Paper III Unit I II IV and V in Engilsh

Unit – 1
DEMAND AND SUPPLY ANALYSIS
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LESSON 1
ELASTICITY OF DEMAND AND APPLICATIONS
1. STRUCTURE
1.1. Objective
1.2. Introduction
1.3. Meaning of Elasticity of Demand
1.4. Types of Elasticity of Demand
1.4.1. Price Elasticity of Demand
1.4.2. Income Elasticity of Demand
1.4.3. Cross Price Elasticity of Demand
1.5. Methods of Calculating Price Elasticity of Demand
1.5.1. Percentage Method
1.5.2. Point Method
1.5.3. Total Expenditure Method
1.5.4. Geometric Method
1.6 . Derivations based on elasticity of Demand
1.7 . Summary
1.8 . Self Assessment Questions
1.9 . Suggested Readings
1.1OBJECTIVE
After reading this lesson, you should be able to

a) Understand the concept of Elasticity
b) Differentiate between different kinds of elasticity
c) Calculate different types of elasticity
d) Comprehend relationship between revenue and elasticity
e) Explain and analyze the relation between slope of the demand curves and their elasticities.
1.2 INTRODUCTION
Law of demand states that when price of a commodity decreases/increases the quantity demanded of the
commodity increases/decreases respectively ceteris paribus. But the law is silent about the quantum of change,
the answer to that is provided by the concept of Elasticity. Elasticity in a layman’s term is the responsiveness of
a dependent factor to a change in the independent factor. Understanding of how elastic or inelastic is a variable
in response to some other variable helps in the decision making, policy formulations, deciding about the
closeness (substitutes or complementary status) of the commodities involved. It is one of the most important
factors that firms take into consideration for deciding whether to change the price of their commodity or bring
changes in some other variables.
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1.3 MEANING OF ELASTICITY OF DEMAND
Elasticity measures the responsiveness of the quantity demanded due to change in the price of the commodity
itself (Price Elasticity), income of the consumer (Income Elasticity) or change in the price of the related
commodity that can be substitute or complementary good (Cross Price Elasticity).
Therefore we have three kinds of elasticity of demand

1. Price elasticity of demand
2. Cross elasticity of demand
3. Income elasticity of demand
It is simply calculated as:

Ed =
If there is a small change in the quantity demanded of a commodity because of change in any one of the underlying factor
that is price of commodity, income or price of related commodity (substitute or complement commodity) then it is said to
be having relatively inelastic demand. The converse that is if there is large change in the quantity demanded in response to
change in any of the above mentioned variables then there is said to be existence of relatively elastic demand. Different
types of elasticity and their measurements is explained under the next topic:
1.4 TYPES OF ELASTICITY OF DEMAND

As mentioned above the change in the quantity demanded can be effected by any of the following three
variables namely:
1) Price of the commodity itself whose quantity has changed
2) Income of the consumer or
3) Price of the related commodity that can be either a substitute or a complementary good.
Accordingly the elasticity can be defined as either of the following:
1) Price elasticity denoted by Ed or Ep or simply E.
2) Income Elasticity of Demand denoted by Ey or EI
3) Cross Price Elasticity of Demand denoted by Exy
1.4.1 Price Elasticity of Demand

This is the most commonly studied form of elasticity that measures how much change is there in the
quantity demanded of a commodity because of change in the price of the commodity itself other things
remaining constant. It is calculated as:
Ed =
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On calculation, price elasticity of demand comes out to be a negative number because it indicates the inverse
relationship between price and quantity demanded. However there is a negative sign in the formula to convert it to
positive and hence price elasticity varies from 0 to +∞.
Example: If the quantity demanded for a good increases by 20% because of a 10% decrease in price, the
price elasticity of demand would be 20% / 10% = 2.
Price Elasticity is impacted by a number of factors like availability of close substitutes (where existence
of close substitutes would make the demand of the commodity elastic and absence of the substitutes
would make it inelastic), categorization of the commodity as necessity, luxury or comfort goods (as
necessities usually have relatively inelastic demand as compared to luxuries that tend to have more
elastic demand).
Calculation of price elasticity would be studied in detail in the next heading.
1.4.2 Income Elasticity of Demand

It shows how responsive is the quantity demanded of a commodity to change in the income of the
consumer ceteris paribus. Here we talk about nominal income of the consumer that is change in the
money income and not the real income which changes because of change in the prices of the
commodities. It is calculated as:
Ey =
Ey =
Income elasticity to a great extent depends on the type of goods under study that is whether the good is
normal or inferior as in case of normal goods income elasticity is positive there being direct relation
between Income of the consumer and the quantity demanded and it comes out to be negative in case of
inferior goods there being inverse relation between income and quantity demanded. There can be a
further division of the income elasticity where it can be categorized as follows:
Different values of income elasticity of Types of goods

demand
Ey > 1 Luxury goods
Ey = 1 Comfort goods
0 < Ey < 1 Necessity
Ey < 0 Inferior goods
If income of a consumer increases by 10% and the quantity demanded of a commodity increases by 20% then
the commodity would have elastic income demand as Ey comes out to be 20%/10% = 2 showing that
commodity is a luxury good.
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Figure 1 Figure 2
As can be seen from the figures above that in case of inferior good there is inverse relation between income of
the consumer and the quantity demanded, when income of the consumer increases his purchasing power
increases and he moves on to the consumption of superior commodity reducing the quantity consumed of the
inferior good. While in case of normal good there is a direct relation between income and quantity consumed as
with an increase in the income consumer consumes more of the commodity if it’s a normal good and by how
much the consumption of the normal good would increase depends upon whether the commodity being talked
about is necessity, luxury or comfort.
1.4.3 Cross Price Elasticity of Demand
It shows how responsive is the quantity demanded to change in the price of a related commodity ceteris
paribus. The related commodity can be a substitute or a complement. It is calculated as:
Exy =
Ey =
Different Values of Cross Price Elasticity Type of Good

Exy = +∞ Perfect Substitutes
0 < Exy < +∞ Substitute goods
Exy = 0 Unrelated
Exy = -∞ Perfect Complements
-∞ < Exy < 0 Complementary goods
Example 1: There are 2 commodities X and Y and there before and after prices and quantity are given as
follows:
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Before After
Price Quantity Price Quantity
(Rs./unit) (unit/month) (Rs./unit) (unit/month)
Commodity Y 20 40 40 30
Commodity X 40 80 40 70
Here cross price elasticity comes out to be
Ey =
Ey = = = -0.125 (Goods are Complementary as there is inverse relation between price of

commodity Y and quantity of commodity X)
Example 2: Calculate cross price elasticity of demand between coffee(X) and tea(Y) from the following data
and comment on the relationship between the two goods.
Before After
Price Quantity Price Quantity
(Rs./unit) (unit/month) (Rs./unit) (unit/month)
lemon(X) 10 20 20 15
Tea(Y) 20 40 20 35
Here cross price elasticity comes out to be
Ey =
Ey = = = -0.125 (Goods are Complementary as there is inverse relation between price of

commodity X and quantity of commodity Y)
Cross price elasticity is positive in case of substitute goods as in the example of Tea and Coffee if price of Tea
increases then people reduce its demand and switch to coffee that is its substitute and has unchanged price
which brings an increase in the quantity demanded of coffee, thereby having a positive relation between price of
tea and quantity demanded of its substitute coffee. Similarly if two goods are complementary like say petrol
and car, then increase in price of petrol would reduce the demand of petrol cars in the market, the cross price
elasticity would hence come out to be negative showing inverse relation between price of one commodity and
its complement. Cross Price elasticity thus helps in establishing the relation between two commodities, whether
two goods are substitutes or complementary to each other or are totally unrelated, as if goods are related then
change in the price of one would have an impact on the other.
1.5 METHODS OF CALCULATING PRICE ELASTICITY OF DEMAND

Price elasticity is one of the most important factors that determine various policy measures undertaken by firms
as well as the government. For example if government imposes tax on a commodity who is relatively price
inelastic then quantity demanded would not reduce by a greater extent as compared to a commodity which is
price elastic. As price of a commodity is the most important determinant of the quantity demanded so is the
price elasticity the most important elasticity, hence it is also sometimes called elasticity only instead of
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specifying price elasticity. Now the question is how to calculate price elasticity or simply elasticity. There are
various methods give by different economists for its classification out of which three are given below:
1.5.1 Percentage Method

According to this method, price elasticity of demand is measured as the ratio of percentage change in quantity
demanded of a commodity to percentage change in its price. This method was devised by Marshall.
Ed =
Ed =
Where = Change in quantity demanded, final quantity-initial quantity, Q2 – Q1
= Change in the price of the commodity itself, final price – initial price, P2 – P1
Example 3:
Price Quantity
10 100
20 80
Here Elasticity is
Ed = = Ed = = 0.2
Using Percentage method following five types of elasticity can be identified:

1) Perfectly Elastic Demand: here demand curve is a horizontal straight line parallel to X axis as at the
same price any amount of the quantity can be demanded. For example in case of demand curve for a
firm under perfect competition, demand is perfectly elastic as if price changes by even a small
proportion, quantity demanded shrinks to 0.
Here Ed = +∞
2) Relatively Elastic Demand: When percentage change in quantity demanded is more than percentage in
price, there is relatively elastic demand. For example: if Price of a commodity decreases by 10% and its
quantity increases by say 20%, there is said to be relatively elastic demand. Demand curve here is flatter
showing % change in Q is greater than % change in P.
Here 1 < Ed < +∞
3) Unitary Elastic Demand: When Percentage change in quantity demanded is equal to percentage change
in price, there is said to be a unitary elastic demand. For example: if Price of a commodity decreases by
10% and its quantity increases 10%, there is said to be unitary elastic demand. Demand curve here is a
Rectangular Hyperbola as % change in Q is equal to % change in Price so area below the demand curve
remains constant.
Here Ed = 1
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4) Relatively Inelastic Demand: When Percentage change in quantity demanded is less than percentage
change in price, there is said to be relatively inelastic demand. For example: if Price of a commodity
decreases by 10% and its quantity increases 5%, there is said to be relatively inelastic demand. Demand
curve here is steeper as % change in Q is less than % change in Price.
Here 0 < Ed < 1
5) Perfectly Inelastic Demand: When change in price has no impact on the quantity and demand curve is
vertical, there is said to perfectly inelastic demand. This takes place in case of absolute necessities.
Here Ed = 0. From the above it can be seen that using percentage method, elasticity varies from Zero to
Infinity as is shown in the Figure below:
Figure 3
1.5.2 Arc Method

The method is also called Arc or average method as it gives the elasticity mid way between two price changes
on a demand curve. To calculate elasticity using Arc method following formula is used:
Ed = =
Point elasticity vs. arc elasticity
Point elasticity of demand Arc elasticity of demand

It refers the proportionate change in quantity It is the price elasticity of demand between two
demanded in response to very small points on a demand curve. In other words it
proportionate change in price. measures price elasticity midway between two
points.
If the changes in the price are very small ,then If the changes in the price are not small, then
we use the point elasticity of demand we use the arc elasticity of demand.
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1.5.3 Total Expenditure Method
This method calculates elasticity by finding out the relation between Price and Total Expenditure. Here
elasticity can be classified into three categories:
a) Elastic Demand: When price and Total Expenditure moves in the opposite direction i.e. if price
decreases quantity increases more than proportionately thereby increasing the total outlay on the
consumption of the commodity and vice versa. It can be illustrated with the following example:
Price(Rs) Quantity (Units) Total expenditure

(P*Q)
10 20 Rs 200
8 30 Rs 240
b) Unitary Elastic Demand: When irrespective of the change in the price total expenditure remains
constant, demand is said to be Unitary Elastic. It can be illustrated with the following example:

(P*Q)
10 20 Rs 200
8 25 Rs 200
c) Inelastic Demand: When price and Total Expenditure moves in the same direction i.e. if price decreases
quantity increases less than proportionately thereby decreasing the total outlay on the consumption of
the commodity and vice versa. It can be illustrated with the following example:

(P*Q)
10 20 Rs 200
8 22 Rs 176
Example 4: From the data given below calculate Elasticity of Demand using Total Expenditure method
Price Quantity of Commodity X Quantity of Commodity Y

1 320 1200
2 200 500
3 150 325
4 120 225
5 110 160
Solution: To calculate elasticity we have to find out whether total expenditure moves in the same direction as
the price or in the opposite direction which has been explained below:
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Price Total Expenditure on Total Expenditure on
Commodity X Commodity Y
1 320 1200
2 400 1000
3 450 975
4 480 900
5 550 800
The calculation above shows that commodity X is relatively inelastic as price and total expenditure on X moves
in the same direction whereas commodity Y is relatively elastic as price and total expenditure on Y moves in
the opposite direction.
1.5.4 Geometric Method

This method is used to calculate elasticity at a point on the demand curve by using the following formula:
Ed =
It is used to measure the elasticity at different points on the straight line or linear demand curve as can be shown
using the following where it is shown that elasticity varies 0 to ∞ on a straight line demand curve.
Figure 4 (a)
As is seen in the figure above Elasticity can be calculated at different points on the linear demand curve using
Geometric method as is shown below:
Ed at Point D = DD’/0 = ∞
Ed at Point S = SD’/SD > 1
Ed at Point R = RD’/RD = 1
Ed at Point L = LD’/LD < 1
Ed at Point D’ = 0/DD’ = 0
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Proof of Geometric method:
Figure 4(b)
When Price falls from OA to OC, quantity demanded increases from OB to OD. Thus we get
∆P = AC = PQ, Initial price = p = OA = PB
∆Q = BD = QM, Initial Quantity = q = OB
Using percentage method of Elasticity and substituting above values we get following:
Ed = = QM/PQ * PB/OB
Now ∆PQM and ∆PBS are similar triangles

BS/PB * PB/OB = BS/OB
Also ∆PBS and ∆ROS are similar triangles, so
BS/OB = OA/AR = PS/PR = Lower segment/Upper segment
Geometric method can also be used to calculate elasticity on a non linear demand curve where elasticity is
measured by drawing a tangent at the point where elasticity is to be calculated and extending it to touch the X
and Y axis and then using the above formula for calculation of elasticity.
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1.6 DERIVATIONS BASED ON ELASTICITY OF DEMAND
Derivation1:
Relation between Average Revenue, Marginal Revenue and Elasticity of Demand
Total Revenue, TR = Price *Quantity = P*Q
Average Revenue, AR = TR/Q = P*Q)/Q = P

Marginal Revenue, MR = ΔTR/ΔQ = Δ (P*Q)/ΔQ = P (ΔQ/ ΔQ) + Q (ΔP/ ΔQ)
MR = P + Q (ΔP/ ΔQ)
Multiplying and dividing above by P we get following
MR = P + Q/P (ΔP/ ΔQ)*P . . . . . . . . . . . . . . . . . . . . . . . . . . . .(1)
Also, Ed = , (-) 1/ Ed =
Substituting the value of Ed in equation (1) we get

MR = P + P*[(-) 1/ Ed], MR = P [1 – 1/ Ed ], MR = AR [1 – 1/ Ed ]
Above result shows relation between MR, AR and Elasticity of demand in the below given results:
a) If demand curve has unit elasticity i.e. Ed = 1, MR = 0

b) If demand curve is relatively elastic i.e. Ed > 1, MR = Positive
c) If demand curve is relatively inelastic i.e. Ed < 1, MR = Negative
It can be presented diagrammatically as follows:
Figure 5
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Derivation 2:
Two Linear Parallel Demand Curves have unequal elasticity at a given price
Two Parallel Demand curves have same slope and slope of the demand curve is given by ΔP/ ΔQ
Using percentage method, we calculate elasticity using the following formula:
Ed = or
Ed =
Figure 6
Ed of demand curve D1 =
In above Figure D1 is parallel to D2, so Slope of demand curve D1 = Slope of demand curve D2
Also initial price P* is same in both the demand curves so in the above two equations we are left with
As can be seen from figure 6, Q1 < Q2 or
Hence proved that Ed of demand curve D1 > Ed of demand curve D2

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Derivation 3:
Two Linear Parallel Demand Curves have unequal elasticity at a given quantity
Two Parallel Demand curves have same slope and slope of the demand curve is given by ΔP/ ΔQ
Using percentage method, we calculate elasticity using the following formula:
Ed = or Ed =
Figure 7
Also initial quantity Q* is same in both the demand curves so in the above two equations we are left with
Ed of demand curve D1 = P1
Ed of demand curve D2 = P2
As can be seen from figure 7, P1 < P2
Hence proved that Ed of demand curve D1 < Ed of demand curve D2
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Derivation 4:
A straight line from the origin that intersects two parallel demand curves has equal elasticity at the point
of intersection
It can be explained with the following figure:
Figure 8
Elasticity of the two demand curves using percentage method:
Ed = or Ed =
So in the above two equations we are left with the following
Now ΔOAB ~ ΔODC
So, AB/OA = DC/OD
Thus proving that the demand curves have equal elasticity at the point of intersection
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Derivation 5:
Two intersecting demand curves have unequal elasticity at the point of intersection
It is explained with the following figure:
Figure 9
Using percentage method we calculate elasticity using following formula:
Ed =
Ed of demand curve D1 is: . . . . . . . . . . . . . . . . . . . . . .(1)
Change in quantity = Q1 to Q’
Change in price = P1 to P2
Ed of demand curve D1 is: . . . . . . . . . . . . . . . . . . . . . . (2)
Change in quantity = Q1 to Q2
Change in price = P1 to P2
Initial price and initial quantity is same in both the above cases i.e ratio is same. So we are left with the
change in quantity/change in price.
Now in case of demand curve D1, change in quantity is Q1 to Q’ or AC
Change in quantity in case of demand curve D2 is Q1 to Q2 or AB
Change in price is same in both the demand curves i.e. P1 to P2.
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So for the comparison we are left with only comparing change in quantity.
As can be seen from the figure above AC < AB or we can say that Ed of D1 < Ed of D2.
Derivation 6:
Relationship between Average Revenue and Marginal Revenue
Let Demand function is given by the following equation:
P = a – bQ
Where P = Price, Q = Quantity, a = Intercept and b = Slope
Total Revenue, TR = P*Q = (a-bQ)*Q = aQ-bQ2
Average Revenue = TR/Q = (aQ-bQ2)/Q = a – bQ = Price . . . . . . . . . . .. . . . . . . . (1)
Marginal Revenue = ΔTR/ΔQ = Δ(aQ-bQ2)/ ΔQ = a – 2bQ . . . . . . . . . . .. . . . . . . . (2)
Thus comparing equation (1) and (2) we get the following results:
1) Intercept of both Average Revenue and Marginal Revenue is same = a, that is both start from the same
point
2) Both AR and MR are downward sloping that is have a negative slope.
3) Slope of MR is 2b and AR is b that is slope of MR is twice the slope of AR, so MR falls twice as fast as
AR and is steeper than the AR. The above three results can be shown in the following figure:
Figure 10
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1.7 SUMMARY
Law of demand stated that there is inverse relation between price and quantity demanded but impact of change
in price is different in different commodities. Some are impacted more while some are impacted less. The
answer to this is not provided by the demand curve itself and hence we have to understand the concept of
elasticity. The chapter thus talked about the concept of elasticity that can be further classified into price, income
and cross price elasticity. It is the price elasticity however that is commonly talked about and has various
methods to calculate to show how responsive is the quantity demanded to change in the price. We have
percentage method, arc method, geometric method and total expenditure method. All of these are used under
specific conditions. Then there is income elasticity that shows the impact of change in income on the quantity
demanded by the consumer. On the basis of income elasticity of demand commodities can be classified as
necessities, comfort, luxury or inferior goods. There is also the concept of cross price elasticity that helps in
measuring how related two commodities are and whether the goods in the question are substitutes or
complements. All these measures of elasticity are helpful in policy formulation by the business firms as well as
competitors. The chapter has talked about various derivations showing how the concept of elasticity can be
utilized in deriving certain mathematical proofs. Elasticity of demand is important to understand as it can be
used for the following decision making:
1) Pricing Decisions: Elasticity of demand of a commodity helps in determining how much price a
commodity can command in the market under different market structures.
2) Price discrimination: Elasticity of demand also helps in setting up differential prices as a producer can
charge a higher price in a market segment having relatively inelastic demand whereas a lower price has
to be charged in the market segment having relatively elastic demand.
3) Government Policy Formulation: Government also takes into consideration the elasticity of demand
while determining the quantum of tax to be imposed as commodities having relatively inelastic demand
can take the burden of tax whereas a commodity having relatively elastic demand would be unable to
take the burden of tax.
1.8 SELF ASSESSMENT QUESTIONS

Check your progress
Exercise 1: True and False
(a) If the cross price elasticity between good X and good Y comes out to be negative the goods are
substitutes.
(b) Arc elasticity gives the elasticity mid way between two points on the demand curve.
(c) If Price increases by 10% and total expenditure on the commodity decreases by 15% then there is
unitary elasticity
(d) Two parallel straight line demand curves having same slope also have same elasticity at a given price
(e) When Marginal revenue becomes negative , Total Revenue also decreases and becomes negative
Ans. 1(F), 2(T), 3(F), 4(F), 5(F)
Exercise 2: Fill in the Blanks

(a) When Price decreases and total expenditure increases, demand must be _ _ _ _ _ _ _
(b) When changes in price is very small we use _ _ _ _ _ _ _ _ _ _ method of calculating price elasticity
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(c) When Marginal revenue is positive, elasticity of the demand curve is _ _ _ _ _ _ _ _
(d) If demand curve has unitary elasticity, the shape of the demand curve is known as _ _ _ _ _ _ _ _
(e) A _ _ _ _ _ _ _ _ demand curve is perfectly elastic.
(f) When demand is elastic, an increase in price causes quantity demanded to_ _ _ _ _ _ _ _ _ _ _ and total
revenue to _ _ _ _ _ _ _ _ _ .
Ans 1. Elastic 2. Percentage method 3. More than one 4. Rectangular Hyperbola
5. Horizontal 6. Decrease more than proportionately, increase.
Exercise 3: Questions
1. Explain the concept of different types of elasticity of demand along with suitable examples.
________________________________________________
________________________________________________
2. Derive the relation between Marginal Revenue, Average Revenue and Elasticity of Demand
________________________________________________
________________________________________________
3. What is the difference between percentage method and Arc method of calculation of Price Elasticity of
Demand
________________________________________________
________________________________________________
4. Show that two parallel linear demand curves have unequal elasticity at a given quantity
________________________________________________
________________________________________________
5. Show that a line that passes through the origin intersecting two parallel demand curves have unequal
elasticity at the point of intersection.
________________________________________________
________________________________________________
1.9 SUGGESTED READINGS
Salvatore Dominick, Micro Economics Theory and Applications, Oxford University Press.
Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House
Pindyk Robert, Microeconomics, Prentice Hall
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LESSON 2
ELASTICITY OF SUPPLY AND APPLICATIONS
1. STRUCTURE
2.1 Objective
2.2 Introduction
2.3 Law of Supply
2.4 Meaning of Elasticity of Supply
2.5 Types of Elasticity of Supply
2.6 Derivations based on elasticity of Demand
2.7 Summary
2.8 Self Assessment Questions
2.9 Suggested Readings
1.1 OBJECTIVE
After reading this lesson you should be able to
a) Explain the concept of Elasticity of Supply

b) Calculate Elasticity of Supply
c) Prove various mathematical derivations using the concept of Elasticity of Supply
1.2 INTRODUCTION
Law of supply is in contrast to law of demand which states that there is direct relation between price of a
commodity and its quantity supplied. It is from the perspective of the producers as if price increases than only
producers have the incentive to supply more as that would cover increased cost of production and desire for
more profits. However Law of supply provides nothing about how sensitive is the quantity supplied to change in
the price of a commodity which we need to understand to know how the supply is going to react to changes in
the price of a commodity as it helps in various policy decisions making. The solution lies in the concept of
elasticity of supply. This chapter explains the concept of elasticity of supply and the methods to calculate the
elasticity. The various mathematical derivations and proofs used in determining the elasticity of supply are also
explained.
1.3 LAW OF SUPPLY

Law of supply states the quantity of a commodity which a firm or producer is willing and able to offer for sale
at a particular or given price during a given period of time.
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There are various factors that have an impact on the supply the most important of them being the price of the
commodity at which consumers are willing to buy it. Supply function is thus a multivariate function as shown
below:
QSx = F (Px, Pr, T, Pf, O)
Where QSx is the quantity being supplied of a commodity
Px is the price of the commodity itself
Pr is the price of the related commodities
T is the technology being used in the production
Pf is the price of factors of production/ raw material being used
O is the objectives/goals of the producer.
1) Price of the commodity: There is direct relation between price of the commodity and supply, as when a
producer produces more because of law of diminishing marginal returns, more output comes with
employment of larger units of factors of production, thereby more and more factors are needed for
producing each additional unit that increases the cost and hence more supply would come from the
producer only if he gets a higher price to cover the increased cost and get profits.
2) Price of Related commodities: When the price of related commodity increases, then it is beneficial for
the producer to stop the production of the existing commodity and go into the production of related
commodity to earn higher profits as it is no longer profitable to produce the existing commodity.
3) Technology: When firm uses a superior technology, more output comes with lesser usage of factors of
production thereby reducing the cost per unit and hence more can be supplied by the producer because
of increase in the productivity. Whereas if an outdated technology is used then more factors of
production are required for production of output which increases the cost of production and producer is
no more willing to supply it at the same price.
4) Price of Factors of Production: If the price of factors of production that go into the production of a
commodity increases, it becomes costly for the producer to produce more as it reduces the profit margin,
therefore more supply would come only at increased price.
5) Objectives of the firm: If the objective of the firm is to capture maximum market share rather than
profit maximization then such a firm would produce and supply more.
Law of supply thus states that there is direct relation between price of a commodity and its supply ceteris
paribus. It can be depicted with the help of a supply schedule and supply curve shown in the figure
below. Supply schedule is the tabular representation showing relation between price of a commodity
and its supply whereas supply curve is the graphical representation between the price and the supply.
When price is P1 producers are willing to sell Q1 of the commodity. However if price increases to P2
then consumer would be supplying higher quantity that is Q2 as there is incentive to earn higher profits.
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Price (Rs) Quantity (Units)
1 10
2 12
3 14
4 16
Figure 1
It is graphical representation of relation between price of a commodity and the quantity being supplied, other
things remaining constant. There can be two types of changes in the supply curve, one is movement on the same
supply curve and other is shift in the supply curve. There is a movement along the supply curve whenever price
changes and shift in the supply curve due to change in any other factor keeping the price of the commodity
constant as is shown below in Figure 2:
Figure 2
Difference between Movement along supply curve and shift in the supply curve
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Movement on the Supply Curve Shift of the Supply Curve
When price of a commodity changes other When factor other than price of a commodity
things remaining constant quantity supplied changes there is change in the quantity
changes which is known as movement on the supplied known as shift in the supply curve.
supply curve.
It happens due to of Law of Supply It does not happen due to of Law of Supply
There are two types of movement in the supply There can be increase (rightward) or decrease
curve: Expansion and contraction (leftward) shift of the supply curve.
There is one single supply curve There are parallel supply curves.
Important facts about law of supply
• Law of supply indicates the positive relationship between price of commodity and quantity supplied, other
things remaining constant.
• Law of supply is one sided as it indicates the effect of change in price on quantity supplied only but does not
explain the effect of change in quantity supplied on price of commodity
• It is the qualitative statement as it explains the direction of change in quantity supplied but does not indicate
the magnitude of change.
• It does not explain any proportional relationship between change in price and the resultant change in quantity
supplied. For this we need elasticity of supply which is the next topic to be done.
1.4 MEANING OF ELASTICITY OF SUPPLY

Elasticity of supply measures the responsiveness of the quantity supplied to the change in the price of the
commodity other things remaining constant. Elasticity thus shows the proportionate change in the quantity
supplied due to proportionate change in the price of a commodity.
There are various factors that have an impact on the elasticity of supply which are given below:
1) Raw Materials: If raw materials used for the production are available in plenty and are available
at less cost then supply can be increased thereby making it elastic whereas if raw materials are
scarce or expensive or both then supply would be inelastic as raw materials cannot be obtained
easily and production cannot increase by a greater quantity in spite of increase in the prices.
2) Nature of the commodity produced: If goods are perishable in nature and cannot be stored then
supply would be inelastic as stock of the good that producer keeps with himself to be brought to
the market as supply with increase in the price would be less but for goods that can be easily
stored supply can increase with increase in price as more stock can be kept of such type of
commodities by the producer rendering the supply elastic.
3) Time to Produce: If producers have enough time with them to respond to changes in price then
supply would be elastic otherwise it would be inelastic. This is because of the fact that when the
goods are not to be provided quickly then producers have enough time to procure the raw
material and produce the commodity and bring it to the market as supply therefore supply would
be relatively elastic and vice versa.
23
4) Number of Producers: If there are many producers in the market, then supply can be increased
easily thereby supply being elastic and vice versa. This is because when price increases all the
producers would increase the production and therefore supply would increase by a
proportionately greater amount making the supply elastic and opposite would be the case if there
are only few sellers of a particular commodity.
1.5 TYPES OF ELASTICITY OF SUPPLY

When Price of a commodity increases/decreases its quantity supplied also increases/decreases ceteris paribus –
Law of Supply. But by how much the quantity would change is given by elasticity of supply. Elasticity of
supply can be measured using the following methods:
1) Percentage Method
2) Arc Method
3) Geometric Method
Percentage Method
Percentage method is the most commonly used method for calculation of elasticity of Supply. This method is
used to calculate elasticity at a particular point on the supply curve. It is calculated as follows using Percentage
Method:
Es = or Es =
Where Change in quantity supplied
Change in Price
Initial Price
Initial Quantity Supplied
There is a positive sign in the above formula indicating direct relation between price and quantity supplied
showing the incentive of the producer to produce more at higher price. Using Percentage method Elasticity of
supply can be classified in the following five categories:
1. Perfectly Elastic Supply: When supply curve is horizontal, parallel to X axis, supply is said to be
perfectly elastic. It shows that even minutest of the change in the price would shrink the quantity
supplied to zero. There is no such example found in real life as it is just an imaginary situation. Es = ∞.
It can be represented using the figure number 3
Price (Rs) Quantity Supplied (units)
10 100
10 120
10 150
:
24
Figure 3
Above figure shows a perfectly elastic supply curve as any number of units of the commodity can be supplied at
the existing price.
Relatively Elastic Supply: When because of 10% change in the price, quantity supplied changes by more than
10%, supply is said to be relatively elastic. Supply curve here is relatively flatter showing that proportionate
change in quantity supplied is more than proportionate change in the price. Es > 1. It is represented in Figure 4
Price (Rs) Quantity (units)

10 100
12 140
15 200
Figure 4
25
Above figure shows when price increases from P2 to P1 then supply increases from Q1 to Q2 but change in
quantity is more than change in the price.
Supply could be elastic for the following reasons:
1) If there is spare capacity in the factory.

2) If there are stocks available.
3) In the long run supply will be more elastic because capital can be varied.
4) If it is easy to employ more factors of production.
1) Unitary Elastic: When because of 10% change in the price, quantity supplied also changes by 10%,
supply is said to be unitary elastic. Supply curve here is a straight line from the origin showing that
proportionate change in quantity supplied is equal to proportionate change in the price.

10 100
12 120
14 140
Es = 1. It is represented in Figure 5
Figure 5
Here when price increases from P1 to P2 quantity supplied also increases from Q1 to Q2 and change in
quantity supplied is equal to change in price.
2) Relatively Inelastic Supply: When because of 10% change in the price, quantity supplied changes by
less than 10%, supply is said to be relatively inelastic. Supply curve here is relatively steeper showing
that proportionate change in quantity supplied is less than proportionate change in the price.

10 100
12 110
15 135
26
Es < 1. It is represented in Figure 6
Figure 6
In figure above when Price increases from P1 to P2, quantity supplied increases from Q1 to Q2 but change
in quantity is less than change in price.
Supply can be inelastic due to the following reasons:
1) Firms operating close to full capacity.

2) Firms have low levels of stocks, therefore there are no surplus goods to sell
3) In the short term, capital is fixed in the short run e.g. firms do not have time to build a bigger
factory.
4) If it is difficult to employ factors of production, e.g. if highly skilled labour is needed
5) With agricultural products supply is inelastic in the short run, because it takes time to grow
crops.
3) Perfectly Inelastic Supply: When there is no change in the quantity supplied irrespective of how much
change is there in the price, supply is said to be perfectly inelastic. Here supply curve is vertical parallel
to Y axis.

10 100
12 100
15 100
27
Figure 7
Here figure above shows that there is no change in the quantity supplied irrespective of the change in the price.
It happens when supply cannot increase that is it is fixed irrespective of how much change there has been in its
price.
For example: Painting of Mona Lisa or any Antique piece whose supply is fixed and cannot be increased
however price it commands in the market, its supply would be always perfectly inelastic (fixed) at all levels of
prices.
Example 1: From the following calculate Elasticity of supply and comment on the relation between price and
quantity supplied
Price Quantity
10 100
8 50
Using percentage method elasticity can be calculated as follows:
Es =
Es = = = 2.5
As Elasticity is greater than one so it is relatively elastic showing that the proportionate change in quantity
demanded is more than the proportionate change in price that is supply is sensitive to the change in price.
quantity supplied
Price Quantity
5 100
10 200
28
Es =
Es= = =1
As Elasticity is equal to one so it is unitary elastic showing that the proportionate change in quantity demanded
is equal to proportionate change in price.
quantity supplied
Price Quantity
2 50
8 80
Using percentage method elasticity can be calculated as follows:
Es =
Es = = = 0.2
As Elasticity is less than one so it is relatively inelastic showing that the proportionate change in quantity
demanded is less than the proportionate change in price that is supply is less sensitive to the change in price.
Arc Method
A limitation of the percentage method is that it gives elasticity at a particular point on the supply curve and if it
is measured for price increase answer is different from when elasticity is calculated for price decrease. To
overcome this problem Arc method is used. This method measures the elasticity mid way between two points. It
is used when there is very small change in the price of the commodity. It can be explained with the following
example
Example 4:
Price Quantity
10 100
8 60
Using Arc method elasticity can be calculated as:
Es = = = 2.25
Here instead of using initial price and initial quantity in the formula as is used in the percentage method, we use
average price and average quantity which is calculated by taking the average of initial and final price and initial
and final quantity respectively. It is giving elasticity between the price 10 and 8 in the above example that is
elasticity is 2.25 neither at price of Rs10 or Rs8 but midway.
29
Example 5:
Point Price Quantity

A 2 10
B 4 40
Calculate Elasticity for the following cases:
1) From Point A to B
2) From Point B to A and
3) Midway between A and B
Solution:
To calculate Elasticity from point A to B and from B to A we would be using Percentage method and for
third case that is midway between A and B Arc method would be used.
A to B
Es =
Es = = = 3
B to A
Es =
Es = = = 1.5
Mid Way between A and B using Arc Method
Es = = = 0.018
Thus the result above shows that elasticity is different when we use different methods as in percentage method
we use initial price and initial quantity as one of the component, so when we calculate for price increase and for
price decrease the initial price and quantity changes thereby giving different results and in case of Arc method
we use average price and average quantity instead of initial price and quantity getting elasticity mid way
between the two points.
Geometric Method
This method calculates elasticity of supply at a point on the linear demand curve by using the formula given
below
30
Es =
= Intercept on X-axis/Quantity supplied at that price

According to Geometric method Elasticity of Supply can be classified under three heads:
1) If Supply curve passes through X axis then it is relatively Inelastic
2) If Supply curve passes through Y axis then it is relatively Elastic
3) If Supply curve passes through Origin it is unitary Elastic
This would be explained using the derivations in the next segment (2.6).
Example 6: Explain how Time factor has an impact on the elasticity of supply
Solution: Time has an important role to play in the production of the commodities as in the long run production
can be easily expanded by increasing even fixed factors of production while in the short run production can be
expanded to a certain extent. Thus elasticity is usually relatively inelastic in the short run and becomes elastic in
the long run.
1.6 DERIVATIONS BASED ON ELASTICITY OF DEMAND

Derivation 1:
If a supply curve passes through the Price Axis (Y axis), it is relatively elastic i.e. Es > 1.
Using Percentage method to calculate Elasticity of supply, we get Es as:
Es =
Es = . . . . . . . . . . . . . . . . . . . . . . . . . . . .(1)
If Price increases from P1 to P2 then:
= Q1Q2 or AC
= P1P2 or BC
P or Initial Price = OP1 = AQ1

Q or Initial Quantity = OQ1
Putting above in Equation 1 we get the following:
Es = . . . . . . . . . . . . . . . . . . . . . . . . . . . .(2)
Now
AC/BC = DQ1/AQ1, Putting this in Equation 2, we get Es as follows:

31
DQ1/OQ1 = DQ1 > OQ1
Thus the above proves that Es > 1 if Supply curve passes through the Y axis or supply curve is flatter.
Figure 8
Derivation 2:
If a supply curve passes through the Quantity Axis (X axis), it is relatively inelastic (Es < 1).
Es =
Es = . . . . . . . . . . . . . . . . . . . . . . . . . . . .(3)
= Q1Q2 or AC
= P1P2 or BC

32
Es = . . . . . . . . . . . . . . . . . . . . . . . . . . . .(4)
Now
AC/BC = DQ1/AQ1, Putting this in Equation 4, we get Es as follows:
DQ1/OQ1 = DQ1 < OQ1

Thus the above proves that Es < 1 if Supply curve passes through the X axis or Quantity Axis, supply curve is
Steeper.
Figure 9
Derivation 3:
If a supply curve passes through the Origin, it is Unitary elastic i.e. Es = 1.
Es =
Es = . . . . . . . . . . . . . . . . . . . . . .(5)
= Q1Q2 or AC
33
= P1P2 or BC

Es = . . . . . . . . .. . . . . . . . . . . . . (6)
Now
AC/BC = OQ1/AQ1, Putting this in Equation 6, we get Es as follows:
=1
Thus the above proves that Es = 1 if Supply curve passes through the origin.
Figure 10
1.7 SUMMARY
As elasticity of demand, elasticity of supply measures responsiveness of quantity supplied to a change in its
price. It varies from zero to infinity. There are three methods that can be used for calculation of Elasticity of
Supply – Percentage method, Arc method and Geometric method. Percentage method is usually used for
measuring elasticity that can classify it in five types namely- Perfectly inelastic, relatively inelastic, unitary
elastic, relatively elastic and perfectly elastic. Arc method gives elasticity in between (midway) changes in price
and quantity. It is indifferent whether elasticity is being calculated for price or price decrease as it uses average
price and average quantity. Geometric method classifies elasticity into three types – relatively elastic, unitary
elastic and relatively inelastic. When supply curve passes through the Y axis it is more than unitary elastic.
When it passes through the origin there is unitary elastic supply curve and if it passes through X axis then it is
34
less than unitary elastic. Elasticity of supply is taken into consideration by government, policy makers and
business firms to determine various measures to be undertaken with respect to various decisions that are taken
by them.

Check your progress
(a) If the supply curve passes through the origin, it is perfectly elastic.
(b) There is no difference between Elasticity of supply and slope of supply curve
(c) When Elasticity of supply is zero, it is called perfectly inelastic supply
(d) Elasticity of supply is unaffected by the expectations about future price
(e) When supply curve is a horizontal straight line parallel to X axis, Es = infinity
(f) Elasticity of a commodity that is perishable in nature has inelastic supply
(g) Elasticity for a rare thing like Kohinoor is Elastic in supply
(h) If supply curve passes through origin it is relatively inelastic
(i) Arc elasticity method of elasticity of supply calculates elasticity midway between two points
Ans. 1(F), 2(F) 3(T), 4(F), 5(T), 6(T), 7(F), 8(F), 9(T)

(a) When Es > 1, supply curve is_ _ _ _ _ _ _
(b) Longer the time period, _ _ _ _ _ _ _ is the supply.
(c) Supply curve that is vertical, parallel to Y axis has _ _ _ _ _ _ _ supply
(d) If factors of production used in the production of a commodity are scarce, supply is _ _ _ _ _ _ _
(e) Supply Curve passing through origin has _ _ _ _ _ Elasticity of supply.
(f) A supply curve that passes through the quantity axis has relatively _ _ _ _ _ supply
Ans 1. Flatter 2.Relatively Elastic 3. Perfectly Inelastic 4. Relatively Inealstic
5.Unitary 6. Elastic
1. Explain the concept of different types of elasticity of supply along with suitable examples.
________________________________________________
________________________________________________
2. Using mathematical derivation, prove that a demand curve that passes through the Price Axis has
relatively elastic supply curve
________________________________________________
________________________________________________
3. Explain the importance of elasticity of supply

________________________________________________
________________________________________________
35
4. How Elasticity of supply is measured, explain using percentage method
________________________________________________
________________________________________________
5. Differentiate between Elasticity of demand and elasticity of supply

________________________________________________
________________________________________________
6. Prove that a supply curve that passes through origin has unitary elasticity
________________________________________________
________________________________________________
7. How elasticity of supply can be measured using Geometric method. Also show how it varies from zero
to infinity on a straight line supply curve
________________________________________________
________________________________________________
8. Explain the difference between percentage method and Arc method of calculating Elasticity of Supply
________________________________________________
________________________________________________

Samuelson Nordhaus, Microeconomics, McGraw–Hill.
36
Unit 2
CONSUMER BEHAVIOR
37
LESSON 1
CONCEPT OF INDIFFERENCE CURVE AND BUDGET LINE

1. STRUCTURE
1.1 Objective
1.2 Introduction
1.3 Concept of Indifference Curve
1.4 Concept of Budget Line
1.5 Consumer’s Equilibrium
1.6 Summary
______________________________________________________________________________
1.1 OBJECTIVE
______________________________________________________________________________
a) Understand the concept of Indifference Curve and Budget Line

b) Understand the slope of Indifference Curve and Budget Line
c) Differentiate between the slope of Indifference Curve and Budget Line
d) Establish and derive the Consumer’s Equilibrium
_____________________________________________________________________________
1.2 INTRODUCTION
______________________________________________________________________________
Law of demand stated that there is inverse relationship between price of a commodity and its quantity
demanded, theory of consumer behavior helps in providing the reason behind the negative slope of demand
curve. Different economists have explained the concept of Utility in different manners like Marshall said that
utility is Cardinal – that can be quantified (measured) using an imaginary unit Util or by the Price that the
consumer is willing to spend on the commodity. Hicks and Allen on the other hand using Indifference Curve
Analysis said that utility is Ordinal that can be only ranked and not measured. Utility is in fact the want
satisfying power of a commodity which is ethically neutral. This chapter deals with the ordinal concept of utility
explaining the concept of Indifference curve and budget line thereby moving to the Consumer’s Equilibrium.
38
1.3 CONCEPT OF INDIFFERENCE CURVE
Concept of Indifference Curve is based on the following assumptions:
1) Rational Consumer: Consumer is rational that is he would like to maximize his satisfaction given the
money income and price of the commodities
2) Ordinal Utility: Utility is Ordinal that is it can be ranked. Consumer can rank various commodities in
terms of satisfaction derived from it. Utility cannot be measured or quantified.
3) Consistency: Consumer is consistent in his choice. If a consumer has revealed his preference for a
particular combination then a consumer would always prefer the same if the conditions are same.
4) Transitivity: If a consumer has preferred A > B and B > C, then by notion of transitivity A > C.
5) Non Satiety: Saturation point has not been reached that is consumer wants more and more of a
commodity.
Based on these assumptions we can now move on to the concept of Indifference Schedule. It would be
explained with the help of the following example:
Table 1
Combinations Units of Tea Units Of Biscuits

A 1 18
B 2 13
C 3 9
D 4 6
E 5 4
Out of the above combinations all having the same price if consumer is indifferent between the five
combinations then he is said to have satisfaction from each of the five combinations.
A=B=C=D=E
Thus tabular representation of different combinations of two commodities that gives the consumer equal
satisfaction is known as Indifference Schedule. It can be plotted in the form of a graph as follows:
Figure 1
39
Indifference Curve is thus the Graphical representation of different combinations of two commodities that gives
the consumer equal satisfaction.
Indifference curve has the following properties:
1) Indifference curves are downward sloping: It can be explained with the concept of absurdity that is
upward sloping, vertical and horizontal indifference curves are not possible, thus the only possible shape
being downward sloping. It can be explained with the following diagram. Figure below shows that if we
increase one of the commodity or both the commodities without reducing the other still we are on the
same indifference curve except the last diagram. The rest figures show that marginal utility of the
commodity that has been increased is zero but it is not possible because of the assumption of non satiety.
Hence the first three shapes are not possible and the only shape possible of the indifference curve is
downward sloping where consumer is reducing one commodity and increasing the other thereby having
the same satisfaction. As in first diagram of the figure below we are increasing both X and Y and still
are on the same Indifference Curve (IC), showing that the impact of increasing X and Y is nil or MUx =
0 and MUy = 0 which goes against our basic assumption of more is better. Similarly in second diagram
IC is horizontal showing that keeping Y constant and increasing X has no impact on the satisfaction as
consumer is on the same IC showing MUx = 0 which is again not feasible. Similarly in vertical IC there
would be zero MUy which is not feasible.
Figure 2
40
2) Indifference Curve is Convex to the origin: Convexity implies that the slope of the indifference curve
reduces as one goes down the indifference curve. The reason for convexity lies in the Diminishing
MRSxy or Marginal rate of substitution which is explained with the concept of slope of indifference
curve.
3) Two Indifference curves can never intersect: This would be explained with the concept of Transitivity
using Figure 3:
As can be seen two points on IC1 that gives equal satisfaction are B = E. Similarly two points on IC2 that
gives equal satisfaction are A = E. By the notion of Transitivity A = B but these two points are on two
different Indifference curves hence A ≠ B showing that two IC’s can never intersect.
Figure 3
4) Higher Indifference curve represents higher satisfaction: It would be explained with the concept of
Indifference Map which is as follows:
Figure 4
41
Indifference curve map is the combination of different Indifference Curves on the same axis such that higher
Indifference Curve represents higher satisfaction. As can be seen from figure 4 initially consumer is at A where
he is having a combination of X and Y, now if the consumer keeps one of the commodities constant and
increases the other he moves to either B or C whereby his satisfaction increases as he has not reduced the other
commodity. Another possibility is to move to point D where consumer increases the consumption of both the
commodities. This shows that points B,C or D gives the consumer higher satisfaction and he has moved to a
higher Indifference Curve showing that an Indifference Curve which is farther from the origin gives higher
satisfaction.
Slope of Indifference Curve
Marginal Rate of Substitution (MRS) gives the slope of Indifference Curve. It shows how many units of
commodity Y the consumer is willing to forego for one additional unit of commodity X such that the
satisfaction of the consumer remains same. It would be explained using the following example and figure:
Table 2
Combinations Units of Tea Units Of MRS

Biscuits
A 1 18 -
B 2 13 5:1
C 3 9 4:1
D 4 6 3:1
E 5 4 2:1
The table above shows that when we move from point A to point B, consumption of commodity Y reduces by 5
units and consumption of X increases by 1 unit and consumer is having the same satisfaction as he is on the
same Indifference Curve. Thus it shows that consumer is willing to forego 5 units of Y for one additional unit of
X if he wants to keep his satisfaction same. Similarly on moving from point B to point C, he is willing to forego
only 4 units of Y for one extra unit of X and this sacrifice of Y for each additional unit of X keeps on
diminishing as we come down the Indifference Curve. The reason being that when Y reduces and X increases
consumer has relatively more of X and less of Y thereby marginal utility of Y increases and X decreases and he
has to give less and less of Y for each additional unit of X and also because the relative capacity to sacrifice of
the consumer reduces as he comes down the Indifference Curve. At point A he has plenty of biscuits and less of
tea thus he is willing to give 5 units of biscuits for one additional cup of tea. But at point D he has only 6 units
of biscuits left thus he cannot sacrifice the same amount of biscuit for each additional cup of tea. The same
thing can be explained graphically by showing that MRS is the slope of the indifference curve and it reduces as
we come down the Indifference Curve. Therefore IC is steeper at the top and flatter at the bottom - the reason
for the convex shape of Indifference curve.
As we know mathematically the slope is change in quantity of Y divided by change in quantity of X. So here
slope is calculated as follows:
From point A to B = -ΔY/ΔX = -5 Biscuits/+1Tea as consumer is reducing biscuits by 5 units so we have a

negative sign and increasing tea by 1 unit will lead to a positive sign.
42
From B to C = -4 Biscuits/+1Tea = -4/1
From C to D = -3 Biscuits/+1Tea = -3/1
From D to E = -2 Biscuits/+1Tea = -2/1
The above slopes are represented by the shaded portion in the Figure 5:
Figure 5
Thus we get the measurement of slope as MRSxy = . It can also be written as:
Reduction in Satisfaction because of decreasing Y = Increase in satisfaction due to increasing X
- (MUy)(ΔY) = (MUx)( ΔX), - (ΔY)/( ΔX) = (MUx) / (MUy)
Thus slope of IC = MRSxy =
Reasons for diminishing MRSxy is:
• Relative capacity to sacrifice commodity Y diminishes as one come down the Indifference curve.
• Change in marginal utility of the commodity as consumption of commodity X increases and commodity Y
decreases, thereby less and less of Y is to be given for an additional unit of X keeping the utility constant.
• Relative importance attached by the consumer to the goods- if commodity Y is more important than consumer
would be willing to give less of units Y for additional unit of good X and vice versa.
43
Indifference curve map depicted what a consumer would like to possess but what a consumer can possess
depends upon the money income of the consumer and prices of the commodities that consumer can consume.
This takes us to the next topic which is Budget Line that would be taken up next:
1.4 CONCEPT OF BUDGET LINE

Budget line shows different combinations of two commodities that consumer can actually possess given his
money income and prices of the two commodities ceteris paribus. This can be explained with the help of an
example:
Let Money Income M = Rs 100
Price of commodity X, Px = Rs 10 per unit
Price of commodity Y, Py = Rs 5 per unit
Now given the above information and assuming that consumer spends his entire money income on either X or Y
or both, we can have following combinations:
 Spending his entire money income on consumption of X he can get 100/10 = 10 units of commodity
X. Here consumer would be at point A in the figure 6.
 Spending his entire money income on consumption of Y he can get 100/5 = 20 units of commodity
Y. Here consumer would be at point B in the figure 6.
 Spending the entire money income on combination of X and combination Y. here consumer can lie
anywhere between points A and B.
Figure 6
A consumer cannot lie above the budget line as he does not have the money income to support that level of
consumption, it being unattainable. Similarly any point below the budget line is though feasible but
44
inefficient as consumer is not spending his entire money income. So points lying on the budget line
represent the feasible and attainable combinations where the consumer would be.
Slope of Budget Line
Slope of any line is given by the mathematical formula of (Y2-Y1)/(X2-X1). Using the same concept slope
of the budget line can be calculated as:
Slope = = =
Thus slope of the budget line is given by the ratio of two prices and negative sign depicts a downward
sloping budget line.
Equation of the Budget Line
Aggregate money income that is M in above case is spent either on commodity X or commodity Y or both.
Thus equation of budget line can be written as:
Money Income = Total expenditure on X + Total Expenditure on Y
M = TEx + TEy
M = PxQx + PyQy
Changes in the Budget Line
There are two types of changes in the Budget Line:
1. Parallel Shift – This happens when the slope of the budget line is same. It takes place when either the
Money Income of the consumer changes keeping constant the prices of the commodities or when the
money income is constant but prices of the commodities change in the same proportion thereby keeping
the slope that is given by –Px/Py unchanged. There can be parallel rightward shift or parallel leftward
shift as is explained with following Example and Diagram
Example 1: Taking the original example and comparing it with two cases one where money income changes
ceteris paribus and other where prices change in the same proportion keeping constant the money income
Original Case: M = Rs 100

Px = Rs 10 per unit
Py = Rs 5 per unit
New Case 1: M = Rs 200 (it has doubled)
Px = Rs 10 per unit
Py = Rs 5 per unit
The above two are represented in the figure below:
45
Figure 7
Above case represents that when money income changes there is parallel shift in the budget line as slope that is
ratio of the prices is same. In above case when money income increased there is a parallel rightward shift. The
reason being that with the prices being unchanged consumer can now consume more of the commodities.
Similarly there would be parallel leftward shift if money income decreases. Other situation when there is
parallel shift in the budget line is given below:
New Case 2: M = Rs 100

Px = Rs 5 per unit
Py = Rs 2.5 per unit
Here both prices are reduced to half showing that there is a parallel rightward shift in the budget line as slope is
still the same and at reduced prices consumer can buy more of the commodities with increased purchasing
power (real income) though his nominal money income is the same. It is represented with the figure 8. Similarly
if prices increase in the same proportion there would be a leftward parallel shift showing decrease in the
purchasing power and hence reduced consumption of the commodities.
46
Figure 8
1) Pivot or rotation or non parallel change movement of the budget line
If there is a change in any of the three variables i.e. money income, price of commodity X or price of
commodity Y in such a manner that the slope changes then there is a rotation of the budget line. Following are
the few cases that can take place. We have compared them with the original case.
New Case 3: M = Rs100
Px = Rs5 per unit (it has halved)
Py = Rs5 per unit
Px = Rs10 per unit
Py = Rs10 per unit (it has doubled)
Px = 20 per unit
Py = 2.5 per unit.
All the above explained cases are shown in the figure 9 and 10:
47
Figure 9 Figure 10
Above two figures show how the budget line rotates along X axis and Y axis because of the change in the slope.
In figure 9 because of reduction in price of commodity X without any change in money income and price of
commodity Y consumer can buy more of commodity X if he spends his entire income on X. The slope of the
budget line reduces to -1 (-5/5) (taking only the absolute value ignoring the negative sign) compared to -2 (-
10/5) the slope of original case making the budget line pivot out and becomes flatter. If however price of X
would have increased there would have been an increase in the slope and reduction in the purchasing power and
hence inward (leftward) pivot of the budget line would have taken place. Similarly in Figure 10 price of
commodity Y has doubled other things remaining constant thereby reducing the purchasing power of the
consumer and reducing the slope to -1, making the budget line pivot along Y axis and flatter. The opposite
would have happened with reduction in the price of commodity Y.
Figure 11
48
Here both Price of commodity X and Price of commodity Y have changed but neither in the same proportion
nor in the same direction thereby making a non parallel movement in the budget line as shown in the figure 11.
Example 2: Let us say there are two consumers A and B. while consumer A has stronger preference for
commodity X. Consumer B has stronger preference for commodity Y. show this using Indifference Curve
analysis and concept of Marginal Rate of Substitution.
Solution: Consumer A having stronger preference for commodity X would be willing to forego more of
commodity Y for an additional unit of commodity X whereas consumer B having stronger preference for
commodity Y would be willing to forego less units of commodity Y for each additional unit of commodity X,
thus in case of consumer A, MRSxy would be more and Indifference curve would be steeper as slope is greater
whereas in case of consumer B, MRSxy would be less and Indifference curve flatter as slope is lesser. This can
be shown using the following figures where figure 12 is of consumer A and figure 13 for consumer B.
Figure 12 Figure 13
Example 3: Explain the concept of Composite good.
Solution: In the Indifference Curve analysis we considered two commodities that is Tea and Biscuit or
commodity X and Y but in reality a consumer consumes various types of products and to show it in a two
dimensional diagram the solution is composite good. Under this all goods except the most important
(commodity X) is plotted on X axis and all other goods clubbed together on Y axis as other goods.
E.g. Weekly Income of consumer = Rs 100, Price of Food (Pf) = Rs 10 per unit
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Figure 14
Composite Good, Slope = Y2 – Y1/X2-X1 = (0 – M)/ (M/Px-0) = -Px
So slope of budget line in case of composite good is nothing but the price of the good on X axis.
1.5 CONSUMER’S EQUILIBRIUM

Equilibrium is a position of rest where there is no tendency to change. A consumer is said to be in equilibrium
when he maximizes his satisfaction given the money income and the prices of two commodities. The concept of
consumer equilibrium is based on the following assumptions:
1. Rational Consumer: Consumer is rational; he would like to maximize his satisfaction within the
constraint of money income and prices of the commodities.
2. Ordinality: Satisfaction cannot be quantified but can be ranked on the basis of utility derived.
3. Monotonic Preferences: Consumer would choose a bundle with more of either of the commodity or
both the commodities. That is more is preferred to less by the consumer.
4. Consistency: Consumer is consistent in his behavior. If the conditions are same consumer would go
with the same set of bundle.
5. Transitivity: If consumer chooses A over B and B over C then A is preferred to C.
For understanding the concept of consumer’s equilibrium we need two things:
 Indifference Curve Map – It is the loci of various indifference curves on the same axis where higher
indifference curve represents higher satisfaction. A consumer would be finally on which indifference
curve would depend on his budget line.
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Figure 15
 Budget Line – It is the loci of various combinations of two commodities that consumer can possess
given his money income and prices of the two commodities.
Figure 16
So from the above two we can analyze that indifference curves represent what consumer desires and budget line
shows what consumer can actually possess. To get the consumer equilibrium we superimpose the above two
that is indifference map and budget line and get the figure 17:
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Figure 17
From figure 17 we see that point A,B and E are within the consumer’s budget set that is the commodities that
consumer can possess. Point C is unattainable given the budget line. Now out of the three points mentioned
above there can be only one equilibrium. Points A and B though attainable but they are not feasible as they are
on a lower indifference curve that gives lesser satisfaction therefore consumer would not stop here. Point E is
the highest point that is within the consumer’s capacity to get. Thus E is the Equilibrium as it is on the highest
Indifference curve and also within consumer’s budget.
Hence it can be said that a consumer is at equilibrium when he reaches the highest indifference curve that is
tangent to the budget line.
The two conditions of budget line that need to be attained are:
First Order Condition: Budget line should be tangent to the highest possible Indifference Curve. So the slope
of the indifference curve and budget line should be equal at the point of equilibrium. Following condition
should be fulfilled:
Slope of Indifference Curve = Slope of Budget Line

MRSxy = =
Second Order Condition: Indifference curve should be convex at the point of equilibrium that is the slope of
Indifference curve or MRSxy should be diminishing. As if slope is increasing or Indifference curve is concave
to the origin there is a corner solution as shown in Figure 18:
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Figure 18
Here Point E is not the point of equilibrium though here Indifference curve is tangent to the budget line as in
case of concave indifference curve it is possible to reach a higher indifference curve without satisfying the
condition of tangency. In figure 18 Point A is the equilibrium where consumer is consuming only commodity Y
and nothing of commodity X. This can be the case when if consumer buys one unit of a commodity then it
being so expensive that he has to go without having anything of the other commodity. This is the case of Corner
Solution as equilibrium is lying at one corner. There can be other case also where consumer is buying only
commodity X and nothing of commodity Y as shown below:
Figure 19
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Example 4: Draw Indifference curves between Pepsi and beer for two individuals Shreyas and Saleem with
Shreyas having stronger preference for Pepsi and Saleem having stronger preference for beer. (Delhi, SOL
B.Com (H), 2011)
Solution: It can be explained with the help of indifference curves and their slope. If we take Pepsi on Y axis
and Beer on X axis then in the first case of Shreyas who has stronger preference for Pepsi he would be willing
to give less and less units of commodity Y (here Pepsi) for each additional unit of X (here Beer) thus having
flatter indifference curves whereas in the second case of Saleem who has stronger preference for commodity X
or Beer he would be willing to give more and more of commodity Y or Pepsi for each additional unit of Beer
thereby having steeper indifference curves. The result is shown in the figure 20:
Figure 20
Example 5: Rohit’s budget line relating to good X and good Y has intercepts of 72 units of good X and 60 units
of Good Y. If the price of Good X is Rs. 5, what is Rohit’s income? Calculate the price of good Y and slope of
the budget line. Write the equation for the budget line. (Delhi, SOL B.Com (H), 2011)
Solution: We know that the Budget line is given by the equation:
M = PxQx + PyQy.
Now if Rohit buys only commodity X then the equation reduces to:
M = PxQx as Qy = 0
M = 5*72 = Rs360 = Money Income
Now if Rohit buys only commodity Y then the equation reduces to:
M = PyQy as Qx = 0
360 = Py*60, Py = Rs 6
Slope of the Budget Line = -Px/Py = -5/6
Equation for Budget Line:

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360 = 5Qx + 6Qy
Example 6: Vandana spends her entire monthly income of Rs 600 on two commodities X and Y. If the price of
X is Rs.30 and price of Y is Rs.10 per unit If she consumes 12 units of X and 24 units of Y. Is she in
equilibrium at this point on her budget line? Show the result in a diagram. (Delhi,SOL B.Com (H), 2011)
Solution: For the consumer to be in equilibrium following condition should be satisfied:
Slope of Indifference Curve = Slope of Budget Line
MRSxy = Px/Py
In above example:
Coordinates of X and Y axis would be calculated as:
M/Px = X coordinate = 600/30 = 20 units and
M/Py = Y coordinate = 600/10 = 60 units
Now if she consumes 12 units of X and 24 units Y she would be spending 12*30+10*24 = 600
Thus she is on the budget line as she is spending her entire money income but whether she is on the highest
Indifference curve or not would be determined by the equilibrium condition, it is explained as:
MRSxy = -30/10 = -3. So if slope of Indifference curve is -3 then she is in equilibrium otherwise not.
Figure 21
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Criticism of Indifference Curve Approach
Indifference curve given by Hicks and Allen though is advancement over the cardinal approach of Marshall but
still it suffers from various limitations like:
1) Assumption of consistency and transitivity my not exist in real life because there are
many behavioral factors that an impact on the consumer’s choice.
2) Indifference curve approach assumes that consumer has full knowledge of all the options
available to him but a consumer is faced by bounded rationality wherein he does not have the time and
knowledge to explore all the possibilities
3) It makes use of mostly two commodity cases and in other cases composite good is taken
wherein all the goods are clubbed under one which is not feasible.
4) The foremost assumption here has been that consumer is rational but in various cases
consumer behaves in an irrational manner having no justification for his choices.
5) Indifference curve analysis is based on Weak Ordering Hypothesis where consumer is
indifferent between various bundles that comprise of different combinations of two commodities.
However Revealed preference theory given by Samuelson is based on Strong ordering which is a step
ahead of the Hicksian approach.
1.6 SUMMARY
Utility or the want satisfying power of a commodity has been the topic of discussion for long. Earlier it was
considered a cardinal concept where an imaginary unit Util was created to measure utility to make a decision
about the commodities to be consumed by the consumer. Later the cardinal approach gave way to ordinal where
utility was taken as a non quantifiable concept and it was assumed that it can be ranked that is consumer can
rank the satisfaction that he gets from different commodities or different combinations but cannot quantify
them. This gave way to the concept of Indifference curve that provided different combinations of two
commodities that the consumer can possess and provides the consumer equal satisfaction. Then there is concept
of Budget Line which provides different combination of commodities that consumer can actually possess with
his money income. These two are then used to reach the equilibrium of the consumer wherein he gets maximum
satisfaction within the budget constraint. However the concept of indifference curve suffers from various
limitations because of the assumptions that it is based on but it does not reduce its usefulness as a step to
understanding consumer behavior.
Check your progress

(a) Indifference curve can be horizontal or vertical.
(b) Slope of Indifference curve increases as we go down the curve.
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(c) In case of concave Indifference curve the condition of tangency of budget line and the indifference curve
is not required
(d) In case of Indifference Map a higher indifference curve show higher satisfaction
(e) A point above the budget line is also attainable by the consumer.
Ans. 1(F), 2(F), 3(T), 4(T), 5(F)

(a) For a consumer to be in equilibrium the slope of indifference curve and budget line should be _ _ _ _ _ _
_
(b) When we shown many commodities on the axis of a Indifference curve it is called _ _ _ _ _ _ _ _ _ _
(c) In case of Concave Indifference curve we have a solution called_ _ _ _ _ _ _ _
(d) Budget Line has a _ _ _ _ _ _ _ _ slope
(e) Monotonic Preference means a consumer chooses a combination that has _ _ _ _ _ _ _ of either one or
both the commodities.
(f) Indiiefernce Curve is based on the assumption of _ _ _ _ _ _ _ utility
Ans 1. Equal 2.Composite Good 3. Corner Solution 4.Negative 5. More 6. Ordinal
1. Explain the concept of Budget Line. What factors can bring a change in the budget Line
________________________________________________
________________________________________________
2. Derive the Consumer’s Equilibrium using the concept of Ordinal Utility

________________________________________________
________________________________________________
3. What are the assumptions of Ordinal Utility Approach.

________________________________________________
________________________________________________
4. What do you mean by Composite Good Concept

________________________________________________
________________________________________________

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LESSON 2
INCOME CONSUMPTION CURVE, PRICE CONSUMPTION CURVE

1. STRUCTURE
1.1 Objective
1.2 Introduction
1.3 Exceptions to Convex shape of Indifference curve
1.4 Concept of Income Consumption Curve
1.5 Concept of Price Consumption Curve
1.6 Summary
1.1 OBJECTIVE
a) Understand the exceptions to convex shape of Indifference Curve

b) Comprehend the Income Consumption curve and Price Consumption curve
c) Divide the price effect into substitution and income effect
1.2 INTRODUCTION
After understanding the Indifference curve and its properties including the property that these curves are convex
to the origin, we shall now relax this assumption and we would be explaining exceptions to convex shape of
Indifference curve. After explaining the budget line and how it changes – parallel shift or pivot we shall now
understand its impact on the consumer’s equilibrium using the concept of Income Consumption Curve and Price
Consumption curve. We shall also explain how the price effect that is change in the consumption of a
commodity due to a change in its price is divided into – Substitution and Income effect using the Hicksian
approach.
1.3 EXCEPTIONS TO CONVEX SHAPE OF INDIFFERENCE CURVE

Under normal conditions indifference curves are convex to the origin because of diminishing marginal rate of
substitution that is as one moves down the indifference curve its slope reduces and it subsequently becomes
flatter because of the fact that now consumer is willing and able to forego less and less units of commodity Y
for each additional unit of X because his relative capacity to sacrifice has reduced and also the marginal utility
of commodity Y increases because it is now scarcely available as compared to commodity X which is available
in plenty as compared to the situation that existed at the upper part of the indifference curve. However there are
some exceptions to this convex shape of indifference curve which can be subdivided under the following heads:
1) Perfect Substitutes
2) Perfect Compliments
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3) Economic Goods
4) Economic Bads
5) Neuters
We would be explaining them one by one.
Case 1: Perfect Substitutes
Perfect substitutes are commodities that have infinite elasticity of substitution between them that is one
commodity can be replaced by a specific number of units of the other commodity at all levels and with extreme
ease.
Example 1: A consumer gets equal satisfaction with 1 unit of ice cream and 2 units of cold drink and he is
willing to forego 1 unit of ice cream for 2 units of cold drink and vice versa. Thus 1 cold drink = 2 ice creams.
These are perfect substitutes or a consumer gets equal satisfaction from 1 unit of coca cola and 1 unit of pepsi.
Thus here 1 coca cola = 1 pepsi.
Here marginal rate of substitution that is how many units of commodity Y consumer is willing to forego for one
additional unit of X remains constant. Earlier we had studied that Indifference curves are convex to the origin
because of Diminishing MRSxy but here as MRSxy is constant so we have Linear Indifference curves where
slope remains constant throughout. These have been shown in figure 1(a).
Case 2: Perfect Compliments
Perfect compliments are commodities that have zero elasticity of substitution between them that is one
commodity cannot be replaced with the other commodity as a specific combination of the two commodities is
required to get a level of satisfaction. Here just increasing one commodity without being supplemented by the
other commodity has no usefulness for the consumer hence satisfaction would not increase with increase in just
commodity. To increase the satisfaction both the commodities have to be increased and in a specific proportion.
Example 2: A consumer would have increased satisfaction only if along with right leg shoe he also gets a left
leg shoe. If we keep on increasing the quantity of right leg shoe without increasing the quantity of left leg shoe,
satisfaction of the consumer would not increase as its just a waste for him. These are perfect complements.
Here marginal rate of substitution that is how many units of commodity Y consumer is willing to forego for one
additional unit of X is zero as goods are not substitutable at all. Here Indifference curves are L shaped. These
have been shown in figure 1(b). Here it shows that X1 units of commodity X and Y1 units of commodity Y are
required to provide the consumer a level of satisfaction. If we keep on increasing X that is shown by horizontal
segment of IC1 satisfaction does not increase and consumer is on same indifference curve. Similarly if we
increase only Y that is the vertical stretch of IC1 satisfaction of the consumer would remain same. Consumer
would move on to a higher Indifference curve with increased level of satisfaction only if both X and Y are
increased and that too in a specific proportion. Thus points X2 and Y2 is on IC2 and X3 and Y3 on IC3.
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Figure 1(a): Perfect substitutes
Figure 1(b): Perfect Compliments
Case 3: Economic Goods
Economic goods are those commodities that satisfy the following characteristics:
1) These goods provide the consumer positive utility or satisfaction

2) Here more is better that is consumer wants more and more of a commodity
3) Example: fast speed internet, dresses, bags etc.
4) Different consumers have different commodities that list under their category of Economic Good, the
concept is not universal.
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Case 4: Economic Bads
Economic bads are those commodities that satisfy the following characteristics:
1) These goods provide the consumer negative utility or dissatisfaction

2) Here less is better that is consumer wants less and less of a commodity
3) Example: corruption, pollution etc.
4) Different consumers have different commodities that list under their category of Economic bad, this
concept too is not universal.
Economic Goods and Economic Bads and their combinations can be jointly shown with the help of figure 2:
Figure 2
Point O or origin is known as bliss or saturation point and IC3 is the IC closest to bliss point in all the quadrants
and having highest satisfaction in all the four quadrants. Now let us take one quadrant at a time and explain it:
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Figure 2(A): Quadrant 1 Figure 2(B): Quadrant 2
Figure 2(C): Quadrant 3 Figure 2(D): Quadrant 4
Quadrant 1:
1) Here both commodity X and commodity are Economic Goods

2) Preference Direction (Direction the movement in which satisfaction increases) is North East
3) Indifference curve is negatively sloped
4) MRSxy is diminishing
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Quadrant 2:
1) Commodity X is Economic Bad and commodity Y is Economic Good

2) Preference Direction is North West
3) Indifference curve is Positively sloped
4) MRSxy is Positive and increasing.
Quadrant 3:
1) Both Commodity X and Y are Economic Bad

2) Preference Direction is South West
3) Indifference curve is Concave
4) MRSxy is Negative and increasing
Quadrant 4:
1) Commodity X is Economic Good and Y is Economic Bad

2) Preference Direction is South East
3) Indifference curve is Positively sloped
4) MRSxy is Positive and decreasing
Example 3: Draw indifference curve for a commodity which is Economic good up to a certain point and then
becomes economic bad.
Solution: Initially the commodity gives positive satisfaction to the consumer therefore is economic good but
after the satiety point it starts giving dissatisfaction and becomes an economic bad. It can be shown in the figure
3:
Figure 3
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Case 5: Neuters
1) Commodity that gives neither positive satisfaction nor dissatisfaction.

2) They have no impact on the consumer’s satisfaction therefore are called neuters.
3) Example: For a vegetarian, price of non-vegetarian food is a neuter.
4) There can be two cases for a neuter:
 Commodity on X axis is neuter and Commodity on Y axis is a normal good
 Commodity on Y axis is neuter and Commodity on X axis is a normal good
Figure 4(A) Figure 4(B)
As can be seen from figure 4(A) Indifference curves are horizontal parallel to X axis when commodity X is a
neuter. If units of commodity X increase it has no impact on the satisfaction as consumer remains on the same
curve, satisfaction would increase only if commodity Y increases and that is when the consumer would move to
a higher Indifference curve.
Similarly figure 4(B) shows that when commodity Y is a neuter Indifference curves are vertical parallel to Y
axis. If units of commodity Y increase it has no impact on the satisfaction as consumer remains on the same
indifference curve, satisfaction would increase only if commodity X increases and that is when the consumer
would move to a higher Indifference curve.
Thus above are few cases where indifference curve is not convex to the origin and hence these are known as
exceptions to the convex shape of Indifference curve.
1.4 CONCEPT OF INCOME CONSUMPTION CURVE

Consumer’s equilibrium depends upon the budget that consumer has which in turn depends on the money
income and prices of the two commodities. Thus if any of these three component changes there is a change in
the consumer’s equilibrium. This change can be depicted with the help of Income Consumption curve (ICC)
which happens because of change in the money income, prices of the commodities remaining constant or with
the Price Consumption Curve (PCC) which happens because of change in the price of one of the commodities
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money income and price of other commodity remaining constant. In this segment we would be talking about
ICC and PCC would be taken up in the next segment.
Income Consumption Curve:
‘ICC is the loci of equilibrium points showing successive changes in the equilibrium and consumption of two
commodities when money income of the consumer changes, other things remaining constant.’
When nominal income of a consumer changes (say increases) ceteris paribus, he can now bring changes in his
equilibrium and consumption pattern which was earlier not attainable. How much change would be there and in
which direction depends upon the income elasticity of demand. So the shape of ICC is dependent on whether
good is a normal commodity or inferior. Let us do all the cases one by one:
1) Normal good: A commodity that has positive relation with income and where law of demand
operates is known as a normal good.
Figure 5(A): X and Y are normal goods
Above figure shows ICC for normal goods on both the axis. Initial budget line is AB and consumer is in
equilibrium at point e1 consuming X1 units of commodity X and Y1 units of commodity Y. Now if money
income increases other things remaining constant budget line makes a rightward parallel shift to A’B’ where
consumer moves to a higher IC2 and new equilibrium at e2 consuming X2 and Y2. Further increase in the money
income to M3 shifts the budget line further to A’’B’’ reaching a higher equilibrium at e3 with X3 and Y3 units of
commodity X and Y. Joining successive equilibrium points e1, e2 and e3 we get the income consumption curve
that traces the path of changed consumption pattern with change in the money income ceteris paribus. Here
income elasticity of demand is positive. It can be further classified into three categories as given by Ernst Engel:
 Luxury Goods – Goods having more than unitary elasticity of income. Ey > 1
 Comfort Goods - Goods having unitary elasticity of income. Ey = 1
 Necessities - Goods having less than unitary elasticity of income. Ey < 1
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All these cases can be further explained with the help of diagrams 5(B), 5(C), 5(D) and 5(E):
Figure 5 (B) : ICC and Demand Curve for Luxury on X axis and Necessity on Y axis
Figure 5(B) shows how we derive Income Consumption Curve (ICC) when on X axis the good is luxury and Y
axis it is necessity. Now here the difference between the goods is of sensitivity towards income. Luxury has
elasticity more than one and necessity has elasticity less than one. So when money income increases there is
proportionately more change in the quantity of luxury then necessity. Thereby ICC is flatter. Demand curve too
has been drawn below the ICC that shows that there is a rightward parallel shift in the demand curve because of
change in the income of the consumer as price of the commodity has not changed. So at the same price now
more of commodity X is being demanded.
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Figure 5 (C): ICC and Demand Curve for Comfort goods
Figure 5(C) shows how we derive Income Consumption Curve (ICC) when there is comfort good on both the
axis. Comfort goods have income elasticity equal to unity, so when money income increases there is a
proportionate change in the quantity of comfort goods. Thereby ICC is a straight line from the origin. Demand
curve too has been drawn below the ICC that shows that there is a rightward parallel shift in the demand curve
because of change in the income of the consumer as price of the commodity has not changed. So at the same
price now more of commodity X is being demanded. However it can be seen that shift in demand curve has
been more in this case as compared to the case of necessity exhibited in Figure 5(B).
2) Inferior Good: A commodity that has inverse relation with income and where law of demand operates
is known as an inferior good.
Figure 5(D): ICC for Inferior goods on X axis and Normal goods on Y axis
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Figure 5(D) shows the derivation of Income Consumption Curve (ICC) for inferior good that has inverse
relation with income and also with price. Initially consumer is at point e1 consuming X1 and Y1 units of
commodity X and Y respectively with ‘M’ money income and Px and Py as prices of the two commodities.
Now if money income of the consumer increases with prices of goods being constant consumer moves on to a
higher budget line A’B’ and higher indifference curve IC2 at equilibrium e2. Though the consumption of inferior
good decreases as consumer now moves to superior commodity with increase in the nominal income. ICC is
thus backward bending. Drawn below is the demand curve for the inferior good where we can see that though
the demand curves are downward sloping but with increase in income there is leftward parallel shift showing
decrease in the consumption of commodity X.
Income Consumption curve can be used to derive Engel curve that shows the relation between Money Income
and consumption of a commodity. The concept was given by Ernst Engel to classify the commodity as Luxury,
comfort, necessity or inferior. Engel curves for different types of commodities are present in Figure 5(E):
Figure 5 (E): Engel Curve for Luxury, Comfort, Necessity and Inferior Goods
Above graph shows the derivation of Engel curve. Its information is obtained from the Income Consumption
curve only. In ICC relation between money income and quantity of commodity is shown indirectly whereas in
Engel curve relationship between money income and quantity is shown explicitly. In figure above the first case
is that of Luxury good where income elasticity is greater than unity showing that proportionate change in the
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quantity demanded is more than proportionate change in the price. Thus gap between M1M2 is less than X1X2.
Engel curve is thus flatter.
Second figure is that of comfort good which has income elasticity = 1 thus proportionate change in money
income is equal to proportionate change in quantity. M1M2 = X1X2. Engel curve is a straight line from the
origin.
Third figure depicts Engel curve for Necessities where Income Elasticity is less than Unitary elastic. Thus
proportionate change in money income is greater than proportionate change in quantity. M1M2 > X1X2. Engel
curve is steeper.
Last panel shows Engel curve for inferior good that has inverse relation with income. Thus when money income
increases quantity demanded decreases as consumer can now consume superior goods because of increased
income and with reduced consumption of inferior good. Engel curve here is therefore downward sloping.
1.5 CONCEPT OF PRICE CONSUMPTION CURVE

As discussed above when there is a change in the income of the consumer prices of the commodities remaining
unchanged the successive equilibriums are traced by drawing an Income consumption curve. Now in this
section we would be discussing about the other part that is price consumption curve (PCC) which is the ‘Loci of
equilibrium points showing the change in the consumption pattern because of the change ij price of one of the
commodity other things that is money income and price of other commodity remaining constant’.
The shape of the PCC is dependent on the price elasticity of demand. Hence we would be showing the
following cases of PCC:
1) Normal Goods: Goods where Law of demand operates that is there is inverse relation between price
and quantity demanded or Elasticity lies between zero to positive infinity. Here also we can have the
following three cases:
A) More than Unitary Elastic demand, Ed > 1
When Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price has
changed is proportionately more. Example: If price of a commodity say X changes by 10% then change in the
quantity demanded of X is more than 10%. It can be shown using the figure 6(A):
The diagram shows that PCC is downward sloping when elasticity of demand of a commodity is more than
unitary elastic. The reason can be explained as: Initially when price of commodity X is Px1 and with a specific
income and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the
respective commodities. Now if price of commodity X reduces to Px 2 with same money income and PY,
elasticity being more than unity consumer increases the consumption of X to X2 and reduces the consumption of
Y to Y2. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of demand.
In case of Ed > 1, with reduction in price of a commodity the total expenditure on the commodity increases. So
in this case it can be explained as: let’s say Price of X falls by 10%, this leads to increase in purchasing power
by 10% but Ed > 1 so change in quantity of X is more than 10% say 12%. Now from where did this extra 2%
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come as purchasing power has increased only by 10%. It has come by reducing the consumption of Commodity
Y to support increased expenditure on commodity X. Thus PCC here is downward sloping. PCC can also be
used to draw the demand curve which has been drawn below the PCC. Initially with Px1 consumer is consuming
OX1 and with fall in price of X to Px2 consumer is consuming more of the quantity of X that is OX2. Here the
proportionate change in quantity demanded is more than proportionate change in price. Therefore demand curve
is flatter.
Figure 6(A): PCC and Demand Curve when Ed > 1
B) Unitary Elastic Demand, Ed = 1
Here when Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price
has changed is equal to the change in price. Example: If price of a commodity say X changes by 10% then
change in the quantity demanded of X is equal to 10%. It can be shown using the figure 6(B):
The diagram shows that PCC is Rectangular Hyperbola when elasticity of demand of a commodity is unitary
elastic. The reason can be explained as: Initially when price of commodity X is Px 1 and with a specific income
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and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the
elasticity being unity consumer increases the consumption of X to X2 and keeps the consumption of Y
unchanged. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of
demand. In case of Ed = 1, with reduction in price of a commodity the total expenditure on the commodity
remains unchanged. So in this case it can be explained as: let’s say Price of X falls by 10%, this leads to
increase in purchasing power by 10% but Ed = 1 so change in quantity of X is equal to 10%. As all the
increased purchasing power is spent on commodity X itself so nothing is left to be spent on commodity Y and
hence its consumption remains unchanged. Thus PCC here is Horizontal Straight Line parallel to X axis. PCC
can also be used to draw the demand curve which has been drawn below the PCC. Initially with Px 1 consumer
is consuming OX1 and with fall in price of X to Px2 consumer is consuming more of the quantity of X that is
OX2. Here the proportionate change in quantity demanded is equal to proportionate change in price. Therefore
demand curve is rectangular hyperbola.
Figure 6(B): PCC and Demand Curve when Ed = 1
C) Less than Unitary Elastic Demand, Ed < 1
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Here when Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price
has changed is proportionately less. Example: If price of a commodity say X changes by 10% then change in the
quantity demanded of X is less than 10%. It can be shown using the figure 6(C):
The diagram below shows that PCC is Upward Sloping when elasticity of demand of a commodity is less than
unitary elastic. The reason can be explained as: Initially when price of commodity X is Px 1 and with a specific
income and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the
elasticity being less than unity consumer increases the consumption of X to X2 and also the consumption of Y to
Y2. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of demand. In
case of Ed < 1, with reduction in price of a commodity the total expenditure on the commodity also reduces. So
in this case it can be explained as: let’s say Price of X falls by 10%, this leads to increase in purchasing power
by 10% but Ed < 1 so change in quantity of X is less than 10% say 8%. As all the increased purchasing power is
spent on commodity X as well as commodity Y so the consumption of the both the goods increases. Thus PCC
here is Upward sloping. PCC can also be used to draw the demand curve which has been drawn below the PCC.
Initially with PX1 consumer is consuming OX1 and with fall in price of X to Px2 consumer is consuming more
of the quantity of X that is OX2. Here the proportionate change in quantity demanded is less than proportionate
change in price as not all the increased purchasing power is spent only on X. Therefore demand curve is steeper.
Figure 6(C): PCC and Demand curve for Ed < 1
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2) Giffen Goods:
Giffen goods are special type of Inferior goods where Law of Demand does not operate that is it has
direct relation between price and quantity demanded and inverse relation with income and quantity
demanded. Here elasticity of demand is negative, Ed < 0. The Price Consumption Curve (PCC) here is
Backward bending as can be shown in the figure 6(D):
Figure 6(D): PCC and Demand Curve for Ed < 0
The above figure gives the PCC for Giffen good and the associated demand curve. PCC in case of giffen good
is backward bending because of the reason that when initially the price of commodity is Px 1 consumer is at e1
on IC1 consuming OX1 units of commodity X which is a giffen good and OY1 of commodity Y. Now with fall
in the price of commodity X which is a giffen good its elasticity of demand being negative consumer reduces
the consumption of this commodity and all the increased purchasing power is spent only on commodity Y,
thereby consumption of good X reduces with a fall in the price of X. the demand curve thus exhibits a positive
relation between price and quantity demanded which is an exception to the Law of Demand.
As we can see above that Price Consumption Curve is also used for deriving the demand curve, but there is a
slight difference between the two. PCC shows the relation between price and quantity demanded of a
commodity impliedly through the budget line as axis nowhere has the price of the commodity as the variable.
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This implied information is directly used in the demand curve where one of the variables on the axis is price of
the commodity. It thus shows the relation between price and quantity demanded explicitly
1.6 SUMMARY
In the previous lesson we talked about the concept of Indifference curve, budget line and consumer equilibrium.
This chapter is an extension of that where it provided for certain conditions where Indifference curve is not
convex to the origin. Few cases are that of Perfect Substitutes, Perfect Complements, Economic Goods,
Economic Bads and Neuters. The chapter also talked about how there can be change in the consumer
equilibrium when there is a new budget line because of change in either the money income of the consumer or
price of one of the commodity. How consumer shifts to new equilibrium can be shown with the help of Income
Consumption Curve that traces out the successive equilibrium points showing different combinations of two
commodities that consumer consumes when his money income changes ceteris paribus. ICC can be drawn in
case of normal goods as well as inferior goods; first one having positive relation with nominal income while the
latter has inverse relation with income. ICC has been used further to derive the Engel curves that shows the
relation between money income and quantity demanded explicitly. Another is the Price consumption curve that
shows the successive changes in the consumption of two commodities because of change in the price of one of
the commodity other things remaining constant. There have been four cases in case of PCC depending upon
elasticity of demand being equal to unity, less than unity, more than unity or negative. PCC has been used to
draw the demand curve showing explicitly the relation between price of the commodity and its quantity
demanded.
1.7 SELF ASSSSMENT QUESTIONS
Check your progress

(a) If the commodity is an economic bad it provides neither satisfaction nor dissatisfaction to the consumer
(b) In case of elasticity of demand greater than unity Price Consumption Curve is downward sloping.
(c) Income consumption curve for inferior good is backward bending
(d) If there is economic bad on both the axis, indifference curve is upward sloping.
(e) For a neuter on X axis the Indifference Curve is vertical parallel to Y axis.
Ans. 1(F), 2(T), 3(T), 4(T), 5(F)

(a) Neuters provide neither _ _ _ _ _ _ _ nor _ _ _ _ _ _ _ _ to the consumer.
(b) For a Giffen good the Price Consumption curve is _ _ _ _ _ _ _ _
(c) When Marginal revenue is positive, elasticity of the demand curve is _ _ _ _ _ _ _ _
(d) If demand curve has unitary elasticity, the shape of the Price Consumption Curve is _ _ _ _ _ _ _ _
(e) An Engel curve shows relation between _ _ _ _ _ _ _ and _ _ _ _ _ _ _ _.
Ans 1. Satisfaction, Dissatisfaction 2.Backward Bending 3.Horizontal parallel to X axis 4.Money Income,
Quantity demanded 5. Horizontal
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1. Explain the concept of Income consumption curve and derive Engel Curve from it
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________________________________________________
2. State the exceptions to convex shape of Indifference curve.

________________________________________________
________________________________________________
3. Draw the Price consumption curve when elasticity of demand is equal to unity.
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4. Draw the indifference curve for two consumers one having stronger preference for commodity X and
other having stronger preference for commodity Y
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LESSON 3
APPLICATION OF INDIFFERENCE CURVE AND BUDGET LINE
1. STRUCTURE
1.1 Introduction
1.2 Objective
1.3 Hicksian approach for Division of Price Effect into Substitution and Income Effect
1.4 Application of Consumer Behaviour: Lump sum subsidy vs excise Subsidy
1.5 Concept of Consumer Surplus
1.6 Summary
1.1 OBJECTIVE
a) Understand the concept of Consumer Surplus

b) Explain the Hicksian Approach for division of Price Effect into Substitution and Income Effect
c) Learn the suitability of Lump sum subsidy and Excise subsidy
d) Comprehend the Revealed Preference Theory
1.2 INTRODUCTION
Price Consumption curve and Income Consumption Curve showed how change in price of a commodity or
nominal income of the consumer respectively have an impact on the consumer’s equilibrium. Professor Hicks
however stated that the price effect or Law of Demand operates because of two forces that work behind it that is
the Income effect and Substitution effect and Price effect is nothing but a cumulative of these two factors.
However these effects also depend on what type of commodity it is that is whether it is a normal good, inferior
good or Giffen good. All this would be studied in the chapter. Secondly Consumer surplus has been much
talked about in every sphere of life where the objective of every consumer is how to maximize his consumer
surplus which is an indicator of the consumer’s satisfaction. Two different views have been given on this by
two different economists – Marshall and Hicks using two different ideologies that is cardinal utility and ordinal
utility respectively. The third issue that finds a place in the chapter is how to decide between two types of
subsidies that government can provide to the consumers that is how to decide which one maximizes the welfare
of the consumer out of Cash (Lump sum) subsidy and Excise (food) subsidy. Lastly the chapter also talks about
Samuelson’s Revealed Preference Theory which is based on strong ordering concept unlike weak ordering
concept of Hicks.
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1.3 DIVISION OF PRICE EFFECT INTO SUBSTITUTION AND INCOME
EFFECT: HICKSIAN APPROACH
Law of Demand states that when price of a commodity reduces other things remaining constant its quantity
demanded increases and vice versa and this is known as the Price effect as it shows impact of price on the
quantity demanded. Professor Hicks has given that this price effect is actually a combination of substitution
effect and income effect which can be segregated using the Compensating Variation Income Method. However
the division depends upon whether the good is a Normal good, Inferior good or Giffen good. Thus we would be
talking about these three one by one:
Division of price effect into substitution and income effect using Hicksian Approach for Normal Good
Normal Good: A commodity that has inverse relation with price and direct relation with income is known as a
normal good. Here Law of Demand is operative that is with reduction in the price of a commodity its quantity
demanded increases and with increase in income its quantity demanded increases.
Price effect: When the price of a commodity reduces/increases other things remaining constant, because of Law
of demand its quantity demanded increases/decreases respectively in case of normal good. This change in the
quantity demanded that is shown by the Price Consumption curve also is known as the Price effect.
Income effect: When price of a commodity changes say decreases other things remaining constant, the
purchasing power or real income of the consumer increases whereby he can buy more of a commodity with the
same nominal income in case of normal goods. This effect is known as the Income Effect that can be traced by
using the Income Consumption Curve
Substitution Effect: When price of a commodity changes let’s say it decreases ceteris paribus then it becomes
relatively cheaper as compared to other commodities and consumer purchases more of it whose price has
reduced with the same money income and price of other commodity. Substitution effect remains same in case of
all commodities whether it is normal good, inferior good or giffen good because of the fact that price effect is
dependent on Price elasticity of demand, Income effect is dependent on Income Elasticity of demand but
substitution effect is based on the concept of rationality of consumer where he would always prefer a
commodity that is relatively cheaper to maximize his satisfaction.
Let us now explain the concept of Hicksian division with the following diagram:
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Figure 1: Normal Good: Division of Price effect into substitution and Income Effect
Above figure shows that initially with a particular money income and prices of the two commodities consumer
is on IC1 at e1 consuming OX1 units of X (X being a normal good). Now if price of commodity X reduces other
things remaining constant the budget line pivots to AB’ and consumer reaches a higher equilibrium e 2 on IC2
consuming OX2 units of commodity X. this increase in the consumption of commodity X is known as the price
effect as it has happened because of change in the price of this commodity. To segregate this effect into
substitution and income effect Hicks has given the concept of Compensating Variation Income line where we
draw a budget line that is parallel to new budget line here AB’ and tangent to old indifference curve here IC 1.
This has been done to take the impact of the increased money income back from the consumer and see what
would have been the consumption of X if it would have been initially cheaper. This line is MN which is tangent
to IC1 at e3 thereby showing that consumer would have consumed OX3 units of commodity X had it been
relatively cheaper. Thus X1 to X3 is the substitution effect. Now to get the income effect we give back the
consumer his increased purchasing power thereby X2 to X3 shows the income effect. Below this we have drawn
the demand curve which shows that initially with price of X being Px 1 consumer was consuming OX1 units of
commodity X and with decrease in the price to Px2 the consumption has increased to OX2. The movement thus
explains why Law of Demand operates. Demand curve here is also flatter showing that the change in quantity is
more because of the fact that both substitution and income effect are forcing the consumer to buy more of the
commodity.
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Division of price effect into substitution and income effect using Hicksian Approach for Inferior Good
Inferior Good: A commodity that has inverse relation with price and also inverse relation with income is
known as a inferior good. Here Law of Demand is operative that is with reduction in the price of a commodity
its quantity demanded increases in spite of the fact that with increase in income its quantity demanded
decreases. This can be explained as below:
Price effect: When the price of a commodity reduces/increases other things remaining constant, because of Law
of demand its quantity demanded increases/decreases respectively in case of inferior good. This change in the
quantity demanded that is shown by the Price Consumption curve also is known as the Price effect.
purchasing power or real income of the consumer increases and it being an inferior good consumer reduces its
consumption as he moves to the consumption of superior commodity. This effect is known as the Income Effect
that can be traced by using the Income Consumption Curve
Figure 2: Inferior Good: Division of Price effect into substitution and Income Effect
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is on IC1 at e1 consuming OX1 units of X (X being a inferior good). Now if price of commodity X reduces other
consuming OX2 units of commodity X. this increase in the consumption of commodity X is known as the price
effect as it has happened because of change in the price of this commodity. To segregate this effect into
draw a budget line that is parallel to new budget line here AB’ and tangent to old indifference curve here IC1.
relatively cheaper. Thus X1 to X3 is the substitution effect which is same as it was in case of normal good. Now
to get the income effect we give back the consumer his increased purchasing power thereby X3 to X2 shows the
income effect which is moving leftward because of the fact that in case of inferior good income effect forces the
consumer to buy less of the commodity whose price has reduced. But still the price effect is rightward that is
consumer is buying more of X as substitution effect is stronger than the income effect and hence law of demand
operates in case of Inferior good. Below this we have drawn the demand curve which shows that initially with
price of X being Px1 consumer was consuming OX1 units of commodity X and with decrease in the price to Px2
the consumption has increased to OX2. The movement thus explains why Law of Demand operates in case of
inferior good as well. Demand curve here is although steeper as compared to normal good as the change in
quantity is less because of the income effect being leftward.
Division of price effect into substitution and income effect using Hicksian Approach for Giffen Good
Giffen Good: A commodity that has direct relation with price and inverse relation with income is known as a
Giffen good. Here Law of Demand is not operative that is with reduction in the price of a commodity its
quantity demanded also decreases and thus Giffen goods is an exception to the Law of Demand. This can be
explained as below:
Price effect: When the price of a commodity reduces/increases other things remaining constant, because of non
operative Law of demand its quantity demanded decreases/increases respectively in case of giffen good. This
change in the quantity demanded that is shown by the Price Consumption curve also is known as the Price
effect.
purchasing power or real income of the consumer increases and it being a giffen good consumer reduces its
consumption as he moves to the consumption of superior commodity. This effect is known as the Income Effect
that can be traced by using the Income Consumption Curve
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Figure 3: Giffen Good: Division of Price effect into substitution and Income Effect
is on IC1 at e1 consuming OX1 units of X (X being a Giffen good). Now if price of commodity X reduces other
consuming OX2 units of commodity X. this decrease in the consumption of commodity X is known as the price
effect as it has happened because of change in the price of this commodity. Here Law of Demand does not
operate as with reduction in price of X its quantity demanded too has reduced. To segregate this effect into
draw a budget line that is parallel to new budget line here AB’ and tangent to old indifference curve here IC 1.
relatively cheaper. Thus X1 to X3 is the substitution effect which is same as it was in case of normal good. Now
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to get the income effect we give back the consumer his increased purchasing power thereby X3 to X2 shows the
income effect which is moving leftward because of the fact that in case of inferior good income effect forces the
consumer to buy less of the commodity whose price has reduced. And here substitution effect is weaker than the
income effect and hence law of demand does not operate in case of Giffen good. Below this we have drawn the
demand curve which shows that initially with price of X being Px 1 consumer was consuming OX1 units of
commodity X and with decrease in the price to Px2 the consumption too has decreased to OX2. The movement
thus explains why Law of Demand does not operate in case of Giffen good. Demand curve here is upward
sloping showing direct relation between price and quantity demanded.
Example 1: All Giffen goods are inferior but all inferior are not Giffen. Explain the statement.
Solution: Giffen goods are special kind of inferior goods where law of demand does not operate as substitution
effect is less than the income effect whereas in case of inferior goods substitution effect being stronger than
income effect law of demand operates. So Giffen goods are those inferior goods where income effect is negative
like all inferior goods but price effect is direct unlike inferior goods where it is indirect. Thus we can say that all
Giffen are inferior but all inferior are not Giffen.
5.4 LUMP SUM SUBSIDY VS EXCISE SUBSIDY
In a welfare economy it is the objective of the government to look after the welfare of the society for which it
provides various kinds of the subsidies to the consumers. Two most common subsidies are cash subsidy (lump
sum) subsidy and excise subsidy (food subsidy). In cash subsidy government provides cash to the consumers
which it can use according to his preference whereas excise subsidy is where government provides per unit cost
of the commodity and only the remaining is to be paid by the consumer. Out of the two excise subsidy can be
used by the consumer only for consuming that commodity whose price has been reduced because of concession
by the government whereas in case of lump sum subsidy the grant can be used on any commodity as per
consumer’s like or dislike. A comparative comparison of the two subsidies is shown using figure 4:
Figure 4: Lump sum subsidy vs Excise Subsidy
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In the figure AB is the original budget line where consumer is on IC1 with equilibrium being at e1 and consumer
is consuming OX1 units of food and is still having OM1 of money income, therefore showing that consumer has
spent AM1 of money income to buy OX1 units of food. Now if government gives excise subsidy then price of
food per unit reduces and budget line pivots to AB’ where consumer moves to a higher Indifference curve IC 2
having equilibrium at e2 where he is consuming OX2 units of food by spending AM2 units of money income.
Now to find the benefit of the excise subsidy to the consumer we see what would have been the expenditure of
consumer on OX2 units of food had there been no excise subsidy given by the government. For this we see what
the consumer would have spent on OX2 units of food without subsidy and it is given by AH which is seen from
the old budget line. Thus M2H is the benefit of excise subsidy to the consumer or cost of excise subsidy to the
government. Now to see what would have been the impact of cash subsidy on the consumer’s welfare, we
assume that instead of excise subsidy government gives cash subsidy such that burden of cash subsidy and
excise subsidy to the government is same. Here budget line of the consumer shifts parallel to right as money
income of the consumer increases. Thus MN is parallel to AB and also MA = M2H to show that cost to the
government of both the subsidies is same. Also MN passes through IC2 and e2 showing that the same bundle is
still available to consumer that was there in case of excise subsidy. Now on MN the only segment where we can
have the indifference curve is Me2, so the consumer reaches IC3 which is the highest indifference curve showing
that cash subsidy increases the welfare/satisfaction of the consumer to the maximum.
1.5 CONSUMER SURPLUS

The concept of surplus was given by Marshall where he used the concept of diminishing marginal utility and
cardinal measurability of utility to show what is consumer surplus. If utility can be measured in terms of price
that the consumer is willing to pay for the commodity then with each successive consumption of the unit
because of diminishing marginal utility the satisfaction keeps on decreasing and hence the price that the
consumer is willing to pay also falls. Now how the consumer surplus can be calculated is given below:
Let us say that the consumer is willing to pay Rs 10 for first unit so we can say that this is the satisfaction that
consumer actually derives from the consumption of the first unit of the commodity. Let us further assume that
consumer is willing to pay Rs 9, Rs 8, Rs 7 and Rs 6 for each successive unit which also represents diminishing
marginal utility from the consumption of additional units. Now if we assume that price of the commodity is Rs
5 then consumer surplus can be shown by the shaded rectangles in the figure below:
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Figure 5: Marshallian Consumer Surplus
Thus consumer surplus can be calculated as the price that the consumer is willing to pay and what he is actually
paying. In the figure it is:
= (10-5) + (9-5) + (8-5) + (7-5) + (6-5) = 15
However if we have to calculate consumer surplus in case of continuous demand curve then it can be calculated
as the area between the demand curve and the equilibrium price as shown in figure 6:
Figure 6: Marshalian Consumer surplus in case of smoothened Demand curve
Marshallian method has been criticized by the advocates of ordinal utility analysis. Prof. J.R. Hicks
rehabilitated the concept of consumer’s surplus by measuring it with indifference curve technique of his ordinal
utility analysis. Indifference curve technique does not make the assumption of cardinal measurability of utility,
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nor does it assume that marginal utility of money remains constant. However, without these invalid
assumptions, Hicks was able to measure the consumer’s surplus with his indifference curve technique.
In Figure below we have measured the quantity of commodity X along the X-axis, and money along the Y-axis.
The indifference curve IC1 touches the point M on Y axis indicating thereby that all combinations of money and
commodity represented on the indifference curve IC1 give the same satisfaction to the consumer as OM amount
of money. If we take combination A on indifference curve IC1 , then here consumer has OQ amount of
commodity X and OB amount of money and it will give the same satisfaction to the consumer as OM amount of
money because both M and A combinations lie on the same indifference curve IC 1. It means that the consumer
is willing to pay MB amount of money for OQ amount of the commodity X. It is thus clear that, given the scale
of preferences of the consumer, he derives the same satisfaction from OQ amount of the commodity X as from
MB amount of money. In other words, he is prepared to give up MB for OQ amount of commodity X. Now,
suppose that the price of commodity X in the market is such that we get the budget line ML (price of X is equal
to OM/OL). We know from out analysis of consumer’s equilibrium that consumer is in equilibrium where the
given budget line is tangent to an indifference curve. It will be seen from Figure that the budget line ML is
tangent to the indifference curve IC2 at point C, where the consumer is having OQ amount of commodity X and
OD amount of money. Thus, given the market price of the commodity X, the consumer has actually spent MD
amount of money for acquiring OQ amount of commodity X. But, as mentioned above, he was prepared to
forego MB amount of money for having OQ amount of X. Thus, DB=CA is the amount of consumer’s surplus
which the consumer derives from purchasing OQ amount of the commodity.
Figure 7: Consumer Surplus: Hicksian Approach
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Example 2: Calculate consumer surplus in the following:
Equilibrium Price Price that consumer is willing to pay /

Marginal Utility
10 8
10 7
10 6
10 5
Solution: Consumer surplus is what the consumer is willing to pay minus what he is actually paying. Thus in
the above example it can be calculated as:
Equilibrium Price Price that consumer is Consumer Surplus

willing to pay / Marginal
Utility
10 8 10 – 8 = 2
10 7 10 – 7 = 3
10 6 10 – 6 = 4
10 5 10 – 5 = 5
Thus using the Marshallian concept of consumer surplus we can see that the total consumer surplus of the
consumer is: 2 + 3 + 4 + 5 = 14
1.6 SUMMARY
The chapter talked about different types of goods that is normal goods, inferior goods and giffen goods and why
the impact of change in the price is different in case of these three types of goods. It made use of the
Compensating Income Variation method propounded by economist Hicks that makes adjustment in the
purchasing power of the consumer to segregate the price effect into income effect and substitution effect. It also
helped us to know why in case of Giffen goods Law of demand is not applicable in spite of these types of goods
belonging to the category of Inferior goods. The reason given was the strength of substitution effect is stronger
than the income effect in case of Inferior good thereby forcing the consumer to buy more when the price of a
commodity reduces ceteris paribus whereas in case of giffen good substitution effect becomes weaker than the
income effect and hence consumer reduces the consumption of the commodity whose price has reduced thereby
producing direct relation between price and quantity demanded of a commodity or upward sloping demand
curve. The chapter also explained the concept of consumer surplus by defining it as the price that the consumer
is willing to pay and what he is actually paying or the equilibrium price. Consumer surplus given by both the
economists – Marshall and Hicks has been discussed in the chapter. The former being based on the Law of
Diminishing Marginal Utility and the latter on the concept of Ordinal utility or Indifference curve. Lastly it
explained why lump sum subsidy and excise subsidy given by the government have different impact on the
consumer and on the basis of satisfaction derived, consumer is better off with the cash subsidy as it takes him to
a higher indifference curve as compared to Excise subsidy.
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(a) Law of demand is not applicable in case of Inferior Good
(b) Hicksian Approach made use of Compensating income variation method to divide price effect into
substitution and income effect.
(c) Lump sum subsidy is better as it increases the satisfaction of the consumer to the highest level
(d) Cost of excise subsidy and lump sum subsidy to the government is different.
(e) Concept of Indifference curve is based on weak ordering hypothesis.
Ans. 1(F), 2(T), 3(T), 4(F), 5(T)
(a) Marshallian concept of consumer surplus is based on the _ _ _ _ _ _ _ _ _ .
(b) For a Giffen good income effect is _ _ _ _ _ _ _ _
(c) In case of Inferior good Law of Demand _ _ _ _ _ _ _ _
(d) Hicks made use of _ _ _ _ _ _ _ _ to divide price effect into income effect and substitution effect
(e) In Giffen good Substitution effect is _ _ _ _ _ _ _ _ than the Income effect.
Ans 1. Law of Diminishing Marginal Utility 2. Inverse/indirect/negative 3. Operates 4.Compensating
Income Variation 5. Weaker/less than
1) Explain the concept of Consumer Surplus using both Marshallian and Hicksian Approach
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________________________________________________
2) All Giffen goods are inferior but all Inferior are not Giffen. Explain it using the concept of Hicks
Compensating Income Variation method
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________________________________________________
3) Why Law of Demand does not operate in case of Giffen good.
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________________________________________________
4) Consumer is better off with cash subsidy than with per unit Excise subsidy” Explain why then all over
the world, grants and aides are always given in the form of excise subsidy rather than cash subsidy?
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________________________________________________
5) Explain the difference between Income effect and substitution effect in all types of goods that is Normal
good, Inferior good and Giffen good
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87
Unit 4
COST OF PRODUCTION
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LESSON 1
SHORT RUN AND LONG RUN COST CURVES
1. STRUCTURE
6.1 Objective
6.2 Introduction
6.3 Different concepts of Cost
6.4 Short Run Cost Curves
6.5 Long Run average cost curve and Long Run marginal cost curve
6.6 Learning Curve
6.7 Summary
1.1 OBJECTIVE
a) Understand the difference between different types of short run cost curves.
b) Understand the relationship between total, average and marginal cost curves
c) Derive Long run average and marginal cost curves.
d) Comprehend the Learning curve and distinguish it from Long Run average Cost curve
1.2 INTRODUCTION
Cost is one of the various important components that have an impact on the quantity that would be demanded
and supplied in the market as cost is one main and crucial factor that has an impact on the price of the
commodity. Cost behaves differently in short run and long run as in the short run we have certain costs that are
fixed in nature and others that are variable, thus in the short run there are two components of cost – fixed and
variable because of the fact that short run is a time period in which certain factors of production cannot be
changed or varied while long run costs are variable in nature as long run is a time period where all the factors of
production become variable even those which were fixed in the short run. Thus there is no fixed component in
cost in the long run. Then there is also a relation between different types of costs that is total, average and
marginal costs that would be taken up in this chapter. Lastly as a firm grows old that is its cumulative output
increases there are various types of learning that goes in the organization like manager’s learn how to deal with
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the various stakeholders, technicians learn what can be various types of problems in an organization and how to
deal with it and so. Thus learning curve traces out the impact of learning on the cost curves.
1.3 DIFFERENT CONCEPTS OF COST

Before proceeding to the short run and long run cost curves it is essential to describe what are the various types
of cost that a production process faces. Some of them have been highlighted below:
Explicit Cost vs Implicit Cost: Explicit costs or out of the pocket costs are those expenditures that firm makes
on outside factors of production. These are the costs that find a place in the financial statements that is trading
account and profit and loss account of a firm. Example: wages and salaries paid to employees, rent of the
building being paid to the landlord, cost of the raw material being paid to the suppliers etc.
Implicit Cost on the other hand is the cost of self owned resources or factors of production. These are not paid
to the outside factors of production. They do not find any place in the financial statements of the company.
Example: Entrepreneur working as manager in his own firm and not drawing any salary rent of the self owned
building where factory is situated etc.
Private cost vs Social cost: When a producer carries on production he takes into consideration only the private
cost or the cost that goes into the manufacturing of goods. This cost is alone responsible for fixing the price of a
commodity and determining the profit maximizing level of a firm. Example: Cost of raw material, wages and
salaries, interest on borrowed capital etc. however there are certain costs that society has to bear because of the
production process of the entrepreneur which is usually not taken into consideration by the producers these
costs are known as the external costs.
Social Cost: Thus social cost is the cost that society has to bear because of the production process along with
the private cost. Social cost = Private cost + External cost
Fixed Cost vs Variable cost: The cost that remains fixed irrespective of the level of output being produced is
known as Fixed cost. It is there even at zero level of output. Fixed cost arises because of fixed factors of
production and hence is applicable only in the short run as there is no fixed factor in the Long run. Example:
Rent of the land which is fixed whether production is carried or not in the short run as in the long run on we can
vacate the place but in the short run we can only shut down the production, cannot exit.
Variable Cost: The cost that changes with the level of production and is zero at zero level of production is
known as variable cost. Example: Cost of Raw material, wages of employees etc. This distinction between fixed
and variable cost is only relevant for short run as in the long run all costs become variable.
Accounting Cost vs Economic Cost: Accounting cost is the cost that finds place in the book of accounts. It is
thus all the explicit cost Example: rent, wages etc whereas economic cost is a summation of all the explicit and
implicit costs that is taken into consideration to calculate economic profits which is different from accounting
profits because of the above reason.
Sunk Cost: The cost that has been incurred in the past and cannot be changed by any action of the firm and is
irrelevant for future decision making is known as sunk cost. Example: expenditure incurred by firm on finding
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out whether a new product would be successful or not is a sunk cost as whether the product is launched or not
the cost has been incurred.
Opportunity Cost: The money or other benefits lost when pursuing a particular course of action instead of a
mutually-exclusive alternative. When economists refer to the “opportunity cost” of a resource, they mean the
value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money
going to a movie, you cannot spend that time at home reading a book, and you cannot spend the money on
something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost
of seeing the movie is the money spent plus the pleasure you forgo by not reading the book.
1.4 SHORT RUN COST CURVES

In the short run as has been discussed above costs can be divided into Fixed cost and Variable cost. The cost
that remain same at all levels of output is known as fixed cost whereas cost that changes with the level of
production is variable cost. Fixed cost is there even at zero level of production whereas variable cost is zero at
zero level of production.
All the fixed and variable cost can be further divided into Total, Average and Marginal costs. Let us take all of
them one by one:
Total Fixed Cost: The cost that is constant at levels of output. It is a straight line parallel to X axis.
Total Variable Cost: The cost curve that is inverse S shaped starting from the origin because of Law of
variable proportion is the total variable cost curve.
Total cost: The summation of total fixed cost and total variable cost is the total cost. All these total cost curves
are shown in the figure below:
Figure 1: Total cost curves
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From the total cost curves we now move to average cost curves and how these can be derived graphically from
the total cost curves.
Average Fixed Cost: Fixed cost per unit of output being produced is known as average fixed cost. AFC =
TFC/Q. It can be derived from AFC shown in figure 2:
To get Average Fixed Cost (AFC) from Total Fixed Cost (TFC) we take three levels of output say 5, 8 and 10
units of output. TFC at all these levels of output is same say Rs 100. Now to calculate AFC at all these levels of
output we draw a ray from the origin that passes through TFC at these levels of output. AFC thus can be
calculated as TFC/Quantity. Graphically it is vertical distance between TFC and output thus it is nothing but the
slope of the rays that have been drawn. So AFC at 5 units, 8 units and 10 units of output is 100/5, 100/8 and
100/10 or 20, 12.5 and 10 respectively. It has been drawn in the figure 2 which shows that AFC is declining.
The shape of the curve is Rectangular Hyperbola as the area below it is constant and equal to TFC.
Figure 2: Derivation of AFC from TFC
Average Variable Cost: Variable cost per unit of output being produced is known as average variable cost.
AVC = TVC/Q. It can be derived from TFC shown in figure 3:
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The method of deriving AVC from TVC is same as we derived AFC from TFC. Here also we have drawn rays
from the origin at three levels of output such that one of the rays is tangent to TVC showing the least possible
slope or lowest value of AVC which is at OQ2. Then another ray is taken at Q1 and Q3 levels of output. Their
corresponding slopes are shown in the panel below such that b’ is the least slope it being tangent to TVC and a’
and c’ being at the same levels though at different levels of output. We thus get a U shaped curve showing that
initially variable cost per unit reduces reaches it minimum and then starts increasing thereby confirming the
law of variable proportion.
Average Cost: Total cost per unit of output being produced is known as average cost.
AC = TC/Q or AFC + AVC. It can be derived from TC shown in figure 4:
The method of deriving AC from TC is same as we derived AVC from TVC. Here also we have drawn rays
from the origin at three levels of output such that one of the rays is tangent to TC showing the least possible
slope or lowest value of AC which is at OQ2. Then another ray is taken at Q1 and Q3 levels of output. Their
corresponding slopes are shown in the panel below such that b’ is the least slope it being tangent to TC and a’
and c’ being at the same levels though at different levels of output. We thus get a U shaped curve showing that
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initially total cost per unit of output reduces reaches it minimum and then starts increasing thereby confirming
the law of variable proportion.
AC and AVC are both U shaped but minimum of AC comes after minimum of AVC and AC is more at all
levels of output as compared to AVC because of presence of AFC though the gap between the two keeps on
reducing as AFC keeps declining but they both never touch each other as AFC is never zero. It has been shown
in figure 5:
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Figure 5: AFC, AVC and AC
It can be seen from above that both AVC and AC are U shaped that is when AVC is declining AC is also
declining and when AVC is rising AC is also rising but there is a stretch from Q1 to Q2 levels of output where
AVC has started rising but AC is still falling. The reason can be that AC is summation of AFC and AVC so
initially till Q1 level of output both AFC and AVC are falling hence AC too is declining but after Q1 AFC is still
falling and AVC has started rising thus both forces are moving in the opposite direction although the force of
AFC here is stronger as compared to AVC hence AC continues to fall till OQ2 level of output after which force
of AVC becomes strong and AC starts rising. Therefore minimum of AC also comes after minimum of AVC
and there is a stretch where AVC is rising but AC is falling.
Marginal Cost: It shows change in the total cost because of producing one additional unit of the commodity. It
is calculated by taking the first difference of either the Total Cost or Total variable cost. It can be calculated as:
MC = =
MC = TCn – TC(n-1) or MC = (TFC + TVC) nth output - (TFC + TVC) (n-1)th output
MC = TFCn + TVCn - TFC (n-1) - TVC (n-1) and as TFC is same for nth unit or (n-1)th unit so
MC = TVCn – TVC(n-1)
Example 1: If cost of producing 10 units is Rs 100 and cost of producing 11 units is Rs 120, then Marginal cost
is cost of producing additional unit of output from 10 to 11 units is
Rs 120 – Rs 100 = Rs 20
It can be derived from TC or TVC any of the curves and method of derivation is same as given below. As
Marginal cost is nothing but the slope of Total cost or total variable cost and is derived by taking the first
difference of TC or TVC with respect to quantity. So to get this we draw tangents at three different quantities
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being taken here it is Q1, Q2 and Q3 and tangents at these points is given by A, B and C. In the panel below
these slopes are shown as A’, B’ and C’ where B’ is the slope that is least representing minimum point of
Marginal cost. MC is also U shaped representing Law of variable proportions. Initially with increase in variable
factor production increases at increasing rate so cost increases but at diminishing rate so MC falls. After
reaching the minimum then with increase in variable factor production increases at decreasing rate so cost
increases at increasing rate that increases the marginal cost. It is being depicted in figure 6:
Figure 6: Derivation of MC from TVC
1.5 LONG RUN COST CURVES
Long run as defined earlier is a time period where all factors of production become variable. Thus there is no
long run fixed cost we only have long run average cost and long run marginal cost. In the long run firm can also
switch between plants that is it can easily move from a small sized plant to a medium sized plant and/or to large
sized plant showing that even the plant size is not fixed in the long run.
Long Run average Cost Curve: Long Run average Cost curve also known as planning curve or envelope
curve. It shows cost per unit of production in the long run. It is obtained by dividing the long run total cost by
the total output being produced. Let us explain the concept of LAC using the figure 7:
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Figure 7: Long Run average cost curve
There are three plants available to the producer – SAC1 (small sized plant), SAC2 (medium sized plant) and
SAC3 (Large sized plant). Now a producer would operate on that plant where cost per unit of production or
SAC is the least. If producer wants to produce Q1 level of output then it can be produced only on SAC1,
however if producer wants to produce Q1’ then its cost per unit of production is least on SAC1. The cost of
production is minimum on small sized plant as compared to medium sized plant till Q2. Also at Q2 levels of
output cost per unit is same on both small sized and medium sized plant thus the final selection of the plant
would depend on the anticipated/future demand. If market conditions are such that demand is going to increase
in the future then producer would make a shift to the medium sized plant as beyond Q2 level of output cost
minimizes on SAC2. Therefore SAC1 would be operative till OQ2 level of output. Similarly SAC2 would be
operative till the intersection of SAC2 and SAC3 that is till OQ3 after which large sized plant would be in usage.
Thus the above curve is reduced to following if we have only three sizes of plants available:
Figure 8: Long Run average cost curve

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However if there are multiple small sized plants then LAC would be a smoothened U shaped curve, the shape
being so because of operation of Law of Returns to Scale. Initially when production increases economies of
scale being greater than diseconomies of scale there are increasing returns to scale because of which LAC falls.
Then when production is increased further economies are exactly equal to diseconomies and there is a constant
return to scale because of which LAC is at its minimum. Further increase in the output leads to a stage where
diseconomies become stronger than the economies and there is decreasing returns to scale whereby LAC starts
increasing. Thus law of returns to scale makes LAC ‘U-shaped’. It is shown in the figure 9:
Figure 9: Long Run average cost curve – U shaped curve
LAC is also called Envelope curve and planning curve. It is called Envelope curve as LAC envelopes all the
short run cost curves and there is no point of the SAC that is above LAC. It is also called the planning curve as
it helps the producer in deciding what would be the optimal output and the corresponding cost associated with
it. It thus helps in the planning or decision making process. Short run average cost curves and Long Run
average cost curve can be combined together to show that the plants that are towards the left of minimum point
of LAC are underutilized whereas plants that are to the right of minimum point of LAC are overutilised. There
is only a single plant whose minimum coincides with the LAC is optimally utilized.
With the technological progress or increase in supply of inputs, LAC curve shifts downward as cost for the
same level of output reduces and with the technological regress or decrease in supply of inputs, LAC curve
shifts upward.
Long Run Marginal Cost Curve
Long run marginal cost curve (LMC) shows the change in long run total cost curve because of increase in the
production by one more unit. Though LMC is derived from the short run average cost curves and Long Run
average cost curve but it does not envelopes the SAC’s, it intersects SAC’s.
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LMC = = = LTC nth unit – LTC (n-1) th unit
Derivation of LMC can be explained with the help of figure 10:
Figure 10: Long Run Marginal Cost curve
To derive Long run marginal cost curve following steps have to be followed:
a. Draw LAC and SAC’s here we have drawn three plant sizes though there can be various plants.
b. Dram the corresponding short run marginal cost curves that passes through the minimum of short
run average cost curves. Thus we have SMC1, SMC2 and SMC3 passing through the minimum of
SAC1, SAC2 and SAC3.
c. As can be seen from the figure above SAC1 has minimum point after the tangency of SAC1 and
LAC showing that this plant is underutilized. Minimum of SAC2 and minimum of LAC
coincides showing that this plant is optimally utilized. SAC3 has its minimum before the
tangency showing that the plant is over utilized.
d. Draw a straight line towards the X axis or away from the X axis from the tangency of SAC and
LAC that intersects the corresponding SMC. Thus we get points a, b and c.
e. Join the points a, b and c to get the Long Run Marginal Cost curve.
Above figure shows that LMC is not an envelope curve although it intersects the SACs and it passes through the
minimum of long run average cost curve. Thus we can see that when LAC is falling LMC is below it, when
LAC is minimum LMC is equal to LAC and when LAC is rising LMC is above it.
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Example 2: Calculate various short run costs from the information given below:
Output (Units) Total Cost (Rs)

0 100
1 150
2 180
3 200
4 210
Solution:
Output TC TFC TVC = AFC= AVC= AC= MC=

TC - TFC TFC/Q TVC/Q AVC+AFC TCn-TCn-1
0 100 100 0 - - - -
1 150 100 50 100 50 150 50
2 180 100 80 50 40 90 30
3 200 100 100 33.33 33.33 66.66 20
4 210 100 110 25 27.5 52.5 10
Example 3: Calculate TFC, TVC, AFC, AVC and MC from the following:
TC = aQ2 + bQ + c
Solution: TC = aQ2 + bQ + c
TFC is that portion of the TC that is not dependent on quantity, Q, so TFC = c
TVC = that portion of cost which is zero when there is no production
TVC = aQ2 + bQ, AFC = TFC/Q = c/Q, AVC = TVC/Q = (aQ2 + bQ)/Q = aQ+b
MC = = = 2aQ+b
Example 4: A firm is producing 30 units. ATC and AVC at this level of output are of Rs55 and Rs50
respectively. Calculate the total fixed cost of the firm.
Solution: TFC=AFC × output = (AC-AVC) × output = (55-50) × 30 = 150
Example 5: If the TC = (50+Q) (90+Q) where TC = total cost ,Q = Units of a good produced, Find TFC, AFC,
TVC, AVC, AC, MC.
Solution:
TC = (50+Q) (90+Q) = 4500 + 140Q + Q2
TC = TFC when Q = 0
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Therefore fixed cost is 4500
AFC = 4500/Q In this case AFC is rectangular hyperbolic in shape.
AVC = (14Q + Q2)/Q
AC = (4500 + 14Q + Q2)/Q
MC = 2Q + 140
1.6 LEARNING CURVE
As an organization grows old that is its cumulative output increases there is a lot of learning that goes in the
organization. It may be in the form of managerial learning, technological learning, learning in supplies,
production. The main emphasis is that cost of production per unit is more when an organization is new and it
reduces over time as less and less hours are required for production of one unit over a period of time and this is
known as learning. It can be presented through the following equation and figure:
Figure 11: Learning Curve
The learning curve effect mostly occurs in the reduction of labour requirements per unit of output. A number of
factors bring this learning curve effect. As cumulative volume of output over successive periods of time
increases, labour and supervisors become more familiar with the work methods or the production process,
which leads to the reduction in the amount of scrap and other types of wastes. Learning curve thus measures the
relation between increase in per worker productivity (which results in reduction in per unit labour cost at fixed
prices) associated with an improvement in labour skills from on the job experience.
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1.7 SUMMARY
Production and cost are closely related with each other as if productivity is higher cost per unit would be lower
and vice versa. Cost can be studied in two time periods: Short run and Long run. The division being on the basis
of whether the factors of production are all variable or there is a component of fixed cost too. Thus in the short
run cost be divided in total fixed cost and total variable cost which are used to further understand the concept of
average fixed cost, average variable cost, then there is also Marginal cost that shows the change in total cost
because of increasing the production by one unit. All these costs have certain specific shape and that is because
of operation of Law of variable proportion. In the long run however we have studied only two costs: Long run
average cost and long run marginal cost, the previous one is U shaped and envelopes all the short run average
cost curves showing that even plant size is variable in the long run. It also helps the producer in making
decision about his optimal production and hence it is called the planning curve. Long run marginal cost curve
shows change in the long run total cost by adding one more unit to the output. It is derived from SAC, SMC but
does not envelopes SAC but only intersects them. Long run cost curves are impacted because of Law of Returns
to scale which is a long run phenomenon as all factors are variable. Lastly the chapter talked about Learning
curve which shows how learning goes on in an organization that leads to reduction in number of hours required
to produce per unit of output thereby reducing cost per unit.
Check your progress

a) Long run average cost curve is the loci of all the minimum points of short run average cost curves.
b) Average fixed cost is rectangular hyperbola in shape.
c) The minimum point of Average variable cost and average cost are parallel above each other
d) Long run marginal cost curve envelopes all short average cost curves
Ans: a) (F), b) (T), c) (F), d) (F)

a) Long run average cost curve is also called _ _ _ _ _ _ _ _ and _ _ _ _ _ _ _ curve.
b) Total Fixed cost curve is _ _ _ _ _ _ _ to X axis.
c) Total Variable cost curve is _ _ _ _ _ _ _ _ shaped.
d) Average fixed cost is _ _ _ _ _ _ in shape.
Ans: a) Envelope and Planning b) Parallel c) Inverse S d) Rectangular hyperbola
1) Explain the concept of Learning Curve and differentiate it from Long run average cost curve.
________________________________________________
________________________________________________
2) Derive LAC and explain why it is called Envelope curve.

________________________________________________
________________________________________________
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3) Is Long run Marginal Cost curve also an envelope curve? Describe the steps for its derivation.
________________________________________________
________________________________________________
4) How is Average Fixed Cost derived from Total Fixed Cost?

________________________________________________
________________________________________________
5) Explain the relation between different types of short run cost curves.
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________________________________________________
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Unit 5
PERFECT COMPETITION
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LESSON 1
PERFECT COMPETITION: LONG RUN ANALYSIS

______________________________________________________________________________
1. STRUCTURE
____________________________________________________________________________
1.1 Objective
1.2 Introduction
1.3 Long run supply curve of the Industry
1.4 Walras and Marshall stability Analysis
1.5 Summary
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1.1 OBJECTIVE
______________________________________________________________________________
a) Understand the concept of Perfect Competition as a market structure.

b) Derive supply curve of the Industry in the long run.
c) Understand the concept of stable and unstable equilibrium using Walras and Marshall concept.
1.2 INTRODUCTION
Perfect Competition is a market structure characterized by many buyers and sellers so that not a single buyer or
seller has any impact on the market price of the commodity, selling homogeneous products that are perfect
substitutes for each other and there is no barrier to entry and exit. However entry and exit is only possible in the
Long run. In the short run firms can earn supernormal profits, normal profits, suffer losses and may even shut
down but neither the new firms can enter the market to take the advantage of supernormal profits that firms are
earning nor the loss making firms can exit the market. The only thing that is possible is to shut down the
operations of the firm to stop incurring the variable costs and hence minimize the losses to only fixed cost as it
would be there irrespective of the fact that whether production is being carried out or not. However the situation
is not same in the long run as here new firms can enter the market and also existing firms can leave the market.
Hence in the long run a steady equilibrium would be attained only when all the firms are making just normal
profits so that there is no incentive for any firm to enter or exit. Also the concept of supply curve of the industry
in long run is quite different from the supply curve of the industry in the short run where it is just the summation
of marginal cost curves of all the firms that exist above the minimum point of short run average variable cost
and below it firms’ would be better off if they shut down as losses are reduced in that manner. The long run
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supply curve of the industry depends on what type of industry it is whether it is increasing cost industry,
constant cost industry or decreasing cost industry, all this would be taken up in this chapter. Lastly the concept
of stable and unstable equilibrium given by two economists Walras and Marshall too would be studied.
1.3 LONG RUN SUPPLY CURVE OF INDUSTRY
The short run supply curve of the industry is obtained by horizontal summation of all the supply curves of the
firms existing in the industry where short run supply curve of a firm is nothing but its marginal cost curve above
the minimum point of short run average variable cost curve. Thus industry’s supply curve is obtained by
horizontal summation of the MC’s of all the firms that lie above the minimum point of SAVC. Now to derive
the supply curve of the industry in the long run we have to understand what are the different types of industries
that exist in the long run and these are explained below:
Industries can be classified as:
1) Increasing Cost Industry

2) Constant Cost Industry
3) Decreasing Cost Industry
Let us take them one by one. First we take the concept of Increasing cost Industry:
INCREASING COST INDUSTRY
An increasing cost industry is one where Law of Diminishing returns to scale are applicable that is economies
of scale are less than the diseconomies of scale and hence when the firms increase their production the price
increases as increased output comes at increased cost. This can be explained with the help of figure 1:
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Figure 1: Long Run Supply curve of Increasing cost Industry
In the figure above, initially the industry is at long run equilibrium at E1 where demand curve D1D1 and Supply
curve S1S1 intersect, the equilibrium price is OP1 and equilibrium quantity of the industry is OQ1. It is long run
equilibrium because at this price all the firms are having just normal profits in the short as well as long run as
following conditions are being satisfied:
1) Short-run marginal cost (SMC) must be equal to its long-run marginal cost
(LMC) as well as short-run average cost (SAC) must be equal to its long-run average cost (LAC) and
both should be equal to MR = AR = P. Thus the first equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
2) LMC curve must cut MR curve from below
Now if because of any external factor demand increases such that demand curve shifts to D2D2, the new short
run equilibrium is at E2 where the price is OP2 and the price being greater than SAC1 firms start earning
supernormal profits in the short run. Because of this two things would happen in the long run:
a) New firms would enter the industry and

b) Existing firms would expand their production.
Because of both the factors supply of the industry would increase but this being an increasing cost industry the
increased output or production comes at increased cost and hence cost curves shift up showing increased cost.
Because of increase in production the supply curve shifts to right and supply would keep on increasing till all
the firms are just earning normal profits and there is no more incentive for the firms to enter the industry. It
happens when supply curve is S2S2 and long run new equilibrium is E3 at price OP3 and quantity OQ3. Thus
joining E1 and E3 we get the supply curve of the Increasing cost industry in the long run. It is given by S ISI
which is the long run supply curve of the Increasing Cost Industry.
“Supply curve of the increasing cost industry in the Long run is Upward sloping showing that increased
output comes at increased cost and hence at increased price.”
Following are the three conditions for the long-run equilibrium of the industry:
1) Quantity demanded in the industry = Quantity supplied by the industry so that the market is cleared and there
is neither excess demand nor excess supply.
2) All firms in the industry are in the equilibrium
3) There should be no tendency for the new firms to enter the industry or for the existing firms to leave it. In
other words, number of firms should be in equilibrium. This implies that all firms in the industry will be earning
only normal profits in the long run
P = MR = LAC = SAC = LMC = SMC
CONSTANT COST INDUSTRY
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A Constant cost industry is one where Law of Constant returns to scale are applicable that is economies of scale
are equal to the diseconomies of scale and hence when the firms increase their production the price remains
same as increased output comes at the same cost. This can be explained with the help of the figure 2:
In the figure, initially the industry is at long run equilibrium at E1 where demand curve D1D1 and Supply curve
S1S1 intersect, the equilibrium price is OP1 and equilibrium quantity of the industry is OQ1. It is long run
2) LMC curve must cut MR curve from below.
Figure 2: Long Run Supply curve of Constant cost Industry

Because of both the factors supply of the industry would increase but this being a constant cost industry the
increased output or production comes at the same cost and hence cost curves remain same. Because of increase
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in production the supply curve shifts to right and supply would keep on increasing till all the firms are just
earning normal profits and there is no more incentive for the firms to enter the industry. It happens when supply
curve is S2S2 and long run new equilibrium is E3 at the same price OP1 and quantity OQ3. Thus joining E1 and
E3 we get the supply curve of the Constant cost industry in the long run. It is given by ScSc which is the long run
supply curve of the Constant Cost Industry.
“Supply curve of the constant cost industry in the Long run is horizontal straight line parallel to X axis
showing that increased output comes at the same cost and hence at the same price.”
DECREASING COST INDUSTRY
A Decreasing cost industry is one where Law of Increasing returns to scale are applicable that is economies of
scale are greater than the diseconomies of scale and hence when the firms increase their production the price
reduces as increased output comes at the reduced cost. This can be explained with the help of figure 3:
In the figure, initially the industry is at long run equilibrium at E1 where demand curve D1D1 and Supply curve
S1S1 intersect, the equilibrium price is OP1 and equilibrium quantity of the industry is OQ1. It is long run
2) LMC curve must cut MR curve from below

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Because of both the factors supply of the industry would increase but this being a decreasing cost industry
the increased output or production comes at the reduced cost and hence cost curves shift down. Because of
increase in production the supply curve shifts to right and supply would keep on increasing till all the firms
are just earning normal profits and there is no more incentive for the firms to enter the industry. It happens
when supply curve is S2S2 and long run new equilibrium is E3 at the reduced price OP3 and quantity OQ3.
Thus joining E1 and E3 we get the supply curve of the Decreasing cost industry in the long run. It is given by
SdSd which is the long run supply curve of the Decreasing Cost Industry.
Figure 3: Long Run Supply curve of Decreasing cost Industry
“Supply curve of the decreasing cost industry in the Long run is downward sloping showing that increased
output comes at the reduced cost and hence at the reduced price.”
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The above can be presented in the form of the following summarized table:
Increasing Cost Diminishing Economies of Cost curves shift Increased output

Industry returns to scale is scale is less than upwards in the comes at
applicable Diseconomies of long run increased price
scale
Constant Cost Constant Returns Economies of Cost curves Increased output
Industry to scale is scale is equal to remain same in comes at same
applicable Diseconomies of the long run price
scale
Decreasing Cost Increasing Economies of Cost curves Increased output
Industry Returns to scale scale is more remain shift comes at reduced
is applicable than downwards in price
Diseconomies of the long run
scale
Economies of scale and Diseconomies of scale: Above it has been mentioned that cost curves shift up or down
because of economies and diseconomies of scale. As a firm expands its production by shifting from one plant to
another in the long run then there are certain positive impacts and certain negative impacts. These positive
benefits that reduce the cost per unit of production are the economies. It can be the reduction in cost of
acquiring raw material, reduction in cost of getting financial support etc whereas the negative impacts that raise
the cost per unit of production are called diseconomies like increased wear and tear, increased conflicts amongst
staff members, increased pollution etc. These both arise as production expands but whether cost would
ultimately increase or decrease depends on the relative strength of these two factors.
1.4 STABILITY ANALYSIS
Equilibrium is said to be stable if because of fluctuation in the price or quantity, equilibrating forces bring it
back to the equilibrium. Walras explained the concept of stable and unstable equilibrium with changes in the
price while Marshall explained it with changes in Quantity.
Let us first explain the concept of Stable equilibrium using Walras and Marshall Analysis. It is explained as
follows:
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Figure 4: Walrasian Stable Equilibrium Figure 5: Marshallian Stable Equilibrium
As can be seen from the figure equilibrium price is OP* at which demand and supply are equal, now if price
increases to OP1 then demand is less than the supply hence supply being greater demand would force the prices
down to the equilibrium again. On the other hand if prices fall to OP2 then demand is more than the supply and
supply being less than the demand increases the price back to the equilibrium. Thus the above case shows that it
is Walrasian stable Equilibrium as demand and supply forces restore the original equilibrium.
From figure 5 we see how Marshallian stable equilibrium is achieved. Initial equilibrium is at E where
equilibrium quantity is OQ*, now if quantity reduces to OQ1 then consumers are willing to pay AQ1 and
producers are willing to supply at FQ1. As consumers are willing to pay more than what producers expect so
more trade would take place and quantity demanded and supplied would increase to OQ*. Similarly if Quantity
increases to OQ2 then consumers are willing to pay GQ2 but producers are willing to supply at BQ2 and as
consumers are ready to pay less than what producers want so less trade would take place and quantity would
reduce to OQ*. Thus above is the case of stable Walrasian and Marshallian equilibrium. Now let us move to
certain cases where there is Unstable Equilibrium. An important point to note here is that if demand and supply
curves are of their normal shape that is demand curve is downward sloping and supply curve is upward sloping
then there would be stable equilibrium both with reference to Walras as well as Marshall. The concept of
unstable equilibrium arises if either of the demand or supply curve is not normal or both are of the opposite
slopes. Few of the cases are given below:
Case 1: When Demand curve is upward sloping and Supply curve is downward sloping
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Figure 6: Walrasian Unstable Equilibrium Figure 7: Marshallian Unstable Equilibrium
In the figure 6 above we see that demand curve is upward sloping and supply curve is downward sloping. Here
equilibrium price is OP* where demand and supply are equal and market is cleared. Now if price increases to
OP1 then demand becomes greater than the supply and hence there is deficit in supply which increases the price
further away from the equilibrium price. Similarly if price reduces to OP 2 then demand is less than the supply
and there is surplus which reduces the price further and price moves away from the equilibrium. Hence here we
can see that the equilibrium is not restored and is the case of Walrasian instability.
Let us examine Marshallian Stability from Figure 7. Initial equilibrium is at E where demand and supply are
equal and equilibrium quantity is OQ*. Now if quantity reduces to OQ1 then producers want more price then
what the consumers are willing to pay thus there is less trade. Similarly if quantity increases to OQ 2 then
consumers are willing to pay more then what the producers expect thus there is more trade. So it shows that
there is movement farther away from the equilibrium showing that it is Marshallian Unstable Equilibrium.
Case 2: When Demand curve is downward sloping and Supply curve is also downward sloping
Here we can have two cases for downward sloping supply curve one when supply curve cuts demand curve
from above and other when supply curve cuts demand curve from below. Both these cases have been explained
using Figure 8 and 9:
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Figure 8: Walrasian Equilibrium Figure 9: Marshallian Equilibrium
Panel A and B show that supply curve is also downward sloping and it cuts demand curve below while in panel
C and D supply curve cuts the demand curve from above.
In panel A there is Walrasian equilibrium condition which shows that E is the initial equilibrium with demand
being equal to supply. Now if price increases to OP1 then demand being greater than supply prices increase
further and move away from the equilibrium. Similarly if price reduces to OP2 then demand is less than the
supply and prices reduce further and move away from the equilibrium showing Walrasian instability. In panel
B equilibrium is at E where equilibrium output is OQ*. Now if quantity reduces to OQ1 consumers are willing
to pay more then what producers want thus there is more trade. If quantity increases to OQ2 then producers want
more then what consumers are willing to pay so there would be less trade and there is movement towards the
equilibrium. Hence it is Marshallian Stability.
In Panel C equilibrium price is OP1, if price increases to OP1 then supply is more than the demand and prices
reduce and come back to the equilibrium. If price reduces to OP2 then demand being more than the supply
prices increase further and moves back to the equilibrium. Thus there is Walrasian stable Equilibrium. In panel
D equilibrium quantity is at OQ*. If quantity reduces to OQ1 then producers want more price than what the
consumers are willing to pay thus there would be less trade and movement away from the equilibrium quantity.
114
Similarly if quantity increases to OQ2 then consumers are willing to pay more than what producers want so
there would be more trade. Hence there is Marshallian Unsatble Equilibrium.
Case 3: When Supply curve is upward sloping and Demand curve is also upward sloping
Here we can have two cases for upward sloping Demand curve one when demand curve cuts supply curve from
above and other when demand curve cuts supply curve from below. Both these cases have been explained :
Figure 10: Walrasian Equilibrium Figure 11: Marshallian Equilibrium
In panel F, OP* is the equilibrium price where demand and supply intersect. Now if price increases to OP1 then
supply is more than the demand and hence price comes back to OP*. Similarly on reduction of price to OP 2
supply is less than the demand and hence price increases to OP*. Thus it shows Walrasian stable equilibrium.
Moving to Marshall Analysis in Panel G, initial equilibrium quantity is OQ*. If quantity reduces to OQ1 then
produces want more than what consumers are willing to pay thus there would be less trade and quantity would
move further away from the equilibrium. Similarly if quantity increases to OQ2 then consumers are willing to
pay more than what producers expect therefore there would be more trade and quantity goes far off from the
equilibrium quantity. Thus panel G is a case of Marshallian Unstable equilibrium.
In Panel H demand curve cuts supply curve from above. Initial equilibrium price is OP*. If price increases to
OP1 then demand becomes more than supply and prices increase further. If price reduces to OP 2 then supply
becomes more than demand and prices reduce further moving away from the equilibrium showing that Walras
is Unstable here. In Panel I initial equilibrium is at OQ* where upward sloping demand curve and supply curve
115
intersects. If quantity reduces to OQ1 then consumers are willing to pay more than what producers expects so
there would be more trade and equilibrium would be restored. On the other side if quantity increases to OQ 2
then producers want more than what the consumers are willing to pay so there would be less trade that makes
the movement back to the equilibrium. Thus this is the case of stable Marshallian equilibrium.
Thus all the above cases reveal that there are various cases where Walras and Marshall are not stable
equilibrium. It usually happens in case when there are exceptions to the normal shape of the demand curve or
the supply curve or both. The study is important as it helps in determining whether the equilibrium is stable and
temporary fluctuations would restore back the equilibrium or not.
_____________________________________________________________________________
7.5 SUMMARY
______________________________________________________________________________
The chapter talked about various types of industries that exist in the long run under perfect competition namely
Increasing cost industry, constant cost industry and Decreasing cost industry. The supply curves here depend on
how the cost changes in response to increase in the production. Thus where in increasing cost industry cost
increases with the increased production, in constant cost industry though there is increase in production but
there is no change in the cost and hence price. In decreasing cost industry the cost reduces when the production
is increased and hence the output increases and cost decreases. This change in the cost curves is result of the
Law of Returns to Scale that operates only in the long run and is dependent on how Economies and
Diseconomies take place. Thus these changes help in achieving a stable equilibrium in the long run when the
whole market is cleared that is demand and supply are exactly equal thereby having no incentive for the new
firm to enter or existing firms to exit. Talking about stable equilibrium the chapter also discussed about
Walrasian and Marshallian equilibrium analysis where Walras made use of the prices and Marshall made use of
the quantity to see whether the equilibrium that we have is stable or unstable. A stable equilibrium is one where
if it is disturbed that is we move away from it then the counter forces come into action and the original
equilibrium is restored. An unstable equilibrium however would be present when the counter forces in fact takes
the variables away from the initial equilibrium thus initial stable equilibrium is not restored without any
intervention by the government or any outside forces. Equilibrium is unstable when either or both of the
demand and supply curves are not of the normal slope. Various cases have been shown in the chapter.
________________________________________________________________________

______________________________________________________________________________
Check your progress

(a) Long run supply curve of an increasing cost industry is upward sloping
(b) Walras studies the concept of stable and unstable equilibrium on the basis of quantity.
116
(c) Entry of new firms take place when the existing firms are having super normal profits in the short run
and this entry take place in the short run itself.
(d) Long run supply curve of the industry is the horizontal summation of marginal cost curves of all the
firms
(e) Marshall made use of the Quantity to study the concept of stable and unstable equilibrium.
Ans: 1. (T), 2. (F), 3. (F), 4. (F), 5. (T)

a) Long run supply curve of constant cost industry is _ _ _ _ _ _ _ _.
b) Entry of new firms and exit of existing firms is possible in the _ _ _ _ _ _ _ .
c) If both demand curve and supply curve are normally sloped that is demand curve is downward sloping
and supply curve is upward sloping then Walras is _ _ _ _ _ _ and Marshall is _ _ _ _ _ _ _ _.
d) If both demand curve and supply curve are opposite that is demand curve is upward sloping and supply
curve is downward sloping then both Wlaras and Marshall are _ _ _ _ _ _ _ _ _ .
Ans: 1) Horizontal straight line parallel to X axis 2) Short Run 3) Stable, Stable 4) Unstable
1) Explain the concept of Stable Equilibrium using the concept of Walras and Marshall
________________________________________________
________________________________________________
2) Derive Long run supply curve of Increasing and Decreasing cost industry.
________________________________________________
________________________________________________
3) Under which scenario there would be Walras unstable and Marshallian stable equilibrium.
________________________________________________
________________________________________________
4) What would happen if the firms are earning supernormal profits in the short run.
________________________________________________
________________________________________________
5) How is Long run supply curve of the Industry different from that of the firm?
________________________________________________
________________________________________________
____________________________________________________________________________

______________________________________________________________________________
117
Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House.
LESSON: 2
Application based on Perfect Competition

______________________________________________________________________________
7 STRUCTURE
____________________________________________________________________________
8.1 Objective
8.2 Introduction
8.3 Impact of Tax and Subsidy on the welfare of the Society
8.4 Impact of Government Price Ceiling on the welfare of the society
8.5 Summary
______________________________________________________________________________
8.1 OBJECTIVE
______________________________________________________________________________
118
a) Understand the concept of Dead weight loss because of Government Intervention.
b) Analyze the impact of Excise Tax on consumers and producers.
c) Understand the impact of subsidy on consumers and producers
1.2 INTRODUCTION
In the previous chapter we talked about how to get long run supply curve of the industry in perfect competition
under different situations of increasing, constant and decreasing cost indutry. We also talked about stable and
unstable equilibrium. The chapter followed the concept of no government or any external intervention, this
chapter however would explain various cases where government comes into picture for the benefit of the
consumers and/or producers. Thus we would find out what is the impact of government policies on the society
and how it changes because of different elasticities of demand and supply curves. This is because if there is
inelastic demand then imposition of tax would have greater impact on the consumer because when tax is
imposed cost for the producer increases and demand being inelastic may be because the good is a necessity or a
habit forming commodity because of which consumer cannot do without it irrespective of the price increase.
Thus producers can easily pass of the tax burden on the consumers. Such type of applications based on the
concept of perfect competition would be taken up in this chapter.
1.3 IMPACT OF TAX AND SUBSIDY ON THE SOCIETY
Economies can be of two types- one where government does not intervene at all and let the market forces
determine its own direction. This is however rare to find as economy can deviate from its stable equilibrium and
bring problems for the society. The other is where there is government that intervenes to stabilize the economy
so that there is not much deviation from the welfare of the consumers and producers. Government can intervene
by either imposing tax or providing subsidy. Tax tends to decrease the purchasing power whereas subsidy
increases the purchasing power of the consumers. So both these concepts would be taken up next:
Case 1: Impact of Excise Tax on the welfare of the Society

Taxes can be of two types: Fixed tax or per unit tax. Fixed tax is irrespective of the number of units bought and
sold in the economy whereas excise tax which is a per unit tax is imposed on every unit that is bought and sold.
It not only impacts the consumers by increasing the cost of the product but also impacts the producers which
can be explained using the diagram below.
In figure 1 initial demand curve is DD and supply curve is SS without any government intervention and
equilibrium is at point E where equilibrium price is OP* and equilibrium quantity is OQ*. Now if government
imposes excise tax on this commodity then the price of the commodity increases and quantity demanded
becomes less as price and quantity are inversely related so consumer would demand less at the increased price.
It is shown by point A where the price that the consumer has to pay is Pb and he demands a quantity of OQ1.
The price that consumer pays to the producer is OPb but producer would retain only OPs out of it as the
remaining that is Pb - Ps is the Excise tax that the producer would get from the consumer but hand it over to the
government. Hence producer would get only OPs which is a price less than the original equilibrium OP*, as
price reduces and there being a direct relation between price and quantity supplied by the producer because of
operation of Law of supply, quantity supplied would also reduce to OQ1. So once again the market is cleared as
119
quantity demanded is equal to the quantity supplied. To get the new equilibrium where quantity demanded is
equal to quantity supplied following four conditions should be satisfied:
1) The quantity demanded and the buyer’s price Pb must lie on the demand curve.
2) The quantity sold and the seller’s price Ps must lie on the supply curve.
3) The quantity demanded must be equal to the quantity supplied.
4) The difference between the price that the buyer pays and what seller receives is the tax. Here it is Pb -
Ps.
To find out who bears the burden of the tax we would find out the changes in the consumer surplus and
producer surplus and net gain or loss or the welfare of the society.
Consumer Surplus: It is the difference between the price that the consumer is willing to pay and what he is
actually paying. Graphically it is the area between the demand curve and the equilibrium price. Here we would
see how imposition of tax impacts the consumer surplus by comparing consumer surplus before imposition of
tax and after it. If consumer surplus increases it shows that tax imposition has been beneficial for the consumers
who are demanding the commodity and vice versa.
Producer Surplus: It is the difference between the price that the producer gets and the price at which the
producer is willing to sell the commodity. Graphically it is the area between the equilibrium price and the
supply curve. Here also we would compare the producer surplus before and after imposition of tax to see how
the tax has impacted the producers. Increase in producer surplus would show that tax is benefitting the
producers and vice versa.
The above comparison would also give an idea as to who is better off and who is worse off after the tax
imposition thereby showing the net impact to the society.
To see the impact of excise tax on consumer and producer surplus and the ultimate impact on the society we can
compare the following table:
Consumer Surplus Producer Surplus

Before Tax H+I+L J+M+K
After Tax H K
Change (After - Before) -I-L -J-M
120
Figure 1: Impact of Excise Tax
From the above table it can be seen that both the producers and consumers have suffered a loss because of
imposition of tax this is because of the fact that consumers had to pay more and producers have got less because
of the imposition of tax. Also the quantity being demanded and supplied too has fallen to OQ1 from OQ*. Thus
loss in consumer surplus to the extent of area I is because of increase in price and loss of area L is because of
reduction in quantity. Similarly in producer surplus loss of area J is because of reduced price that producer is
getting and loss of area M is because of lesser quantity that producer is able to sell after tax imposition. If we
include third party that is government also in the analysis as it is the government that is the beneficiary as it gets
the tax amount, we can find out the net impact on the society as:
Net Welfare to the society = Impact on consumers + Impact on Producers + Impact on Government
=-I–L–J-M+I+J
= - L – M = Dead Weight Loss
It is shown by the shaded portion in figure 1 above shown by the triangle ABE. Thus it shows that the society is
ultimately at a loss as measured by the Dead weight loss which is defined as the net loss to the society. In this
case the burden is being equally shared by the consumers and the producers as the reduction in consumer
surplus and producer surplus is same, but there would not be always the same case. The sharing of burden
depends upon the elasticity of demand and supply curve.
121
Case A:
Demand curve is inelastic as compared to supply curve: Burden falls mainly on the consumers.
As demand is relatively inelastic as compared to the supply curve so consumers are not able to reduce the
consumption of this commodity it being inelastic may be because it is a necessity or habit forming commodity.
Supply on the other side is relatively elastic that is its quantity supplied can be easily changed by the producers.
Thus here producers would be able to pass on most of the burden to the consumers though not the entire
because the demand is not perfectly inelastic. The diagram below shows how the imposition of excise tax leads
to increase in price for the consumers and reduction in revenue for the producers and the net dead weight loss to
the society.
Figure 2: Impact of Excise tax on relatively inelastic demand
Here it can be seen that initial equilibrium is at E and price is OP* where market demand and supply is equal at
OQ*. Now with imposition of excise tax quantity demanded reduces at increased price that consumers have to
pay at OPb, out of this suppliers would get OPs and remaining that is Pb - Ps would go to the government as
excise tax revenue. Here it can be seen that out of the total burden of tax consumers are facing more burden as
their price increased from OP* to OPb which is quite high while for producers the impact is only to the extent of
P*Ps. Dead weight loss here is also the same shown by the shaded portion that is the triangle.
Case B:
Demand curve is elastic as compared to supply curve - Burden falls mainly on the suppliers.
122
As demand is relatively elastic as compared to the supply curve so consumers are able to reduce the
consumption of this commodity it being elastic may be because it has close substitutes available or it is not that
important for consumption. Supply on the other side is relatively inelastic that is its quantity supplied cannot be
easily changed by the producers. Thus here producers would not be able to pass on most of the burden to the
consumers though not the entire burden has to be borne by the producers because the supply is not perfectly
inelastic. The diagram below shows how the imposition of excise tax leads to increase in price for the
consumers and reduction in revenue for the producers and the net dead weight loss to the society.
Figure 3: Impact of Excise tax on relatively elastic demand
Here it can be seen that initial equilibrium is at E and price is OP* where market demand and supply is equal at
OQ*. Now with imposition of excise tax quantity demanded reduces at increased price that consumers have to
pay at OPb, out of which suppliers would get OPs and remaining that is Pb - Ps would go to the government as
excise tax revenue. Here it can be seen that out of the total burden of tax consumers are facing less burden as
their price increased from OP* to OPb which is less while for producers the impact is quite high to the extent of
P*Ps. Thus for them price has reduced to a greater extent. Dead weight loss here is also the same shown by the
shaded portion of the triangle.
There is a formula that provides the extent of burden borne by the buyers in the form of increased prices:
Pass through fraction = Es / Es - Ed
Different cases can be:
123
1) Demand Inelastic, Ed = 0
Pass through fraction = 1 so all tax is borne by the buyers
2) Demand elastic, Ed = ∞
Pass through fraction = 0 so all tax is borne by the suppliers
Case 2: Impact of Subsidy on the welfare of the Society

When government imposes tax the quantity consumed and supplied reduces as it makes the consumption of
goods expensive for the consumer and for the producers the price that they get also reduces thereby making it
less profitable to supply more. Hence imposition of tax is to curtail (reduce) the consumption of any
commodity. On the other side there is a concept of subsidy that makes the commodity cheaper for the consumer
and producers get higher price as the difference between what the consumers pay and what the producers get is
borne by the government. Thus Subsidy can be seen as the negative tax. Here also the following four conditions
needs to be satisfied to reach the equilibrium
1) The quantity demanded and the buyer’s price Pb must lie on the demand curve.
2) The quantity sold and the seller’s price Ps must lie on the supply curve.
3) The quantity demanded must equal the quantity supplied.
4) The difference between the price that the seller receives and what the buyer pays is the subsidy.
The impact of subsidy (per unit) on the consumers, producers and the whole society and how it is shared
between the consumers and producers is shown in the figure 4:
124
Figure 4: Impact of Subsidy on the society
The figure here shows that initially equilibrium is at OP* and OQ* where there is no intervention by the
government and quantity demanded is equal to quantity supplied. Now if government provides subsidy on the
consumption of this commodity then price that the consumers have to pay reduces from OP* to OP b and price
that the producers get increases from OP* to OPs. Thus according to law of demand consumers would demand
more at the reduced price which is OQ1 shown by the intersection of Pb and the demand curve. Similarly as
price for the producers increases so according to Law of Supply producers would supply more which is again
OQ1 that we got by the intersection of OPs and the supply curve. So again the quantity demanded and quantity
supplied is equal and the market is cleared showing that this is the new equilibrium. However now the price that
consumers pay and the price that producers get is different because of the fact that government bears the burden
of per unit price of the commodity which in above case is equal to the difference between P s - Pb. Here we can
see that Ps > Pb and also the benefit of subsidy is being equally shared by both the consumers and producers.
Subsidy as can be seen from the figure above increases the consumption and production of quantity so it is
imposed where government wants to increase the welfare of the society by increasing the consumption of a
commodity. Here also we can have different cases depending upon the elasticities of demand and supply curves
where the benefit of subsidy is not equal for the producers and consumers. These cases are shown below:
125
Case 1:
Demand curve is inelastic as compared to supply curve - Benefit accrues mainly to the consumers.
Figure 5: Impact of Subsidy on the society in case of relatively Inelastic Demand Curve
As can be seen from the figure above that initially the equilibrium was at E where consumer was consuming
OQ* and producers supplying the same at price OP*. Here demand is relatively inelastic as compared to the
supply curve showing that consumers are not that sensitive to the price and its quantity demanded would not
change much because of the change in price. Supply curve however being relatively elastic is more sensitive to
changes in price wherein producers would change the supply by a greater magnitude because of the change in
the price. Now if government provides subsidy then price that consumers pay have to be reduced by a greater
extent to persuade them to consume more whereas suppliers would supply more even at small change in the
price. Thus more benefit of subsidy here is given to the consumers as compared to the producers which is also
seen above as price for consumers have reduced by a greater extent from OP* to OPb whereas for suppliers have
little benefit of subsidy as there price increased by a significantly smaller amount shown by OP* to OPs.
Case 2: Demand curve is elastic as compared to supply curve – Benefit accrues mainly to the suppliers
Figure 6: Impact of Subsidy on the society in case of relatively Elastic Demand Curve
126
Here benefit of subsidy that accrues to the producers is more as compared to the benefit that consumers have.
This is because here demand is relatively elastic as compared to the supply curve. So consumers would buy
more with even a slight decrease in price whereas to motivate producers to sell more they have to be given a
significantly higher price as supply is relatively inelastic. Thus in this case the major benefit of subsidy is to the
producers then the consumers.
All these above facts should be taken care of by the government to decide where to impose tax and where to
provide subsidy so that its objective can be fulfilled. Where government thinks that it wants to reduce the
consumption of a particular commodity there tax can be imposed and where a commodity is such that its
consumption would increase the welfare of the society there subsidy can be provided.
1.4 IMPACT OF GOVERNMENT PRICE CEILING ON THE SOCIETY
Earlier chapter showed how the market behaves without any intervention by the government. However there is
no such economy which is fully left to the market forces. Government intervenes in various ways one of them
we have studied in the previous topic whereby government imposed per unit tax or provided per unit subsidy.
The objectives though in both the cases have been different. While by imposing tax government wants to reduce
the consumption of the commodity on which tax is imposed and by providing subsidy it wants to increase the
consumption of the particular commodity. There is another way in which government can regulate the market
and that is by imposing ceiling on the price. Price ceiling is where government fixes the maximum price that a
producer can charge and it would be effective only if it is kept below the equilibrium price as if the maximum
price is above the equilibrium then it would defeat the basic purpose behind price regulation. Reduced price
would have an impact on the producers as well as consumers but how differently they would be impacted that is
who would gain and who would suffer can be seen by comparing the consumer surplus and producer surplus
before and after the imposition of ceiling. Also the net impact on the society can be calculated by measuring the
Dead weight loss. It has been explained in the figure 7:
Figure 7: Impact of Price Ceiling
127
In the figure above initially the equilibrium is at E where demand and supply curve intersect and there is no
government intervention. Price is OP* at which quantity demanded and supplied is OQ*. Now if government
imposes a price ceiling that is the maximum price that can be charged at Pc then at reduced price because of
Law of Demand quantity demanded increases to OQd but at reduced price because of Law of Supply quantity
supplied reduces to OQs and hence there comes a shortage shown by the gap between quantity demanded and
quantity supplied. To see the impact of intervention we would compare the consumer and producer surplus
before and after which is shown in the table below. Consumer surplus is the difference between the price that
the consumer is willing to pay and the price that he actually pays whereas producer surplus is the difference
between the price that the producer gets and what he is willing to sell at.
Before Intervention After Intervention

Consumer Surplus A+B+C A+B+D
Producer Surplus D+F+G G
Thus it can be seen that consumer’s gain D and lose C it is because the consumers who get the commodity they
get it at reduced price so they are benefitted but the consumers who are rationed out because of shortage they
lose to the extent of C. But the area of D is more than the area of C hence consumers are net benefitted.
Producers on the other hand loose to the extent of D and F. D is lost because of reduction in price and F because
of reduced quantity that they are selling now. So the net loss to the society or the Dead weight loss is calculated
as:
Net loss to the society = change in Consumer surplus + change in producer surplus
= D – C + (- D – F)
= - C – F = Dead weight loss due to government intervention.
One important thing to be noted here is that government should not impose price ceiling on a commodity that is
absolutely essential as the consumers that do not get the commodity because of it being in shortage after price
reduction cannot do without it and it would lead to problems like Black Marketing and Hoarding.
There is another case where consumers also lose which is in case of inelastic demand curve when the following
situation would arise:
128
Figure 8: Price ceiling: impact on consumer and producer surplus when demand is inelastic
In the figure above demand curve is relatively inelastic (demand not much price sensitive) and supply curve is
elastic (highly price sensitive supply) where initial equilibrium is at E and equilibrium price is OP* and quantity
is OQ*. Now if government reduces the price and fixes it at OPc then there would be shortage as at reduced
price quantity demanded increases but quantity supplied falls, leading to deficit. Here on comparing the
consumer and producer surplus before and after the intervention of the government we can see that following
changes take place:
Before Intervention After Intervention

Consumer Surplus A+B+C A+B+D
Producer Surplus D+F+G G
Dead weight loss is = - C – F
Here net loss to the consumers is D – C that is they gain D and lose C and area of C is more than D showing
that consumers are ultimately at a loss. This situation is contrary to the above where consumers were at a gain
as area of C was smaller than that of D.
Producers are always at a loss because of regulated price here the loss is same as it was earlier that is – D – F.
Thus whether consumers gain or lose depends on the elasticity of demand and supply curves.
129
1.5 SUMMARY
This chapter talked about various types of intervention that government makes. Three cases have been
undertaken: imposition of Excise tax, granting of subsidy and imposition of Price Ceiling. Here the impact of all
these three on the society that is consumers, producers and government is seen where it shows that society faces
a dead weight loss that is net loss to the society because of imposition of tax or price ceiling. However in case
of subsidy society gains at the cost of the government. Now how much would be the impact of these
interventions on the consumers and producers depend on the elasticity of demand and supply. It is necessary for
the government to be aware about these before imposition of tax, price ceiling or granting subsidy as the impact
would be different depending upon the responsiveness of quantity demanded and supplied to changes in price
when tax is imposed or prices are fixed or subsidy is provided. If government wants to restrict the consumption
of a commodity then excise tax should be applied whereas if consumption has to be increased of a particular
commodity then subsidy can be provided on the same.
Check your progress

(a) In case of inelastic demand curve the burden of excise tax is more on consumers.
(b) Price ceiling is beneficial for the producers as it increases the producer surplus.
(c) Subsidy is a negative tax as it brings benefit to the consumers.
(d) In case of elastic demand curve burden of excise tax is more on consumers.
(e) Price ceiling means fixation of price which is usually above the equilibrium price.
Ans. 1(T), 2(F), 3(T), 4(F), 5(F)

(a) The burden of excise tax that can be passed on to the consumers is given by a function called_ _ _ _ _ _
_.
(b) Price ceiling is effective only if government fixes the price _ _ _ _ _ _ _ _ the equilibrium price.
(c) In case of inelastic demand the burden of excise tax is _ _ _ _ _ _ _ _ on consumers.
(d) Price ceiling _ _ _ _ _ _ _ _ the producers surplus.
Ans (a) Pass though Fraction , (b) below, (c) More, (d) reduces
1) How is the equilibrium obtained in case of long run under conditions of Perfect Competition?
________________________________________________
________________________________________________
2) What is Price Ceiling? How does it impact the Society?

________________________________________________
________________________________________________
130
3) Are subsidies actually beneficial for the consumers? Show using the concept of consumer and producer
surplus.
________________________________________________
________________________________________________
4) How do we measure Dead weight loss to the society in case of imposition of excise tax by the
government?
________________________________________________
________________________________________________
5) Explain the impact of Tax on the consumers and producers in case the demand is relatively inelastic
________________________________________________
________________________________________________
6) What be the impact on the society of Price ceiling if the price that government fixes is set above the
equilibrium price
________________________________________________
________________________________________________
7) What is Consumer surplus and Producer surplus. Explain using the concept given by Marshall.
________________________________________________
________________________________________________
131

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Unit – 1

DEMAND AND SUPPLY ANALYSIS

ELASTICITY OF DEMAND AND APPLICATIONS

After reading this lesson, you should be able to

Therefore we have three kinds of elasticity of demand

It is simply calculated as:

1.4 TYPES OF ELASTICITY OF DEMAND

1.4.1 Price Elasticity of Demand

1.4.2 Income Elasticity of Demand

Different values of income elasticity of Types of goods

Different Values of Cross Price Elasticity Type of Good

Here cross price elasticity comes out to be

Ey = = = -0.125 (Goods are Complementary as there is inverse relation between price of

Here cross price elasticity comes out to be

Ey = = = -0.125 (Goods are Complementary as there is inverse relation between price of

1.5 METHODS OF CALCULATING PRICE ELASTICITY OF DEMAND

1.5.1 Percentage Method

Where = Change in quantity demanded, final quantity-initial quantity, Q2 – Q1

Using Percentage method following five types of elasticity can be identified:

1.5.2 Arc Method

Point elasticity vs. arc elasticity

Point elasticity of demand Arc elasticity of demand

Price(Rs) Quantity (Units) Total expenditure

Price(Rs) Quantity (Units) Total expenditure

Price(Rs) Quantity (Units) Total expenditure

Price Quantity of Commodity X Quantity of Commodity Y

1.5.4 Geometric Method

Now ∆PQM and ∆PBS are similar triangles

Relation between Average Revenue, Marginal Revenue and Elasticity of Demand

Total Revenue, TR = Price *Quantity = P*Q

Average Revenue, AR = TR/Q = P*Q)/Q = P

Substituting the value of Ed in equation (1) we get

a) If demand curve has unit elasticity i.e. Ed = 1, MR = 0

It can be presented diagrammatically as follows:

As can be seen from figure 6, Q1 < Q2 or

Hence proved that Ed of demand curve D1 > Ed of demand curve D2

As can be seen from figure 7, P1 < P2

Hence proved that Ed of demand curve D1 < Ed of demand curve D2

Elasticity of the two demand curves using percentage method:

So in the above two equations we are left with the following

Now ΔOAB ~ ΔODC

So, AB/OA = DC/OD

Using percentage method we calculate elasticity using following formula:

Ed of demand curve D1 is: . . . . . . . . . . . . . . . . . . . . . .(1)

Ed of demand curve D1 is: . . . . . . . . . . . . . . . . . . . . . . (2)

Now in case of demand curve D1, change in quantity is Q1 to Q’ or AC

Change in quantity in case of demand curve D2 is Q1 to Q2 or AB

Change in price is same in both the demand curves i.e. P1 to P2.

Relationship between Average Revenue and Marginal Revenue

Let Demand function is given by the following equation:

Where P = Price, Q = Quantity, a = Intercept and b = Slope

Total Revenue, TR = P*Q = (a-bQ)*Q = aQ-bQ2

Average Revenue = TR/Q = (aQ-bQ2)/Q = a – bQ = Price . . . . . . . . . . .. . . . . . . . (1)

Marginal Revenue = ΔTR/ΔQ = Δ(aQ-bQ2)/ ΔQ = a – 2bQ . . . . . . . . . . .. . . . . . . . (2)

1.8 SELF ASSESSMENT QUESTIONS

Exercise 2: Fill in the Blanks

1.9 SUGGESTED READINGS

Pindyk Robert, Microeconomics, Prentice Hall

ELASTICITY OF SUPPLY AND APPLICATIONS

a) Explain the concept of Elasticity of Supply

1.3 LAW OF SUPPLY

QSx = F (Px, Pr, T, Pf, O)

Where QSx is the quantity being supplied of a commodity

Px is the price of the commodity itself

Total Revenue, TR = Price Quantity = PQ

Total Revenue, TR = PQ = (a-bQ)Q = aQ-bQ2