may be noted that with this distribution, MRH = MRW
= MC for EN = RQ. Hence, MRH = MRW = CMR = MC. Naturally the
profits are maximized. These profits are BERT.

It shows that the price charged at home is higher (PN) and
the amount sold is lower (ON) than in the foreign market where the
price charged is lower (OA or RQ) and the amount sold is higher
(NQ).

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11.7 QUESTIONS

1. Explain the features of monopoly.
2. What are the various types of monopoly.
3. Explain how a monopolist attains an equilibrium in the short run.
4. What is discriminating monopoly? Describe the essential
conditions for price discrimination.
5. How monopolist attains an equilibrium under discriminating
monopoly?
6. Explain in detail the concept of dumping.

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12

MONOPOLISTIC COMPETITION

Unit Structure :

12.0 Objectives
12.1 Introduction of monopolistic competition
12.1.1 Features / Characteristics
12.2 Equilibrium or Price-output determination of the firm under
monopolistic competition
12.3 Product differentiation
12.4 Selling Costs
12.5 Wastes of Monopolistic Competition
12.6 Introduction : Oligopoly market
12.6.1 Classification / Types
12.7 Features or characteristics of Oligopoly
12.7.1 Price rigidity or Stability
12.7.2 Kinky (Kinked) Demand Curve
12.8 Questions

12.0 OBJECTIVES

 To study the meaning and features of monopolistic competition.
 To understand the equilibrium of a firm in the short run and long
run under monopolistic competition.
 To study the concepts of product differentiation and selling cost.
 To study the wastes of monopolistic competition.
 To study the meaning and types of oligopoly.
 To study various features of oligopoly market.

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12.1 INTRODUCTION OF MONOPOLISTIC
COMPETITION

The term ‘monopolistic competition’ is used interchangeable
with the term ‘imperfect competition’.

The concept of ‘Monopolistic Competition’ was introduced by
Prof. E. H. Chamberlin in his book, ‘Theory of Monopolistic
Competition’. Monopolistic Competition refers to that market
situation,’ where there is large number of sellers producing a
commodity with their own peculiarities.’ This means the commodity
is not identical or homogeneous. There is product differentiation.
Each producer is producing a different type of a commodity than
the others.

Monopolistic Competition strictly means a market with
competitive monopoly of a large number of sellers.

12.1.1 Features/ Characteristics:

1. Large Number of Firms: Monopolistic competition is
characterized by a large number of firms producing a similar
product. Each firm will have a definite group of customers and
enjoys a some sort of monopoly in respect of the particular
group of customer. Each firm has to face competition from the
other firms. Therefore, each firm has to make efforts for
maintaining and increasing its market share. As the number of
firms is large, each firm produces a relatively smaller share of
the total market supply.

2. Product differentiation: The large number of firms under
monopolistic competition produces differentiated products which
are relatively close substitutes for each other but not perfectly
substitutes. Each firm, in order to attract maximum buyers will
have its own peculiarities of the product which distinguishes its
product from other similar products in the market. This is called
as product differentiation.

Product differentiation may occur in many ways. The firm
may have its own quality, Brand- name, material used,
packing, appearance, fragrance, shape, technology etc. of
the commodity.

3. Easy entry and exit: The entry in and exit from such a market is
not very difficult. There are no such restrictions on the entry and
exit of firms. Though each faces competition, is independent in
case of price and output decisions.

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4. Selling costs: The market is characterized by selling costs. In
order to attract and better known to the customers the firm has
to go for sales promotion activities like advertising, free service
and buy one and get one more free etc. For this each firm
requires to be incurred huge amount of money. These expenses
are called as selling costs.

5. Sloping demand curve: Each firm under this type of market has
a downward sloping demand curve because the demand for a
commodity of a monopolistic competitive firm is more elastic.
The demand curve is less steep than the demand curve of a
monopoly firm.
6. Concept of Group: Professor Chamberlin used the word group
instead of industry. Under monopolistic competition, there is
heterogeneity and therefore he has used the concept of group
to imply a collection of firms producing closely related but not
homogeneous goods. Under monopolistic competition, due to
qualitative differences and buyers’ preferences, there are wide
divergences in the curves of cost of production and a variety of
demand curves. The result is heterogeneity of prices and
variations over a wide range of output and in profits.

12.2 EQUILIBRIUM OR PRICE-OUTPUT
DETERMINATION OF THE FIRM UNDER
MONOPOLISTIC COMPETITION

The monopolistic competition pricing can be divided into twp
broad categories, short run equilibrium of a firm and long run
equilibrium of a firm. We deal each of them separately.
12.2.1 Short run equilibrium :
Like any other type of market the equilibrium of a firm under
monopolistic competition will be established where the MR is equal
to MC. In the short run period, the firm may make profits, incur
losses or may have no profit no loss situation.
The demand curve of a firm under monopolistic competition
may differ in its elasticity from firm to firm. However, it will neither
be perfectly elastic nor perfectly inelastic. The slope of AR curve
may therefore vary accordingly. We can understand the three
possibilities of short run equilibrium with the help of following
diagrams.

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Y SMC Y SMC

C SAC C
SAC
P P
A B
Price, e
revenue, e SAR
costs
SAR
MR SMR

O Q Output X O Q Output
X


Y SAC

A B SMC
P C
SAVC
e
SAR
SMR

O Q Output X

Figure 12.3

The above three diagrams shows that there are three
possibilities of short run equilibrium of a firm in the monopolistic
competition.

Fig. 12.1 shows that, SMC curve cuts the SMR curve at
point ‘e’ when the average cost is OA or QB and the price or
average revenue is OP. The price or average revenue is more than
the average cost and hence the firm enjoys profits as shown by the
area PCBA.

In Fig. 12.2 the SMR = SMC and SAC curve is tangent to
SAR curve and hence the firm earns only normal profit. It means
the firm neither earns excess profits nor does it incur any losses.

In Fig. 12.3 the SMR = SMC, SAVC curve is tangent to SAR
curve and SAC lies above the SAR. It means that average cost is
more than the average revenue hence the firm has to incur losses

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shown by the area ABCP but its price or average revenue is just
sufficient to take care of the average variable costs.

Thus, the short run equilibrium may enable this firm in
monopolistic competition to earn profits, to sustain losses and with
no profit no loss situation.


If the firm is earning supernormal profits, more firms will
enter the ‘group’ in the long-run. If the firm is incurring losses, firms
will leave the group in the long-run. If the firm is making no loss no
profit in the short run, it will continue to remain in the same position
in the long-run.

Y MC
LAC
C
P c1
Price,
revenue, e
costs LAR

MR

O Q Q1 Output X

Figure 12.4

In the long-run, at point ‘e’ the LAC long run average cost
curve become tangent to the LAR long run average revenue curve
or the demand curve. Since at this point, the slope of the AR and
AC curves is equal to the MR and MC curves will intersect vertically
below it. This is shown by point ‘e’ in the following diagram.

The long-run equilibrium conditions are- MR = MC and AR =
AC.
As the firm is earning just normal profit, there is no tendency
for the number of firms in the group to change. Thus, the long run
equilibrium of the firm implies equilibrium for the group as a whole
also.

Since the long run equilibrium is shown by the tangency
between the AR and AC curves; it implies that the equilibrium
output OQ will necessarily be less than the least cost output OQ1.
This is true because a downward sloping AR curve can be
tangential to U shaped AC curve at some point to the left of the
minimum point (c1). It means that in the long run economies of

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scale are not fully exploited by the firm and there is excess or
unutilized capacity equal to OQ1 amount of output.

12.3 PRODUCT DIFFERENTIATION

Monopolistic competition is characterized by product
differentiation and selling costs. Product differentiation emerges out
of the typical nature of competition in such market. Each individual
firm in a group producing a particular type of commodity has to face
the competition from the other firms in the group. The competition is
of two types i.e. price competition and product differentiation.

Price competition is reflected in the individual price setting
of a firm. The firm may set a slightly lower price than its rivals for
inducing the buyers to purchases its product. Thus price decisions
are independently taken by every firm.

Product competition is reflected in the product
differentiation. Product differentiation implies the special features
introduced by the firm so as to distinguish its product from the other
similar products in the market.

It may occur in many ways. The firm may have its own
physical features of the product such as color, shape, appearance,
size, fragrance etc. which may be helpful in giving some distinction
to its product.

The firm may also have a different technique of
production or other qualities of the product. Sometimes the brand-
name, trade- mark, packing etc. are also used for product
differentiation.

The product differentiation is a specific character
introduced by each individual firm in the monopolistic competition.

12.4 SELLING COSTS

The firm in order to bring its distinguishing character to
the notice of the customer has to spend on advertising and publicity
of its product through other methods of sales promotion. Most of
the firms spend on advertising on radio and television. The modern
age is in fact an age of advertisement hence the firm has to spend
sizeable amount of money on advertisements. The market in the
modern days has changed in such a manner that the customers are
prejudiced in favour of certain goods. At present, they go to the
market with predetermined choice of the products, mostly formed
by the advertisements. Considering this the firms have to spend a

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lot on publicity, if they have to induce the customers to buy their
product. They try to impress upon the customer the specialties of
differentiating qualities of their product. The expenses incurred on
such sales promotion activities are called as selling costs.

Prof. Chamberlin has defined selling costs as, “costs
incurred in order to alter the position or shape of the demand curve
for a product.”

12.5 WASTES OF MONOPOLISTIC COMPETITION

Under monopolistic competition there are several wastes
and both the consumers and factors of production are exploited.
These wastes have been pointed out by Prof. Chamberlin. The
wastes are-

1 Excess Capacity- Under monopolistic competition a firm’s
equilibrium output is less than the optimum output. The average
cost at the equilibrium level is more than minimum. There is
excess or unused capacity, which is a waste in monopolistic
competition.
2 High Price for the Consume- Under monopolistic competition a
consumer has to pay a higher price for a product than under
perfect competition even in the long run period. Though the firm
is earning only normal profits the price paid by the consumer is
more than that under perfect competition.
3 Selling Cost- Under monopolistic competition extra expenditure
is incurred by firms on competitive advertising to increase
individual sales. The advertising is considered as a waste under
monopolistic competition because it leads to wasteful
competition among rival firms and increase cost which is not
necessary in the market. This cost is passed on to the
consumers in the form of higher price. Thus, competitive
advertising is a clear waste of resources.
4 Unemployment- In monopolistic competition, the problem of
unemployment is created due to many reasons. One of these is
the fact that the productive capacity is not fully utilized under
monopolistic competition and therefore, employment is not
increased. Further, in order to maintain high prices, production
is sacrificed and this may create cyclical unemployment.
5 Lack of Specialization- Since there are many rival firms
producing similar but not identical products the scope for large
scale production is limited by smallness of size. There is
inadequate specialization and a firm can not reap the
advantages or economies of large scale production. Thus

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consumers are deprived of the fruits of specialization and large
scale production.
6 Cross Transport- There is a waste of cross transport under
monopolistic competition. The product of Calcutta manufacturer
may be sold in Mumbai and a similar product of Mumbai may be
sold in Calcutta. The consumers have to pay an increased price,
which would include transport costs. If the Calcutta producer
serves the Calcutta market and Mumbai producer serves the
Mumbai market, transport cost can be avoided and consumers
would be benefitted. But this does not happen because of
product differentiation and every rival producer likes to capture
the market throughout India.

12.6 INTRODUCTION – OLIGOPOLY MARKET

Oligopoly is that form of imperfect competition where there
are a few firms in the market producing either homogeneous
product or producing products which are close but not perfect
substitutes of each other. It differs from monopoly as well as perfect
competition and monopolistic competition.

The term ‘Oligopoly’ is derived from the Greek words ‘oligos’
which means a few and ‘pollis’ which means to sell. In short,
oligopoly means literally few sellers.

According to Baumol, ‘Oligopoly is an industry with a small
number of large firms.’ It is characterized by the existence of a
large number of buyers but a few sellers producing either
homogeneous or differentiated products.

According to Stigler, ‘Oligopoly is that situation in which
firm’s market policy is based on the expected behavior of close
rivals.’ Oligopoly is a market situation in which there are more than
two sellers.

12.6.1 Classification/ Types :

Oligopoly can be classified under different bases.

1. Perfect (Pure) Oligopoly and Imperfect (Differentiated)
Oligopoly: - This classification is made on the basis of product
differentiation. Oligopoly is perfect if the product produced by
the competing firms is homogeneous or identical. On the other
hand, oligopoly is imperfect when the firms produce products
which are close but not perfect substitutes.

2. Open Oligopoly and Close Oligopoly: - This classification is
done on the basis of freedom to enter the industry. An open

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oligopoly refers to that market situation where the new firms are
free to enter the industry. A closed oligopoly is that market
situation where the new firms are not allowed free entry into the
industry.

3. Collusive Oligopoly and Non- Collusive Oligopoly: -This
classification is done on the basis of agreement or
understanding among the firms. A collusive oligopoly refers to
that market situation where the firms instead of competing,
comes together to fix the prices and outputs of the industry. A
non-collusive oligopoly implies lack of any understanding or
agreement among the firms.

4. Partial Oligopoly and Full Oligopoly: - This classification is done
on the basis of presence of absence of price leadership. Partial
oligopoly refers to that market situation where the industry is
dominated by one large firm which is looked upon as the price
leader. Rest of the smaller firms look to the price leader for
fixing the price of their products. Full oligopoly refers to that
situation where price leadership is clearly visible by its absence.

5. Syndicated Oligopoly and Organized Oligopoly: - This
classification is done on the basis of the degree of coordination
to be found among the firms. The former refers to that situation
where the firms sell their products through a centralized
syndicate. The latter refers to that situation where the firms
organize themselves in to a central association for fixing prices,
outputs, quotas and sales etc.

12.7 FEATURES OR CHARACTERISTICS OF
OLIGOPOLY

Main features of oligopoly are:
1. Few sellers: - There are few dominant or large firms, each
producing a significant portion of the total output.

2. Homogeneous or differentiated products: - The output in an
oligopolistic market may be either homogeneous or
differentiated.

3. Barriers to entry: - There are restrictions to entry of new firms.

4. Mutual interdependence: - This is the only feature which sets
oligopoly apart from other market structures. It means that price
and output decisions of one firm affect the similar decisions of
other firms. Because of high degree of interdependency
amongst firms, the demand curve faced by an oligopolistic firm
is undefined.

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Since the demand curve is undefined the solution is
indeterminate. Based on different behavioral assumptions a
different solution is obtained. One such solution is price
leadership i.e. there is one dominant or large sized firm which is
a price leader. The other small firms accept this price.
5. Selling cost: - Heavy selling costs are incurred by firms to attract
customers.

12.7.1 Price Rigidity or Stability :

An important characteristic of oligopoly is price rigidity. Price
rigidity refers to the situation of kinked demand curve. In this
situation oligopolistic price remains constant over a period of time in
spite of changes in demand and cost conditions in the industry.

In other words, each oligopolist will support and follow to the
prevailing or going on price to avoid uncertainties in the market.
Hence there is price rigidity which suggests absence of price
movement by the oligopolist.
There are number of reasons for price rigidity. They are-

1. There is a lot of uncertainty in due to the reactions of the rival
firms.

2. The seller may increase their sales promotion efforts to increase
their sales at the current prices instead of reducing it.

3. A stable price might have been established through agreement
and prolonged negotiations.
4. In order to prevent the entry of new firms, the existing sellers
may set the price at a lower level. The firm would not like disturb
the existing price to achieve this objective.
12.7.2 Kinky (Kinked) Demand Curve :

The kinked demand curve was first introduced by Paul M.
Sweezy to explain price rigidity under oligopoly. The kinked
demand curve represents the pattern of business behavior of a firm
which has no inventive either to raise of to lower its price. The firm
formulates its attitude on an estimate of what its rivals will do or will
not do. We can explain this with the help of following figure.

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Y D

Price
& cost A P
MC

A
E
N D1

O Output M X

MR
Figure 12.5

In the alongside diagram DD1 is the demand curve (average
revenue) with a kink at point ‘P’ which shows that the firm is
producing and selling the OM output at OA price. MR is the
marginal revenue curve corresponding to the kinked demand curve.
It has a discontinuous portion AN.
MC is the marginal cost curve passing through the point ‘E’
at which the oligopolist is maximizing his profits at the prevailing
price OA. In other words, the oligopolist will be in equilibrium at
point ‘E’ and the prevailing price is OA at which kink is found in the
demand curve DD1.

At OA price, PD portion of the demand curve is highly
elastic. It shows that if the firm raises its price, other firm will not
follow it. As a result, its sales will fall considerably. The
corresponding portion of the MR curve is positive so that any
increase in price will not only reduce total sales but also total
revenue and profits also.
On the other hand, PD1 portion of the demand curve below
p is less elastic. It shows that if the firm reduces its price below OA,
its rival firms also reduce their prices. The corresponding part of the
MR curve below N is negative, No doubt firm’s sales would
increase, but the total profits would be less than before. Thus it is
clear that, the firm will have no incentive either to raise or to lower
the established price. Hence, the prevailing price OA will remain
rigid.

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12.8 QUESTIONS

1. Explain the characteristic features of monopolistic competition.

2. Explain how a firm attains an equilibrium in the short run and
long run under monopolistic competition.

3. Discuss the wastes of monopolistic competition.

4. Explain the meaning and features of Oligopoly market.

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13
Module 6

PRICING METHODS AND CAPITAL
BUDGETING

Unit Structure :

13.0 Objectives
13.1 Introduction
13.2 Importance of Pricing Policy
13.3 Pricing Objectives
13.4 Factors affecting pricing policy
13.5 Methods of Pricing
13.6 Questions

13.0 OBJECTIVES

After having studied this lesson you should be able :-
 · To Know in detail the concept of pricing
 · To understand different methods and kinds of pricing
 · To identify the factors affecting pricing policy
 · To apply pricing decision at the time of introducing new
products

13.1 INTRODUCTION

Pricing assumes a significant role in a competitive economy.
Price is the main factor which affects the sales of a organisation. A
good price policy is of great importance to the producers,
wholesalers, retailers and the consumers. Marketers try to achieve
their long-run pricing objectives through both price policies and
price strategies. If the prices are high, few buyers purchase and if
the prices are low, many buyers purchase. Thus market may be
reduced or increased. That is, the price increases in relation to the
sales revenue. Thus pricing is a critical situation.

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Therefore, a sound pricing policy must be adopted to have
maximum sales revenue. In the early stages of men, prices were
set by buyers and sellers negotiating with each other. The seller
may demand a higher price than expected and the buyer may offer
a price less than the expected one. Ultimately they arrive at an
agreeable price through bargaining. Now in the competitive
economy, development of large business aims to have one price
policy. In certain cases, the buyer looks at the price as an indicator
of product quality. If the price is higher, the buyer believes the
products to be of high quality.

In case the quality is not up to the mark he expects, he feels
that the price is high. Hence, one cannot say that the price is high
or low, without considering the quality of the product to be
purchased. The price is greatly affected or influenced for future
production and marketing. Prices play an important role in the
economy. The time within which the product is sold varies. The
goods, which are of a perishable nature and frequent changes of
style, may not be stocked for long time. In the case of durable
goods, they can be stocked for longer time, in the hope of getting
favorable price rise. Holding the stock depends upon the financial
resources of farmer, mi, middleman, wholesaler etc., and the perish
ability of the goods.

13.1.1 Price
Price may be defined as the exchange of goods or services in
terms of money. Without price there is no marketing in the society.
If money is not there, exchange of goods can be undertaken, but
without price; i.e., there is no exchange value of a product or
service agreed upon in a market transaction, is the key factor which
affects the sales operations.

What you pay is the price for what you get.
Price is the exchange value of goods or services in terms of
money. Price of a product or service is what the seller feels it worth,
in terms of money, to the buyer.

13.2 IMPORTANCE OF PRICE POLICY

A well formed price policy has special importance if price rise
is a continuous process in planned economy. It has not only the
influenced the living standard of people but due to increase in the
expenditure of full planning, the prescribed aims and objectives of
the planning are shattered. As a result, there is obstruction of
economic development. But in underdeveloped countries, with
economic development, price rise is quite natural. Till the increase
in monetary income of the public is more than price rise, there is no
comprehension. But when there is more price rise than investment

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and national income, there is a need to protect from the defects of
monetary fluctuations. It requires price regulation.

In short, in developing countries, the significance of price
policy can be known from the following facts:

1. To Maintain Appropriate Living Standard. Price rise lets living
standard of people fall and economic development of the country is
obstructed. To maintain the proper living standard, price control is
essential.

2. To Maintain Planning. As price rises, the work of planning
increases which results in obstruction in the prescribed aims and
objectives of the planning. To maintain the planning process in a
fine manner, prices should be controlled at all costs.

3. Protection from Monetary Fluctuations. When price increase
is more than investment and national income increases, monetary
fluctuation defects are created. To remove them appropriate price
control is required.

4. Establishment of Balance in Demand and Supply. In a
developing economy, due to changing circumstances, balance of
demand and supply disrupts by which consumer, producer and
investor have to take hardships. This shows that there is need to
balance the demand and supply in a proper way.

5. For Well Adjusted Distribution Management. With the view
point of consumers for quick supply of goods on less prices
distribution management should be well adjusted. For this, it is
necessary to control the consumer price.

6. Multifaceted Development of National Resources. The major
objective of economic planning is multifaceted development of
national resources. Thus, price policy should be quite independent
as price regulation can adjust this motto.

13.3 PRICING OBJECTIVES

To perform the marketing job efficiently, the management has
to set goals first pricing is no exception. Before determining the
price itself, the management must decide the objectives of pricing.
These objectives are logically related to the company's overall goal
or objectives. The main goals in pricing may be classified as
follows.

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13.3.1. Pricing for Target Return (on investment) (ROI):
Business needs capital investment in the shape of various
types of assets and working capital. When a businessman invests
capital in a business, he calculates the probable return on his
investment. A certain rate of return on investment is aimed. Then,
the price is fixed accordingly. The price-includes the predetermined
average return. This is seller-oriented policy. Many well-established
firms adopt the objective of pricing in terms of "return on
investment." Firms want to secure a certain percentage of return on
their investment or on sales. The target of a firm is fixed in terms of
investment For instance a company may set a target at 10 or 15%
return on investment. Further this target may be for a long term or
short term. Wholesalers and retailers may follow the short term,
usually a year they charge certain percentage over and above the
price, they purchased, which is enough to meet operational costs
and a desired profit. This target chosen, can revised from time to
time. This objective of pricing is also known as pricing for profit.
Certain firms adopt this method as a satisfactory objective, in the
sense they are satisfied with a certain rate of return.

13.3.2. Market Share:
The target share of the market and the expected volume of
sales are the most important consideration in pricing the products.
Some companies adopt the main pricing objective so as to maintain
or to improve the market share towards the product. A good market
share is a better indication of progress. For this, the firm may lower
the price, in comparison to the rival products with a view to capture
the market. By reducing the price, customers are not exploited
rather benefited. The management can compare the present
market share with the past market share and can know well
whether the market share is increasing or decreasing When the
market shares decreasing, low pricing policy can be adopted by
large scale manufacturers who produce goods needed daily by the
consumers. So margin of profit comes down because of low price,
but the competitions are discouraged from entering the market. By
low pricing policy, no doubt, market share can be increased,
besides attracting new users.

13.3.3. To Meet or Prevent Competition:
The pricing objective may be to meet or prevent competition.
While fixing the price, the price of similar products, produced by
other firms, will have to be considered. Generally, producers are
not in a haste to fix a price at which the goods can be sold out one
has to look to the prices of rival products and the existing
competition and chalk out proper price policy so as to enable to
face the market competition. At the time of introduction of products
to the market, a low price policy is likely to attract customers, and
can establish a good market share. The low price policy
discourages the competitors.

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13.3.4. Profit Maximisation:
Business of all kinds is run with an idea of earning profit at the
maximum. Profit maximisation can be enjoyed where monopolistic
situation exists. The goal should be to maximise profits on total
output, rather than on every item- The scarcity conditions offer
chances for profit maximisation by high pricing policy. The profit
maximisation will develop an unhealthy image. When a short-run
policy is adopted for maximising the profit, it will exploit the
customers. The customers have a feeling of monopoly and high
price. But along run policy to maximise the profit has no drawbacks.
A short-run policy will attract competitors, who produce similar
goods at low cost. As a result, price control and government
regulations will be introduced.

13.3.5. Stabilize Price:
It is a long-time objective and aims at preventing frequent and
violent fluctuations in price. It also prevents price war amongst the
competitors. When the price often changes, there arises no
confidence on the product. The prices are designed in such away
that during the period of depression, the prices are not allowed to
fall below a certain level and in the boom period, the prices are not
allowed to rise beyond a certain level. The goal is to give and let
live. Thus firms forego maximum profits during periods of short
supply of products.

13.3.6. Customer Ability to Pay:
The prices that are charged differ from person to person,
according to his capacity to pay. For instance, doctors charge fees
for their services awarding to the capacity of the patient.

13.3.7. Resource Mobilization:
This is a pricing objective, the products are priced it such away
that sufficient sources are made available for the firms' expansion,
developmental investment etc. Marketers are interested in getting
back the amount invested as speedily as possible. The
management may fix a higher price and this trend will invite
competitors with low priced similar products.

13.3.8. Survival and growth:
An important objective of pricing is survival and achieving the
expected rate of growth. Profits are less important than survival.
According to P. Drucker, avoidance of loss and ensuring survival
are more important than maximisation of profit.

13.3.9. Prestige and goodwill:
Pricing also aims at maintaining the prestige and enhancing
the goodwill of the firm.

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13.4 FACTORS AFFECTING PRICING POLICY

Price policy is government by external factors and internal
factors. External factors are-elasticity of demand and supply
competition goodwill of firm, trend of the market, and management
policy. Keeping in view above facts, certain general considerations
which must be kept in view while formulating a suitable price policy
are listed below:

(A) Internal Factors

(1) Organisational Factors :
Pricing decisions occur on two levels in the organisation.
Over-all price strategy is dealt with by top executives. They
determine the basic ranges that the product falls into in terms of
market segments. The actual mechanics of pricing are dealt with at
lower levels in the firm and focus on individual product strategies.
Usually, some combination of production and marketing specialists
are involved in choosing the price.

(2) Marketing Mix
Marketing experts view price as only one of the many
important elements of the marketing mix. A shift in any one of the
elements has an immediate effect on the other three-Production,
Promotion and Distribution. In some industries, a firm may use
price reduction as a marketing technique. Other firms may raise
prices as a deliberate strategy to build a high-prestige product line.
In either case, the effort will not succeed unless the price change is
combined with a total marketing strategy that supports it. A firm that
raises its prices may add a more impressive-looking package and
may begin a new advertising campaign.

(3) Product Differentiation
The price of the product also depends upon the characteristics
of the product. In order to attract the customers, different
characteristics are added to the product, such as quality, size,
colour, attractive package, alternative uses etc. Generally,
customers pay more price for the product which is of the new style,
fashion, better package etc.

(4) Cost of the Product
Cost and price of a product are closely related. The most
important factor is the cost of production. In deciding to market a
product, a firm may try to decide what prices are realistic,
considering current demand and competition in the market. The
product ultimately goes to the public and their capacity to pay will
fix the cost; otherwise product would be flapped in the market.

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(5) Objectives of the Firm
A firm may have various objectives and pricing contributes
its share in achieving such goals. Firms may pursue a variety of
value-oriented objectives, such as maximizing sales revenue,
maximising market share, maximising customer volume, minimizing
customer volume, maintaining an image, maintaining stable price
etc. Pricing policy should be established only after proper
considerations of the objectives of the firm.

(B) External Factors

External factors are those factors which are beyond the
control of an organisation. The following external factors would
effect the pricing decisions :

1. Demand
The nature and condition of demand should be considered
when fixing the price. Composition of the market, the nature of
buyers, their psychology, their purchasing power, standard of
living, taste, preferences and customs have large influence on
the demand. Therefore the management has to weigh these
factors thoroughly. If the demand for a product is inelastic, it is
better to fix a higher price for it. On the other hand, if demand is
elastic, lower price may be fixed.

2. Competition:
In modern marketing, a manufacturer cannot fix his own price
without considering the competition. A number of substitutes
enter the market these days. Hence the influence of substitutes
has also to be considered when fixing a price. A firm must be
vigilant about the prices charged by competitors for the similar
products. If prices are fixed higher than the prices charged by
competitors, the customers are likely to switch over to the
products of competitors. On the other hand, if the prices
charged are much lower than the prices of the rivals, the
customers may become suspicious about the quality and hence
lower price may not lead to higher sales. To avoid competitive
pricing, a firm may resort to product differentiation. Sometimes a
higher price may itself differentiate the product. In view of these,
the management must be very careful in determining the prices.

3. Distribution channels:
Distribution channels also sometimes affect the price. The
consumer knows only the retail price. But there is a middleman
working in the channel of distribution. He charges his profit.
Thus when the articles reach the hands of consumers, the price
becomes higher. It sometimes happens that the consumers
reject it.

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4. General Economic conditions:
Price is affected by the general economic conditions such as
inflation, deflation, trade cycle etc. In the inflationary period the
management is forced to fix higher price. In recession period, the
prices are reduced to maintain the level of turnover. In boom
period, prices are increased to cover the increasing cost of
production and distribution.

5. Govt. Policy:
Pricing also depends on price control by the Govt, through
enactment of legislation. While fixing the price, a firm has to
take into consideration the taxation andtrade policies of govt.

6. Reactions of consumers:
An important factor affecting pricing decisions is the attitude of
consumers. If a firm fixes the price of its product unreasonably
high, the consumers may boycott the product.

13.5 METHODS OF PRICING

There are four basic pricing policies. They are:
1. Marginal Cost pricing
2. Full -Cost pricing
3. Multi-product pricing
4. Limit pricing : Bain’s Model.

13.5.1. Marginal Cost pricing
Under both full cost pricing and rate of return pricing, the
prices are set on the basis of total cost (variable cost + fixed cost).
Under the marginal cost pricing, the price is determined on the
basis of marginal or variable cost. In this method, fixed costs are
totally excluded.

Under marginal cost pricing, prices are determined on the
basis of marginal cost and not on the basis Of fixed cost. In case of
marginal cost pricing, fixed cost is ignored. The firm uses those
costs that are directly attributed to the output of a specific product.
Pricing decision involves planning for the future and as such, it
should be dealt solely With the anticipated Wand estimated
revenues, expenses and capital outlays. All type of past outlays, i.
e. : historical cost and sunk cost give rise to the full cost.

The important objective of a firm is to maximise profits, to
attain this objective the firm seeks to fix its prices so as to maximise
its total contribution to fixed costs. The above objective is achieved
by - considering each product in isolation and fixing its price at a
level which is calculated to maximize its total contribution.

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There are two assumptions in this regards:
(1) Possibility of Market separation: The firm should be able to
separate its markets so that he can charge higher price in one
market and lower price in other markets (i.e. price
discrimination).
(2) There are no legal restrictions: Now, we will see in terms of
graphical representation how to determine price under the
marginal cost pricing principle.
Y

LMC

J
PRICE AND COST

P1 LAC

P2 K
P3 L
P4
M

AR/D
MR
O X
A B C
QUANTITY
Marginal Cost Pricing – Excess Profits Case

Figure 13.1
• Figure 13.1 shows three possible prices which a public utility
enterprise may charge given the freedom it is granted by the
government. In case the public utility enterprise enjoying monopoly
is not regulated by the government, it may have the freedom to
charge profit maximising price. In Figure, OP1 is the profit
maximising price of the output, as at this output level LMC = MR. If
the government follows the average cost pricing rule for regulating
the price of the product of the public utility enterprise, the price will
be OP3. It may be noted that D = LAC at price OP3. At price OP3
the public utility enterprise obtains a fair return but it leads to non-
efficient allocation of resources. For the efficient allocation of
resources the marginal cost pricing rule is to be followed. In Figure ,
the price which equals marginal cost is OP2 and it is obtained at
the intersection of the demand curve with LMC. Since OP2 > OP3.
the public utility enterprise manages to earn profits which are larger
than what may be considered as fair return on investment. In the
diagram the excess profits are equal to the area of the rectangle

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P4P2KJvI — the difference between marginal and average cost per
unit at the output OB, multiplied by OB or (KM x OB). In this case,
the allocation of resources is also efficient.

Thus, The marginal cost pricing, however, may not always
ensure fair return to a public utility enterprise.
Advantages of Marginal Cost pricing
(1) This method is very useful in a competitive market.
(2) This method helps in optimum allocation of resources. It
is particularly useful
when the products have low demand.
(3) This method is suitable to pricing over the life cycle of the
product
(4) It is the most suitable .method of short run pricing.
(5) The method is useful at the time of introducing a new
product.
Disadvantages of Marginal cost pricing
(1) Firms may not be able to cover up costs and earn a fair return
on capital employed.
(2) It requires a better understanding of marginal costing technique.
(3) When costs are decreasing this method is not suitable because
it will result losses.
(4) This method is not suitable for long run.

13.5.2. Cost plus Pricing:
The theory of full cost pricing has been developed by Hall and
Mitch. According to them, business firms under the conditions of
oligopoly and monopolistic competitive markets do not determine
price and output with the help of the principle of MC = MR. They
determine price on the basis of full average cost of production AVC
+ AFC margin of normal profit.

This is the most common method used for pricing. Under the
method, the price is fixed to cover all costs and a predetermined
percentage of profit. In other words, the price is computed by
adding a certain percentage to the cost of the product per unit.
Under this method, cost includes production cost (both variable and
fixed) and administrative and selling and distribution cost (both
variable and fixed). This method is also known as margin pricing or
average cost pricing or full cost pricing or mark-up pricing. This
method is very popular in wholesale trade and retail trade.

Cost plus pricing is a most commonly adopted method. Under
this method, cost of product is estimated and a margin of some kind
of profit is added on the bases of which the pricing is determined.
Empirical evidences have shown that a majority of the business

164

firms usually set prices for their products on the basic of cost plus a
fair profit percentage.
Briefly, thus

Cost-plus Pricing = Cost + Fair Profit.
Cost : In cost-plus pricing principle in practice, cost refers to full
allocated cost. According to Joel Dean there are however, three
different concepts of the cost component used in the formula of
cost pricing
1. Actual cost;
2. Expect cost, and
3. Standard cost.

Actual cost refers to historical cost for the latest available period. It
covers wage bills, raw-material costs, and overhead charges at the
then current output rate. Expect cost means a forecast for the
pricing period on the basis of expected prices, output rates and
productivity. Standard cost refers to a normal cost determination at
some normal rate of output at a given level of capacity utilisation
and productivity at a normal level.

In practice, usually, the cost base is determined from
engineering estimates plus cost experience- historical data and
projections. Fair Profit: By fair profit is usually meant a fixed
percentage of profit mark-up. It is arbitrarily determined. Typically, it
is determined at 10 per cent in many cases. However, fair profit
mark-up differs from industries to industries and among different
firms in the same line of production. These variations are due to
many factors, such as
— differences in turnover rate,
— differences in risks,
— differences in competitive intensity; and
— differences is traditions or customary fixation of profit margin in
different business.

Apparently, the ‘ Fair Profit ’ in cost plus pricing principle in
practical business is fundamentally different from the concept of
‘Normal Profit’ in economic analysis.

Advantages of Cost plus Pricing
(l) This method is appropriate when it is difficult to forecast the
future demand.
(2) This method guarantees recovery of cost. Hence it is the safest
method.
(3) It helps to set the price easily.
(4) Both single product and multi product firms can apply this
method for pricing.

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(5) It ensures stability in pricing.
(6) If this method is adopted by all firms within the industry, the
problem of price war can be avoided.
(7) It is economical for decision making.
Disadvantages Of Cost Plus Pricing
(l) This method ignores the effect of demand.
(2) It does not consider the forces of market and competition.
(3) This method uses average costs, ignoring marginal or
incremental costs.
(4) This method gives too much importance for the precision of
allocation of costs.

13.5.3 MULTI-PRODUCT PRICING
Big firms usually produce a number of related products at the
same time. These are multi product firms. The multi-product firm.
thus, involves a ‘product line’ or ‘multi-product’ pricing. In multi-
product pricing strategy, the firm considers that the demands for the
various goods are inter-related. Secondly, it can enjoy a greater
cost economy in the sense that production costs tend to be lower
when the goods are produced in a joint operation.

Multi goods produced by the firm may be in two categories :
• Substitutes/competitive
• Complementary

For this reason the firm has to look into the cross — elasticity
of demand for the multi-product. Complementary products will have
negative price — Cross-elasticity demand coefficient. Substitutes
products will have a positive price-cross-elasticity demand
coefficient.

In multiple products, therefore when converting products are
produced, the firm considers demand elasticity. The product having
inelastic demand will be high priced. While, the product having
more elastic demand will be low priced. Similarly, cost functions will
be taken into account. More costly items will be high priced, with
high margin for the make-up.

The multi-product pricing strategy is to manipulate the
combination of prices for different items, until an optimum or profit
maximising price structure is determined.

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Price
CMR

P MC
P1
2
B
E A E

AR2(D2)
AR1(D1)

MR 2
MR

Q Q1 Q2 Quantity

Multi – Product Pricing
Figure 13.2
In case of jointly demanded complementary products, for
instance in case of telephone exchange services, such as
telephone connection and telephone services, two different price
lends are prescribed. Installation charges and the use charges.
Again, use charges will vary as per the number of calls. Obviously,
a price structure is to be evolved that lends to profit and sales
maximisation.
13.5.4 LIMIT-PRICING: BAIN’S MODEL
Price, as we have discussed in the earlier sections of this
chapter has to cover the cost and bring a reasonable profit to the
producer. Exceptions if at all, are made in very few cases. In an
oligopoly market, price is rigid due to uncertainties prevailing in
oligopoly situations. Even a monopolist who is a price maker may
charge a high price in order to avoid an entry of a substitute product
or service is totally protected by law.

In an oligopoly situation, entry is free. However there are a
number of factors that prevent entry. The existing firms always
have a fear or threat of potential entry. It is in the interest of the
existing or established firms to prevent the potential entry so that
they can maintain their share of market and profit, which may not
attract or induce the potential entry. Such a price is called limit-
price, which was profounded by J. Bain.
Bain’s theory of Limit-price was published in 1949 in an
article and subsequently his important work “Barriers to New
Competition” was published in 1956. Limit price is a price charged
by the firms to discourage entry of a new firm into the market. It is a
price set by firms which is above the long run average cost (LAC).
The price is above LAC, that is, a price higher than long-run price

167

charged in a perfectly competitive market. It has remained higher
because of barriers to potential entry. Limit price is also below
monopoly price (where P>MC=MR) where profits are maximised.
The existing firms in the market do not charges monopoly prices in
order to discourage a new entry,

The limit price theory is based on the following assumptions :
1. There is a determinate long-run demand curve for industry
output, which remains unaffected by price adjustment of sellers
or by entry.
2. The first assumption leads to determinate market marginal
revenue curve.
3. There is effective collusion among the established oligopolist.
4. The established firms in the market can decide a limit price,
below which entry will not occur. The limit price set depends on:
i) Estimation of cost of the potential entrant
ii) Market elasticity of demand
iii) Shape and level of LAC
iv) Size of the market
v) Number of firms in the industry
5. Above the limit price, entries are attracted, leading to a
considerable concerning the sales of existing firms in the post
entry period.
6. Existing firms try to maximize their profit in the long-run.

Based on the above assumptions we will explain the limit-price
theory with help of fig.

In figure, the market demand curve is ‘DABD’. The
corresponding marginal revenue curve is ‘Dabm’. Limit price is set
at PL, which is at point A on demand line. AD, part of demand line
is uncertain to the existing firms as the behavior of the entrant is
known. AD’ part of demand curve and a part of marginal revenue
line are certain for the existing firms.

If the existing firms fix the limit price PL, then they could
charge the monopoly price, that is the price where LAC1 =
MC1=MR where the corresponding price is Pm. However this price
will be uncertain after the entry of a new firm. Hence profit in the
post entry period too are uncertain, therefore, they must be risk
discounted. Price Pl will bring a certain amount of profit whereas at
Pm2 (where LAC2 = MC2 =MR at point b on MR line). Price Pm2
is lower Pl. Hence the limit set by Pl price is not relevant.

When entry preventing price Pl is decided, the alternatives
available to the existing firms are:

168

(i) To charge Pl price and prevent entry.
(ii) To charge a price less than Pl and prevent entry (that is Pm
price which is less than Pl)
(iii) To Charge a price above Pl and face uncertainty situation
that arises after the new entry.

If entry takes place, the established (existing) firms either
have to functions with uncertainties with regard to demand, price
and profit or must have collusion. In case of collusion the existing
firms have to share the market demand with the new entrant and
face the consequent impact on profit. According to Bain firms
charge limit price which is lower than monopoly price, to prevent
entry and secure maximum long-run profit.

Limit price, therefore, is a price that discourages or prevents
entry. It is argued that a firm can deter entry by keeping its price
relatively low.

13.6 QUESTIONS:-

1. What are the objectives of pricing policy?
2. Explain the method of cost-plus pricing. What are its
limitations?
3. Discuss the major factors involved in or affecting the pricing
policy.
4. Describe the important pricing methods.
5. Write notes on:
a) Cost-plus pricing.
b) Marginal Cost Pricing.
c) Bain’s Limit Pricing Model.
d) Multi Product Pricing



169

14

CAPITAL BUDGETING

Unit Structure :

14.0 Objectives
14.1 Introduction
14.2 Meaning of Capital Budgeting
14.3 Importance or Significance of Capital Budgeting
14.4 Need for Capital Budgeting
14.5 Problems and difficulties in Capital Budgeting
14.6 Stages of Capital Budgeting
14.7 Introduction : Methods of Capital budgeting
14.8 Investment Criteria / Investment Appraisal
14.9 Questions

14.0 OBJECTIVES

After having studied this lesson you should be able :-
 To Know in detail the concept of Capital Budgeting
 To understand different methods and kinds of pricing
 To identify the factors affecting Capital Budgeting
 To know the concept of Investment Criteria/Investment
Appraisal.
 To understand different methods of Capital Budgeting

14.1 INTRODUCTION

Every business has to decide upon its investment, as it
involves high risk. An apt decision on investment program leads a
business firm to achieve its high profit; hence a methodology to
assist the management to take correct decision on its investment
proposals is quintessential for which capital budgeting technique
would assist. Capital budgeting is concerned with designing and
carrying through a systematic investment program.

170

14.2 MEANING OF CAPITAL BUDGETING

Meaning: Capital budgeting implies a process of conceiving,
generating, evaluating and selecting the most profitable investment
proposal or project. It involves a plan for the investment of funds.
Project planning refers to a long-term planning in respect of capital
expenditure on a scheme or project.

Capital Budgeting is also referred to as Project
Planning. Capital budgeting is concerned with designing and
carrying through a systematic investment programme. It is
concerned with planning and control of capital expenditure.

Capital budgeting refers to the process of planning
capital projects, raising funds and efficiently allocating resources to
those capital projects. Capital budgeting decisions may be defined
as the decision of the firm to invest its current finances most
efficiently in long-term productive activities, with expenditure on
flow of future benefits over a long period.

14.3 IMPORTANCE OR SIGNIFICANCE OF CAPITAL
BUDGETING

The Major issues in Capital budgeting or project planning are:
(a) Determining the worthiness of the investment project.
(b) The cost ant returns form of project.
(c) The availability of funds and their allocation.
(d) Organising a project, determining the resources and
assigning the responsibilities of the different departments.
(e) Co-ordinating and controlling the entire scheme
(f) Estimating the time for the completion of the project.

Capital budgeting is issued for:
(1) Expansion of production facilities.
(2) Entering new product lines.
(3) Replacement of worn-out capital and equipment.
(4) Planning major advertising campaigns.
(5) Employee training Programmes.
(6) Research and Development.
(7) Decision to purchase or rent equipments.
(8) Undertake any other investment project which would
result in costs and revenue over a long period. Capital Budgeting
has great significance in decision regarding financing investments.
Firms classify investment as follow:

171

1. Investment to develop, produce and sell new products or new
markets.
2. Investment to replace worn-out equipments.
3. Expenditure incurred to reduce the cost of labour through
training programmes and other inputs.
4. Investment to expand production facilities in response to
demand for traditional products
5. Investment top comply with government regulations like
pollutions control, health and safety regulation, etc.
6. Capital Budgeting decisions are very significant for the manager
and owner of the firm due to the following reasons:
a) Long-term investment involves commitment of funds it would
be difficult to reverse and hence proper project planning is
inevitable.
b) The finance involved is quite large which would affect the
profitability of the firm.
c) Since project are long period, the impact of capital budgeting
on profitability has great relevance.
d) Capital budgeting helps to reduce uncertainties and improve
profitability.

Capital budgeting are vital for the reputation of the
management. the expected rate of returns on total capital depends
on capital budgeting.

Thus capital budgeting has great significance in the
investment planning and profitability of the firm.

14.4 NEED FOR CAPITAL BUDGETING

The need for capital budgeting arises due to the following
reasons:
a) To provide a framework for the future courses of action.
b) For capital budgeting.
c) To avoid lass of capital invested.
d) Long term investment is fixed capital influences the business
actions in the long run.
e) To reduce the degree of risk and uncertainty.
f) To achieve flexibility and control influence the business
actions in the long run.
g) To ensure optimum utilization of resources and avoid
wastage.
h) To direct capital funds to specific uses and earn maximum
returns.
i) Serves as an index of business performance.

172

The investment projects involve large sums of money. Long-
term investments once made cannot be reversed without significant
loss of capital. The whole conduct of business will be affected if
there is no project planning.

Investment decision broaden the base on which profit will be
earned. A proper mix of capital investment is important to ensure
adequate rate of return on investment.

Long-term investment decisions are extensive. The decisions
extended beyond the current accounting period and correctness
cannot be determined immediately. Because of time factor
involved, capital budgeting decisions are subject to higher degree
of risk and uncertainty than short-run decisions.

Capital budgeting is very essential because its absence may
lead to considerable loss. Capital budgeting is necessary to know
the rate of return on long-term investments.

Capital budgeting is given more and more attention because
of the increasing trends towards separation of ownership from
management. Companies with strong demands, weak resources
position and tight financial positio9n give great importance to capital
budgeting techniques. Capital budgeting has now become one of
the most important areas of managerial decision making.

14.5 PROBLEM AND DIFFICULTIES IN CAPITAL
BUDGETING

(1) Problem of selecting the most profitable investment project.
(2) Problem of measuring the most intangible benefits involved in
a particular project.
(3) Difficulty of measuring even the tangible benefits due to the
dynamic nature of the economy.
(4) Due to inflation, estimates of the cost and benefits may not be
valid.
(5) Inadequate information due to lack of statistical records.
Budgetary limitations and huge cost are major problems in
project planning.

Project planning is complex and it requires proper analysis for
arriving at a rational decision.

The capital budgeting problem consists of broadly three
questions.
(1) How much money will be needed for expenditure in the near
future.
(2) How much money will be available.

173

(3) How the available money be allocated among the various
competing projects.

The first is to make survey of opportunities and select projects
on the basis of their prospective profitability.

The second problem involves measuring the cost of capital -
how much can be raised internally and, how much externally.

The third problem is how to ratio the funds. This is crux of
capital budgeting problem for it amounts to selection of project.

The starting point for a capital budget is a survey of company’s
anticipated needs for capital i.e. the demand for capital. The
discovery and development of goods investment proposals require
effort.

The supply of capital is the problem of finding the sources
form where money will come and how much will be available. A
distinction must be made between internal and external sources.

The principal marginal problems in connection with internal
sources are:
a) To forecast how much cash will be generated internally.
b) To decide how much cash to payout in dividends.
c) To decide how much of remaining should be tied in long-
term projects.

As regards to external sources much depends upon the state of
the capital market and the company’s reputation and financial
stability.

The basic aim of capital budgeting is to maximise the firm’s
long-run profit potential. The firm must select the most profitable
project for investment. There might be capital rationing and all
profitable investment opportunities may not be accepted.

The basic problem in capital budgeting consist of (1)
determining the cost of capital (2) determining the rate of return on
different investment proposals under consideration. (3) Ranking
them on basis of profitability.

The expected return on the various projects has to be compared
with the cost of capital to determine which project to drop and which
one to select as the best investment among the profitable ones.

174

14.6 STAGES OF CAPITAL BUDGETING

Since the planning is a complex process. It consists of several
stages.

(1) Search for new investment proposals: The project planning
process begins with the creation of new ideas of investment
proposal

The management has to discover new investment
opportunities for deciding the most profitable investments. The
investment proposal should consider the governmental policies,
performance of the existing industries, their input-output framework,
knowledge of commercial geography, awareness of demand
condition and technologies, advancements etc.

(2) Profit classification: In project planning, the projects are
classified in to following categories.
(a) Expansion of existing products.
(b) Expansion for existing markets.
(c) Replacement for maintenance
(d) Replacement for cost reduction.
(e) Innovations.
(f) Environmental investments.
(g) Others not covered by the above.

Investments in all this categories are evaluated under project
planning.

(3) Analysis of costs and Benefits: This involves:

(a) Estimating cash flows: cash flows refer to the changes in
revenues and costs of capital. the management has to forecast
changes in cash flows which may emerge from each investment
project. it is difficult to select a suitable method of cash flow
analysis.

(b) Computing the cost of Capital: in computing the cost of
capital, the availability of funds at the firm’s disposal has to be
considered.

(4) Measurement of investment worth: for comparison and
ranking of different investment proposals, a common denomination
is essential. The criteria for measuring investment worth are based
on the discounting principle.

(5) Feasibility study: Feasibility study implies a detailed analysis
about costs, means of financing, location, technology to be used,

175

requirement and availability of factor implies, demand potentiality,
sales revenue expected, profitability etc.
(6) Decision making: After ranking the investment proposals,
selection of suitable project to meet the objective in consideration is
an important aspect of project planning.
(7) Implementation: Implementation of the selected investment
proposal involves the construction of the plant building, choice of
machineries, training of the staff, etc.
(8) Performance Review: There is a systematic evaluation of the
operation of the project. This will help to prevent over optimism over
pessimism and arrive at a cautious decision-making in future.

14.7 INTRODUCTION : METHODS OF CAPITAL
BUDGETING
Every business has to decide upon its investment, as it
involves high risk. An apt decision on investment program leads a
business firm to achieve its high profit; hence a methodology to
assist the management to take correct decision on its investment
proposals is quintessential for which capital budgeting technique
would assist. Capital budgeting is concerned with designing and
carrying through a systematic investment program.

14.8 INVESTMENT CRITERIA / INVESTMENT
APPRAISAL

Capital investment decisions are based on whether the
management wants to replace the old equipment or install the new
equipments. Whenever there are technological changes then old
equipments have to be replaced by new ones. When a new
equipment is to be purchased then the question about investment
appraisal arises.
There are certain methods of evaluating proposed capital
expenditure or what may be called the investment criteria. The
measurement of investment worth is a very important aspect of
project planning. The most commonly adopted investment criteria
are:
(A) Payback Period method ( PBP ).
(B) The Net Present Value method ( NPV).
(C) The Internal Rate of Return Method ( IRR).
14.8.1 Payback Period method:
The pay-back period method measures the time required to
recover the original investment outlay from the annual cash inflow
expected from the investment project. The pay-back period is used

176

to find out the period of time required to return the initial investment.
It is measured in terms of money. This method is also known as
pay off or payout period method. This is the most simple method
and commonly used in capital budgeting for calculating investment
appraisal. It indicates only the number of years required to recover
the original investment and does not measure the rate of return.

The formula to calculate Pay- Back Period is :
Original or Initial Investment
Pay-Back Period =
Annual Return or Cash flow

Suppose project A involves the initial investment of Rs. 75,000
and The annual cash flow is Rs. 15,000. The pay-back period is
as under:
Original or Initial Investment 75,000
Pay- Back Period = = 5 years
Annual Return or Cash flow 15,000

Now Project B involves the initial investment of Rs. 80,000 and
the annual cash flow is
Rs. 20,000/-. then pay-back period for project B is as under:

Pay- Back Period = = 4 years

If a firm applies the pay-back period criteria then project B will
be accepted and project A
will be rejected. Though project B involves higher capital outlay
but its capacity to recover initial investment, period is rapid.
Hence, the project B is considered to be good.

Example (1) Equal Annual Earnings :
Suppose a firm has five investment proposal with relevant data.
Rank these proposals under pay-back period.

Calculation of PBP

Project Initial Annual Cash Life in Years
Investment Flow (Rs.)
(Rs.)
A 20,000 4,000 8
B 6,000 2,000 3
C 8,000 4,000 5
D 12,000 3,000 10
E 15,000 2,500 15

177

From the above illustration, Pay Back Period is to be calculated
and re-ranked as follows:-

Project Initial Annual Pay Back Ranking
Investment Cash Flow Period
(Rs.) (Rs.)
A 20,000 4,000 5 IV
B 6,000 2,000 3 II
C 8,000 4,000 2 I
D 12,000 3,000 4 III
E 15,000 2,500 6 V

Pay-Back Period of Project A = = 5 years
Pay- Back Period of Project B = = 3 years
Pay- Back Period of Project C = = 2 years
Pay- Back Period of Project D = = 4 years
Pay- Back Period of Project E = = 6 years

On the basis of pay-back period method, Project ‘C’ is
considered to be good because it has lowest pay-back period of 2
years, other projects are also ranked accordingly. Project B, Project
D, Project A and then Project E. This method is very popular in
U.S.A for evaluating their overseas investments.

Example (1) Differences in Annual Earnings :
In case of projects which yield cash in varying amounts, the
pay-back period may be obtained through the cumulative total of
annual returns until the total equals the original investment outlay.
The number of figures added will give the pay-back period. For
example, suppose that the total cost of a project is Rs. 10,000
which yields cash flows over 5 years as given in col. 3 of the Table.
The table shows also the calculation of pay-back period.

178

Calculation Of PBP

Year Total Fixed Annual Cash Cumulative
Column 1 Outlay Flow Column total
Column 2 3 (Rs.) Column 4 (Rs.)
(Rs.)
1st 10,000 4,000 4,000
2nd - 3,500 7,500
rd
3 - 2,500 10,000 *
4th - 1,500 11,500
5th - 1,000 12,500

As the table shows, the cumulative total of annual outlay of
the project at the end of the 3rd year. Thus, the pay-back period of
the project is 3 years.

Advantages of PBP method:-
1) This method is simple to calculate.
2) It is easy to understand, safe and more realistic.
3) This method gives information about liquidity.
4) This method helps in selecting less risky projects.
5) This method is appropriate for assets with same economic
life.
6) In this method gross earnings are taken into consideration
complications in estimating capital wastage over the time
period are avoided.

Disadvantages of PBP method:-
1) This method does not consider time value of money.
2) The pay back period does not consider profitability.
3) This method ignores the cash flow variation.
4) This method puts undue emphasis on liquidity and ignores
capital wastage.
5) This method also ignores other objectives.

Example (3) : Pay Back Period

Project Initial Net Cash Flow (Rs.)
Outlay
Year 1 Year 2 Year 3 Year 4
(Rs.)
A 6,00,000 1,00,000 1,50,000 1,50,000 2,00,000
B 6,00,000 1,00,000 2,00,000 3,00,000 3,00,000

179

In case of Project - A, the pay-back period is
1,00,000+1,50,000 + 1,50,000 + 2,00,000 = 6,00,000 i.e. 4
years are needed to recover initial investment outlay.
Now in case of Project-B, the pay-back period is 1,00,000 +
2,00,000 + 3,00,000 = 6,00,000. i.e. initial investment is
recovered within 3 years.
Hence, Project-B is desirable than Project-A.

14.8.2 The Net Present Value Method (NPV):
The net present value of an investment proposal is the
difference between the total of present values of the estimated
annual cash flows over the life of the project and the initial
investment of the project. If net present value is positive then
the investment in the project will be profitable. if net present
value is negative then investment will be unprofitable.

The investment proposal that simply breaks even, will have a
net present value of Zero. NPV is found out by:

NPV = [Present value of the gross earnings] - [Net Cash
investment ]
In this method, the value of time is considered very important.
This method is based on the economic reasoning of discounting
future cash flows to make them comparable. Money received at
present is more valuable than equivalent amount of money
received next year or the year after. The value of money will not
remain the same in future because money received today can
be invested to earn certain rate of interest.
If we represent the discount rate by ‘r’ then,
A
NPV = 1
1 r
Where: A 1 = value in the first year
r = rate of interest
For e.g. if we invest Rs. 1000 at 10% interest rate then after one
year we will get Rs 1100. It means Rs 1000 of this year is
equivalent of Rs 1100 of next year.
In other words, Rs 1000 received next year will be less than Rs
1000 of this year. The amount received next year should be
discounted by the prevailing interest rate. Suppose A1 is Rs 100
and r is Rs 10% then the present value of A1 is as under:-

A1 100 100
NPV = = = = 90.91
1  r 10.1 1.1

180

From this example, it is clear that the Rs.100 of next year will be
equal to Rs.90.91 of this year. The formula to calculate Gross
Present Value of ‘n’ number of years is as under: -

A1 A2 AS An
GPV = + + + …..+
1  r 1  r  2
1  r  3
1  r n
Problem : Calculate the net present value from the following:
Initial outlay of the project = Rs. 3,00,000
Life of the project = 5 years
Scrap value of the project at the end of the 5 years = 15,000
Net cash flow: 1st year = Rs. 45,000 2nd year Rs.
58,000 3rd year = Rs. 65,000
4th year = Rs. 66,000 5th year = Rs.
60,000
Rate of Interest = 10%

Year Net Discount GPV
Cash Factor at (Rs.)
Flow 10%
(Rs.)
1st 45,000 0.91 45000 × 0.91 = 40,950
2nd 58,000 0.83 58000 × 0.83 = 48,140
3rd 65,000 0.75 65000 × 0.75 = 40,950
4th 66,000 0.68 66000 × 0.68 = 48,140
th
5 60,000 0.62 60000 × 0.62 = 37,200
GPV = 2,19,920

Now initial investment = Rs. 3,00,000
Scrap value at the end of 5 years = Rs. 15,000
The present scrap value = (15,000 x 0.62) = Rs. 9,300
Present Value of Investment = Initial Investment — Present
Scrap Value
= Rs. 3,00,000 — Rs. 9,300
= Rs. 2,9O,700/-

NPV = GPV — Present Value of Investment
NPV = Rs. 2,19,920 — Rs. 2,90,700
NPV = Rs. —70780

In this example, the net present value is negative hence,
the project is unprofitable.

181

Ranking Proposals :
If there are a number of investment proposals then we have
to calculate the net present value of cash flows of each proposal by
using the following formula:

Gross present value of the proposal
Net Present Value ( NPV ) =
Initial Investment

The project will be more profitable if the net present value
index is high. We can also rank the various projects according to
their net present value index.

Let us apply the above formula to find out the relative
profitability of the five proposal as under:

Proposals Initial Annual Life Discount Period NPV Ran
investment Cash in Factor at Value of Index king
(Rs) Flow Years 10% total
(Rs.) cash
flow
(Rs)
1 2 3 4 5 6=3×5 7=6 ÷ 2
A 60,000 12,000 15 7.76 92,120 1.55 III
B 85,000 23,000 22 8.89 204,470 2.40 II
C 25,000 5,000 07 5.03 25,150 1.00 V
D 20,000 4,000 10 6.32 25,280 1.26 IV
E 4,20,000 2,00,000 20 8.64 1728,000 4.11 I

On the other basis of the above table, Proposal ‘E’ is most
profitable followed by B and A and D. If any project has NPVI less
than one, the project should not be accepted.

14.8.3 Internal Rate of Returns ( IRR ):
This is another method of evaluation of projects based on the
discount cash flow technique. This method considers time factor
and therefore takes into account the opportunity cost of investment.
The basic approach of this method is that the amount of money
received today has more value than the amount of money received
after a year and so on. This method is the same as the MEC
(Marginal Efficiency of Capital) concept of J. M. Keynes in his
General theory of Interest and Money. The Internal Rate of Return
(IRR) is the rate of discount which equates the present value of the
income stream over the life of the machine with the present value of
the net cash investment. In other words, the net cash benefits are
discounted at that rate of discount which reduces the net present
value to zero.

182

The relevant formula is:
A1 A2 AS A4 An
= + + + +…..+
1  r 1  r 2 1  r 3 1  r 4 1  r n
Where: C = Current net investment (cost of the project)
= Income stream of the project over different years (t=1 . . .n)
t = time period
r = internal rate of return

If internal rate of return is greater than the opportunity rate of
interest then the project is accepted. If internal rate or return is
less than the opportunity cost of investing available funds else
where then the project is rejected.

Advantages of IRR :
1) It considers the time value of money.
2) It considers the cash flow over the entire life of the project.
3) The calculation of the cost of capital is not a pre-condition for
the use of the method.

Disadvantages of IRR :
1) It is difficult to understand.
2) It is difficult to use in practice.
3) Its calculation is complicated.

14.9 QUESTIONS

1) Explain the meaning of Capital Budgeting?
2) What is the Importance or Significance of Capital Budgeting?
3) Explain the Need for Capital Budgeting?
4) What are the Problems and difficulties in Capital Budgeting?
5) Explain the different stages of Capital Budgeting?
6) Describe the Pay Back Period method of project appraisal.
7) Explain the Net Present Value method of Capital Budgeting.
8) Write Short note on :-
(a) Internal Rate of Return method.

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F.y.b.a. economics - eng (rev)

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