MANAGERIAL ECONOMICS

UNIT – I: Managerial Economics – Nature and Characteristics – Scope – Relationship with

other disciplines – Laws of Demand.

UNIT – II: Concept of Utility – Law of Diminishing Marginal Utility – Concept of Consumer
Surplus –Elasticity of Demand - Types.

UNIT – III: Factors of Production–Law of returns – Law of variable proportions – Law of re-
turns to scale – Economies of Large Scale Production.

UNIT – IV: Market Structures – Price and Output determination under perfect competition,
monopoly, monopolistic competition and oligopoly.

UNIT - V: National Income – Concepts, Measurement and Difficulties in measurement – Ine-

qualities of Income – Causes.

TEXT BOOK: Managerial Economics – R.L.VARSHNEY & K.L.MAHESHWARI

Managerial Economics - S.SANKARAN
BOOKS FOR REFERENCE:
1. Managerial Economics Analysis, Problems & Cases – P.L.MEHTA.
2. Principles of Economics, Economic Analysis – V.LOKANATHAN.
3. Economic Analysis – K.P.M. SUNDHARAM & E.N. SUNDHARAM.
4. Managerial Economics – CAUVERY, SUDHANAYAK, GIRIJA

Economics: Refers to the study of economics.

Refers to something that is cost-effective.

Adam Smith - Wealth Definition (1723-90: “Economics is the science of wealth”. He is the author of the famous
book “Wealth of Nations” (1776). He is known as the Father of Political Economy because he was the first per-
son who put all the economic ideas in a systematic way. It is only after Adam Smith, we study economics as a
systematic science. - Criticism: [“a dismal science”, “a dark science”, all about money,
Alfred Marshall – welfare definition: (1842-1924) wrote a book Principles of Economics in 1890. In it, he de-
fined economics as “a study of mankind in the ordinary business of life”. An altered form of this definition is:
“Economics is a study of man’s actions in the ordinary business of life”. - Criticism: [science of economics, Ma-
terial production, not analytical, scarcity and choice]
Lionel Robbins - Scarcity Definition: “Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses”. Robbins has given the above definition in his
book “An Essay on the Nature and significance of Economic Science” -Criticism: [Labour, economic problems]
Samuelson’s definition - modern economics: “Economics is a social science concerned chiefly with the way so-
ciety chooses to employ its resources, which have alternative uses, to produce goods and services for present
and future consumption”.
 Net Economic Welfare (NEW): “Net Economic Welfare (NEW) is an adjusted measure of total national
output that includes only consumption and investment items that contribute directly to economic wel-
fare”
 Main Divisions of Economics;
o Consumption; Production; Exchange; Distribution.

Managerial Economics:

Applies economic tools and techniques to business and administrative decision making

"Concerned with application of economic concepts and economic analysis to the problems of formulat-
ing rational managerial decision." - Edwin Mansfield

Managerial economics is the application of economic theory and quantitative methods (mathematics
and statistics) to the managerial decision-making process.

Economic Concepts
Management Decision (applications) Managerial Economics Optimum Solutions
or Problems Quantitative
methods
Management Decision problems
 Product Selection, output
and pricing.
 Internal strategy.
 Organisation design.
 Product development promo-
tion strategy.
 Worker hiring and training.
 Investment and financing.
 Selecting business area.
 Sales promotion.
Economic Concepts
 Marginal Analysis.
 Theory of consumer de-
mand.
 Theory of the firm.
 Industrial organisational and
firm behaviour.
 Public choice theory.
Quantitative Techniques
 Numerical analysis.
 Statistical estimation.
 Forecasting procedures.
 Game theory concepts.
 Optimisation techniques.
 Information systems.

Features of Managerial Economics

 It is more realistic, pragmatic and highlights on practical application of various economic theories to
solve business and management problems.
 It is a science of decision-making. It concentrates on decision-making process, decision-models and de-
cision variables and their relationships.
 It is both conceptual and metrical and it helps the decision-maker by providing measurement of various
economic variables and their interrelationships.
 It uses various macroeconomic concepts like national income, inflation, deflation, trade cycles etc to un-
derstand and adjust its policies to the environment in which the firm operates.
 It also gives importance to the study of non-economic variables having implications of economic perfor-
mance of the firm. For example, impact of technology, environmental forces, socio-political and cultural
factors etc.
 It uses the services of many other sister sciences like mathematics, statistics, engineering, accounting,
operation research and psychology etc to find solutions to business and management problems.

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 utilization of available
resources, come under the banner of managerial economics.
3. Rational: Managerial economics is (ratinonal) 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 macro
economic 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 utilization 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 organization but also prescribes the means of
achieving these goals.

Scope

1. Demand Analysis and Forecasting

2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
6. Environmental issues.
Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in
transforming productive resources into goods that are to be sold in the market. A major part of managerial
decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to
management for preparing production schedules and employing resources. It will help management to
maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other
factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in
Managerial Economics.

Cost And Production Analysis: A firm’s profitability depends much on its cost of production. A wise manager
would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost
estimates and choose the cost-minimising output level, taking also into consideration the degree of
uncertainty in production and cost calculations. Production processes are under the charge of engineers but the
business manager is supposed to carry out the production function analysis in order to avoid wastages of
materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost
and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale
and cost control.

Pricing Decisions, Policies And Practices: Pricing is a very important area of Managerial Economics. In fact,
price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the
correctness of the price decisions taken by it. The important aspects dealt with this area are: Price
determination in various market forms, pricing methods, differential pricing, product-line pricing and price
forecasting.

Profit Management: Business firms are generally organized for earning profit and in the long period, it is profit
which provides the chief measure of success of a firm. Economics tells us that profits are the reward for
uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct
estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit
measurement constitute the most challenging area of Managerial Economics.

Capital Management: The problems relating to firm’s capital investments are perhaps the most complex and
troublesome. Capital management implies planning and control of capital expenditure because it involves a
large sum and moreover the problems in disposing the capital assets off are so complex that they require
considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of
return and selection of projects.

Relationship with other disciplines

1. Managerial Economics with Economics.

2. Managerial Economics and theory of decision making.
3. Managerial Economics and Operations Research.
4. Managerial Economics and Statistics.
5. Managerial Economics and Accounting.
6. Managerial Economics and Mathematics.
7. Others.

Managerial Economics with Economics: Managerial economics has been described as economics applied to
decision making. It may be studied as a special branch of economics, bridging and gap between pure econom-
ic theory and managerial practices. Economics has two main branches – micro and Marco economics.
 Micro Economics: micro means small. It studies the behaviour of the individual units and small
groups of such units. It is a study of particular firms, particular households, individual prices,
wages, incomes, individual industries and particular commodities. Thus micro economics gives a
microscopic view of the economy.
 Macro Economics: macro means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total employ-
ment, general price level, wage level, cost structure, etc., thus macroeconomics is aggregative
economics.

Managerial Economics and Theory Of Decision Making: the theory of decision making is a relatively new sub-
ject that has significance for managerial economics. In the entire process of management and in each of the
management activities such as planning, organising, leading and controlling, decision-making is always essen-
tial. In fact, decision making is an integral part of today’s business management. A manager faces a number
of problems connected with his/her business such as production, inventory cost, marketing, pricing, investment
and personnel.

Managerial Economics and Operations Research: mathematicians, statisticians, engineers and other teamed
up together and developed models and analytical tools which have since grown into a specialised subject,
known as operation research. The basic purpose of the approach in to develop a scientific model of the system
which may be utilised for policy making.
Managerial Economics and Statistics: statistics is important to managerial economics. It provides the basis for
the empirical testing of theory. Statistics is important in providing the individual firm with measures of the
appropriate functional relationship involved in decision-making. Statistics is a very useful science for business
executives because a business runs on estimates and probabilities.

Managerial Economics and Accounting: managerial economics is closely related to accounting. It is concerned
with recording the financial operation of a business firm. A business is started with the main aim of earning
profit. Capital is invested it is employed for purchasing properties such as building, furniture, etc. and for
meeting the current expenses of the business.

Managerial Economics and Mathematics: mathematics is yet another important subject closely related to man-
agerial economics. For the derivation and exposition of economics analysis, we require a set of mathematical
tools. Mathematics has helped in the development of economic theories and now mathematical economics has
become a very important branch of the science of economics.

Demand [Total quantity customers are willing and able to purchase]

Demand is the quantity of a good or service that customers are willing and able to purchase during a specified
period under a given set of economic conditions. The time frame might be an hour, a day, a month, or a year.
Three important things
o It is the quantity desired at a given price.
o It is the demand at a price during a given time.
o It is the quantity demanded per unit of time.

 Direct Demand: Demand for consumption products.

o Utility: Value
 Derived Demand: Demand for inputs used in production
Q = F (P); Where Q represents quantity demanded; F means function, and P represents price
of the good.

Determinants of demand (Elements)

a) Price of the goods.

b) Income of the buyer.
c) Tastes of the buyers.
d) Seasons prevailing at the time of purchase.
e) Fashion.
f) Advertisement and sales promotion.
g) Nature of commodity.
h) Range of alternative uses of a commodity.
i) The proportion of market supplied.

Law of Demand (First Fundamental Law of Economics)

The law of demand states that the quantity demanded of a good or service is inversely related to the selling
price.

All other Elements remaining unchanged (The following’s are)

 No change in the consumer’s income
 No change in consumer’s tastes and preferences
 No changes in the prices of other goods
 No new substitutes for the goods have been discovered
 People do not feel that the present fall in price is a foreword to a further decline in price.
𝑑𝑄𝐷
Symbolically, the law of demand may be summarized as QD = f (P) and 0
𝑑𝑝
Equation QD = f states that QD, the quantity demanded of a good or service, is functionally related to the selling
𝑑𝑄𝐷
price P. Inequality 0 asserts that quantity demanded and price are inversely related. The downward-
𝑑𝑝
sloping demand curve illustrates the inverse relationship between the quantity demanded of a good or service
and its selling price.

Demand Schedule

The law of demand can be illustrated through a demand schedule. A demand schedule is a series of quantities,
which consumers would like to buy per unit of time at different prices.

Demand of a Price of apple per unit (in rupees) 5 4 3 2

Consumer for apples Quantity demanded of apples (in dozens) 1 2 3 4
Demand Curve

Demand curve is a diagrammatic illustration of the quantities of a good or service

that consumers are willing and able to purchase at various prices, assuming that the

Price
influence of other demand determinants (element) remaining unchanged.

Demand

The reasons behind the law of demand i.e. inverse relationship between price and quantity demanded are fol-
lowing:
a) Income effect.
b) Substitution effect.
c) Diminishing marginal utility.

EXCEPTIONS TO THE LAW OF DEMAND: The law of demand does not apply to the following cases:
 Apprehensions about the future price.
 Status goods.
 Giffen goods.

The Market Demand Curve: The market demand also increases with a fall in price and vice versa. The law of
demand is a theoretical explanation of the expected behaviour of individual economic units when confronted
with a change in the price of a commodity.

DEMAND FUNCTION: The functional relationship between the demand for a commodity and its various determi-
nants may be expressed mathematically in terms of a demand function, thus: Dx = f (Px, Py, M, T, A, U)
where, Dx = Quantity demanded for commodity X; f = functional relation; Px = The price of commodity X; Py
= The price of substitutes and complementary goods; M = The money income of the consumer; T = The taste
of the consumer; A = The advertisement effects; U = Unknown variables or influences.

The above-stated demand function is a complicated one. Again, factors like tastes and unknown influences are
not quantifiable. Economists, therefore, adopt a very simple statement of demand function, assuming all other
variables, except price, to be constant. Thus, an over-simplified and the most commonly stated demand func-
tion is: Dx = f (Px), which connotes that the demand for commodity X is the function of its price. The tradition-
al demand theory deals with this demand function specifically. It must be noted that by demand function,
economists mean the entire functional relationship i.e. the whole range of price-quantity relationship and not
just the quantity demanded at a given price per unit of time. In other words, the statement, 'the quantity de-
manded is a function of price' implies that for every price there is a corresponding quantity demanded. To put
it differently, demand for a commodity means the entire demand schedule, which shows the varying amounts
of goods purchased at alternative prices at a given time.

SHIFT IN DEMAND CURVE: When demand curve changes its position retaining its
shape (though not necessarily), the change is known as shift in demand curve.

The increase in demand is shown by the shifts of the demand curve to the right
from DD to D2 D2. The decrease in demand is shown by the shift to the left from
DD to D1 D1. The increase and decrease in demand are shifts in the demand
curves.

Reasons for Shift in Demand Curve

 Fall in the consumer’s income.

 Substitution effect. (Price of substitute falls or increase)
 Advertisement.
  Price.
 Seasonal demand.

Elasticity of Demand

The law of demand explains that demand will change due to a change in the price of the commodity. But it
does not explain the rate at which demand changes to a change in price. The concept of elasticity of demand
measures the rate of change in demand. The concept of elasticity of demand was introduced by Alfred Mar-
shall. According to him “the elasticity (or responsiveness) of demand in a market is great or small according as
the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given
rise in price”.

Types of Elasticity of Demand (Kinds)

1. PRICE ELASTICITY: Elasticity of demand for a commodity with respect to change in its price.
2. CROSS ELASTICITY: Elasticity of demand for a commodity with respect to change in the price of its
substitutes.
3. INCOME ELASTICITY: Elasticity of demand with respect to change in consumer’s income.
4. PRICE EXPECTATION ELASTICITY OF DEMAND: Elasticity of demand with respect to consumer’s expecta-
tions regarding future price of the commodity.

PRICE ELASTICITY: The price elasticity of demand is the percentage change in the quantity demanded of a good
or a service given a percentage change in its price. A formal definition of price elasticity of demand (e) is given
below:

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %∆𝑄𝑑

ep = EP = the measure of price elasticity (e) is called co-efficient of price
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %∆𝑃
elasticity.

Measurement of price elasticity of demand

 Percentage method.
 Point method or slope method.
 Total outlay method.
 Arc method.

PERCENTAGE METHOD: This is measured as the relative change in demand divided by relative change in price (or)
percentage change in demand divided by percentage change in price.

 Elastic demand, if the value of elasticity is greater than 1.

 Inelastic demand, if the value of elasticity is less than 1.
 Unitary elastic demand, if the value of elasticity is equal to 1.
 Perfectly inelastic demand, if the value of elasticity is zero.
 Perfectly elastic demand, if the value of elasticity is infinity.

Elastic demand Inelastic demand Unitary elastic demand

 Perfectly inelastic demand Perfectly elastic demand

Point method or slope method: We can calculate the

price elasticity of demand at a point on the linear de-
mand curve. Formula to find out ep through point
method is,

𝐿𝑜𝑤𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒

ep=
𝑈𝑝𝑝𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒

TOTAL OUTLAY METHOD: We can measure elasticity through a change in expenditure on commodities due to a
change in price.

 Demand is elastic, if total outlay or expenditure increases for a fall in price (ep > 1).
 Demand is inelastic, if total outlay or expenditure falls for a fall in price (ep < 1).
 Elasticity of demand is unitary, if total expenditure does not change for a fall in price (ep=1).

Types of elasticity of demand

Changes in price
ep=1 ep<1 ep>1
Fall in price Total outlay remains constant. Total outlay falls. Total outlay rises.
Rice in price Total outlay remains constant. Totally outlay rises. Total outlay falls.

Arc method: Segment of a demand curve between two

points is called an Arc. Arc elasticity is calculated from
the following formula;

𝑞1−𝑞2 𝑝1−𝑝2
ep= ÷
𝑞1+𝑞2 𝑝1+𝑝2

∆𝑞 ∆𝑝
= ÷ where
𝑞1+𝑞2 𝑝1+𝑝2

∆𝑞 = change in quantity demanded. P1 = original price.

∆𝑝 =change in price of the commodity. P2 = new price.
q1=original quantity. q2 = new quantity.

Cross-Elasticity of Demand

The responsiveness of demand to changes in prices of related goods is called cross-elasticity of demand (relat-
ed goods may be substitutes or complementary goods). In other words, it is the responsiveness of demand for
commodity x to the change in the price of commodity y.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋

ec =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑦

∆𝑞𝑥 𝑝𝑦
ec = x
∆𝑝𝑦 𝑝𝑐
A significant characteristic of cross-elasticity is that if cross-elasticity between two goods is positive, the two
may be regarded as substitutes for each other, Moreover, the greater the cross-elasticity, the closer the substi-
tute. Likewise, if cross-elasticity of demand for two related goods is negative, the two may be regarded as
complementary of each other: the higher the negative cross-elasticity, the higher the degree of complemen-
tarily.
Measures of cross-elasticity of demand
 Infinity - Commodity x is nearly a perfect substitute for commodity y.
 Zero - Commodities x and y are not related.
 Negative - Commodities x and y are complementary.

Factors determining elasticity of demand:

a) Nature of the commodity.

b) Uses of commodity.
c) Existence of substitutes.
d) Postponement of demand.
e) Amount of money spent.
f) Habits.
g) Range of prices of commodity.

MARGINAL UTILITY: Marginal Utility is the addition made to the total utility by consuming one more unit of a
commodity

Relationship between marginal utility and total utility

Marginal utility Total utility
Declines. Increases.
Reaches zero Reaches maximum
Become negative Declines

LAW OF DIMINISHING MARGINAL UTILITY: “The additional benefit which a person derives from a given increase of
his stock of a thing diminishes with every increase in the stock that he already has”.

The law of diminishing marginal utility explains an ordinary experience of a consumer. If a consumer takes
more and more units of a commodity, the additional utility he derives from an extra unit of the commodity
goes on falling. Thus, according to this law, the marginal utility decreases with the increase in the consumption
of a commodity. When marginal utility decreases, the total utility increases at a diminishing rate.

LAW OF EQUI-MARGINAL UTILITY: “If a person has a thing which can be put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all”.

Assumptions

a) The consumer is rational so he wants to get maximum satisfaction.

b) The utility of each commodity is measurable.
c) The marginal utility of money remains constant.
d) The income of the consumer is given.
e) The prices of the commodities are given.
f) The law is based on the law of diminishing marginal utility.

EXPLANATION OF THE LAW: Suppose there are two goods X and Y on which a consumer has to spend a given in-
come. The consumer being rational, he will try to spend his limited income on goods X and Y to maximise his
total utility or satisfaction. Only at that point the consumer will be in equilibrium. According to the law of equi-
marginal utility, the consumer will be in equilibrium at the point where the utility derived from the last rupee
spent on each is equal. Symbolically the consumer will be in equilibrium when

𝑀𝑈𝑥
=
𝑀𝑈𝑦
= MUm Where MUx = Marginal utility of commodity X
𝑃𝑥 𝑃𝑦
𝑀𝑈𝑥 𝑀𝑈𝑦
MUy = Marginal utility of commodity Y; Px = Price of commodity X;
and Py = Price of commodity Y; MUm = Marginal utility of money.
𝑃𝑥 𝑃𝑦

are known as marginal utility of money expenditure. They explain the mar-
ginal utility of one rupee spent on commodity X. and the marginal utility of
one rupee spent on commodity Y

Consumer’s Equilibrium Consumer’s equilibrium is graphically portrayed. Since marginal utility curves
 of goods slope downward, curves depicting.

𝑀𝑈𝑥 𝑀𝑈𝑦
and will also slope downward. Taking the income of a consumer as
𝑃𝑥 𝑃𝑦
given, let his marginal utility of money be constant at OM utilise in
𝑀𝑈𝑥
is equal to OM (the marginal utility of money) when OH amount of good x
𝑃𝑥
is purchased;
𝑀𝑈𝑦
is equal to OM when OK quantity of good Y is purchased. Thus, when the
𝑃𝑦
𝑀𝑈𝑥 𝑀𝑈𝑦
consumer is buying OH of X and OK of Y, then = = MUm
𝑃𝑥 𝑃𝑦

Therefore, the consumer will be in equilibrium when he buys OH of X and OK of Y. No other allocation of money
expenditure will yield greater utility than when he buys OH of X and OK of Y. Sup pose the money income of
the consumer falls. Then the new marginal utility of money will be equal to OM; then the consumer will in-
crease the purchases of good X and Y to OH and OK respectively.

Limitations of the Law

 INDIVISIBILITY OF GOODS: The theory is weakened by the fact that many commodities like a car, houses
etc. are indivisible. In the case of indivisible goods, the law is not applicable.
 THE MARGINAL UTILITY OF MONEY IS NOT CONSTANT: The theory is based on the assumption that the marginal
utility of money is constant. But that is not really so.
 THE MEASUREMENT OF UTILITY IS NOT POSSIBLE: Marshall states that the price a consumer is willing to pay for
a commodity is equal to its marginal utility. But modern economists argue that, if two persons are pay-
ing an equal price for given commodity, it does not mean that both are getting the same level of utility.
Thus utility is a subjective concept, which cannot be measured, in quantitative terms.
 UTILITIES ARE INTERDEPENDENT: This law assumes that commodities are independent and therefore their
marginal utilities are also independent. But in real life commodities are either substitutes or comple-
ments. Their utilities are therefore interdependent.
 INDEFINITE BUDGET PERIOD: “We are not, of course compelled to distribute our incomes according to the
law of substitution or equi-marginal expenditure, as a stone thrown into the air is compelled, in a sense
to fall back to the earth, but as a matter of fact, we do in a certain rough fashion, because we are rea-
sonable.”

Importance

According to Marshall, “the applications of this principle extend over almost every field of economic activity.” It
applies to consumption: Every rational human being wants to get maximum satisfaction with his limited
𝑀𝑈𝑥 𝑀𝑈𝑦 𝑀𝑈:
means. The consumer arranges his expenditure in such a way that, = = so that he will get maximum
𝑃𝑥 𝑃𝑦 𝑃𝑥:

satisfaction.

 IT APPLIES TO PRODUCTION: The aim of the producer is to get maximum output with least-cost, so that his
profit will be maximum. Towards this end, he will substitute one factor for another till MP1/P1 = MPC/PC
=MPN/PN
 DISTRIBUTION OF EARNINGS BETWEEN SAVINGS AND CONSUMPTION: According to Marshall, a prudent person will
endeavour to distribute his resources between his present needs and future needs in such a way that the
marginal utility of the last rupee put in savings is equal to the marginal utility of the last rupee spent on
consumption.
 IT APPLIES TO DISTRIBUTION: The general theory of distribution involves the principle of substitution. In dis-
tribution, the rewards to the various factors of production, that is their relative shares, are determined
by the principle of equi-marginal utility.
 IT APPLIES TO PUBLIC FINANCE: The principle of ‘Maximum Social Advantage’ as enunciated by Professors
Hicks and Dalton states that, the revenue should be distributed in such a way that the last unit of ex-
penditure on various programmes brings equal welfare, so that social welfare is maximised.
 EXPENDITURE OF TIME: Prof. Boulding relates Marshall’s law of equi-marginal utility to the expenditures of
limited time, i.e. twenty-four hours. He states that a person should spend his limited time among alter-
native uses such as reading; studying and gardening, in such a way that the marginal utility from all
these uses are equal.
 CONSUMER’S SURPLUS: Marshall defines Consumer’s surplus as follows: “The excess of price which a person
would be willing to pay rather than go without the thing, over that which he actually does pay, is the
economic measure of this surplus of satisfaction. It may be called consumer’s surplus.”
Indifference Curve Analysis

An indifference curve is the locus of different combinations of two commodities giving the same level of satis-
faction.

Assumptions of indifference curve analysis

a) The consumer is rational. So, he prefers more goods to less goods.
b) He purchases two goods, X and Y only.
c) The price that a consumer pays for a commodity indicates the level of utility derived by him.
d) His income remains constant
e) His tastes, preferences, habits remain unchanged.

Indifference Schedule

An indifference schedule is a statement of various combinations of two commodities that will equally be ac-
cepted by the consumer. The various combinations give equal satisfaction to the consumer. Therefore he is
indifferent between various combinations. Let us assume that the consumer buys two commodities – bananas
and biscuits. Then the indifference schedule will be:

Combination (Good X) Biscuits (Good Y) Bananas

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

From the above schedule it can be understood that while the number of biscuits is increasing, the number of
bananas is decreasing so that the level of satisfaction is the same for all the combinations. Therefore the con-
sumer is indifferent between the combinations A, B, C, D and E.

Indifference Curve: The data in the indifference schedule can be

represented in the graph with one commodity on the X-axis and
another commodity in the Y-axis The various combinations of the
two commodities are plotted and joined to form a curve called
indifference curve. In the figure IC is an indifference curve show-
ing combinations of the two commodities given in the schedule.

All the points on this curve give equal level of satisfaction to the
consumer. Indifference curve is otherwise called ‘iso –utility
curve’.

Indifference Map: Indifference Map is a group of indifference

curves for two commodities showing different levels of satisfac-
tion. In this indifference map, it should be clearly understood that
a higher indifference curve denotes higher level of satisfaction and
a lower indifference curve represents lower level of satisfaction.
Being rational, the consumer will always choose a higher indiffer-
ence curve to get maximum satisfaction, other things being equal.

Properties of an Indifference curve

a) Indifference curves slope downwards to the right.
b) Indifference curves are convex to the origin.
c) No two indifference curves can ever cut each other.

All indifference curves slope downwards from left to right: The downward slope of indifference curve must be
attributed to the fact that the consumer in substituting good X by good Y, increases the amount of Y and re-
duces the amount of X. If the indifference curve were horizontal line running parallel to X axis then the combi-
nation which it represents is the same amount of Y but more and more of X. In that case, the satisfaction from
the combination will not be equal. For the same reason, it can be said that indifference curve will not be verti-
cal.

All indifference curves are convex to the origin:This is because of the operation of a principle known as ‘Dimin-
ishing Marginal Rate of Substitution’. The indifference curves are based on this principle. If they are concave to
the origin, then it will mean that MRS is increasing. Indifference curve cannot be straight line except when the
goods are perfect substitutes

Indifference curves slopes downwards

Marginal rate of substitution between X and Y refers to the amount of com-

modity Y to be offered in exchange for one unit of X commodity. The MRS
goes on diminishing as consumer goes on substituting X for Y.

The third assumption is that no two indifference curves can ever cut each other. we find two indifference
curves do cut each other

No two indifference curves intersect each other

Marginal rate of substitution: Marginal Rate of Substitution (MRS) is the rate at which the consumer is pre-
pared to exchange goods X and Y Consider. There are two reasons for this.
1) The want for a particular good is satiable so that when a consumer has its more quantity, his intensity
of want for it decreases. Thus, when consumer in our example, has more units of food, his intensity of
desire for additional units of food decreases.
2) Most of the goods are imperfect substitutes of one another. If, they could substitute one another per-
fectly. MRS would remain constant.

Income Elasticity

Income elasticity of demand is the degree of responsiveness of demand to the change in income.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
ey =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

∆𝑞 ∆𝑦
Symbolically ey = ÷ where q and y. stand for quantities demand and income respectively.
𝑞 𝑦

∆𝑞 𝑦
= ÷ ∆ means change
𝑞 ∆𝑦

Nature of Commodity and Income Elasticity

For all regular goods, income elasticity is positive although the degree of elasticity fluctuates as per the nature
of commodities. Consumer goods are usually categorised under three classes, viz. necessities (essential con-
sumer goods), comforts and luxuries.

Income Elasticity of different consumer goods

Commodities Coefficient of income elasticity Impact of expenditure

Necessities Less than unitary (ey<1) Less than proportionate change in income
Comforts Almost equal to unity (ey=1) Almost proportionate change in income
Luxuries Greater than unity (ey>1) More than proportionate increase in income

Importance of Elasticity of demand

a) Price discrimination.
b) Levy of taxes.
c) International Trade.
d) Determination of volume of output.
e) Fixation of wages for labourers.
f) Poverty in the midst of plenty.
Demand Forecasting

“Demand forecasting is an estimate of sales during a specified future period based on a proposed marketing
plan and a set of particular uncontrollable and competitive forces".

Demand Forecast and Sales Forecast: “Sales forecast is an estimate of sales in monetary or physical units for a
specified future period under a proposed business plan or programmer or under an assumed set of ‘economic
and other environment forces, planning premises, outside business/ antiquates which the forecast or-estimate
is made”.

Components of demand forecasting system

 Market research operations to procure relevant and reliable information about the trends in market.
 A data processing and analysing system to estimate and evaluate the sales performance in various
markets.
 Proper co-ordination of steps (i) and (ii) above.
 Placing the findings before the top management for making final decisions.

Objectives of Demand Forecast

a) Short Term Objectives.

o Drafting of Production Policy.
 Routine Supply of Materials.
 Best Possible Use of Machines.
 Regular Availability of Labour.
o Drafting of Price Policy.
o Appropriate Management of Sales.
o Organising Funds.
b) Long Term Goals.
o To settle on the production capacity.
o Labour Requirements.
o Production Planning.

Importance of Demand Forecast

a) Management Decisions.
b) Evaluation.
c) Quality and Quantity Controls.
d) Financial Estimates.
e) Avoiding Surplus and Inadequate Production.
f) Recommendations for the future.
g) Significance for the government.

Methods of Demand Forecast

No demand forecasting method is 100% precise. Collective forecasts develop precision and decrease the prob-
ability of huge mistakes

1. Methods that relay on Qualitative Assessment:

Forecasting demand based on expert opinion. Some of the types in this method are:
 Unaided Judgment.
 Prediction Market.
 Delphi Technique.
 Game Theory.
 Judgmental Bootstrapping.
 Simulated Interaction.
 Intentions and Expectations Surveys.
 Conjoint Analysis.

2. Methods that rely on quantitative data:

 Discrete Event Simulation.
 Extrapolation.
 Quantitative Analogies.
 Rule-Based Forecasting.
 Neural Networks.
 Data Mining.
 Causal Models.
 Segmentation.
Production Function

PRODUCTION: Production is the conversion of input into output. The factors of production and all other things
which the producer buys to carry out production are called input. The goods and services produced are known
as output. Thus production is the activity that creates or adds utility and value. In the words of Fraser, "If con-
suming means extracting utility from matter, producing means creating utility into matter". According to Ed-
wood Buffa, “Production is a process by which goods and services are created"

FACTORS OF PRODUCTION: As already stated, production is a process of transformation of factors of production

(input) into goods and services (output). The factors of production may be defined as resources which help the
firms to produce goods or services.

Characteristics of Factors of Production

1) The ownership of the factors of production is vested in the households.

2) There is a basic distinction between factors of production and factor services. It is these factor ser-
vices, which are combined in the process of production.
3) The different units of a factor of production are not homogeneous. For example, different plots of land
have different level of fertility. Similarly labourers differ in efficiency.
4) Factors of production are complementary. This means their co-operation or combination is necessary
for production.
5) There is some degree of substitutability between factors of production. For example, labour can be
substituted for capital to a certain extent.

PRODUCTION FUNCTION: Synonymous to the demand theory that pivots around the concept of the demand func-
tion, the theory of production revolves around the concept of the production function. A production function
can be an equation, table or graph presenting the maximum amount of a commodity that a firm can produce
from a given set of inputs during a period of time.

The concept of production function portrays the ways in which the factors of production are combined by a firm
to produce different levels of output. More specifically, it shows the maximum volume of physical output avail-
able from a given set of inputs or the minimum set of inputs necessary to produce any given level of output.

The production function comprises an engineering or technical relation, because the relation between inputs
and outputs is a technical one. The production function is determined by a given state of technology. When the
technology improves the production function changes, because the new production function can yield greater
output from the given inputs or smaller inputs will be enough to produce a given level of output. Further, the
production function incorporates the idea of efficiency. Thus, production function is not any relation between
inputs and outputs, but a relation in which a given set of inputs produces a maximum output. Therefore, the
production function includes all the technically efficient methods of producing an output.

The production function can be expressed in an equation in which the output is the dependent variable and
inputs are the independent variables. The equation is expressed as follows: Q= f (L, K, T……………n) Where, Q =
output; L = labour; K = capital; T = level of technology; n = other inputs employed in production.

Uses of production function

 Cost function. (maximum output)
 Knowledge. (Production process)
 Productivity. (maximum profit)
 Decision Making.

Types of production function

 The fixed proportion production function.

 The variable proportion production function.

FIXED PROPORTION PRODUCTION FUNCTION: A fixed proportion production function is one in which the technology
requires a fixed combination of inputs, say capital and labour, to produce a given level of output. There is only
one way in which the factors may be combined to produce a given level of output efficiently. In this type of
production, there is no possibility of substitution between the factors of production. The fixed proportion pro-
duction function is illustrated by isoquants which are ‘L’ shaped or ‘right angle’ shaped.
 Let us suppose that at point A, the output is one unit. The isoquant Q1 passing
through the point A1 shows that one unit of output is produced by using 2 units
of capital and 3 units of labour. In other words, the capital-labour ratio is 2:3.
In this case with 2 units of capital, any increase in labour beyond 3 units will
not increase output and, therefore, labour beyond 3 units is redundant. Similar-
ly, with 3 units of labour, any increase in capital beyond 2 units is redundant.

The kink point shows the most efficient combination of factors. The capital labour ratio must be maintained for
any level of output. The output can be doubled by doubling the quantity of inputs, that is, two units of output
can be produced by 4 units of capital and 6 units of labour. Thus isoquant q2 passes through the point A2.
The line OA describes a production process that is a way of combining inputs to obtain certain output. The
slope of the line shows the capital labour ratio.

VARIABLE PROPORTIONS PRODUCTION FUNCTION: The variable proportion production function is that most familiar
production function. In this case, a given level of output can be produced by several alternative combinations
of factors of production, say capital and labour. It is assumed that the factors can be combined in infinite
number of ways. The common level of output obtained from alternative combination of capital and labour is
given by an isoquant Q.

The isoquant Q is the locus of efficient points of produce a given level of output. The
isoquant is continuous, smooth and convex to the origin. It assumes continuous
substitutability of capital and labour over a certain range, beyond which factors
cannot substitute each other.

Since the variable proportions production function is the most common we discuss
below in detail the isoquant representing the variable the proportions production
function.

Short Run and Long Run Production Function

The short run is a phase in which the organisation can alter manufacturing by changing variable factors such as
supplies and labour but cannot change fixed factors such as capital. The long run is a phase adequately long so
that all factors together with capital can be altered. The factors which can be increased in the short run are
called variable factors, since they can be easily changed in a short period of time. Hence, the level of
production can be increased within the limits of existing plant capacity during the short run. Thus, the short
run production function proves that in the short run the output can be increased by changing the variable
factors, keeping the fixed factors constant. In other words, in the short run the output is produced with a given
scale of production, that is, with a given size of plant. The behaviour of production in the short-run where the
output can be increased by increasing one variable factor keeping other factors fixed is called law of variable
proportions.

To understand the different stages of the production functions, it is essential to understand the relationship
between (i) Marginal Product and Total Product and (ii) Marginal Product and Average Product.

Relationship between Marginal Product and Total Product

 When marginal product is positive, the total product increases.

o When marginal product increases, the total product will be increasing at an increasing rate
o When marginal product remains constant, the total product will be increasing at a constant rate
o When marginal product decreases but is positive, the total product will be increasing at a decreasing
rate
 When marginal product is zero, the total product reaches the maximum and remains constant
 When marginal product is negative, the total product decreases.

SHORT RUN THE LAW OF VARIABLE PROPORTIONS: The law examines the relationship between one variable factor and
output, keeping the quantities of other factors fixed.

Definition: As the proportion of one factor in a combination of factors is increased, after a point, first the mar-
ginal and then the average product of that factor will diminish.

Assumptions of the law

a) Only one factor is made variable and other factors are kept constant.
b) This law does not apply in case all factors are proportionately varied. i.e. where the factors must be
used in rigidly fixed proportions to yield a product.
 c) The variable factor units are homogenous i.e. all the units of variable factors are of equal efficiency.
d) Input prices remain unchanged.
e) The state of technology does not change or remains the same at a given point of time.
f) The entire operation is only for short-run, as in the long-run all inputs are variable.

Three stages of law: The behaviour of the output when the varying quantity of one factor is combined with a
fixed quantity of the other can be divided into three stages. They are

a) Increasing returns stage.

b) Decreasing returns stage.
c) Negative returns stage.

Fixed Factor Variable fac- Total product Average prod- Marginal prod- Stages
Machine tor labour in units uct in units uct in units
1 2 3 4 5
1+ 1 10 10 10 Increasing
1+ 2 22 11 12 Returns
1+ 3 36 12 14
1+ 4 52 13 16
1+ 5 66 13.2 14
1+ 6 76 12.6 10 Decreasing
1+ 7 80 11.4 4 Returns
1+ 8 82 10.2 2
1+ 9 82 9.1 0
1+ 10 78 7.8 -4 Negative Re-
turns

Stage I: Stage of increasing returns: Stage I ends

where the average product reaches its highest (max-
imum) point. During this stage, the total product, the
average product and the marginal product are in-
creasing. It is notable that the marginal product in
this stage increases but in a later part it starts declin-
ing. Though marginal product starts declining, it is
greater than the average product so that the average
product continues to rise.

Stage II: Stage of decreasing returns: Stage II ends at the point where the marginal product is zero. In the
second stage, the total product continues to increase but at a diminishing rate. The marginal product and the
average product are declining but are positive. At the end of the second stage, the total product is maximum
and the marginal product is zero.
Stage III: Stage of negative returns: In this stage the marginal product becomes negative. The total product
and the average product are declining.

Long-run production function - Returns to Scale

In the long run, all factors can be changed. Returns to scale studies the changes in output when all factors or
inputs are changed. An increase in scale means that all inputs or factors are increased in the same proportion.

Three phases of returns to scale: The changes in output as a result of changes in the scale can be studied in 3
phases. They are

a) Increasing returns to scale

b) Constant returns to scale
c) Decreasing returns to scale

INCREASING RETURNS TO SCALE: If the increase in all factors leads to a more than proportionate increase in output,
it is called increasing returns to scale. For example, if all the inputs are increased by 5%, the output increases
by more than 5% i.e. by 10%. In this case the marginal product will be rising.
CONSTANT RETURNS TO SCALE: If we increase all the factors (i.e. scale) in a given proportion, the output will in-
crease in the same proportion i.e. a 5% increase in all the factors will result in an equal proportion of 5% in-
crease in the output. Here the marginal product is constant.
DECREASING RETURNS TO SCALE: If the increase in all factors leads to a less than proportionate increase in output,
it is called decreasing returns to scale i.e. if all the factors are increased by 5%, the output will increase by less
than 5% i.e. by 3%. In this phase marginal product will be decreasing.
 Scale
Total product Marginal product Phases
Machine Labour
1 1 4 4
2 2 10 6
I Increasing Returns
3 3 18 8
4 4 28 10
5 5 38 10
II Constant Returns
6 6 48 10
7 7 56 8
III Decreasing Returns
8 8 62 6

Explain the different phases of returns to scale. When Marginal product in-
creases (AB), total product increases at an increasing rate. So there is increas-
ing returns to scale. When Marginal Product remains constant (BC), Total Prod-
uct increases at a constant rate and this stage is called constant returns to
scale. When Marginal Product decreases (CMP), Total Product increases at a
decreasing rate and it is called decreasing returns to scale.

Difference between Short run (Laws of returns) and Long run (Returns to scale) Production function

Laws of returns Returns to scale

Short run Production function
Only one factor is varied and all other factors are kept
constant
Factor proportions are changed
Law does not apply when the factors must be used in
fixed proportions to produce a product.
Increasing returns are due to the indivisibility of factors
and specialisation of labour. Diminishing returns are due
to non-optimal factor proportion and imperfect elasticity of
substitution of factors.
Long run Production function
All the factors are varied
Factor proportions are not changed. The Scale
changes.
Law does apply when the factors must be used in
fixed proportions to produce a product.
Increasing returns to scale are due to economies
of scale while diminishing returns to scale are due
to diseconomies of scale.

Production function through Iso-quants

The isoquant analysis helps to understand how different combinations of two or more factors are used to pro-
duce a given level of output, considering two factors of production. (Capital and labour)

Combination Units of Capital Units of Labour Output in Units

A 1 12 1000
B 2 8 1000
C 3 5 1000
D 4 3 1000
E 5 2 1000

it is clear that all combinations with different quantities of labour and capital result in the same level of pro-
duction of 1000 units.

The two axes measure the quantities of labour and capital and the curve
IQ shows the different combinations that produce 1000 units of output.
Each of the points R1, R2, R3, R4 and R5 on the curve shows a capital-
labour combination that can produce 1000 units of output. Therefore
the curve is known as an equal product curve or an isoquant curve.

Thus an isoquant or isoproduct curve represents different combinations

of two factors of production that yield the same level of output.

Characteristics of an isoquant
  The isoquant is downward sloping from left to right i.e. it is negatively sloped.
 An isoquant is convex to the origin because of the diminishing marginal rate of technical substitution.
Marginal rate of technical substitution of factor X (capital) for factor Y (labour) may be defined as the
amount of factor Y (labour) which can be replaced by one unit of factor X (capital), the level of output
remaining unchanged.
∆𝐿
MRTS CL = MRTS can be calculated using the formula.
∆𝐶

Thus the marginal rate of technical substitution is always declining. Hence the isoquant is always convex to the
origin. The slope of the isoquant represents marginal rate of technical substitution.

1. Higher the isoquant, higher will be the level of output produced. A set of isoquants which represents differ-
ent levels of output is called “isoquant map”. In the isoquant map, the isoquants on the right side represent
higher levels of output and vice versa.

ISOCOST LINE: The isocost line plays an important role

in determining the combination of factors that the
firm will choose for production. An isocost line is de-
fined as locus of points representing various combina-
tions of two factors, which the firm can buy with a
given outlay. Higher isocost lines represent higher
outlays (total cost) and lower isocost lines represent
lower outlays.

The isocost line depends on two things :

1) Prices of the factors of production and

2) The total outlay, which a firm has to make on the factors of production.
Given these two, the isocost line can be drawn. The slope of the isocost
line is equal to the ratio of the prices of two factors. Thus the slope of the
isocost line is given as
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑎𝑐𝑡𝑜𝑟 𝑋 (𝐶𝑎𝑝𝑡𝑖𝑎𝑙)
Slope of Isocost line =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑎𝑐𝑡𝑜𝑟 𝑌 (𝐿𝑎𝑏𝑜𝑢𝑟)

Producer’s Equilibrium

A rational producer always tries to achieve largest volume of output from a given factor-expenditure outlay on
factors such that these factors are combined in an optimal or most efficient way. The producer maximises his
profits and produces a given level of output with least combination of factors. This level of cost combination of
factors will be optimum for him.

In figure, E is the point of equilibrium, where isoquant IQ2 is tangen-

tial to isocost line at AB. Given budget line AB, points ‘P’, ‘N’ and ‘F’
are beyond the reach of the producer and points ‘R’ and ‘S’ on
isoquant IQ1 give less output than the output at the point of equilib-
rium ‘E’ which is on IQ2. The amount spent on combinations R, E, S
is the same as all the three points lie on the same isocost line. But
the output produced at point E is higher as E lies on a higher
isoquant.

Given the isocost line and the series of isoquants (isoquant-map), a producer will choose that level of output,
where a given isocost line is tangential to the highest possible isoquant.

Thus the producer is in equilibrium at point E where the isoquant is tangential to the isocost line. At this point,
the slopes of the isoquant and the isocost line are equal. Thus at the equilibrium point the marginal rate of
technical substitution is equal to the price ratio of factors. Hence, the condition for producers’ equilibrium is
MRTSxy = PX/PY.
At this point of equilibrium, the combination E (that is OL of labour and OQ of capital) is called least cost
The Cobb – Douglas Production Function

The simplest and the most widely used production function in economics is the Cobb-Douglas production func-
tion. It is a statistical production function given by professors C.W. Cobb and P.H. Douglas. The Cobb-Douglas
production function can be stated as follows: Q = bLaC1-a in which Q = Actual output; L = Labour; C = Capital;
b = number of units of Labour; a = Exponent∗ of labour; 1-a = Exponent∗ of Capital

According to the above production function, if both factors of production (labour and capital) are increased by
one percent, the output (total product) will increase by the sum of the exponents of labour and capital i.e. by
(a+1-a). Since a+1-a =1, according to the equation, when the inputs are increased by one percent, the output
also increases by one percent. Thus the Cobb Douglas production function explains only constant returns to
scale. This is mainly because the addition of
Q. Q =bLaCb.

In the above production function, the sum of the exponents shows the degree of “returns to scale” in produc-
tion function.
a + b >1 : Increasing returns to scale
a + b =1 : Constant returns to scale
a + b <1 : Decreasing returns to scale

Large Scale Production – Kinds of Economies

ECONOMIES OF SCALE: ‘Economies’ mean advantages. Scale refers to the size of unit. ‘Economies of Scale’ refers
to the cost advantages due to the larger size of production. As the volume of production increases, the over-
head cost will come down. The bulk purchase of inputs will give a better bargaining power to the producer
which will reduce the average variable cost too. All these advantages are due to the large scale production and
these advantages are called economies of scale.

There are two types of economies of scale

a) Internal economies of scale;

b) External economies of scale

a) INTERNAL ECONOMIES OF SCALE: ‘Internal economies of scale’ are the advantages enjoyed within the produc-
tion unit. These economies are enjoyed by a single firm independently of the action of the other firms. For in-
stance, one firm may enjoy the advantage of good management; another may have the advantage of more up-
to-date machinery. There are five kinds of internal economies. They are

TECHNICAL ECONOMIES: As the size of the firm is large, the availability of capital is more. Due to this, a firm can
introduce upto- date technologies; thereby the increase in the productivity becomes possible. It is also possible
to conduct research and development which will help to increase the quality of the product.
FINANCIAL ECONOMIES: It is possible for big firms to float shares in the market for capital formation. Small firms
have to borrow capital whereas large firms can buy capital.
MANAGERIAL ECONOMIES: Division of labour is the result of large scale production. Right person can be employed
in the right department only if there is division of labour. This will help a manager to fix responsibility to each
department and thereby the productivity can be increased and the total production can be maximised.
LABOUR ECONOMIES: Large Scale production paves the way for division of labour. This is also known as speciali-
sation of labour. The specialisation will increase the quality and ability of the labour. As a result, the productivi-
ty of the firm increases.
MARKETING ECONOMIES: In production, the first buyer is the producer who buys the raw materials. As the size is
large, the quantity bought is larger. This gives the producer a better bargaining power. Also he can enjoy credit
facilities. All these are possible because of large scale production. Buying is the first function in marketing.
ECONOMIES OF SURVIVAL: A large firm can have many products. Even if one product fails in the market, the loss
incurred in that product can be managed by the profit earned from the other products.

b) External economies of scale: When many firms expand in a particular area – i.e., when the industry
grows – they enjoy a number of advantages which are known as external economies of scale. This is not the
advantage enjoyed by a single firm but by all the firms in the industry due to the structural growth.

They are
 Increased transport facilities
 Banking facilities
 Development of townships
 Information and communication development
All these facilities are available to all firms in an industrial region.

DISECONOMIES OF SCALE: The diseconomies are the disadvantages arising to a firm or a group of firms due to
large scale production.
INTERNAL DISECONOMIES OF SCALE: If a firm continues to grow and expand beyond the optimum capacity, the
economies of scale disappear and diseconomies will start operating. For instance, if the size of a firm increases,
after a point the difficulty of management arises to that particular firm which will increase the average cost of
production of that firm. This is known as internal diseconomies of scale.
EXTERNAL DISECONOMIES OF SCALE: Beyond a certain stage, too much concentration and localisation of industries
will create diseconomies in production which will be common for all firms in a locality. For instance, the expan-
sion of an industry in a particular area leads to high rents and high costs. These are the external diseconomies
as this affects all the firms in the industry located in that particular region.

Market Structure

Market generally means a place or a geographical area, where buyers with money and sellers with their goods
meet to exchange goods for money. In Economics market refers to a group of buyers and sellers who involve
in the transaction of commodities and services.

Characteristics of a market

1) Existence of buyers and sellers of the commodity.

2) The establishment of contact between the buyers and sellers. Distance is of no consideration if buyers
and sellers could contact each other through the available communication system like telephone, agents,
letter correspondence and Internet.
3) Buyers and sellers deal with the same commodity or variety. Since the market in economics is identified
on the basis of the commodity, similarity of the product is very essential.
4) There should be a price for the commodity bought and sold in the market.

Classification of Markets

A. Market according to Area: Based on the extent of the market for any product, markets can be classified
into local regional, national and international markets.
o Local Market.
o Regional Market.
o National Market.
o Global Market.
B. Market according to time (Marshall)
 Very Short Period.
 Short-period.
 Long Period.
C. Market according to competition: These markets are classified according to the number of sellers in the
market and the nature of the commodity. The classification of market according to competition is as fol-
lows.

Market

Perfect Competition In perfect competition

Monopoly Duopoly Oligopoly Monopolistic

Perfect competition Large number of sellers selling homogenous products.

Monopoly Single seller.
Duopoly Two Sellers.
Oligopoly A few sellers’ homogeneous or differentiated products.
Monopolistic Large number of sellers selling differentiated products.

Perfect Competition

Perfect competition is a market situation where there is infinite number of sellers that no one is big enough to
have any appreciable influence over market price.

“The more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same
thing at the same time in all parts of the market”. – Marshall.
Features and conditions of perfect competition (characteristics)

1) LARGE NUMBER OF BUYERS AND SELLERS: As there are a large number of buyers and sellers, no individual
buyer or seller can influence the price of product, which is determined by collective effect of all the buy-
ers and sellers.
2) HOMOGENEOUS PRODUCT: As the product of all the firms is homogenous or identical, all the firms sell their
product at the market price. No firm can charge any price more than the price prevailing in the market.
3) FREE ENTRY AND FREE EXIT: All the firms are free to join or leave industry. There is no restriction on their
entry and exit. Hence, if the industry is accruing profits, new firms will enter into the market. Contrarily,
if the industry is suffering loss, many firms will leave the market.
4) PERFECT KNOWLEDGE ABOUT MARKET CONDITIONS: Since all the buyers and sellers hold perfect knowledge of all
the market conditions, there is free movement of buyers and sellers. Advertisement and selling methods
do not have an effect on consumer behaviour.
5) PERFECT MOBILITY OF FACTORS OF PRODUCTION: The factors of productions should be free to move from one
use to another or from one industry to another easily to get better remuneration.
6) INDEPENDENCE OF DECISION MAKING: All buyers and sellers are fully independent. None of them is commit-
ted to anyone. Hence, the buyers are free to purchase the required commodity from any seller and
sellers are free to sell their commodity to any buyer or buyers. The price of a commodity at a particular
time tends to be equal all over the market which all the firms have to follow.
7) ABSENCE OF SELLING AND TRANSPORTATION COSTS: It is assumed that selling and transportation costs have no
role to play in the determination of price.

Nature of revenue curves (price under perfect competition)

Under perfect competition, the market price is determined by the market forces namely the demand for and
the supply of the products. Hence there is uniform price in the market and all the units of the output are sold
at the same price. As a result the average revenue is perfectly elastic. The average revenue curve is horizon-
tally parallel to X-axis.
Since the Average Revenue is constant, Marginal Revenue is also constant and coincides with Average Reve-
nue. AR curve of a firm represents the demand curve for the product produced by that firm

 AR > AC Supernormal Profits

 AR = AC Normal profits
 AR < AC Losses
 AR < AC < AVC Shut down point

Short run equilibrium price and output determination under perfect competition

 Since a firm in the perfectly competitive market is a price-taker, it has to adjust its level of output to
maximise its profit. The aim of any producer is to maximise his profit.
 The short run is a period in which the number and plant size of the firms are fixed. In this period, the
firm can produce more only by increasing the variable inputs.
 As the entry of new firms or exit of the existing firms is not possible in the short-run, the firm in the
perfectly competitive market can either earn super-normal profit or normal profit or incur loss in the
short period.

Supernormal (profit) Equilibrium: E is the point of stable equilibrium as MC = MR and the MC cuts the MR
from below.

This is point the firm produces OM amount of

the output. To produce this output, the firm Supernormal profit
incurs an average cost of MF, while it earns
average revenue of ME. Since at equilibrium AR>AC
ME > MF, the firm makes a profit of FE per
unit of output sold. Again, since the total rev- AR – AC = Av. Profit
enue earned when OM is sold is OPEM and ME – MF = EF
the total cost incurred to produce the same
output is ORFM, the total profit earned at that TR > TC
level of output is RPEF.
TR – TC =total profit

OPEM–OREM = RPFF
Normal Profits: With the condition of Normal profit
MC = MR and the MC cuts the MR from
below, if E is the point of stable equilib- AR = AC
rium, output of the firm is OM. produce
this output, the firm incurs an average AR – AC = Av. Profit
cost ME, while it earns average revenue,
which is also equal to ME. Thus, we see ME – ME = Zero
that the firm just makes a normal profit
– i.e., its AR = AC. Since the total reve- TR = TC
nue earned and the total cost incurred
at output OM is OPEM, the firm earns a TR – TC = Total Profit
normal profit.

Losses: At the point of equilibrium i.e. E where MR = MC, the firm produces OM amount of the output. To pro-
duce this output, the firm incurs an average cost of PF, while it earns average revenue, which is equal to ME.
Since at equilibrium MF > ME, (AR<AC) the firm incurs a loss of EF per unit of output produced. Again, since
the total revenue earned when OM output is sold is only OPEM, while the total cost incurred at output OM is
ORFM, the firm incurs a total loss of PRFE. This is actually the situation of the firm minimising its losses.

Losses In-spite of incurring loss, the firm could

continue its functioning since its Aver-
AR < AC age Variable Cost is being covered. At
output OM, the firm covers its AVC,
AR – AC = Av. Profit. which is equal to MG. Hence, as long as
the firm is recovering at least its AVC, it
ME – MF = -EF would be possible for this firm to con-
TR <TC tinue functioning.

TR – TC = Total Profit

OPEM – ORFM = -PRFE

Shut Down Point: With MR = MC, the firm attains equilibrium at point E where, it produces OM amount of the
output. To produce this output, the firm incurs an average cost of MF, while it earns average revenue ME. At
equilibrium MF > ME, the firm incurs a loss of EF per unit of output produced. Since the total revenue earned is
only OPEM, while the total cost incurred is ORFM, the firm incurs a total loss of PRFE. The loss incurred is too
much for this firm to continue, as this firms’ AVC curve is also above its AR = MR curves – i.e. it is unable to
cover even its AVC. In the above situation, at output OM, the firm’s AVC, is equal to MG, which is greater than
the AR = ME. Hence, this firm is not even recovering its daily or running expenses, so it should shut down.

Shot Down Point

AR < AVC < AC

ME < MG < MF

AR – AC = Av. Profit

ME – MF = -EF

TR – TC = Total Profit

OPEM – ORFM = PRFE

Long Run Equilibrium of a Firm under Perfect Competition

The long run, due to the assumption of free entry and exit of the firms, it is not possible for the firms to make
super-normal profits nor is it possible for them to incur losses. Hence, due to the size of the industry increasing
or decreasing in the long run, firms can only earn normal profits in this time period.

The possibility of only normal profits can be explained as under.

 Long Run Equilibrium under Perfect Competition

Suppose that the firm is earning a super-normal profit in the long run, since the industry’s price (OP) (i.e. the
firm’s AR’ = MR’ = OP’) is greater than its AC. In this situation, new firms would find this area of production to
be attractive and hence they would enter this industry in large numbers. With the number of firms increasing,
the supply in the industry also rises. As the supply rises, the price will start lowering. This will go on until the
supply curve becomes S1 to S. This leads to fall in price from P' to P. The firm’s AR=MR curve becomes tan-
gential to the firms LAC at point E and so from the situation of earning supernormal profits the profit’s size has
been reduced to normal profit.

Suppose that the firm is incurring losses in the long run since the industry’s price (OP) (i.e. the firm’s AR’’ =
MR’’ = OP”) is lower than its AC. In this situation, some of the firms that are unable to recover even their AVC
will shut down and leave the industry. With the number of firms decreasing, the supply in the industry also
falls. As the supply keeps falling, the price will start rising. Thus, price rises from P" to P. This will go on until
the supply curve becomes S2 to S. The firm’s AR=MR curve becomes tangential to the firms LAC and so from
the situation of incurring losses, the firm’s revenues have improved so as to convert losses into normal profits.

Advantages of Perfect Competition

1) There is consumer sovereignty in a perfect competitive market. The consumer is rational and he has per-
fect knowledge about the market conditions. Therefore, he will not purchase the products at a higher
price.
2) In the perfectly competitive market, the price is equal to the minimum average cost. It is beneficial to
the consumer.
3) The perfectly competitive firms are price-takers and the products are homogeneous. Therefore it is not
necessary for the producers to incur expenditure on advertisement to promote sales. This reduces the
wastage of resources.
4) In the long run, the perfectly competitive firm is functioning at the optimum level. This means that max-
imum economic efficiency in production is achieved. As the actual output produced by the firm is equal
to the optimum output, there is no idle or unused or excess capacity.

Monopoly

Monopoly is a market structure in which there is a single seller, there are no close substitutes for the commodi-
ty it produces and there are barriers to entry.
“Broadly, the term Monopoly is used to cover any effective price control, whether of supply or demand of ser-
vices or goods; narrowly it is used to mean a combination of manufacturers or merchants to control the supply
price of commodities or services”. – Thomas.

Characteristics of Monopoly

 There is a single producer of a commodity.

 There is absence of competition.
 There are no close substitutes for a monopoly product.
 Cross-elasticity of demand for a monopoly product is zero in the case of pure monopoly and very low in
the case of simple monopoly.
 The monopolistic firm has control over supply of its commodity.
 There is no distinction between firm and industry under monopoly.
 Cases of pure monopolies are not found in developed countries. However, such cases of pure monopolies
are found in developing countries.
 A monopolist will prevent entry of new firms in the long run.

Types of Monopoly

NATURAL MONOPOLY: Natural monopoly is due to natural factors. For example, a particular raw material is con-
centrated at a particular place and this gives rise to monopoly exploitation of such material.
PUBLIC UTILITY MONOPOLY: Governmental authorities seize complete control and management of some utilities to
protect social interests. For example, posts and telegraph, telephones, electric power, railway transport, provi-
sion of water, are monopolies of the government and local authorities. There may be private monopolies of
public utility services.
FISCAL MONOPOLY: To prevent exploitation of employees and consumers, government nationalises certain indus-
tries and acquires fiscal monopoly power over them.
LEGAL MONOPOLY: Some monopolies are engendered and protected under certain laws. Inventors of new pro-
cesses, articles or devices obtain monopoly powers for such inventions under patent, trade mark and copyright
laws.
VOLUNTARY MONOPOLY THROUGH COMBINATIONS: To eliminate competition and thereby secure higher prices, firms
producing a particular product may come together and make monopoly agreements. These are known as in-
dustrial combinations. When all the firms merge into one organisation, such a monopoly takes the form of a
trust.
TECHNICAL: Monopoly power may be enjoyed due to technical reasons. A firm may have control over raw mate-
rials, technical knowledge, special know-how, scientific secrets and formula that enable a monopolist to pro-
duce a commodity. e.g., Coco Cola.
LARGE AMOUNT OF CAPITAL: The manufacture of some goods requires a large amount of capital or lumpiness of
capital. All firms cannot enter the field because they cannot afford to invest such a large amount of capital.
This may give rise to monopoly. For example, iron and steel industry, railways, etc.

Price under Monopoly

The aim of the monopolist is to maximise profit therefore; he will produce that level of output and charge that
price that gives him maximum profits. He will be in equilibrium at that price and output at which his profits are
the maximum. In other words, he will be in equilibrium position at that level of output at which marginal reve-
nue equals marginal cost.

In order to achieve equilibrium, the monopolist should satisfy two conditions:

 Marginal cost should be equal to marginal revenue.

 The marginal cost curve should cut marginal revenue curve from below.

Short run equilibrium of a firm under monopoly

Abnormal Profit under Monopoly Loss under Monopoly

AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost curve and MC is
the marginal cost curve. Up to OQ, level of output marginal revenue is greater than marginal cost but beyond
OQ the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium where
MC=MR. Thus, a monopolist is in equilibrium at OQ level of output and at OP price. He earns abnormal profit
equal to PRST. However, it is not always possible for a monopolist to earn super normal profits. If the demand
and cost situations are not favourable, the monopolist may incur short run losses.

Long run Equilibrium of a Firm under Monopoly

The firm has the time to adjust his plant size or to use the existing
plant so as to maximise profit.

The monopolist is in equilibrium at OL output where LMC cuts MR

curve. He will charge OP price and earn an abnormal profit equal to
TPQH.
Advantages
 Monopoly firms have large-scale production possibilities and also can enjoy both internal and external
economies. This will result in the reduction of costs of production. Output can be sold at low prices. This
is beneficial to the consumers.
 Monopoly firms have vast financial resources which could be used for research and development. This
will enable the firms to innovate quickly.
 There are a number of weak firms in an industry. These firms can combine together in the form of mo-
nopoly to meet competition. In such a case, market can be expanded.
Disadvantages
 A monopolist always charges a high price, which is higher than the competitive price. Thus a monopolist
exploits the consumers.
 A monopolist is interested in getting maximum profit. He may restrict the output and raise prices. Thus,
he creates artificial scarcity for his product.
 A monopolist often charges different prices for the same product from different consumers. He extracts
maximum price according to the ability to pay of different consumers.
 A monopolist uses large-scale production and huge resources to promote his own selfish interest. He
may adopt wrong practices to establish absolute monopoly power.
 In a country dominated by monopolies, wealth is concentrated in the hands of a few. It will lead to ine-
quality of incomes. This is against the principle of the socialistic pattern of society.

Methods of Controlling Monopoly

1) LEGISLATIVE METHOD: Government can control monopolies by legal actions. Anti-monopoly legislation
has been enacted to check the growth of monopoly. In India, the Monopolies and Restrictive Trade
Practices Act was passed in 1969. The objective of this Act is to prevent the unwanted growth of pri-
vate monopolies and concentration of economic power in the hands of a small number of individuals
and families.
2) CONTROLLING PRICE AND OUTPUT: This method can be applied in the case of natural monopolies. Gov-
ernment would fix either price or output or both.
3) TAXATION: Taxation is another method by which the monopolistic power can be prevented or restricted.
Government can impose a lump-sum tax on a monopoly firm, irrespective of its level of output. Con-
sequently, its total profit will fall.
4) NATIONALISATION: Nationalising big companies is one of the solutions. Government may take over such
monopolistic companies, which are exploiting the consumers.
5) CONSUMER’S ASSOCIATION: The growth of monopoly power can also be controlled by encouraging the
formation of consumers associations to improve the bargaining power of consumers.

Comparison between perfect competition and monopoly

Perfect Competition Monopoly

Average revenue curve is a horizontal straight line parallel
to X axis .Marginal revenue is equal to average revenue
and price.
At the equilibrium, MC = MR = AR. That is price charged is
equal to marginal cost of production.
The firm in the long run comes to equilibrium at the mini-
mum point or the lowest point of the long run average cost
curve. The firm tends to be of optimum size operating at
the minimum average cost.
Equilibrium can be conceived only under increasing cost
and not under decreasing or constant cost conditions
The firm can earn only normal profit in the long run and
may earn super profit in the short run.
Price will be lower and the output is large.
Both average revenue curve and marginal reve-
nue curve are downward falling curves. Marginal
revenue is less than average revenue and price.
At the equilibrium, MC = MR < AR that is price
charged is above marginal cost.
Even in the long run equilibrium the firm will be
operating at a higher level of average cost. The
firm stops short of optimum size.
Equilibrium situation is possible at increasing,
decreasing or constant cost conditions.
But monopoly firm earns super normal profit
both in short run and long run.
Price is higher and the output will be smaller.

Price Discrimination: Price discrimination means the practice of selling the same commodity at different prices
to different buyers. If the monopolist charges different prices from different consumers for the same commodi-
ty, it is called price discrimination or discriminating monopoly.

Definition: Price discrimination may be defined as “the sale of technically similar products at prices which are
not proportional to marginal cost”. For example, all cinema theatres charge different prices for different classes
of people.

Conditions of Price Discrimination

 The demand must not be transferable from the high priced market to the low priced market. If rich
people do not buy the high-priced deluxe edition of the book, but wait for the low-priced popular edi-
tion to come out, then personal discrimination will fail.
 The monopolist should keep the two markets or different markets separate so that the commodity will
not be moving from one market to the other market. If it is possible to buy the product in the cheaper
 market of the monopolist and sell it in the dearer market, there can never be two prices for the com-
modity. If the industrial buyer of cheap electricity uses it for domestic consumption, then trade dis-
crimination will fail.

The above two conditions are essential to adopt price discrimination.

Monopolistic Competition

Monopolistic competition refers to the market situation in which a large number of sellers produce goods which
are close substitutes of one another. The products are similar but not identical. The particular brand of product
will have a group of loyal consumers. In this respect, each firm will have some monopoly and at the same time
the firm has to compete in the market with the other firms as they produce a fair substitute. The essential fea-
tures of monopolistic competition are product differentiation and existence of many sellers.

Features of Monopolistic Competition

 Existence of large number of firms.

 Product differentiation.
o Physical difference.
o Quality difference.
o Imaginary difference.
o Purchase benefit
 Absence of Inter-dependence.
 Selling cost.
 Free entry and exit.

Assumptions of monopolistic competition:

 There are a significant number of sellers as well as buyers in the groups.

 Products of the sellers are separated, however they are close substitutes of one another.
 Three is free entry as well as exit of the organisation in the group.
 The objective of the firm is to maximise profits, both in the short run as well as in the long run.

Price determination under monopolistic competition

a) SHORT TERM EQUILIBRIUM OF A FIRM: Short term implies to the period where a firm is not able to regulate
the supply of its product as per the demand. Owing to this reason, a firm is not able to accomplish
much taking into account its profit situation in the short run. Thus, in the short-run, there could be
three contingencies concerning profit.
 Abnormal profit.
 Normal or zero profit.
 Loss.

ABNORMAL PROFIT: In short run an organisation could be capable of ac-

quiring abnormal profit only as soon as the demand of the organisa-
tion’s profit is extremely high and there is not close substitute to its
product. Under these circumstances, the organisation can establish a
high price for its product and can acquire abnormal profit. This can be
achievable only in the short-run, as no new organisation can become
involved in the market in the short run.

In the figure, 'E' is the point of equilibrium of firm because at this point
marginal cost and marginal revenue of the firm are equal. At this point
‘OP’ is the equilibrium price, OQ is the equilibrium quantity of produc-
tion and sale, PC is the profit per unit. In this situation, the firm is
earning abnormal profit equal to the area PBTC.
Supernormal Profit under Monopolis-
tic Market

NORMAL PROFIT OR ZERO PROFIT: If the demand of the organisation's product is not extremely high, the organisa-
tion could acquire only normal profit once average revenue is a little more than the average cost or zero profit
as soon as average revenue and average cost are equal.

(A) following diagram 'E' is the point of equilibrium of firm because at this point marginal cost and marginal
revenue of the firm are equal. At this point, ‘OQ’ is the equilibrium quantity, ‘OA’ is the price per unit and ‘OD’
is the cost per unit. Here, average revenue is slightly more than average cost; in this case, the firm accrues
profit equal to the area of ‘ABCD’. (B) above, 'E' is the point of equilibrium of firm because at this marginal cost
and marginal revenue of the firm are equal. At this point, ‘OQ’ is the equilibrium quantity, ‘OP is the price per
unit and ‘OP’ is also the cost per unit. Here, average revenue and average cost are equal. Therefore, the firm is
not making any profit or loss.
LOSS: In short-run, a firm may have to suffer loss when demand of the area ABCD
product of firm is so weak that the firm has to sell its product at a price
less than its cost, in this case, average revenue of the firm is less than its
average cost.

Average revenue of the firm is less than its average costs. “E” is the point
of equlibrium. At this point, “OQ” is the equlibrium quantity, “OD” is the
price per unit and “QA” is the cost per unit. Here, price per unit is less
than cost per unit. Therefore, the firm is suffering a loss equal to the

Long-term equilibrium of a firm

Long term is the period where an organisation could regulate the supply of its product as per its demand. It is
the period where new organisatin can further more become involved in the market. in this situation, an
organisation at all times acquires normal profit, as in case an organisation is acquiring abnormal profit in short
term, new organisation will become involved in the market. it wil add to the supply of the product and
consequently the price of the product will decline. This series of new organisations getting involved in the
market will carry on till the organisation is in the poistion of acquiring normal profit only. In contrast, if an
organisatin is suffering a loss in the short run, several organisatin will leave the industry. In this situtaion,
supply of the product will decline and price of the product willl rise to the level of average cost or a little more
than the average cost. Consequently, the organisation will acquire normal profit. Nevertheless, following two
conditions should be fulfilled for the equlibrium of an organisation in the long run.
 Marginal cost as will as marginal revenue of all the organisation should be equal.
 Average cost as will as average revenue of all the organisatin should be equal.

Long run Equilibrium under Monopolistic Market

‘E’ is the point of equilibrium. At this point, MC = MR. At this point, ‘OM’ is
the equilibrium quantity, ‘OP’ is the equilibrium price and ‘QM’ is the
average cost. At this point, average cost and average revenue are equal. It
satisfies the conditions of normal profit. In this situation, the firm is
accruing normal profit equal to the
area of PQRS.

Defects or wastes of monopolistic competition

 UNEMPLOYMENT: Under monopolistic competition, the firms produce less than optimum output. As a result,
the productive capacity is not used to the fullest extent. This will lead to unemployment of resources.
 EXCESS CAPACITY: Excess capacity is the difference between the optimum output that can be produced
and the actual output produced by the firm. In the long run, a monopolistic firm produces an output
which is less than the optimum output that is the output corresponding to the minimum average cost.
This leads to excess capacity which is regarded as waste in monopolistic competition.
 EXPLOITATION: Under imperfect competition the output is restricted, so that price is kept higher than the
marginal cost (AR>MC). The excess of the price on MC represents real extra burden on the community
i.e. exploitation. Under perfect competition this exploitation is not possible as price is equal to AC and
MC. (AR=MC=AC)
  ADVERTISEMENT: There is a lot of waste in competitive advertisements under monopolistic competition.
The wasteful and competitive advertisements lead to high cost to consumers.
 CROSS TRANSPORT: The existence of cross transport is another factor contributing to waste of imperfect
competition. A firm in India may be a selling a commodity in India while the same product produced in
India may be sold abroad. This is also the result of absence of perfect competition and presence of prod-
uct differentiates.
 SPECIALISATION: Another waste of imperfect competition is the failure of each firm in India to specialise in
the production of those commodities for which it is best suited.
 STANDARDISATION: Under imperfect competition, standardisation which helps in reducing cost is not possi-
ble. No produce can take the rich producing particular design on larger.
 TOO MANY VARIETIES OF GOODS: Introducing too many varieties of a good is another waste of monopolistic
competition. The goods differ in size, shape, style and colour. A reasonable number of varieties would be
desirable. Cost per unit can be reduced if only a few are produced.
 INEFFICIENT FIRMS: Under monopolistic competition, inefficient firms charge prices higher than their mar-
ginal cost. Such type of inefficient firms should be kept out of the industry. But, the buyers’ preference
for such products enables the inefficient firms to continue to exist. Efficient firms cannot drive out the in-
efficient firms because the former may not be able to attract the customers of the latter.

Oligopoly

Oligopoly refers to a form of imperfect competition where there will be only a few sellers producing either ho-
mogenous or differentiated products.

“Oligopoly is market situation in between monopoly and perfect competition in which the number of sellers is
more than one but is not so large that the market price is not influenced by any one of them” - John Robinson.

Characteristics of Oligopoly

a. SMALL NUMBER OF SELLERS: There are more than one sellers of a product however; the number is not so
huge in order to generate perfect competition of monopolistic competition.
b. INTERDEPENDENCE OF SELLERS: All the sellers are dependent on each other. They are not free to establish
their own marketing and price policies. Activities of one seller have an effect on others.
c. HOMOGENOUS PRODUCT: The product of all the sellers is identical or a close substitute to each other.
d. UNIFORMITY OF PRICE: All the sellers adopt a uniform price policy due to the uniformity of their product.
e. PRICE RIGIDITY: As the activities of all sellers are inter-reliant, the sellers prefer not to change the price of
their product too often. For that reason, the market price happens to be steady.
f. ENTRY & EXIT OF FIRMS: The entry as well as exit of organisations is relatively difficult because of non-
availability of raw materials, labour, etc.
g. INCONSISTENCY IN FIRMS: All the organisations operating in a market are not precisely similar to each oth-
er. One organisation could be huge and another organisation could be tiny.
h. UNCERTAINTY OF DEMAND CURVE: Demand curve is extremely erratic. An organisation cannot predict its de-
mand curve without difficulty because it is extremely difficult to predict whether or not the competitors
will change their policies of the organisations. It is moreover extremely difficult to predict the level of
such changes. For this reason, the demand curve of an oligopoly organisation is constantly erratic.

Price-output determination under oligopoly

(Kinky Demand Curve) Short Period: The kinked demand curve was first employed by Prof. Paul M. Sweezy to
explain price rigidity under oligopoly. In an oligopoly market, the firm knows that if it increases price, other
firms will not follow; but if price is reduced, other firms will follow the price reduction. In some respect, the
price output analysis in oligopoly is simple. Since each seller wants to avoid uncertainty, every oligopolistic firm
will adhere to the point of kink, where it is safe and where it can anticipate the reaction of its rivals. However,
the firm will neither increase nor decrease price.

This is an important consequence of the existence of the kink in the de-

mand curve of the firm. Because, of the vertical section in MR, i.e. un-
certainty range, without affecting the price or level of output. Under
these circumstances, equality between MC and MR will not determine the
point of equilibrium. The profits will, however, be determined as in any
other market, by the difference between AR and AC. With a given mar-
ginal cost of production, OP is more likely to be the profit-maximising
price. The length of the discontinuity portion in the MR depends on the
relative elasticity of demand at point E of AR. The greater the elasticity
of demand of the portion of AR above point E and the lower the elasticity
of demand of the portion of AR below point discontinuity portion of MR,
the bigger will be the discontinuity portion of MR.

Price Rigidity: Another important feature of oligopoly is price rigidity. Price is sticky or rigid at the prevailing
level due to the fear of reaction from the rival firms. If an oligopolistic firm lowers its price, the price reduction
will be followed by the rival firms. As a result, the firm loses its profit. Expecting the same kind of reaction, if
the oligopolistic firm raises the price, the rival firms will not follow. This would result in losing customers. In
both ways the firm would face difficulties. Hence the price is rigid.

National Income: National income refers to the value of commodities and services produced by a country
during a year.

Marshall defined national income as follows : “The labour and capital of a country acting on its natural re-
sources produce annually a certain net aggregate of commodities, material and immaterial, including services
of all kinds……… This is true net annual income or revenue of the country, or the national dividend”.

From the national income of a country, we can find out whether the country is rich or poor. And from the com-
position of national income, we can find out the relative importance of agriculture, industry and service sector
in the economy.

National Income Committee of India,: “ National income estimate measures the volume of commodities and
services turned out during a given period counted without duplication.”

Modern Definition: “the net output of commodities and services flowing during the yar from the country’s pro-
ductive system in the hands of the ultimate consumers.

Concepts of National Income:

1) Gross Domestic Product (GDP)

a. The Product Method.
b. The Income Method.
c. Expenditure Method.
2) GDP at factor cost
3) Net Domestic Product.
4) Nominal and Real GDP.
5) GDP deflator.
6) Gross National Product (GNP)
a. Income Method to GNP.
b. Expenditure method to GNP.
c. Value added method to GNP.
7) GNP at Market prices.
8) GNP at factor cost.
9) Net National product (NNP)
10) NNP at market prices.
11) NNP at factor cost.
12) Domestic Income.
13) Private Income.
14) Personal income
15) Disposable Income.
16) Real Income.
17) Per Capital Income.

Methods of Measuring National Income:

a. Product Method: According to this method, the total value of final goods and services produced ina
country during a year is calculated at market prices. To find out the GNP, the data of all productive
activities, such as agricultural products, wood received from forests, minerals received from mines,
commodities produced by industries, the contributions to production made by transport, communica-
tions, insurance companies, lawyers, doctors, teachers, etc., are collected and assessed at market
prices. Only the final goods and services are included and the intermediary goods and services are
left out.
b. Income Method: According to this method, the net income payments received by all citizens of a
country in a particular year are added up, i.e., net incomes that accrue to all factors of production by
way of net rents, net wages, net interest and net profits are all added together but income received in
the form of transfer payments are not included in it. The data pertaining to income are obtained from
different sources, for instance, from income tax department in respect of high income groups and in
case of workers from their wage bills.
c. Expenditure Method: According to this method, the total expenditure incurred by the society in a
particular year is added together and includes personal consumption expenditure, net domestic in-
vestment, government expenditure on goods and services, and net foreign investment. This concept
is based on the assumption that national income equals national expenditure.
d. Value Added Method: Another method of measuring national income is the value added by indus-
tries. The difference between the value of material outputs and inputs at each stage of production is
the value added. If all such differences are added up for all industries in the economy, we arrive at
the gross domestic product.
Difficulties or Limitation In Measuring National Income

There are many conceptual and statistical problems involved in measuring national income by the income
method, product method, and expenditure method.

a. Problems in income method.

 Owner occupied houses.
 Self-employed persons.
 Goods meant for self-consumption.
 Wages and salaries paid in kind.
b. Problems in Product method.
 Services of Housewives.
 Intermediate and final goods.
 Second hand goods and assets.
 Illegal actives.
 Consumer’s services.
 Capital gains.
 Inventory changes.
 Depreciation.
 Price changes.
c. Problems in expenditure method.
 Government services.
 Transfer payments.
 Durable use consumer’s goods.
 Public expenditure.

Importance of National Income Analysis:

1. For the economy.

2. National policies.
3. Economic planning.
4. Economic models.
5. Research.
6. Per capital income.
7. Distribution of income.

Inequalities of Income

Income inequality is the unequal distribution of household or individual income across the various participants
in an economy. Income inequality is often presented as the percentage of income to a percentage of popula-
tion.

The Causes of Economic Inequality

 The difference in income plays a role

o Wages of labour market.
o Education affects wages.
o Growth in technology widen income gap.
o Gender does matter.
o Personal factors.
 Inequality is vicious cycle.(rich get richer and poor get poorer)
 Economic policies and structure.
o Economic neoliberalism.
o Globalisation.