Spell Classes (Get the spell of success.

) ® 1

CHAPTER – 1
ECONOMICS, ECONOMY AND CENTRAL PROBLEMS OF AN ECONOMY

ECONOMY: Economics is a subject matter that studies different economic activity as directed
towards the maximization of satisfaction or maximization of profit at the level of an individual, and
maximization of social welfare at the level of the country as a whole.

ECONOMIC ACTIVITY: By an economic activity we mean that activity which is based on or is

related to the use of scarce resources for the satisfaction of human wants. Example - consumption,
investment.

SCARCITY OF RESOURCES AND THE PROBLEM OF CHOICE:

SCARCITY: It is a situation when demand for a good exceeds its supply even at a zero price.
Example- in a government hospital, medicines may be given to the patients free of charge. Still,
demand for medicines may be exceed their supply. It is a situation of scarcity.

ECONOMIC PROBLEM:
It is the problem of choice arising out of the fact that:
 Scarcity: Resources are scarce in relation to their wants.
 Alternative users: Resources have alternative users.
Like, for example, land may be used to grow wheat or rice or may be used for the construction of
building.

SCARCITY AND CHOICE ARE INSEPARABLE:

Scarcity and choice are inseparable at all levels of decision- making:
 At the consumer’s level: Scarcity means limited income, and ‘choice’ means allocation of
income to the purchase of different goods and services in a manner such that he maximizes his
satisfaction.
 At the producer’s level: Scarcity means limited resources and ‘choice’ means limited
resources and ‘choice’ means allocation of resources to the production of different goods and
services in a manner such that social welfare is maximized.
 At the national level: Scarcity means limited national resources and ‘choice’ means usage of
resources in a manner such that social welfare is maximized.

MICROECONOMICS AND MACROECONOMICS:

Microeconomics: When economic problem or economic issues are studied considering small
economics units like an individual consumer, or an individual producer, we are referring to
microeconomics.
 Microeconomics also studies how scarce resources are allocated amongst competing objectives
using Price Theory. Its central concepts are:
 Demand: how do individuals form their demand for goods and services
 Supply: how do firms decide what and how much to supply
 Market: interaction between demand and supply to determine the price and quantity of goods
and services.
 It studies how prices of goods and services are determined in commodity market (product
pricing) and how prices of factors of production are determined in factor market (factor
pricing).
 Central problem of allocation of resources is dealt by micro economics.
 Micro economic variables are individual demand, individual supply, market demand and market
supply.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 2

Vital components of Microeconomics:

Theory of consumer behavior: It analysis how a consumer allocates his income to different uses so
that he maximizes his satisfaction.
Theory of producer behavior: It analysis how a producer exercises his choice on the use of different
inputs and how he decides what to produce and how much. The producer focuses on the maximisation
of profits.
Theory of price: It studies how price of goods are determined in the commodity market and how
prices of factors of production are determined in the factor market.

Macroeconomics studies economic activities related to economy as a whole; Such as national income,
balance of payments, inflation and unemployment.
 Macro economics deals with issues relating to overall level of output and employment and
issues relating to the overall price level in the economy.
 It studies how the productive capacity of an economy or national income changes overtime and
how stability is achieved and maintained in an economy.
 It deals with the central problem of fuller utilization and growth of resources.
 Macro economic variables are aggregate demand and aggregate supply.
Vital components of Macroeconomics:
Theory related to equilibrium level of output and employment: It studies how equilibrium is struck
when AS=AD.
Theory related to inflationary and deflationary gap in the economy: It studies how departure from
full employment equilibrium output causes inflationary gap or deflationary gap.
Theory of multiplier: It analysis the process of income generation owing to investment expenditure in
the economy.
Fiscal and monetary policies: These relate to budgetary measures and monetary measures,
respectively, to correct the situations of inflationary and deflationary gap.
Money supply and credit creation: It studies the components of money supply and how commercial
banks add to money supply through credit creation.
Government budget: It focuses on the measurements and impact of budgetary deficits in the economy.
Exchange rate and BOP: It analysis how exchange rate is determined in the international money
market and how BOP impacts the level of economic activity in the domestic economy.

DIFFERENCE BETWEEN MICROECONOMICS AND MACROECONOMICS

Basis Micro-economics Macro-economics
Meaning Microeconomics is the study of the Macroeconomics is the study of the
behavior of individual economic units. economy as a whole.
Dealing It deals with the economic activities of a It deals with the aggregate like aggregate
firm or an industry. consumption, aggregate investment,
national income etc.
Theory It is concerned with the theory of It is concerned with the theory of
determination of equilibrium level of determination of equilibrium level of
prices of goods and factors of output, employment and income for the
production. economy.
Tools Demand and supply are the main tools Aggregate demand and aggregate supply
of analysis. are the main tools of analysis.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 3

POSITIVE AND NORMATIVE ECONOMICS:

POSITIVE STATEMENT: The positive statements describe what was, what is and what would be
under the given sets of circumstances all these statement are capable of empirical verification. On the
basis of their empirical verification, we can find out the degree of truth in such statements. These
statements do not pass any value judgment.
Positive analysis makes statements which claim facts about the universe and are concerned with 'what
is, what was or what will be'.
 These statements determine cause and effect relationship and are capable of empirical
verification.
 The objective of positive analysis is the establishment of scientific laws.
 They do not pass any value judgment.
E.g.1. Population of India is increases at the rate of 1.8% per annum.
2. If income of industrial workers increases, their demand for necessities also increases

NORMATIVE STATEMENT: Normative statements describe ‘what ought to be’. Its objective is to
determine the norms or aims. These statements pronounce value judgment. These are opinion relating
to right or wrong of a particular policy matter, and are always a matter of debate.
Normative analysis makes statements which use value judgments to state 'what ought to be'.
 These statements are opinions related to right or wrong of a particular policy.
 The objective of normative analysis is the determination of ideals.
 These are not capable of empirical verification.
E.g.1. Necessary goods should be provided to the poor mass at subsidized rates.
2. Agricultural income tax waiver is desirable policy in the government’s budget.

ECONOMY: Economy is a system spread over a particular area that reveals the nature and level of
economics activities in that area. It shows how people of the concerned area earn their living.

ECONOMY AND ITS TYPES (ON THE BASIS OF NATURE):

Economic activities, economies are classified as:
1. Market economy
2. Centrally planned economy
3. Mixed economy
1. Market economies: Market economies are those economies in which economic activities are
left to the free play of the market forces. Producers are free to produce those goods and services
which are high in demand, so that they are able to maximize their profits. There is no
interference by the government regarding what and how much to produce and what or how
much to consume. Market Economy is the one in which economic activities are left to the free
play of market forces.
 Factors of production are privately owned.
 Economy functions with a motive of earning profits.
 The market forces of demand and supply determine the prices of commodities and factors of
production.
 The government plays a minimal role.
 The central problems of what, how and for whom are left on the market forces

2. Central planned economies: Are those economies in which the course of economic activities is
dictated or decided by some central authority or by the government. A central authority decides
how much of wheat and how much of rice are to be produced. Only a central authority decides

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 4

the overall basket of goods and services that the people can consume. Centrally Planned
Economy is the one in which government plays a major role in economic activities.
 Factors of production are owned by the government.
 Economy functions with a motive of welfare.
 Government decides the price at which goods and services are exchanged.
 The central problems of what, how and for whom to produce are decided by the government.

3. Mixed economy: Exhibits the characteristics of both market economies and centrally planned
economies. In these economies, economic activities are generally left to the free play of the
market forces, but simultaneously the government exercises its control with a view to regulating
the overall course of production, consumption and investment. The government intervenes to
ensure social justice along with a higher level of growth.

CENTRAL PROBLEM OF AN ECONOMY / BASIC ECONOMY PROBLEMS:

 “An economic problem is basically the problem of choice which arises due to scarcity of
resources having alternatives uses”.
 An economic problem is the problem of choice arising out of unlimited wants and limited
resources which can be put to alternate uses.
 Scarcity leads to the problem of choice.
 Economic Problem arises due to:
a. Unlimited human wants (recurring in nature)
b. Limited (scarce) resources
c. Alternative use of resources
 Opportunity cost is defined as the value of the next best alternative that is foregone when a
choice is made.
The basic economic problem gives rise to the central problems of allocation of scarce.
Every economy faces three central problems. These are offshoots of the basic problem of recourses
allocation. These are; 1. What to do produce, 2. How to produce, 3. For whom to produce.
1. What to produce?
It is standard knowledge that resources are scares in relation to human needs. We cannot
produce all goods as much as we wish to produce.
Example: If the choice is to be made between bread and butter, the problem is whether to
produce more of bread or more of butter?
It involves two-fold decisions;
 The economy has to decide what goods and services are too produced. For instance,
which of the consumer goods like sugar, cloth, wheat, ghee, etc. are to produced and
which of the capital goods like machinery, tractors, etc. , are to be produced . Similarly,
choice has also to be made between the production of war time goods like rifles, guns,
tanks and peace time goods like bread or butter.
 When an economy has taken a decision as to what goods or services are to be produced,
then it has to decide about its quantity. How much of consumer goods and how much of
capital goods are to be produced. For instance, if an economy decides to produce more
of cloth and wheat within a given period and with limited means, then it will have to
produce less of machines.

2. How to produce?
This problem is concerned with the choice of technique of production. For example, production
of cloths is possible either by handlooms or by modern machines. This problem is concerned
with the efficient use of resources

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 5

Example: Cloth can be produced using both the techniques i.e. by handlooms and power looms.
Thus which technique should be used to produce cloth?
It implies more production at less cost. Broadly,
There are two techniques of production:
 LABOUR INTENSIVE TECHNIQUE: Under this technique, labor is used more than
capital.
 CAPITAL INTENSIVE TECHNIQUE: Under this technique, capital is used more than
labor. Efficient techniques of production is that which uses the least amount of scares
resources to provide the same amount of output in other words, the production would be
undertaken at minimum cost.

3. For whom to produce?

This is problem of distribution of final goods and services, or briefly the problem of distribution
of production .value of production in an economy is identical with the value of income. Thus
the problem of distribution of production implies the problem of distribution of income.
Example: If a farmer produced 100 quintals of wheat, what amount should he pay to the land
owner as rent, what amount to laborer as wages, what amount to capital owner as interest and
what amount should he retain as profit?
This problem has two aspects:
 The first aspects relates to personal distribution. How should production be distributed
among different individuals and household of the society? It is also concerned with the
problem of inequality in the distribution of income.
 The second relates to functional distribution. How should output be distributed among
different factors of production viz. land, labor, capital and entrepreneur as their reward
for the act of production? It is not related to the problem of inequality.

PRODUCDUCTION POSSIBILITY CURVE (PPC): PPC is a curve showing alternative production

possibilities of goods with the given resources and technique of production. It is also called production
possibility boundary or production possibility frontier.
Economists also call it transformation line or transformation curve.
Production possibility curve shows different combination of two goods which can be produced with the
given resources on the assumptions that 1.Resourses are fully and efficiently utilized and 2. Technique
of production remains constant.

CONCEPT OF PRODUCTION POSSIBILITY CURVE:

 A Production Possibility Frontier gives the various combinations of two goods that can be
produced in an economy by efficiently utilizing the given resources and technology.
 It is based on few assumptions:
i. An economy can produce only two goods.
ii. Technology is given and remains constant.
iii. Resources remain fully and efficiently utilized.
iv. Resources can be removed from production of one commodity and can be used for the
production of another commodity.
v. Resources are not equally efficient in producing different products.
vi. Law of diminishing marginal returns is applicable.
A producer with the given resources (and given technology) may have the choice to produce rice or
wheat. If all the resources are used for the production of wheat alone then 100 lakh tonnes of wheat can
be produced. And, if all the resources are used for the production of rice alone then 40 lakh tones of
rice can be produced. If he decides to produce both wheat and rice, then various combinations of the
two goods can be produced, as shown in table
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 6

Goods Production Possibilities

A B C D E
Wheat(lakh tones) 100 90 70 40 0
Rice (lakh tones) 0 10 20 30 40

10 A B
90 C
80 • Unattainable Point
Wheat 70 D
(lakh tones) 60
50
40
30
20
10
0 E X
10 20 30 40
Rice (lakh tones)

PRODUCTION POSSIBILITY CURVE AND RESOURCE ALLOCATION-

MICROECONOMICS:
If the production of one commodity is increased then production of the other is to be decreased. This is
because resources and technology are constant.
Using the concept of PPC, we can explain the problem of resources allocation. Figure is used to
illustrate our point. The figure shows different combinations of rice and wheat that a farmer can
produce with the given resources (his land) and technology.
If all the resources are used in the production of Rice, the farmer can produce 40 lakh tonnes of Rice
corresponding to point ‘E’ on the other hand, if all the resources are used in the production of Wheat,
he can produce 100 lakh tonnes of Wheat corresponding to point ‘A’ between ‘A’ and ‘E’ one think of
various possible combinations of wheat and rice that can be produced; owing to the limited recourses,
the farmer has to confront with the problem of choice or the problem of allocation of resources to the
production of rice and wheat.
FEATURES OF PRODUCTION POSSIBILITY CURVE:
 A PPC shows different combinations of two goods that can be produced when all resources are
fully and efficiently utilized. (It represents the maximum amount of output that an economy
can produce and the point at which economy is functioning.
 A PPC slopes downward from left to right. It is because to produce more of one good with
given resources less of another good has to be produced.
 A PPC is concave to origin. It is because marginal rate of transformation increases as we move
along a PPC i.e. more units of one commodity is sacrificed to produce an additional unit of
another commodity. (The concave shape of the PPF reflects that the marginal opportunity cost
or marginal rate of transformation increases. MRT increases because factor substitutability
reduces as more resources shift from the production of one good to another.)
 A point inside the PPC curve reflects under-utilization or inefficient utilization of resources.
 An outward shift of the PPC curve reflects growth of resources. Conversely, inward shift of
PPC reflects destruction of resources.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 7

TWO BASIC PROPERTIES OF PPC:

Production possibility curve has two basic properties:
 Production possibility curve slopes downward: Production possibility curve slopes
downward from left to right. It is because in a situation of fuller utilization of the given
resources, production of both the goods cannot be increased. More of good-X can be produced
only with less of good-y.
 Production possibility curve is concave to the point of origin: It is because to produce each
additional unit of good-X, more and more units of goods-Y will have to be sacrificed than
before. Opportunity cost of producing every additional unit of goods-X tends to increase in
terms of the loss of production of good-Y. In other words, production will obey the law of
increasing opportunity costs.

SHIFTING/ ROTATION OF PRODUCTION POSSIBILITY CURVE:

The production possibility curve will shift/rotate under the following conditions:
 Change in Resources:
 Recourses are increased: If resources are increased, we can produce more of both the
goods. Accordingly, PPC shifts to the right, as in figure (from ab to a1b1):
Y
a1

COMMODITY-Y

Given resources When resources are increased

o COMMODITY-X b b1 X

Overtime, an entrepreneur may acquire more resources, (say) in the form of capital stock. This
enhances his production capacity. Accordingly, PPC shifts to the right, from ab to a1b1.
 Recourses are reduced: If resources are reduced, we can produce less of both the
goods. Accordingly, PPC shifts to the left, as in figure (from ab to a1b1):
Y
a

a1

COMMODITY-Y

When resources are reduced Given resources

o COMMODITY-X b1 b X

Capital stock of an entrepreneur may shrink overtime. This reduces his production capacity.
Accordingly, PPC shifts to the left, from ab to a1b1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 8

 2. Change in Technology:
 Efficient technology for the production of commodity-X: Efficient technology for the
production of commodity-X would mean more production of X with the same resources.
Accordingly, PPC would rotate (NOT SHIFT) as shown in figure (from ab to ab1):
Y

COMMODIT-Y

Given technology efficient technology for X

o COMMODITY-X b b1 X

Efficient technology for commodity-X raises productivity of X. accordingly, more of X can be

produced with the same resources. Thus, PPC rotates to the right, from ab to ab1. Constant technology
for commodity- Y implies that maximum production of Y remains constant and equal to oa.
 Efficient technology for the production of commodity-Y: Efficient technology for the
production of commodity-Y would mean more production of Y with the same resources.
Accordingly, PPC would rotate (NOT SHIFT) as shown in figure (from ab to a1b):
Y
a1

COMMODITY-Y

Given technology Efficient technology for Y

o COMMODITY-X b X

Efficient technology for commodity-y raises productivity of Y, accordingly, more of Y can

be produced with the same resources. Thus, PPC rotates from ab to a1b. constant technology
for commodity –X implies that maximum production of x remains constant and equal to ob.
 Efficient technology for the production of both X and Y: Efficient technology for the
production of both X and Y with the same resources. Accordingly, PPC would shift to
the right as shown in figure (from ab to a1b 1): Y
a1

COMMODITY-Y

Given technology Efficient technology for X and Y

o COMMODITY-X b b1 X
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 9

Efficient technology for commodity-X as well as for commodity-y raises productivity of both X
and Y. accordingly, more of X as well as of Y can be produced with the same resources. Thus,
PPC shifts to the right from ab to a1b1.

PRODUCTION POSSIBILITY CURVE AND MACROECONOMICS:

The concept of PPC is used in macroeconomics as well. At the macro level two questions are often
discussed with reference to PPC. These are:
 Are national resources being FULLY utilized?
 Are national resources being EFFECIENTLY utilized?
If resources are not fully utilized or if these are not efficiently utilized then total output in the economy
will be less than the potential output.
Y

A fuller utilization of resources

Under utilization
Wheat Inefficient utilization
Of resources

f g

o Rice D X

 Any point on AD corresponds to:

 Fuller utilization of resources and
 Efficient utilization of resources.
 Any point inside AD (like point For G)corresponds to:
 Under utilization of resources or
 Inefficient utilization of resources.
Example of under utilization of resources:
Labor is underutilized (or less than fully employed) in India: mass unemployment in India proves this
point. Accordingly, in India: actual output < potential output
GROWTH OF RESOURSES: Overtime an economy may generate or acquire more resources. Gulf
countries, for example, have acquired additional sources of oil. By selling oil these countries have
acquired more capital goods. They have enhanced their production capacity. Accordingly, their PPC
has shifted to the right. Fig.9 shows shift in PPC to the right when availability of resources increases.
Y
P Growth of resources

Rice
Initial
resources

o Wheat D P X
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 10

Owing to increase in resources, (which generally happens in every economy overtime) PPC shifts to
the right. Is shows higher level of output of both the goods. Thus, PP shows higher level of output than
AD.

OPPORTUNITY COST: Opportunity cost refers to value of a factor in its next best (or second best)
alternative use.

MARGINAL OPPORTUNITY COST: Total resources remaining constant, when (using the given
technology) allocation in use Use-2 is increased, there is a loss of output in use-1 (ΔQ1) and gain of
output in use-2 (ΔQ2)
The rate at which output in use-1 is lost for every additional units of output in use-2 implies
marginal opportunity cost.

Marginal Rate of Transformation Of a good along a PPF is defined as the ratio of one good that
needs to be sacrificed for the production of an additional unit of another good.
The marginal rate of transformation of Butter is the amount of Bread that needs to be sacrificed to
produce an additional unit of Butter. MRT is also termed as Marginal opportunity cost.
∆
MRT = OR = ∆

(To be explained with the help of schedule given above)

Possibilities Output of Output of MOC

Bread Butter (MRT)
(units) (units)
I 150 0 -
II 140 10 10/10 = 1
III 120 20 20/10 = 2
IV 90 30 30/10 = 3
V 50 40 40/10 = 4
VI 0 50 50/10 = 5

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 11

CHAPTER -2
CONSUMER’S EQUILIBRIUM
Meaning of Consumer Equilibrium: Consumer’s equilibrium is a situation where a consumer
maximizes his satisfaction with his limited income and has no tendency to change the pattern of
expenditure.
CONCEPT OF UTILITY
In economics, the term ‘utility’ refers to that quality of a commodity by virtue of which our wants are
satisfied. In other words, wants satisfied power of goods is called utility. This is assumed to be
measured in terms of cardinal number, such as 1,2,3,4, etc. these numbers are called utils or units of
utility. Thus, 4 utils of utility are greater than 3 utils of utility, 3 utils of utility, 3 utils are greater than
2, and so on.
Basic Concepts:
Utility: It is the satisfaction that a consumer derives from the consumption of a commodity.
TOTAL UTILITY AND MARGINAL UTILITY
Total Utility: It is the sum of total satisfaction that a consumer derives when a certain units of a
particular commodity are consumed.
It is the sum of marginal utility.
TU = ∑MU
Marginal Utility: It is the additional utility derived from the consumption of an additional unit of the
commodity.
It is also defined as net change in total utility due to a unit change in consumption of a commodity.
Marginal Utility =
Marginal Utility is also defined as the additional satisfaction that is derived from the consumption of
the last unit of a commodity.
Marginal Utility = TUn – TUn-1

 As long as total utility increases,

marginal utility remains positive.
A Point of satiety
 When total utility reaches its
maximum, marginal utility becomes TU TU
zero.

 When total utility falls, marginal utility

becomes negative. Units of a commodity

Points to be noted:
 If TU increases at increasing rate, MU MU
also increases.

 If TU increases at diminishing rate,

MU falls but remains positive.

 Point of satiety- Saturation point

(consumer will not like to consumer
more than this) Units of a commodity
MU

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 12

Relationship between Total Utility and Marginal Utility

RELATION BETWEEN TU AND MU
 TU = ∑MU.
 TU increases so long as MU is positive.
 When MU is zero, TU is maximum.
 When MU is negative, TU starts diminishing.
 Decreasing MU implies that TU is increasing at a decreasing rate.
Law of Diminishing Marginal Utility:
The law explains the behavior of marginal utility when an individual consumer consumes a commodity.
According to the law, as more and more units of a commodity is consumed, the marginal utility derived
from each successive unit eventually decline. (The word eventually in the definition signifies that
marginal utility may initially increase)
The law of diminishing marginal utility forms the basis for determining the point of consumer’s
equilibrium.
Assumptions of the law:
 Rational consumer: Consumer is assumed to be rational. He aims at maximizing his benefits
from consumption, given his income and prices of the goods.
 Cardinal measurement: Utility can be measured in quantitative terms i.e. individual can give a
specific number to the amount of satisfaction they derive from the consumption of the
commodity.
 Standard unit: It is assumed that reasonable amount of the commodity forms a unit of the
commodity.
 No time gap: All the units of a commodity are consumed in a stipulated time period, one after
the other.
 Constant Price: All units of the commodity are purchased at same price.
 Constant marginal utility of money: Like other commodities marginal utility of money should
fall; however in the law it is assumed that marginal utility of money remain constant.
The law can be explained with the help of a schedule and diagram

Units of a TU MU
commodity
1 10 10
2 18 8 MU
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2 MU
Units of a commodity

CONCEPT OF CONSUMER’S EQUILIBRIUM

Consumer’s equilibrium refers to a situation of maximum satisfaction while he is spending his given
income across different goods. In other words, ”A consumer is in equilibrium when he regards his
actual behavior as the best possible under the circumstances and feels no necessity to change his
behavior as long as circumstances remains unchanged’’.
The consumer is in equilibrium when, given his income and market prices, he plans his expenditure in
such a manner that he maximizes his total satisfaction.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 13

UTILITY ANALYSIS AND CONSUMER’S EQUILIBRIUM:

Two Approach to explain Consumers equilibrium
1. Marginal Utility Analysis
2. Indifference Curve Analysis
Marginal Utility Analysis
Assumptions: Same as for the law of diminishing marginal utility
One Commodity Case:
A consumer spends her income on a commodity such that she derives maximum satisfaction subject to
her income and price of the commodity. While consuming a commodity consumer has to pay a price
for it. She would like to consume more units of a commodity as long as its marginal utility in Rs is
greater than the price paid for it. When marginal utility in Rs become equal to the price of the
commodity, she will stop the consumption. This will be the state of equilibrium. She would not like to
purchase more units as if she does so the marginal utility of the commodity in Rs becomes less than the
price of the commodity (due to the law of diminishing marginal utility). It’s a situation of loss for the
consumer.
Thus a consumer is in equilibrium when:
1. Marginal utility of commodity in Rupee is equal to Price of the commodity.
Where: Marginal utility of commodity in Rupee =
2. Marginal utility must decline.
The concept can be explained with the help of an illustration (utility schedule) and diagram:
Let Marginal utility of Rupee = 2
Price of commodity =3
Units TU MU MU Pric Behaviour
consu in in in Rs e
med utils utils
1 10 10 =5 3 MU in Rs> P P/ E
consumption MU P
2 18 8 =4 3 MU in Rs> P
consumption MU
3 24 6 =3 3 MU in Rs= P
attain o
equilibrium Q1 Q Q2
4 28 4 =2 3 MU in Rs< P Units of commodity
consumption consumed
5 28 0 =0 3 MU in Rs< P
consumption In the diagram, Consumer
6 24 -4 3 MU in Rs< P attains equilibrium at point E
=-
consumption when she consumes OQ units of
2 a commodity. If she purchases
When the consumer consumes 1st unit, she gets OQ1 units Marginal utility is
marginal utility equal to Rs 5 whereas she pays Rs 3 more than the price, she can
for it, thus she will like to purchase more units. When further add to the utility and if
she purchases 2nd unit, she again derives utility higher she purchases OQ2 units
than the price, thus she will continue to buy more. As marginal utility is less than the
she purchases the 3rd unit, utility becomes equal to price paid, thus is a situation of
price which is the state of equilibrium. She will stop loss for her.
the consumption here as if she purchases 4 th unit utility
derived will be less than the price paid for it, which
will be a situation of loss for her.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 14

What if conditions of equilibrium are not satisfied?

 MU in Rs > Price of the commodity, the consumer should increase the consumption so that
marginal utility falls and becomes equal to the price (such that condition of equilibrium is
satisfied).
 MU in Rs < Price of the commodity, the consumer should decrease the consumption so that
marginal utility increase and becomes equal to the price (such that condition of equilibrium is
satisfied).

Two Commodity (or several commodities) case

(Law of Equi-Marginal Utility)
When a consumer consumes two commodities, she would like to maximize utility subject to the
constraints i.e. her income and price of two commodities.
Suppose consumer consumes two commodities X and Y.
If the consumer was consuming commodity X, she would be in equilibrium when:
= Px
Alternatively it can be written as;
= MUm
Similarly the consumer will attain equilibrium for commodity Y when:
= MUm
Since marginal utility of money is same in both equations, equation (i) is equal to equation (ii),
therefore
= = MUm
Thus a consumer is in equilibrium (when he consumes two commodities) when he spends his limited
income in such a way that the ratios of marginal utilities of two commodities and their respective prices
are equal.
The equilibrium conditions for consumer consuming two commodities are:
 The ratio of marginal utility to its price of one commodity is equal to the ratio of the marginal
utility to the price of the second commodity.
 Marginal utilities of both commodities must be decreasing.
 Expenditure made on the two commodities must be equal to the income of the consumer i.e.
Px.Qx + P y.Qy = Y
The concept can be explained with the help of an illustration (utility schedule)
Let Price of commodity X = Rs 3 per unit
Price of commodity Y = Rs 2 per unit
Marginal utility of money = 2
Consumers income = Rs 18

Units MU of X MU of Y
consumed
1 24 14 8 7
2 18 10 6 5
3 12 6 4 3
4 9 4 3 2
5 6 2 2 1

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 15

According to the conditions of equilibrium:

 The ratio of marginal utility to its price of one commodity is equal to the ratio of the marginal
utility to the price of the second commodity i.e.
= = Mum
The ratios are equal when (i) 4 units of X and 3 units of Y are consumed
(ii) 5 units of X and 4 units of Y are consumed.
 Marginal utilities of both commodities must be decreasing as can be seen in the schedule.
 Expenditure made on the two commodities must be equal to the income of the consumer i.e.
Px.Qx + P y.Qy = Y
Thus:
(i) When 4 units of X and 3 units of Y are consumed
4 x 3 + 3 x 2 = 18 (equilibrium established)
(ii) When 5 units of X and 4 units of Y are consumed.
5 x 3 + 4 x 2 = 23 (over budget)
The condition is satisfied when 4 units of X and 3 units of Y are consumed.

What if ratios are not equal?

 If > , it would mean that marginal utility of last rupee spent on good X is greater than
marginal utility of last rupee spent on good Y. Thus consumer can increase her satisfaction by
spending a rupee more on good X and a rupee less on good Y i.e. to attain equilibrium
consumer should increase the consumption of good X and decrease the consumption of good Y
so that the ratios are equal.
 If < , it would mean that marginal utility of last rupee spent on good X is less than
marginal utility of last rupee spent on good Y. Thus consumer can increase her satisfaction by
spending a rupee more on good Y and a rupee less on good X i.e. to attain equilibrium
consumer should increase the consumption of good Y and decrease the consumption of good X
so that the ratios are equal.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 16

CHAPTER-3
CONSUMER’S EQUILIBRIUM-INDIFFERENCE CURVE ANALYSIS

Cardinal and Ordinal Concepts of Utility:

Cardinal utility: cardinal concept of utility suggests that utility (satisfaction from the consumption of a
commodity) can be measured in terms of units like 2,4,6,and8.
Ordinal utility: ordinal concept, on the other hand, suggests that utility cannot be measured in terms of
units. It can at best be ranked or compared as high or low.

Concept of Indifference Set and Indifference Curve:

Indifference Set: it is a set of those combinations of two goods which offer the consumer the same
level of satisfaction. So that, the consumer is indifferent across any number of combinations in his
indifference set.
Table 1 Different combination of apples and oranges.
Combination No. of No. of
Apples Oranges
A 1 10
B 2 7
C 3 5
D 4 4

Notes the following observation relating to table 1:

 Combination A,B,C and D are specified by the consumer according to his tastes and
preferences.
 Each combination offers the same level of satisfaction to the consumer. So that (in terms of the
level of satisfaction), combination A =combinationB =combinationC =combinationD.
 As there is no difference among combinations A, B, C and D. we may say that the consumer is
indifferent across these combinations. Accordingly, these combination together form an’
indifference set ‘of the consumer.

Indifference Curve Analysis:

Practically consumer finds it difficult to measure utility in utils. Instead consumer can give preference
for one combination of goods over another. A consumer would like to purchase more quantity of goods
but his income and prevailing prices of the goods restrict his extent of consumption.
What consumer can afford to buy depends upon:
i. Consumer’s income
ii. Prices of two goods
The combination of the quantities of two goods is called as bundle. For example, (x1,x2) would mean x1
quantity of good 1 and x2 quantity of good 2.

The Budget Set

The budget set refers to all those bundles of two goods that consumer can buy with given income and
prices of two goods. (It includes all those combinations of two goods which either cost equal to or even
less than consumer’s income).

The Budget Constraint

A budget constraint highlights what a consumer can afford. It states that a consumer can spend his
income on two goods in such a way that expenditure made on two goods is less than or equal to his
income. Mathematically it can be written as:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 17

Px.Qx + P y.Qy ≤ Y where PX = Price of commodity X

Ax= Quantity of commodity X
Py = Price of commodity Y
Qy= Quantity of commodity Y
Y = Income of the consumer
Thus budget constraint shows the various bundles of two goods that a consumer can buy given his
income and prices of two goods.
Graphical presentation of budget constraint is the budget line.
Suppose a consumer has a budget of Rs. 20 to be spent on two goods: good 1 and good 2. If price of
good 1 is `4 each and price of good 2 is `2 each, the consumer can purchase various bundles
(combinations of two goods) which determine the budget line. The possible combinations are:
Combinations Good 1 Good 2
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0

Budget line is the locus of all bundles of two goods that a consumer can purchase with his given
income and prices of two goods. All points on or below the budget line are affordable, whereas points
above the budget line are not affordable.
In the diagram AB represents the budget
line. All points on budget line are affordable.
Point C lies within budget line and is
A affordable but is considered inferior as
compared to the points on budget line as it
Good 2 means lesser quantity of either one or both
.C .D the goods.
Point D lies outside the budget line and thus
is not affordable.
B
Good 1

Budget line slopes downward, implying that if a consumer wants to increase the consumption of good
1, he will have to give up some units of good 2. Thus it indicates trade-off that a consumer has to make
between the two goods. The extent of trade-off is given by the slope of the budget line.
Slope of Budget Line
A Let us select two points, point C and point
C D on the budget line. Equation of budget
Good 2 (x1,x2) line at different points would be:
Δx2 At point C
(x1+Δx1,x2+Δx2) P1x1+P2x2= M ------(i)
Δx1 D At point D
B P1 (x1+Δx1)+P2(x2+Δx2)= M
Good 1 Or
P1 x1+ P1Δx1+P2x2+ P2Δx2= M--------(ii)

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 18

By subtracting eq. (i) from eq. (ii)

P1Δx1+ P2Δx2=0
By rearranging the values
Δx2= -
Δ 2
Δ
=- 2

Thus, Slope of budget line is the ratio of the prices of two commodities.
=-

Consumers Preferences:
Consumer’s preferences highlights consumer’s wants. These preferences are graphically represented
through an indifference curve.
An indifference curve is the locus of all combinations of two goods which provide same level of
satisfaction. Since all combinations on an indifference curve give same utility, a consumer is indifferent
about any combination.
Assumptions:
 Rationality: Consumer is assumed to be rational. He aims at maximizing his benefits from
consumption, given his income and prices of the goods.
 Ordinarily: Consumer can order or rank the subjective utilities derived from the commodities.
He has a scale of preference between different combinations of the two goods thus can always
tell his preference or indifference between different alternatives.
 Preferences are based on Diminishing marginal rate of substitution:
 Marginal rate of substitution is defined as the rate at which a consumer is willing to
sacrifice one commodity to obtain some units of the other commodity.
 It is assumed that with every increase in the quantity of one commodity the consumer is
willing to forego lesser quantity of the other commodity.

Monotonic Preferences: A consumer’s preferences are monotonic if between any two bundles, the
consumer prefers the bundle which has more of at least one of the goods and no less of the other good
as compared to the other bundle. For example a consumer with monotonic preference will prefer the
bundle (2, 3) to the bundles (2, 2), (1, 3) and (3, 1) bundles.

Indifference Curve and Indifference Map: A consumer’s preferences over the set of available
bundles can be represented diagrammatically. Such a curve joining all points representing bundles
among which the consumer is indifferent is called an indifference curve.
An indifference curve is the locus of different combinations of goods that yield the same level of utility
to the consumer.
The diagram shows an indifference curve.
All points (e.g. point A and point B) on this
curve give same level of utility thus a
Good 2 A consumer is indifferent about these
combinations.

B
IC

Good 1

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 19

An indifference curve slopes downward from left to right. It reflects that in order to consume more
units of good 1 consumer needs to give up some units of good 2.

Indifference Map: A collection of indifference curves that represent different levels of satisfaction
that a consumer derives from consuming different bundles of two commodities is called an indifference
map.
A consumer can have many indifference
curves. All points on IC1 shows that a
Increasing utility consumer derives same level of
Good 2 IC3 satisfaction by choosing any combination.
IC 2 However if he moves to IC2 the
IC 1 satisfaction increases as he is able to get
Good 1 more of either one or both the goods. Thus
a higher IC represents greater level of
satisfaction or utility for the consumer.

Indifference Curve:
Indifference curve is a diagrammatic presentation of an indifference set of a consumer. It is a locus of
all such points which shows different combinations of two commodities (like apples and oranges)
yielding the same level of satisfaction to the consumer. Each point on the indifference curve indicates
one combination of two goods. Each combination yields the same level of satisfaction.
Diagrammatic presentation of table 1 gives the following curve.

Y
10 A Indifference curve
(Diagrammatic presentation
8 of indifference set)
7 B
0ranges 5 C
4 D IC

o 1 2 3 4 X
Apples
IC is an indifference curve. Each point on the curve shows a combination of goods, offering the same
level of satisfaction to the consumer. Thus, level of satisfaction of the consumer at point A is the same
as at points B ,C, or ,D.

IC is an indifference curve. Each point on the curve shows a combination of two goods, offering the
same level of satisfaction to the consumer. Thus, level of satisfaction of the consumer at point A is the
same as at points B, C, or D.
Each point on the curve (like A,B,C,…….) shows one combination of apples and oranges. Since each
combination offers the same level of satisfaction to a consumer, this curve is called indifference curve.

Monotonic preference of the consumer and downward sloping IC: A monotonic preference of the
consumer is the basic assumption of IC analysis. It means the consumer preferences are such that
greater consumption of a commodity always offers him a higher level of satisfaction. Implying that the
consumer is never finds himself in a situation of negative marginal utility.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 20

IC slopes downward, or it shows a negative slope: consumption of good-x is negatively related to

consumption of goods –y (increases in one implies decrease in the other) that IC tends to slope
downward, or it shows a negative slope. This is related to monotonic preferences of the consumer.

Marginal rate of substitution (MRS): MRS is the same as slope of IC. It shows the amount of good-y
that the consumer is willing to give up for one more unit of goods-x. it is measured as: Δy/Δx between
any two points on IC. It is determined by the consumer himself, according to his preferences.

Slope of IC shows MRS (marginal rate of substitution): assume that initially the consumer is at
point A, buying 5 units of good-y and 2 units of goods-x. if he is asked to give up some amount of
good-y in place of one more unit of good-x, he is willing to do it at the rate 2:1. This is =Δ y/Δx =2/1.
This is MRS (marginal rate of substitution) which is also the slope of IC. Thus, in figure MRS
(between A and C) = Δy/Δ x =2/1 =2. [often’ ˍ’ sign is prescribed as a prefix before the value of MRS.
Thus, we write MRS:-2, to indicate that this is negative slope as IC curve tends to slope downward.]

Y Slope of IC = MRS

5 A

4 ΔY=2

3 C
Good-Y
2 ΔX=1 IC

o 1 2 3 4 5 X
Goods - X
Slope of IC( between A and C) = Δy/Δx =2/1= -2 = MRS
The consumer is willing to sacrifice 2 units of good-y for 1 more unit of goods-x. This is according to
his preferences.

IC is convex to the origin: IC is normally convex to the origin. It is because the slope of IC (Δ y/Δx)
tends to decline, or because MRS tends to decline as we move along the curve, left to right.
A set of ICs drawn in a graph is called indifference map.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 21

Y
Indifference Map

Goods-Y

Ic4

Ic3
Ic2
Ic1

O Goods-X X

 Higher IC shows higher level of satisfaction.

 ICs need not be parallel to each other.
 ICs never touch or intersect each other.

With reference to figure, following observation need to be carefully noted:

 Higher IC (to the right and above another IC) indicates higher level of satisfaction. Thus, IC4
indicates higher level of satisfaction than IC3; IC 3 indicates higher level of satisfaction than IC2,
and IC2 indicates higher level of satisfaction than IC 1.
 Each IC in the difference map indicates a different preference set of the consumer, and it
corresponds to a different level of consumer’s income.
 ICs need not be parallel to each other.
 ICs do not touch or intersect each other.
ICs do not cross or intersect each other:
Yes, ICs do not cross or intersect each other. What, if they do? Well, we get inconsistent results.
Illustrate, point C is to the right and above point B. implying that point C must yield higher level of
satisfaction than point B. but, because IC1 and IC2 are interesting, we get inconsistent result as under:
A and B are on IC1, implying A = B (in terms of satisfaction level).
A and C are on IC2, implying A = C (in terms of satisfaction level).
If A = B, and A = C, we can conclude that B =C (in term of satisfaction level).but this is not true. We
have already noted that C. must offer higher level of satisfaction, as it is to the right and above B. thus,
we get inconsistent result in case ICs cross each other.
Properties /characteristics of ICs.
The above discussion reveals following characteristics of indifference curve:
 IC slopes downward, left to right.
 Slopes of IC indicates MRS.
 The slopes of IC (or MRS) tend to diminish as we move down the curve. Because of which IC
is convex to the origin.
 In an indifference map, higher IC indicates higher level of satisfaction.
 ICs do not cross or intersect each other.
 When two commodities are consumed, IC neither touches X-axis nor Y-axis.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 22

CHAPTER-4
THEORY OF DEMAND
CONCEPT OF DEMAND:
Demand for a commodity refers to the desire to buy a commodity backed with sufficient purchasing
power and the willingness to spend. But in economics, demand has a distinct meaning.
Example: supposing, you desire to have a color TV, but you don’t have enough money to buy it. Then,
this desire will remain just a wishful thinking; it will not be called demand. And, if in spite of having
enough money, you do not want to spend it on color TV, demand does not emerge. The desire becomes
demand only when you are ready to spend money to buy TV.

DEMAND AND QUANTITY DEMANDED: At higher price quantity demanded will be low, and at
lower price quantity demanded will be high. The term demanded refers to various quantities of a
commodity that the consumer is ready to buy at different possible prices of a commodity. On the other
hand, quantity demanded refers to a specific quantity to be purchased against a specific price of the
commodity.
Demand refers to various quantities of a commodity that the consumer is ready to buy at different
possible prices of that commodity. Quantity demanded refers to a specific quantity to be purchased
against a specific price of the commodity.

Demand schedule: demand schedule is that schedule which expresses the relation between different
quantities of the commodity demanded at different prices.
Demand schedule is of two types:
 Individual Demand Schedule.
 Market Demand Schedule.

Individual demand schedule: Individual demand schedule is defined as the quantities of a given
commodity which a consumer will buy at all possible prices, at a given moment.
Individual demand schedule is a table showing different quantities of a commodity that one particular
buyer in the market is ready to buy at different possible prices of the commodity at a point of time.
Example: Is an individual demanded schedule. It indicates the different quantities of ice cream to be
bought by a consumer at different prices, at a given time.
Table: 1 individual demand schedule
Price of ice cream (rs.) Quantity demanded (units)
1 4
2 3
3 2
4 1

It is seen from table 1 that as the price of ice cream increases, quantity demanded tends to decrease.
When price is Rs. 4 per cup, then the consumer demands one cup; when price falls to Rs. 1 per cup; the
demand increases to 4 cups.

Market Demand Schedule: Market demand schedule is one that shows total demanded of all the
consumers in the market at different prices of the commodity.
Market demand schedule is a table showing different quantities of a commodity that all the buyers in
the market are ready to buy at different possible prices of the commodity at a point of time.
Example: there are only 2 buyers in the market; market demand schedule for (say) ice cream may be
drawn as under:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 23

Price of ice cream A’s demand B’s demand Market demanded

(rs) (1) (2) (3) (1+2)
1 4 5 4+5=9
2 3 4 3+4=7
3 2 3 2+3=5
4 1 2 1+2=3
Demand curve: Demand curve is simply a graphic representation of demand schedule showing how
quantity demanded of a commodity is related to its own price. Like demand schedule, concept of
demand curve includes:
 Individual demand curve
 Market demand curve
 Individual demand curve: Individual demand curve is a curve showing different quantities of
a commodity that one particular buyer is ready to buy at different possible prices of the
commodity at a point of time.

Price of ice cream (rs.) Quantity demanded (units)

1 4
2 3
3 2
4 1

Y
D
4

3 Demand curve

Price (Rs.) 2

1 D

o 1 2 3 4 X
Quantity (units)
Demand curves slopes downward. It shows inverse relation between price and quantity demanded.
Thus, 4 units of the commodity are demanded when prices is Rs. 1 per unit while only 1 unit is
demanded when the price is Rs. 4 per unit.
In this diagram, quantity of the commodity is shown on X- axis and price on Y-axis. DD is the demand
curve. It is a graphic presentation of individual demand schedule, as in table 1
Demand curve slopes downward from left to right indicating inverse relationship between own price of
the commodity and its quantity demanded.
 Market Demand Curve: market demand curve is the horizontal summation of the individual
demand curves. It shows various quantities of a commodity that all the buyers in the market are
ready to buy at different possible prices of the commodity at a point of time.
Price of ice cream A’s demand B’s demand Market demanded
(rs) (1) (2) (3) (1+2)
1 4 5 4+5=9
2 3 4 3+4=7
3 2 3 2+3=5
4 1 2 1+2=3

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 24

Y
4 D A’s Demand curve

Price (Rs.) 2

1
D

o 1 2 3 4 X
Quantity (units)

Y
4 D B’s Demand curve

3
Price (Rs.)
2

1 D

o 1 2 3 4 5 X
Quantity (units)

Y
4 D
Market demand curve
3

Price(Rs.) 2

1
D

o 1 2 3
4 5 6 7 8 9 X
Quantity (units)
A and B are two buyers in the market. Fig .2(1) is A’s demand curve. Fig. 2(2) is B’s demand curve.
Fig. 2(3) is the market demand curve. When a price is 1 Rs. per ice cream cup, A’s demanded is for 4
cups and B,s when the price is 1 Rs. Per cup. Accordingly, market demand is 4+5=9 cups market
demand is 1+2 = 3 cups. Market demand curve also slopes downward showing inverse relationship
between own price of the commodity and its quantity demanded.
Demanded function or determinants of demand: Demand function shows the relationship between
demand for a commodity and its various determinants. It shows how demand for a commodity is
related to, say, own price of the commodity or income of the consumer or other determinants.
Corresponding to two aspects of demand, viz., individual demand and market demand, we have two
types of demand function.
 Individual demand function.
 Market demand function.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 25

 Individual Demand Function: individual demand function shows how demand for a
commodity, by an individual consumer in the market, is related to its various determinants. Its
various determinants. It is expressed as under.
Dx = F(Px, Pr, Y,T,E)
( Here, Dx = Quantity demanded of the commodity – X; P x = Own price of commodity – X; Pr
= Price of related goods; Y = Consumer’s income; T = Consumer’s tastes and preference; E =
Consumer’s expectations.)

 Own price of commodity: Other things being equal, with the rise in own price of the
commodity, its demand contracts, and with a fall in price, its demand extends. This inverse
relationship between our price of the commodity and its demand is called Law of Demand.
 Price of related goods: Demand for a commodity is also influenced by change in price of
related goods. These are of two types:
 Substitute goods: These are the goods which can be substituted for each other, such as tea
and coffee, or ball-pen and ink-pen. In case of such goods, increase in the price of one
causes increase in demand for the other and decrease in the price of one causes decrease in
the demand of other.
 Complementary goods: These are those goods which complete the demand for each other
and therefore demanded together. Pen and Ink, Bread and Butter may be cited as examples.
In case of complementary goods, a fall in the price of one causes increase in the demand of
other and rise in the price of one causes decrease in the demand for the other.
 Income of the consumer: Change in the income of the consumer also influences his demand
for different goods. The demand for the Normal goods tends to increase with increase in
income, and vice-versa. On the other hand, the demand for Inferior goods like coarse grain
tends to decrease with increase in income, and vice-versa.
Normal Goods: are those in case of which there is a positive relationship between income and
quantity demanded. Other things remaining constant, quantity demanded increases in response
to increase in consumer’s income and vice-versa.

Inferior Goods: are those in case of which there is a negative relationship between income and
quantity demanded. Other things remaining constant, quantity demanded decreases in response
to increase in consumer’s income and vice-versa.

 Tastes and preferences: The demand for goods and services also depends on individual’s taste
and preference. Taste and Preferences of the consumers are also influenced by advertisement,
change in fashion, climate, new inventions etc.
 Expectations: If the consumer expects a significant change in the availability of the concerned
community in the near future, he may decide to change his present demand for the community.

 Market demand function: market demand function shows how market demand for a
commodity (or aggregate demand for a commodity in the market) is related to its various
determinants. Or, it shows the relationship between market demand for a commodity and its
various determinants. It is expressed as under:
Mkt. Dx = F (Px, Pr, Y, T, E,N,Yd)
Px, Pr, Y, T, E have already been discussed in case of individual demand function. We
discussed the remaining factor (N and Yd) as under:
 Population Size: Demand increase with increase in number of buyers for a commodity. Ex:
Owing to a substantial increase in the number of buyers, the demand for cars has
substantially risen in India.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 26

 Distribution of Income: Market demand is also influenced by the distribution of income in

the society.

Law of Demand:
The law of demand states that, other things being equal, quantity demanded increases with a decrease
in own price of the commodity, and vice versa. In other words, there is an inverse relationship between
quantity demanded of a commodity and its own price, other things remaining constant. The term ‘other
things being equal’ implies that all other determinants of demand, other than own price of the
commodity, remain constant.

The law of demand states that other things remaining constant, there is an inverse relationship between
quantities demanded and own price of the commodity.

Assumptions of the law of demand: law of demanded holds good when “other things remain the
same”. It means factor influencing demand other than own price of the commodity are assumed to be
constant. Thus,
 Tastes and preferences of the consumers are assumed to remain constant.
 There is to be no change in the income of the buyers.
 Prices of the related goods do not change.
 Consumers do not expect any significant change in the availability of the commodity in the near
future.

Why more of a good is purchased when their prices fall?

Or
Why does demand curve slope downward?
Downward slope of demand curve indicate that more is purchased in response to fall in price. Thus,
there is inverse relationship between own price of a commodity and its quantity demanded. This may
be explained in terms of the following factors:
 Law of Diminishing Marginal Utility: according to this law, as consumption of a commodity
increases, marginal utility of each successive unit goes on diminishing to a consumer. Accordingly,
for every additional unit to be purchased, the consumer is willing to pay less and less price. We
know, price of a commodity is equated with marginal utility of the commodity.
 Income Effect: income effect refers to change in quantity demanded when real income of the buyer
change owing to change in price of the commodity. With a fall in price, real income increases.
Accordingly, demanded for the commodity expands.
 Substitution Effect: substitution effect refers to substitution of one commodity for the other when
it becomes relatively cheaper. Thus, when own price of commodity- y. accordingly, X is substituted
for y. tea and coffee are substitutes. With a fall in the price of tea, it is substituted in the place of
coffee. It is expansion of demand due to substitution effect.
 Size of Consumer Group: when price of a commodity falls, it attracts new buyers who now can
afford to buy it. Accordingly, demand expands.
 Different Users: a good may have several users. Milk, for example, is used for making curd,
cheese and butter. If price of milk reduces it will be put to different uses. Accordingly, demand for
milk expands.

Exceptions to the Law of Demand:

Law of demand has some exceptions as well. There are some commodities whose demand expands
when their prices rises and contracts when their price fall. In such situations, the demand curve DD
slopes upwards from left to right as shown in figure. Following are some notable exceptions to the law
of demand:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 27

 Articles of Distinction: according to Prof. Veblen, there are certain goods which command
social distinction. Veblen calls them as ‘article of social distinction’. These articles are high in
demand only because their prices are very high. If their prices fall, they will no longer be
considered as article of distinction and so their demand will decrease. Thus these goods defy the
law of demand. Precious diamonds and vintage cars may be cited as example.
 Giffen Goods: Giffen goods are highly inferior goods, showing a very high negative income
effect. As a result, when price of such commodities falls, their demand also falls, even when
they happen to be relatively cheaper than other goods. This is popularly known as ‘Giffen
paradox’.
 When consumers judge quality of a commodity by its price: law of demand is violated when
consumers judge the quality of a commodity by its price. The emerging trend to buy ‘organic’
farm products explains this phenomenon. Perhaps it is owing to a huge price difference between
‘organic’ and non organic products in the market, that richer section of the society consider
organic products as of very high quality. Accordingly, quantity demanded of these products has
tended to rise even when their prices are extremely high.

Movement along a demand curve and shifts in demand curve:

Movement along a demand curve refer to moving ‘up or down’ the demand curve. When we move
down the curve, it is situation of extension of demand: buying more in response to decreases in own
price of the commodity. When we move up the curve, it is situation of contraction of demand: buying
less in response to increases in own price of the commodity. Thus, movement along the demand curve
refers to extension or contraction of demand.
Movements along the demand curve refer to extension or contraction of demand.
Extension of Demand: occurs when quantity demanded increases in response to a fall in own price of
the commodity.
Contraction of Demand: occurs when quantity demanded decreases in response to a rise in own price
of the commodity.
Shifts in demand curve: refers to all such situation when demanded for a commodity increases or
decreases due to changes in other determinants of demand, other than own price of the commodity. In
such situations, quantity demanded of a commodity increases even when own price of the commodity
remains constant.
Tabular and diagrammatic illustration: following are the tabular and diagrammatical illustrations of
different situations relating to movements along a demand curve and shifts in demand curve.
Movements along a demand curve: movements along a demand curve refer to extension and
contraction of demand. These are caused by changes in own price of the commodity.

Extension of Demand:
(Moving down the demand curve)
Other things being equal, when with a fall in price, quantity demanded of a commodity rises; it is called
extension of demand (or expansion of demand). As shown in following table and curve when the price
of ice cream is Rs.5, one cup is demanded. When price reduces to Rs. 1, demand extends to 5 cups of
ice cream.
Price Quantity Description
(Rs.) (units)
5 1 Fall in own price of the
commodity
1 5 Rise in quantity demanded
Extension of demand is indicated by a movement down the demand curve, as from point A to

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 28

Y
5 A EXTENSION OF DEMAND

3
Price (Rs.)
2

1 B
D
o X
1 2 3 4 5
Quantity (units)

Extension of demand refers to increases in quantity demanded of a commodity due to a fall in its own
price.
Diagrammatically, it means a movement down the demand curve, like from A to B.
Contraction of Demand:
(Moving up the demand curve)
Other things remaining the same, when with a rise in price, quantity demanded of a commodity
decreases, it is called a contraction of demand. As shown in the following table and curve, when price
of ice cream is Rs. 1 per cup, demand is for 5 cups; when price rises to Rs. 5 per cup, demand contracts
to 1 cup only.
Contraction of Demand
Price Quantity Description
(Rs.) (units)
1 5 Rise in own price of the
commodity
5 1 Fall in quantity demanded

Like extension of demand, contraction of demand is indicated by a movement up the demand curve, as
from point B to A in fig
Y

5 B CONTRACTION OF DEMAND

3
PRICE (RS.)
2

1 A
D
o 1 2 3 4 5 X
QUANTITY (UNITS)
Contraction of demand refers to decreases in quantity demanded of a commodity due to a rise in its
own price.
Diagrammatically, it means a movement up the demand curve, like from B to A.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 29

Shifts in Demand curve:

Shifts in demand curve include
 Forward shifts- forward shifts in demand curve refer to increases in demand.
 Backward shifts- backward shifts in demand curve refer to decreases in demand.
Shifts in demand curve occur due to change in other factors, other than own price of the commodity.

Forward shift in demand curve – Increase in Demand:

Forward shifts in demand curve (increases in demand) refers to a situation when quantity demanded of
a commodity increases, even when own price of the commodity is constant. It is illustrated by table 6
and fig.8
Increases in demand
Increases in demand
Price of x Quantity demanded of x
(Rs.) (units)
10 20
10 30

A INCREASES IN DEMAND

PRICE (RS.)

10 A B PRICE
D2
D1

o X
10 20 30
QUANTITY (UNITS)
Increase in demand refers to increase in quantity demanded of a commodity at its existing price.
Diagrammatically, it means a forward shifts in demand curve, as from D1 to D2.
Causes of Increases in Demand
(Situations when demand curve shifts forward.)
Important causes of increase in demand are as under:
 When income of the consumer increases.
 When price of substitute good increases.
 When price of complementary good falls.
 When taste of the consumer shifts in favor of the commodity due to change in fashion or
climate.
 When availability of the commodity is expected to reduce in the near future.

Backward Shift in Demand Curve – Decrease in Demand

Decrease shifts in demand curve (decrease in demand) refers to a situation when quantity demanded of
a commodity decreases, even when own price of the commodity is constant.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 30

Decrease in demand
Decrease in demand
Price of x Quantity demanded of x
(Rs.) (units)
10 30
10 20

PRICE (RS.)

10 B A Price

D2 D1

o 10 20 30 X
QUANTITY (UNITS)

Cause of Decreases in Demand

(Situations when demand curve shifts backward)
Important causes of decreases in demand are as under:
 When income of the consumer falls.
 When price of the substitute good decreases.
 When price of the complementary good increases.
 When taste of the consumer shifts against the commodity due to change in fashion or climate.
 When availability of the commodity is expected to rise in the near future.

Difference between extension and increase in Demand.

Extension of demand Increase in demand
This is caused only by change in own price of the This is caused by change in determinants, other
commodity. than own price of the commodity.
Decreases in own price of the commodity is the Several causes: these include increases in income,
only causes. increases in price of the substitution good,
decreases in price of the complementary good, and
change in tastes and preferences in favor of the
commodity.
Diagrammatically, this is shown as a downward Diagrammatically, this is shown as a forward
movement (left to right) on the same demand shifts in demand curve.
curve.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 31

Difference between contraction and decrease in demand

Contraction of demand Decreases in demand
This is caused only by change in own price of the This is caused by change in determinants. Other
commodity. than own price of the commodity.
Increases in own price of the commodity is the Several causes: these include decrease in income,
only causes. decrease in price of the substitute good, and
change in tastes and preferences against the
commodity.
Diagrammatically, this is shown as an upward Diagrammatically, this is shown as backward
movement (right to left) on the same demand shifts in demand curve.
curve

Cross Price Effects: How price of related goods (substitute/complementary) affects demand for a
commodity?
Effect of change in price of related good on the demand for a commodity is called cross price effect.
We know related goods are:
 Substitute goods;
 Complementary goods.
Accordingly, we can split our discussion into two parts, as under:
 Demand for a commodity in relation to price of the substitute goods: Let us consider tea
and coffee as two substitute goods. Let tea be the commodity demanded of which demand curve
is D1 as shown in figure.
 Increases In price of substitute good: Initially, if price of tea is OP, quantity purchased is
OT. Mow, suppose the price of tea remains constant but the price of coffee increases. How
would you react as a consumer?
Y

K1 K2
P1
D2
D1 (TEA)
(TEA)
PRICE

o T1 T2 X
QUANTITY

Demand curve for tea shifts to the right when price of the substitute commodity (coffee)
increases. Thus, the consumer shifts from D1 to D2, buying more of tea even when its price
is constant.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 32

 Decreases in price of substitute good: If price of coffee decreases, you will tend to
substitute some coffee in place of tea.
Y

P1 K2 K1

D2 (TEA)
PRICE D1 (TEA)

o T2 T1
QUANTITY
Demand curve for tea shifts to the left when price of the substitute commodity (coffee)
decreases. Thus, the consumer shifts from D1 to D2, buying less of tea even when price of tea is
constant.
 Demand for a commodity in relation to price of the complementary goods: Let us consider
car and petrol as complementary goods. Let cars be the commodity demanded of which the
demand curve is D1 as shown in figure.
 Increases in price of complementary goods: Initially, if price of cars (say swift) is OP1,
number of cars purchased is OT1 (=p1k1). Now, suppose this price remains constant but the
price of petrol increases.
How would the consumers react to such a situation? They would tend to buy less cars is
constant.
Now, even when price of cars is constant, p1k2 cars are purchased, because price of petrol has
increased. This is a situation of decreases in demand or backward shift in demand curve.
Accordingly, demand curve shifts from D1 to D2.
Y

K2 K1
P1

D1 (cars)
PRICE D2
(Cars)

o T2 T1 X
Quantity
Demand curve for cars shifts to the left when price of the complementary good (petrol)
increases. Thus, the consumer shifts from D1 to D2, buying less of cars even when their
price is constant.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 33

 Decreases in price of complementary good: If price of petrol decreases, people will have
the tendency to buy more cars, even when price of cars is constant.
Y

K1 K2
P1

PRICE D1
(Cars) D2
(Cars)

o T1 T2 X
QUANTITY
Demand curve for cars shifts to the right when price of the complementary goods (petrol)
decreases. Thus, the consumer shifts from D1 to D2, buying more of cars even when their price
is constant.

Relationship between Income and Demand

If our income rises, we generally tend to buy more of goods. More income would mean more pens,
more shirts, more shoes, more cars, and so on.
 Normal goods – these are the goods the demand for which increases as income of the buyers
rises. There is a positive.
 Inferior goods- these are the goods the demand for which decreases as income of buyers rises.
Thus, there is negative relationship between income and demand. Or, in case of inferior goods,
income effect is negative.

Impact of tastes and preferences on demand for a commodity

Tastes and preference of the buyers are determined by three factors, as under:
 Individual likes and dislikes: You tend to buy more or less of a commodity simply because
your likes and dislike tend to change.
 Trends and fashions: You are influenced by the emerging trends and fashions. You simply
want to be ‘trendy’; accordingly, you prefer to buy more of a commodity.
 Climate environment: Your tastes and preferences tend to change with change in climate
environment. Winter season induces you to goods like, tea and coffee while summer induces
you to goods like, cold drink and ice cream.

Favorable and unfavorable change in tastes and preferences

Favorable change- A favorable change in tastes and preference causes a forward shift in demand curve
from d1 to d2 (or from ‘a’ to ‘b’).
Unfavorable- an unfavorable shifts in tastes and preferences causes a backward shifts in demand curve
from d1 to d3 (or from ‘a’ to ‘c’).

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 34

Favorable Change.

Backward shifts in demand

C A B curve (a c) owing to
P in tastes and preferences for
a unfavorable change
Commodity.
D2 forward shifts in demand
PRICE D3 D1 curve (a b) owing to
favourable shifts in
Tastes and Preference for a

O QUANTITY X commodity.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 35

CHAPTER-5
ELASTICITY OF DEMAND
Concept of Elasticity of Demand:
The elasticity of demand measures the responsiveness of the quantity demanded of a good, to change in
its price, price of other goods and changes in consumer’s income. When change in quantity demanded
is measured with respect to change in price of the commodity, it is called price elasticity of demand.
When change in quantity demanded is measured with respect to change in income of the buyers, it is
called income elasticity of demand.
When change in quantity demanded is measured with respect to change in price of other commodity, it
is called cross elasticity of demand.

Price Elasticity of Demand and Its Measurement.

Price elasticity of demand is a measurement of percentage change in demand due to percentage change
in own price of the commodity.

Price elasticity of demanded may be defined as the percentage change in the quantity demanded of a
commodity dividend by the percentage change in the price of that commodity.

Measurement of Price Elasticity of Demand

There are different methods of measuring price elasticity of demand;
 Total expenditure method.
 Proportionate method.
 Geometric method.

 Total expenditure or total outlay method: according to this method, one finds out how much
and in what direction total expenditure changes as a result of change in the price of a
commodity. We can consider three possible situations:
 If rise or fall in price of a commodity makes no change in its total expenditure, then
elasticity of demand is unitary.
 If with fall in price of a commodity, total expenditure increases and with rise in its price,
total expenditure decreases, then demand for that commodity is greater than unitary elastic.
 If with fall in price of a commodity, total expenditure decreases and with rise in its price
total expenditure increases, then demand for that commodity is less than unitary elastic. In
this, case total expenditure goes in the same direction as the price does.
Table: 1 shows the effect of change in price on elasticity of demand

Table 1 Total Expenditure Method:

Situation Price of Quantity (kg) Total Effect on total Elasticity of
commodity expenditure expenditure demand
(rs.) (rs.)
A 2 4 Same total Unitary elastic
1 8 8 expenditure Ed =1
B 2 8 8 Total Greater than
1 10 10 expenditure unitary
Increases Ed>1
C 2 6 6 Total Less than
1 4 4 expenditure unitary
decreases Ed < 1

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 36

Unitary elastic demand: Situation A of table 1 shows that when price of the commodity is rs. 2, the
total expenditure Rs.8 when price falls to Re. 1, the total expenditure remains Rs. 8 thus, change in
price has no effect on total expenditure.
Greater than unitary elastic: Situation B of the above table shows that when the price of the
commodity is Rs. 2, the total expenditure is Rs. 8.When the price of the commodity falls to Re. 1, the
total expenditure rises to Rs. 10. In this case, change in total expenditure is in the opposite direction to
change in price.
Less than unitary elastic: situation C of the above table shows that when price of the commodity is
Rs.2, the total expenditure is Rs. 6. When the price falls to Re. 1, total expenditure also comes down to
Rs. 4. In this case, change in total expenditure is in the same direction as the change in price.
The total expenditure method of measuring elasticity of demand is expressed diagrammatically in fig.1
Total expenditure curve
Y
T
R
Ed>1
N B

Ed=1

M C
Ed<1
P E D

O Total expenditure X
TB shows inverse relationship between price and total expenditure.
It is a situation when Ed >1.
EC shows positive relationship between price and total expenditure.
It is a situation when Ed < 1.
BC shows total expenditure as constant in response to increases or decreases in price.
It is a situation when Ed = 1.

 Proportionate or percentage method: The second method of measuring elasticity of demand

is called proportionate or percentage method. Under this method, elasticity of demand is
measured by the ratio of the proportionate (percentage) change in quantity demanded to the
proportionate (percentage) change in price. It is worked out as under:

Percentage Method:
Ed = (–) Percentage Change in Quantity
Percentage Change in Price

# Percentage Change in Quantity = Change in Quantity X 100

Initial Quantity

# Percentage Change in Price = Change in Price X 100

Initial Price
Proportionate Method:
E d = (–) ∆Q X P
∆P Q

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 37

Here, ∆Q = Q1 – Q; ∆P = P1 – P;
Ed = Price Elasticity of Demand;
Q = Initial Demand; Q1 = New Demand;
P = Initial Price; P1 = New Price;
∆Q = Change in Demand; ∆P = Change in Price.

HERE, E d = Price elasticity of demand; Q1= new demand

Q= initial demand P 1= new price
P= initial price ΔP = change in price
ΔQ= change in demand

Geometric Method:
Geometric method measures price elasticity of demand at different points on the demand curve. it is
also called ‘point method of measuring elasticity of demand’. As specific in the syllabus, we are to use
this method only with reference to a linear demand curve, as in fig.
Estimation of price elasticity of demand using point method.
Y
M Upper segment

Mid-point

P•
Price

Lower segment
N
o Quantity X

MN is a straight line demand curve sloping downward. P is a mid- point on the demand curve. it
divides the demand curve into two equal segments, lower segment (PN) and upper segment (PM).
Ed =Lower segment , corresponding to a particular point on the demand curve.
Upper segment

In this figure, MN is a straight line demand curve. P is a specific point on the demand curve. The point
p divides the demand curve. The point p divides the demand curve into two segments, viz. lower
segment. PN and upper segments PM. Elasticity of demand at point p is estimated as the ratio between
lower segments (PN) and upper segment (PM).

Ed= PN (lower segment from p)

PM (upper segment from p)

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 38

Ed=∞ Price elasticity of demand at different points on straight

Line demand curve

M Ed>1

A
Ed=1
P
Price
Ed<1
Midpoint B
Ed=0
O N X
Quantity
P is midpoint on the demand curve
At point p, Ed=1 (lower segment = upper segment)
Between M and p, Ed>1 (lower segment >upper segment)
Between P and N Ed<1 (lower segment<upper segment)
At point M, Ed=∞ (because upper segment =0)
At point N, Ed=0 (because lower segment=0)

Following situations are evident from fig.2

1. Ed=1 (unity): if point p is at the middle of the demand curve, then, lower segment =upper
segment
Accordingly, Ed= PN = 1
PM

2. Ed>1(greater than unity):

At point A, Ed=AN > 1, because AN>AM.
AM

3. Ed<1(less than unity):

At a point B, Ed =AN > 1, because BN<BM.
AM
4. Ed =0 (zero):At the point N(where the demand curve touches the X- axis),
Ed = 0 = 0.
NM
5. Ed= ∞(infinity):At point M (where the demand curve touches the y-axis),
Ed= NM=∞
0
[Note: any real number divided by zero tends towards infinity].

Relationship between Price Elasticity of Demand and Total Expenditure.

Prof. Marshall works out a relationship between price elasticity of demand and total expenditure. He
estimates the degree of price elasticity of demand depending on the change in total expenditure
following a change in own price of the commodity. He observes three different situations, as under:
 If rises or fall in own price of a commodity causes no change in total expenditure on the
commodity, and then elasticity of demand is unitary.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 39

 If a fall in own price of a commodity causes a rises in total expenditure and a rise in price
causes a fall in total expenditure on the commodity, then elasticity of demand is greater than
unitary.
 If a fall in own price of a commodity causes a fall in total expenditure and a rise in price causes
a rise in total expenditure on the commodity, then elasticity of demand is less than unitary.

Degree of price elasticity of demand – a geometric presentation

Various degrees of elasticity of demand are geometrically presented. We are focusing on five distinct
cases, as under:
 Perfectly elastic,
 Perfectly inelastic
 Unitary elastic,
 More than unitary elastic or elastic
 Less than unitary elastic or inelastic.

 Perfectly elastic demand: A perfectly elastic demand refers to the situation when demand is
infinite at the prevailing price. It is a situation where the slightest rise in price causes the
quantity demanded of the commodity to fall to zero.
Fig. illustrates this situation. DD is a perfectly elastic demand curve, parallel to X- axis. It
shows that if price is slightly increased from Rs. 4, the demand falls to zero .at the prevailing
price of RS.4, quantity demanded may be 10, 20, 30 or any number of units of the commodity.
In such a situation, elasticity of demand is infinite (or Ed=∞).it may be noted that under perfect
competition demand curve facing a firm is perfectly elastic.

Y Perfectly Elastic Demand [Ed=∞]

D
4

Price (Rs.) 2

O 10 20 30 X
Quantity (units)
We know, slope of a horizontal straight line=0
We also know that,
Ed= 1 × p
Slope of demand curve Q
Accordingly, Ed at any point on DD
=1 × P = ∞
0 Q

 Perfectly inelastic demand: A perfectly inelastic demanded refers to a situation when change
in price causes no change in the quantity demanded. Even a substantial change in price does not
impact quantity demanded. Fig. illustrates this situation. In such situations, demand curve is
parallel to Y-axis like DD in fig. when price is Rs. 2, demanded is for 4 units. When price rises
to Rs. 4 or to Rs. 6 quantity demanded remains constant at 4 units. Hence, elasticity of demand
is zero 9(or Ed=0).
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 40

Perfectly inelastic demanded [Ed=0]

Y D

Price(Rs.)
2

D
o 2 4 X
Quantity (units)

We know, slope of a vertical straight line=∞

We also know that,
Ed= 1 × P
Slope of demand curve Q
Accordingly, Ed at any point on DD.
= 1 × P = 0.
∞ Q

 Unitary Elastic Demand: It is a situation when change in quantity demanded in response to

change in own price of commodity is such that total expenditure on the commodity remains
constant.
Total expenditure = quantity purchased× price
In fig, when price is OP, quantity demanded is OB, total expenditure is OB, total expenditure is
OB(quantity )×OP (price)=area OBTP
Likewise, when price is OP1, quantity demanded is OC, total expenditure is
OC (quantity) × OP1 (price) = area OCRP1
Area OBTP=Area OCRP1, implying that total expenditure remains constant even after change
in price of the commodity. Hence, elasticity of demand is unity (or Ed=1).

Y Unitary elastic demand [Ed=1]

D

P T

P1 R

Price
O Quantity B C X

When price falls from OP toOP1, total expenditure on the commodity remains constant (area
OBTP=areaOCRP). Accordingly, elasticity at point T=1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 41

 Greater than unitary elastic demand: Demand is greater than unitary elastic when change in
quantity demanded in response to change in price of the commodity is such that total
expenditure on the commodity increases when price decreases, and total expenditure decreases
when price increases. In fig. when price is OP, quantity demanded is OB, total expenditure is
OB×OP = area OBTP. Likewise, when price fall to OP1, quantity demanded is OC1 total
expenditure is OC×OP1= area OCRP1.a glance at the diagram shows that area OCRP1. >area
OBTP. It implies that total expenditure increases in response to decreases in price of the
commodity.Hence, elasticity of demand is greater than unity (or Ed>1).
Y

T
P
P1 R

Price

O Quantity X
when price falls from OP to OP1, total expenditure on the commodity increases(area OCRP1>area
OBTP). Accordingly, elasticity at point T>1.

 Less than unitary elastic demand: demand is less than unitary elastic when change in quantity
demanded in response to change in price of the commodity is such that total expenditure
increases when price rises. In fig. 8, at price op, quantity demanded is OB, total expenditure is
OB×OP=area OBTP. Likewise, when price is OP1 and quantity demanded is OC, total
expenditure is OC×OP1= area OCRP1. Clearly, area OCRP1 is smaller than area OBTP. It
implies that total expenditure is reduced in response to fall in price of the commodity. Hence,
elasticity of demand is less than unity (or Ed<1)
Y

P T

Price
P1 R

O Quantity X

When price falls from OP to OP1, total expenditure on the commodity also falls (area OCRP1<area
OBTP). Accordingly, elasticity at point T<1.
Unitary elasticity of demand at all points of demand curve-a special case: Elasticity of demand
happens to be equal to unity (or equal to one ) at all points of demand curve when demand curve is
rectangular hyperbola. By definition, rectangular hyperbola is a curve under which all rectangular areas
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 42

are equal as shown total expenditure on the commodity remains constant, no matter price of the
commodity increases or decreases. Thus, area OBTP=area OEJP1. Hence, elasticity of demand is unity
(or Ed=1) at all points on the demand curve.

Y
D

P Ed=1
T

Price K Ed=1
P1 J

o B E X
Quantity
Demand curve is rectangular hyperbola. At any point on this demand curve, ED=1.because total
expenditure remains constant to increases or decreases in price of the commodity.
Note: it is a mathematical property of the rectangular hyperbola that area of all rectangles formed under
it (from any point on the curve) is the same.

Flatter the curve, greater the elasticity.

Remember, if two demand curves are shooting from the same point, then flatter the curve, greater the
elasticity of demand. In this situation,
Shooting from the common point’s, demand curve d2, and is flatter and therefore, more elastic than
demand curve d1. This is how it happens:
If price of the commodity falls from OS to OS1, demand curve d1 shows a rise in quantity demanded
from zero to OL1, while demand curve d2 shows a rise in quantity demanded from zero to OL 2,
implying that, for a given change in price, change in quantity is greater corresponding to d2 than d 1.
Hence, d2 is more elastic than d 1.
Y

S1 D2

Price

D1

o L1 L2 X
Quantity

Shooting from a common point (s), curve d2 is flatter than curve d1. Accordingly, d2 is more elastic
than d1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 43

Factors affecting price elasticity of demand: price elasticity of demand is high or low, depending on
various factors. Some of the important determinants of price elasticity of demand are as under:
 Nature of commodity: Ordinarily, necessaries like salt, kerosene, oil, matchboxes, textbooks,
seasonal vegetables, etc., have less than unitary elastic (inelastic) demand. Luxuries, like air-
conditioner, costly furniture, fashionable garments, etc, have greater than unitary elastic
demand. Comforts like milk, transistor, cooler, fans, etc, have neither very elastic nor very
inelastic demand. Jointly demanded goods, like, bread and butter, pen and ink, camera and film,
ordinarily show a moderate elasticity of demand. For example, rise in price of butter will not
substantially reduce its demand if the demand for bread has not decreased.
 Availability of substitutes: demand for goods which have close substitutes (like, tea and
coffee, being close substitute of each other) is relatively more elastic. Because, when price of
such a good rises, the consumers have the option of shifting to its substitute. Goods without
close substitute like cigarettes and liquor are generally found to be less elastic in demand.
 Diversity of uses: Commodities that can be put to a variety of uses have elastic demand. For
instance, electricity has multiple uses. It is used for lighting, room-heating, air conditioning,
cooking etc. if the price of electricity increases, its use may be restricted only to important
purpose like lighting. Other uses may be abandoned. On the other hand, if a commodity such as
paper has only a few uses, its demand is likely to be less elastic.
 Postponement of use: Demand will be elastic for goods, the consumption of which can be
postponed. Demand for residential houses may be cited as an example. People often defer their
demand for residential houses when interest rates on the loans are high.
 Income level of the buyer: Elasticity of demand for a good also depends on the income level of
its buyers. If the buyers of a good are high-end consumer (with high level of income) they will
not be expected to be low. Example: demand for luxury cars by the multi-billionaires. On the
other hand, if income level of the buyers of a good is low, elasticity of demand is expected to be
high. Example: demand for small cars by the middle class people in India.
 Habits of consumer: Goods to which consumer become accustomed or habitual will have
inelastic demand like cigarettes and tobacco. It is because of this factor that demand for
cigrattes and liquor does not reduce even when these goods are highly taxed.
 Proportion of income spent on a commodity: Goods on which consumer spend a small
proportion of their income (toothpaste, boot-polish, newspaper, needles, etc). Will have an
inelastic demand. On the other hand, goods on which the consumers spend a large proportion of
their income (cloth, scooter, etc.), tend to have elastic demand.
 Price level: Elasticity of demand also depends on the level of price of the concerned
commodity. Elasticity of demand will be high at higher level of the price of the commodity and
low at the lower level of the price.
 Time period: Demand is inelastic in short period but elastic in long period. It is because, in
long run, a consumer can change his consumption habits more conveniently than in the short
period.
Briefly, goods with multiple uses, carrying a high price tag, and having a large number of close
substitutes tend to show higher elasticity of demand than the goods which are low priced, are
essentials of life and do have close substitutes.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 44

CHAPTER-6
PRODUCTIONS FUNCTIONS AND RETURN TO A FACTOR

Concept of Production Function:

Production function thus studies the functional relationship between physical inputs and physical
output of a commodity. It is purely a technical relationship between material outputs on the one hand
and material inputs on the other. Usually, it is expressed in terms of the following equation:
Qx= f (l, k)
It says that Qx (production of commodity-x) is the function of L (labor) and K(capital). Using some
arbitrary values, we may write that,
40x=f (5L, 4K) ……………… (1)
It say that maximum of 40 units of commodity-x can be produced using 5 units of labor and 4 units of
capital
Or, 45x=f (6L, 4K) …………….. (2)
Implying that maximum of 45 units of commodity-x can be produced using 6 units of labor and 4 units
of capital.
Or, 80x=f (10L, 8k) ………………. (3)
Implying that maximum of 80 units of commodity-x can be produced using 10 units of labor and 8
units of capital.
It is this relationship between physical inputs (i.e., 10 units of capital and 5 units of labor) and physical
output (100 units of the commodity produced) which is known as production function.
In the words of Watson, “production function is the relationship between a firm’s production (output)
and the material factor of production (input).’’
It is important to note that production function does not establish any economic relation between inputs
and output. It only establishes a technical relation between inputs and output. It is the engineers (not
yield the maximum output of (say) 100 units of commodity-x.thus, writes koutsoyiannis, ’’the
production function is purely a technical relation which connects factor inputs and output.’’
It is equal important to note that a production function is always defined with respect to a given
technology or a given technical know-how. Over time, technical know-how may improve, accordingly,
it may become possible to produce 110 units of commodity-x (instead of 100 units) with the same
inputs. It is a situation of shift (or change) in production function.

Fixed and variable factors:

Factor of production are classified as:
 Fixed factor, and
 Variable factors.
 Fixed factor: fixed factors are those the application of which does not change with the change
in output. In fact, fixed factors (like machines) are installed before output actually commences.
Thus, a machine is there even when output is zero. Let us assume that machines can produce
maximum 1000 units of commodity –x. it means that for any change in output ranging between
0-1000 units; input of machines (fixed factor) remains constant.
 Variable factor: variable factors are that the application of which varies (or changes) with the
change in output. Labor is an example of a variable factor. You need more labor to produce
more units of a commodity, other things remaining constant. Thus, use of a variable factor is
zero when output is zero; it increases as output increases.

Production function when one factor is a fixed factor and other is a variable factor:
When one factor is a fixed factor and the other is a variable factor, production function may be
specified as under:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 45

Qx=f (L, K)
Here, QX= Output of good-x
L= Labor, a variable factor
K= Capital, a fixed factor.
In this type of production function, output can be increased only by increasing the application of L (the
variable factor). The following equations illustrate this point further:
40x= f(5L,4K)……………(1)
45x=f(6L,4K)…………….(2)
We find that K is constant at 4 units. Output increases from 40 to 45 units of commodity –x because
input of L has increased from 5 to 6 units. Since k is constant and only L changes, the ratio or
proportion between L and K.
Tends to change. The generates the law of variable proportions which is discussed in section 3 of the
chapter.

TP (Total Product), MP (Marginal Product), AP (Average Product) of the variable factor.

TP (Total Product):
It is the sum total of output produced by all the units of a variable factor along with some constant
amount of the fixed factors used in the process of production. Let us consider L (labor) as the variable
factor and K(capital) as the fixed factor. Assumes also that long with some constant application of the
fixed factor (say one machine), the producer is using 1 through 6 units of the variable factor. The
resultant output is 10,12,15,12,10,6 units of the commodity corresponding to each unit of labor used. In
such a situation,
TP= 10+12+15+12+10+6
= 65 units of the commodity.

TP is the sum total of output of each units of the variable factor used in the process of production. This
is also called total return of the variable factor.

MP (Marginal Product):
Mp refers to change in TP when one more unit of the variable factor is used (fixed factor remaining
constant). Example: if output increases from 40 to 45 units when the inputs of labor is increased from 5
to 6 units (input of capital remaining constant), then
Mp= 45 - 40 = 5

TP when 6 units of TP when 5 units increases in TP when

Labor are used of labor are used 1 more unit of labor is used
MP=5 is to be attributed to the 6th unit of labor. Likewise,
Mp of 1 st unit of L = TP of 10 units of L – TP of 9 (or 10-1) units of L
Or,
MP of 10 th unit of L = TP of 1 unit of L – TP of 0 (or 1-1) units of L
Generalizing it we can say that:
MPnth=TPn-TPn-1
If you have understood the technique of estimating MP, you should also understand the fact that by
adding up MP of all the units of a variable factor, we get TP
n
Thus, TP=⅀
I=1
Mp refers to change in TP when one more unit of the variable factor is used, fixed factor remaining
constant.
Sum total of MP corresponding to each unit of the variables factor makes up TP.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 46

AP (Average Product)
AP is output per unit of the variable factor.
It is estimated as under:
AP= TP total product / output
L units of the variable factor
AP refers to physical output per unit of the variable factor used in the process of production.

Illustration (estimation of AP, MP, and TP)

Following table illustrates the estimation of AP, MP and TP, using hypothetical figures. The table is
based on the assumption that L (labour) is the variable factor, and some constant amount of fixed factor
is used in the process of production.
L(units of labour) TP(Total product) AP(average product) MP(marginal product)
1 50 50÷1=50 TP1-TP0=50-0=50
2 90 90÷2=45 TP2-TP1=90-50=40
3 120 120÷3=40 TP3-TP2=120-90=30
4 140 140÷4=35 TP4-TP3=140-120=20
5 150 150÷5=30 TP5-TP4=150-140=10
6 150 150÷6=25 TP6-TP5=150-150=0
7 147 147÷7=21 TP7-TP6=147-150=-3

When 6 units of labor (or variable factor) are employed:

TP= AP×L=25×6=150
TP=⅀MP
=50+40+30+20+10+0
=150
AP=TP =150=25
L 6
MP of 6th =TPn-TPn-1
= TP6-TP5
=150-150=0
Likewise, when 7 units of labor are employed:
TP= AP×L=21×7=147
TP=⅀MP
= 50+40+30+20+10+0-3
=147
AP= TP = 147 = 21
L 7
th
MP of 7 unit = TPn-TPn-1
=TP7-TP6
= 147-150= -3
Negative MP:
Yes, MP can be negative in certain situations. Particularly when there is excessive employment (or
disguised unemployment) as in some public sector undertakings in India. Excessive employment
(employment of workers more than required) reduces overall efficiency of the workers. Because of
which MP may be negative. In such situations, TP increases when some workers are withdrawn.

Returns to a factor: The Law of Variable Proportions:

Law of variable proportions states that as more and more of the variable factor is combined with the
fixed factor, a stage must ultimately come when marginal product of the variable factor starts declining.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 47

This is essence of the law of variable proportions or the law of diminishing returns (also called law of
diminishing marginal product).
Explanation of the law:
The law of variable proportions is explained with the help of table and fig.
Table: Law of variable proportions- increasing returns, diminishing returns and negative returns

Units of land Units of labour Total product Marginal product

1 1 2 2 Increasing MP
1 2 5 3 implying increasing
1 3 9 4 return to a factor.
1 4 12 3 Diminishing MP
1 5 14 2 implying
1 6 15 1 diminishing returns
1 7 15 0 to a factor.
1 8 14 -1 Negative MP
implying negative
return to a factor.

[Note: where MP stops increasing, from that very point it starts diminishing. Thus, overlapping is
indicated in the above table when MP=4.]
The table shows that as more and more units of labour (variable factor) are used, MP (marginal
product) tends to rise till 3 units of labour are employed. In this situation, TP (total product) increases
at the increasing rate. This is situation of increasing returns to the factor. But, with the application of 4th
unit of labour, situation of diminishing returns sets in: MP starts decreasing and TP increasing only at
the decreasing rate.
Diminishing MP reduces to zero. Total output is maximum (=15), when marginal output is zero.
Eventually, MP may be negative. Now output (TP) starts declining (as from 15 to 14) when 8th unit of
labour is employed.

You must note important observation as these

 When MP is increasing (from 2 to 3 to 4), TP is increasing at increasing rate: first 2 units are
added to TP, then 3 and then 4 units of output.
 When MP is decreasing (from 4 to 3 to 2 to 1),TP is increasing at a diminishing rate: addition to
TP reduces from 4 to 3 to 2 to 1 unit.
 When MP is zero, there is no addition to TP.
 Hence, TP is maximum when MP=0.
 When MP is negative, TP starts declining.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 48

Y
TP curve

T
Point of inflexion •
TP

Total product K•

Stage 1st Stage 2nd Stage 3 rd

o L S X
Y

Increasing Diminishing negative

Returns Returns Return

Marginal product stage 1 stage 2 stage 3 MP Curve

o E

Units of the variable factor (labour)

o L S X

 Stage 1is between o to k on the curve TP. In this zone, MP is increasing and TP is increasing at the
increasing rate.
 2. Stage 2 is between K to T. in this zone, MP is decreasing and TP is increasing at the decreasing
rate.
 Stage 3 is beyond point T. now TP starts declining because MP is negative.
 K is the point of inflexion where TP stops increasing at the increasing rate and instead, starts
increasing at the decreasing rate.

Point of Inflexion: It is a point from where slope of TP changes. Up to this point, TP has been
increasing at the increasing rate. From this point onwards. TP increases, but only at the diminishing
rate.
It is a point which coincides with the end of stage 1 of production (as MP stops increasing at this point)
or this is a point which marks the beginning of stage 2 of production (as MP starts diminishing from
this point.)in fig.K is the point of inflection.

Causes of increasing returns to a factor: Increasing returns to a factor occur because of the following
factors:
 Fuller utilization of the fixed factor: in the initial stages, fixed factor (such as machine)
remains underutilized. Its fuller utilization calls for greater application of the variable factor
(labour). Hence, initially (so long as fixed factor remains underutilized) additional units of the
variable factor add more and more to total output, or marginal product of the variable factor
tends to increase.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 49

 Increased efficiency of the variable factor: additional application of the variable factor
(labour) enables process based division of labour that raises efficiency of the factor.
Accordingly, marginal productivity of the factor tends to rise.
 Better coordination between the factors: so long as fixed factor remains underutilized,
additional application of the variable factor tends to improve the degree of coordination between
the fixed and variable factors. As a result total output increases at the increasing rate.

Causes of diminishing returns to a factor: diminishing returns to a factor or the law of diminishing
returns may be explained in terms of the following factors:
 Fixity of the factor: fixity of the factor (s) is the principal causes behind the law of diminishing
returns. As more and more units of the variable factor are combined with the fixed factor, the
latter gets excessively utilized. It suffer greater wear and tear and losses its efficiency. Hence,
the diminishing returns.
 Imperfect factor substitutability: factors of production are imperfect substitutes of each other.
More and more of labor cannot be continuously used in place of capital. Accordingly,
diminishing returns are bound to set in if only the variable factor is increased to increase output.
 Poor coordination between the factors: increasing application of the variable factor (along
with the fixed factor) stretches the limit of idea factor ratio. This result in poor coordination
between the fixed and variable factor, causing diminishing returns.

Assumptions of the Law:

The law of variable proportions is based on certain assumptions. These are as follow:
 Ratio in which factor of production are combined can be changed.
 Units of the variable factor are homogeneous or equally efficient and are increased one by one.
Thus, diminishing returns start occurring not because latter units of the variable factors are less
efficient than the former ones, but because of the fixity of the factor.
 State of technology does not change.

Three stage of production:
 Stage 1, when MP is increasing, called the stage of increasing return.
 Stage 2, when MP is diminishing, called the, and stage of diminishing
return
 Stage 3, when MP is negative, called the stage of negative returns.

A situation of constant return to a factor

Between the situation of ‘increasing return to a factor’ and ‘diminishing returns to a factor’, a firm may
have a situation of constant returns to a factor. It is situation when MP of the variable factor tends to
remain constant even more and more of the variable factor is combined with the fixed factor (S). When
MP is constant (say=10), TP will increase only at a constant rate: every time it will increases by 10
units of output.

Postponement of the Law:

Postponement of the law of variable proportions (the situation of the diminishing MP) is possible under
two situations, as under
 When there is improvement in technology used in the process of production. So that greater
output is achieved with the same inputs.
 When some substitute of the fixed factor is discovered. So that the constraint of fixity of the
factor is removed. However, such a situation is very rare, if not impossible.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 50

Relation between: 1. TP and MP, and 2. AP and MP

Table and figure shows how TP, MP and AP are related to each other.
TP, MP, and AP
Units of land Units variable MP TP (=⅀MP) AP=(TP\L)
(hectares)- fixed factor (L) (no. of (output of rice in (Output of rice in (Output of rice in
factor workers tones) tonnes) tonnes)
employed)
1 0 - 0 -
1 1 6 6 6
1 2 14 20 10
1 3 28 48 16
1 4 24 72 18
1 5 8 80 16
1 6 4 84 14
1 7 0 84 12
1 8 -4 80 10

90
80 TP
70 r
60
50 K
40
30
20
10

0 1 2 3 4 5 6 7 8

30 a
20
10 AP

o 1 2 3 4 5 6 7 8MP X
MP is increasing till 3 units of labor are employed. Accordingly, between 0 to k, TP is increasing at an
increasing rate.
Between 3 to 7 units of labor, MP is declining. Accordingly, between k to r, TP is increasing at
diminishing rate.
When 7 units of labor are employed, MP=0.accordingly, at point r,TP is maximum
Beyond 7 units of labor, MP becomes negative. Accordingly beyond r, TP starts declining.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 51

Observations: Relation between TP and MP:

Table and fig. offer following observations on the relation between TP and MP.
 So long as MP is increasing, TP is increasing at increasing rate. Table and fig. show that till the
3rd unit of variable factor, MP is increasing from 6 to 14 to 28 tonnes of rice. Accordingly,
while the 1st unit of labour contributes 6 tonnes of rice to total output, 2nd unit contribute 14
tonnes and the 3rd unit contributes 28 tonnes. Implying that TP is increasing at increasing rate.
 When MP starts diminishing, TP increases only at a diminishing rate. It starts happening when
4th unit of labour is used. MP of the 4th unit is 24 tonnes of rice, of the 5th unit it is 8 tonnes of
rice, and of the 6th unit it is just 4 tonnes of rice. Accordingly, when 4th unit of labour is used,
TP increases by 24 tonnes; when 5th unit of labour is used, TP increases by 8 units, and when 6th
unit of labour is used, TP increases only by 4 tonnes. Implying that TP is increasing only at
decreasing rate.
 When MP=0, there is no addition to TP. It happens when 7th unit of labour is used.
Corresponding to zero MP, TP is maximum.
 When MP is negative, TP starts declining. It happens when 8th unit of labour is employed. TP
diminishes from 84 to 80, and MP is 80-84=-4.

MP is the rate of TP
Increasing MP implies TP is increasing at increasing rate. Diminishing MP implies that TP is
increasing at diminishing rate. Zero MP implies that TP stops increasing. Negative MP implies
reduction in TP.

Observation: relation between AP and MP

 AP increasing so long as MP>AP. It happens in fig. till point ‘a’ where AP is at its top.
 AP decreases when MP<AP. It happens in figure beyond point ‘a’ where AP is at its top.
 AP is at its maximum when AP=MP. It is exactly at point ‘a’ in fig. thus, MP curve cuts AP
curve from its top.
 MP may be zero or negative, but AP continuous to be positive.
Geometrically, MP and TP show the following relationship:
Y

MP

Marginal product
Increasing M

o units of the variable factor X

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 52

TP

Total
Product
TP increases at
Increasing rate
[Note: steepness of the
TP curve is increasing]
o X
Units of the variable factor

TP

Total
Product TP increase at a
constant rate
[note: a rising straight line shows
a constant rate of increase]

o Units of the variable factor X

Marginal Declining MP
Product

MP

X
o Unit of the variable factor

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 53

TP
Total
Product TP rises at a declining rate
[Note: steepness of the TP curve
Is decreasing]

o Units of the variable factor X

Marginal
Product

zero and negative MP

o MP X
Units of the variable factor
Y

Total
Product
TP
Corresponding to zero MP, TP reaches
Its peak and corresponding to negative
MP,TP starts declining
o Units of the variable factor X

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 54

CHAPTER-7
CONCEPTS OF COST
Concept of Cost
The expenditure incurred in producing a commodity is called cost. The expenditure incurred by a firm
on factor as well as non factor inputs (for the production of a commodity) is called cost of production.
OR
Cost of production refers to expenditure incurred by a firm on the factor inputs (land, labour, capital
and entrepreneurship) as well as non-factor inputs (raw material) for the production of a commodity.
Expenses incurred in formation of total cost on the 4 factors of production are rent, wages, interest and
profit (normal Profit).
Explicit and Implicit Cost
All inputs may not be purchased from the market. A producer may use some self-owned inputs.
Example: instead of hired workers from the market, producer may use his family labour. Likewise, a
producer may use his own land instead of taking it on lease. Expenditure incurred by the producer may
use his own land instead of talking it on lease. Expenditure incurred by the producer on the purchase of
inputs from the market is called explicit cost. Estimated expenditure on the use of self-owned inputs is
called implicit cost.
Flow chart: measurement of cost
Cost = opportunity cost

Explicit cost Implicit cost

Opportunity cost of Opportunity cost of using

Hiring /purchasing inputs self-owned inputs
From the market

Payment made by a firm to others Market value of self – owned inputs

For hiring/ purchasing inputs from in their next best alternative use
The market

Economic costs:
Economic costs = Explicit costs + Implicit costs (including Normal profit)
Where,
Explicit cost = Expenditure incurred on the factors hired by the producer, where the payment is made
to the outsider. Example: Payment for raw material, electricity etc., Salaries paid to workers.
Implicit cost = Imputed expenditures incurred on self owned factors of production, where no actual
payment is made. Example: Depreciation, interest on self-owned capital, rent on self owned capital.
Normal profit = the minimum profit the producers expect. It’s remuneration to the entrepreneur for
undertaking risk and organizing the production process.
Selling and Production costs:
Selling costs refer to the expenditure incurred by the producer in order to promote sale of the
commodity.
E.g. expenditure on advertisement.
Production cost refers to the expenditure incurred by a producer used in the process of production on
factor as well as non-factor inputs.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 55

Types of cost:

Short Run Cost

Total cost Average cost Marginal cost

Total fixed Total variable Average fixed Average variable

Cost Cost Cost Cost
Total Cost
Total Fixed Cost:
 The cost which remains constant at all levels of output is called as total fixed cost.
 Total fixed cost is the sum total of expenditure incurred by the producer on the purchasing or
hiring of fixed factors of production.
 It is incurred on fixed factors of production like plant and machinery. By definition the
application of these factors cannot be changed in short period (short period is the period of time
which is too short to change the application of fixed factors). Therefore, fixed costs are constant
costs of the short period.
 Since fixed factors are installed even before actual production starts, thus TFC is incurred even
at zero level of output.
 The production of a commodity shall continue even if fixed cost is not recovered.
 TFC curve is parallel to x-axis.
 Examples: Rent, Interest, Salaries to permanent employees, Depreciation, Minimum telephone
bill etc.

Total fixed cost Y

Units of output Total fixed cost
(rs.)
0 10
1 10
2 10
3 10 TFC
4 10
5 10 TFC
6 10

X
Output (units)
TFC is a horizontal straight line parallel to X- axis, showing that total fixed cost is constant at all levels
of output. It is=RS. 10, even when output is zero.

Total Variable Cost:

 These vary with the level of output, i.e. they change with the change with change in output.
 They increase with increase in output and decrease when output decreases.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 56

 Variable costs are zero at zero level of output.

 These are incurred by the producer on the use of variable factors of production. These are also
known as prime costs or direct costs.
 The behavior of total variable cost is governed by the law of variable proportions. When
output increases at increasing rate, the total variable cost increases at diminishing rate and
when total product increases at diminishing rate the total variable cost increases to increasing
rate.
 The production is discontinued if variable cost is not recovered.
 Some e.g. of variable costs are wages, payment for raw material, etc.
 Total variable cost has an inverted ‘S’ shape curve.
Table: Total variable cost
Units of Total variable Y TVC
output cost
0 0
1 10
2 18 Total Variable
Cost
3 24
4 28
5 32
6 38

0 X

Output
TVC increases with increase in output. Initially, it increases at decreases rate (till point A). it increases
at an increasing rate when diminishing returns to a factor starts operating.
Fixed Costs and Variable Cost- A Contrast
Fixed costs Variable costs
 Fixed costs do not change with change in  1. Variable costs change with change in
quantity of output. quantity of output .
 Fixed costs remain the same whether  2. Variable costs are zero when output is
output is zero or maximum. zero. These costs increases when output
Example: increases when output increases and
 Rent decrease when output decreases.
 Wages of permanent staff. Example:
 License fee  Cost of raw material.
 Cost of plant and machinery.  Wages of casual labour.
 Expenses on electricity.

Total Cost:
 Total cost is the sum totals of total fixed cost, and total variable cost.
TC = TFC + TVC
 At zero unit of output Total Cost is equal to total fixed cost.
 Since total fixed cost is constant at all levels, total cost curve is parallel to total variable cost
curve.
 The behavior of total cost is governed by law of variable proportions

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 57

Fixed cost, variable cost, and Total cost.

Output Fixed Variable Total cost Y TC
(units) cost(RS.) cost(RS.) (Rs.) Total TVC
0 10 0 10 Cost
1 10 10 20
2 10 18 28
TC,TVC,
3 10 24 34 TFC
4 10 28 38
5 10 32 42
6 10 38 48
TFC

O Output(units X

TC=TFC+TVC
 TFC is constant at all levels of output.
 TVC increases as output increases.
 TC is parallel to TVC. It shows that the difference between TC AND TVC (=TFC) is
constant.

Average Cost:
Average Fixed Cost
Average fixed cost is the fixed cost incurred per unit of output. AFC diminishes as output
increases.
AFC = Total Fixed Cost = TFC .
Quantity of Output Q
The AFC curve never touches the axis and is a rectangular hyperbola.

Rectangular hyperbola

Output(units)
AFC is rectangular hyperbola. It shows
 That AFC decreases as output increases.
 AFC×Q at any level of output is the same because,
AFC×Q=TFC
Which is constant at all level of output.
Thus : 4×2.5=10
8×1.25=10

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 58

Average Variable Cost:

 Average variable cost is the per unit variable cost of production.

 AVC = Total Variable Cost = TVC

Quantity of Output Q
 AVC curve is ‘U’ shaped and the behavior of AVC is governed by the variable law of
proportions i.e. when output increases at increasing rate, the variable cost increases at
diminishing rate thus average variable cost falls and when output increases at diminishing
rate, the variable cost increases at increasing rate thus average variable cost increases.
Y
OUTPUT TVC AVC

0 0 -
1 20 20
2 30 15
3 35 11.67 Average
45 11.25 Variable
Cost
5 60 12
6 80 13.33
7 120 17.14
8 180 22.5 o Unit of output X
Average (Total) Cost:
 Cost per unit of output produced is called average cost or unit cost of production.
 AC = Total Cost = TC .
Quantity of Output Q
 AC curve is ‘U’ shaped and AC behavior is governed by the law of variable proportions i.e.
when output increases at increasing rate, total cost increases at diminishing rate thus average
cost falls and when output increases at diminishing rate, total cost increases at increasing rate
thus average cost increases.

OUTPUT TFC TVC AVC AC

Y
0 100 0 - ∞
1 100 20 20 120
2 100 30 15 65
3 100 35 11.67 45
4 100 45 11.25 36.25
5 100 60 12 32
6 100 80 13.33 30
7 100 120 17.14 31.43
8 100 180 22.5 35
Marginal Cost:
Marginal cost is the change in total cost when an additional unit of output is produced.
OR
Marginal cost is the addition to total cost due to the addition of one unit of output.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 59

MC = Change in total cost = TC .

Change in output Q

MC = TCn – TCn-1
OR
MC = TVCn – TVCn
Since total cost shows exactly the same behavior as total variable cost thus marginal cost can also be
defined as the change in total variable cost when an additional unit of output is produced.
MC = TVCn – TVCn-1
MC = Change in total variable cost = Δ TVC .
Change in output ΔQ
The behavior of MC is governed by the law of variable proportions. The MC curve is ‘U’ shaped.
OUTPUT TFC TVC MC

0 100 0 -
1 100 20 20
2 100 30 10 MC
3 100 35 5
4 100 45 10
5 100 60 15
6 100 80 20
7 100 120 40 o Units of Output X
8 100 180 60
Unit of output
[** MC is variable cost only as by definition additional cost cannot be fixed cost; it can be only
variable cost. Accordingly the sum total of MC corresponding to different units of output becomes
TVC.
∑MC = TVC **]
Relationships:
Average cost and Average Variable Cost
 Both the curves are ‘U’ shaped.
 Both are governed by the law of variable proportions.
 AC – AVC = AFC.
 At initial levels of output AC and AVC are far from each other, further the gap keeps reducing
but the two curves cannot intersect each other, as AFC continues to fall but cannot be zero.
Y
AC
AVC

AC, AVC

o N N1 X
Unit of output
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 60

Average Cost and Average Fixed Cost:

 AC – AFC = AVC.
 When AVC falls AC and AFC are close to each other, and when AVC increases, the gap
between AC and AFC increases.
X AC

AC,AFC

AFC
o Y
Average Cost and Marginal Cost:
 When MC is greater than AC, average cost increases,
 When MC is equal to AC, average cost is constant.
 When MC is less than AC, average cost decreases.
[Note: MC should intersect AC at its midpoint.
Y
MC AC

MC,AC

0 Unit of output X
Total Cost and Marginal Cost:
 When total cost increases at a diminishing rate, Marginal cost decreases. (Till point a
in the diagram)
 When total cost increases at an increasing rate marginal cost increases. (after point a
in the diagram)
Y TC

MC

o X

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 61

Average Variable Cost and Marginal Cost:

 When marginal cost is greater than average variable cost, average variable cost increases.
 When marginal cost is equal to average variable cost, average variable cost is constant.
 When marginal cost is smaller than average variable cost, average variable cost decreases.
Y

o MC AC X

Total Variable Cost and Marginal Cost:

 When total variable cost increases at a diminishing rate marginal cost decreases. (Till point
a in the Diagram
 When total cost increases at and increasing rate marginal cost increases. (after point a in the
diagram)

TVC a

MC

Average Cost, Average Variable Cost , and Marginal Cost:

 Marginal cost curve intersects average cost and average variable cost at their minimum
point.
 Minimum point of marginal cost curve is prior to minimum point of average variable cost
curve followed by the minimum point of average cost curve.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 62

 As long as MC is less than AC and AVC, both AC and AVC fall.

 When MC is equal to AC and AVC, both AC and AVC are constant and minimum.
 As long as MC is greater than AC and AVC, both AC and AVC increase.
Y
AVC
MC AC

X
Time Element and Cost:
 Very short or market period: Very short period is also referred to as market period. It is so
short period that production cannot be increased. Accordingly, it becomes immaterial
whether the producer can cover his cost of production or not at the prevailing price of the
product.
 Short period: It is the period of time during which production can increased only by
increasing the Variable factors. Application of fixed factor remains constant. The producer
can control only the variable cost, not the fixed cost. Accordingly, the producer must cover
at least variable costs of production during short period.
 Long period: It is the period of time during which production can be increased by way of
additional application of all the factors of production. Accordingly, the producer must cover all
costs of production. In fact all costs are of the nature of variable costs in the long run because
no factor is a fixed factor in the long run. Accordingly, all costs are under the control of the
producer, and therefore must be covered.
In short, while during the market period, cost factor becomes irrelevant, the producer must
cover at least variable costs during the short period, and all costs, during the long period.

Formulas:
(1) Total Cost:
a. T C = TFC + TVC
b. TC = TFC at zero unit
c. TC = TFC at zero unit + ∑MC
d. TC = AC x output
(2) Total Fixed Cost:
a. T F C = TC – TVC
b. TFC = AFC x Q
c. TFC = TC at zero unit
d. TFC is constant at all levels.
(3) Total Variable Cost:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 63

a. T VC =TC-TFC
b. TVC=AVC x Q
c. TVC = ∑MC
d. T V C = MC at 1st unit
e. T VC is zero at zero units.
(4) Average fixed Cost:
a.AFC = AC – AVC
b.AFC = TFC/Q
(5) Average Variable Cost:
a. AV C = AC – AFC
b. AVC = TVC/ Q
(6) Average Cost:
a. AC = AVC + AFC
b. AC = TC/ Q
(7) Marginal Cost:
a. MC = TCn – TCn-1
b. MC = TVCn – TVCn-1
c. MC = ΔTC /ΔQ
d. MC = ΔTVC/ΔQ
e. MC = TVC at 1st unit of output

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 64

CHAPTER-8
CONCEPT OF REVENUE
REVENUE
Revenue refers to the money receipts of a firm from selling its output.
Suppose, you are running a factory producing ice cream. You produce 1000 ice cream daily. By selling
these ice creams you get RS. 1000. in economics, this amount of RS. 1000 is called revenue.
In the words of Dooley,” the revenue of a firm is its sale receipts or money receipts from the sale of a
product.” It is also called sale proceeds.
Revenue and Profit are different concepts:
The concept of revenue is different from the concept of profit. The following equation shows the
difference:
Profit = revenue – cost
Revenue= costs + profit
Concept of Revenue

Total Marginal Average

Revenue Revenue Revenue

TOTAL REVENUE
Total Revenue is the amount of money a firm receives when it sells a given level of output.
 TR = Price x output
 TR = AR x output
 TR = ΣMR

AVERAGE REVENUE
Average Revenue is the per unit revenue received by the firm from the sale of the commodity. It is the
price of the commodity. The AR curve is downward sloping, indicating that in order to increase the
sales of a firm, it needs to reduce the per unit price of the commodity.
 AR = TR/ OUTPUT
 The AR curve represents the demand for a firm's product. Hence, it is also the demand curve
faced by the firm.

MARGINAL REVENUE
Marginal Revenue is the additional revenue earned by a firm when an additional unit of output is sold.
 When output increases by one unit MR = TRn – TRn-1
 When output increases by more than one unit MR =ΔTR/Output.

RELATIONSHIP BETWEEN TR, AR AND MR:

Relationship between TR, AR and MR depends upon the form of market i.e. whether the market is a
form of perfect competition, monopoly or monopolistic competition.
Relationship between TR, AR and MR in Perfect competition (When all units can be sold at same
price):
Perfect Competition refers to a market form where:
 There are large number of buyers and sellers.
 The product sold is homogeneous i.e. identical in all respect. Product sold by one firm is exactly
similar to the product sold by the other firm. It is the perfect substitute of the product of the
other firms.
 Price of the product is determined by the industry, thus an individual firm has no control over
the price. Uniform price prevails in the market i.e. all the units are sold at same price.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 65

Unit of output Price TR AR MR

0 - 0 - -
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
Relation between TR and MR
 Since all the units can be sold at same price, Marginal Revenue remains constant and Total
Revenue increases at a constant rate
 Total Revenue is zero at zero unit of output; Marginal Revenue is constant at all levels.
 Total Revenue curve is a positively sloped straight line passing through the origin.
 Marginal Revenue curve is a horizontal straight line parallel to x- axis.
Y

TR

TR, MR

MR

o X
Unit of output
Relation between AR and MR
 Since all the units can be sold at same price, Marginal Revenue is equal to marginal Revenue.
 Marginal Revenue and Average Revenue curves coincide and are horizontal straight line parallel
to x-axis.
 The Average Revenue curve i.e. the demand curve of the firm is perfectly elastic.

AR=MR

AR,MR

Unit of output

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 66

Relationship between TR, AR and MR in Imperfect Competition (when more output can be sold
at lower the price)
Unit of output Price TR AR MR
0 - 0 - -
1 10 10 10 10
2 8 18 8 8
3 6 18 6 0
4 4 16 4 -2
5 2 10 2 -6
Relation between TR and MR
 When MR is falling but positive, TR is increasing at a diminishing rate till point a in the diagram.
 When MR is zero, TR is at its maximum point at point a in the diagram.
 When MR is negative, TR starts to fall after point a in the diagram.

Y
a

TR,MR TR

a X
Units of output
MR
Relationship between AR and MR:
 Both AR and MR fall.
 MR is less than AR because additional units are sold at lower price thus every addition made to
the total revenue will be less than the price.
 MR can be negative, but AR can never be negative.
 MR and AR curves are steep in shape as the product sold has no close substitute available in the
market.
 The Average Revenue curve i.e. the demand curve of the firm is relatively inelastic.
Y

AR,MR

AR

X
MR
Units of output

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 67

Units of output Price TR AR MR

0 - 0 - -
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4
Relation between TR and MR
 When MR is falling but positive, TR is increasing at a diminishing rate till point a in the diagram.
 When MR is zero, TR is at its maximum point at point a in the diagram
 When MR is negative, TR starts to fall after point a in the diagram.

TR,MR MR

MR
Units of output
Relationship between AR and MR:
 Both AR and MR fall.
 MR is less than AR because additional units are sold at lower price thus every addition made to
the total revenue will be less than the price.
 MR can be negative, but AR can never be negative.
 MR and AR curves are flat in shape as the product sold has large number of close substitute
available in the market.
 The Average Revenue curve i.e. the demand curve of the firm is relatively elastic.
Y

AR,MR

AR

o Units of output X

MR

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 68

Relationship between total, average and marginal revenue

Discuss on the behavior of TR,AR, and MR reveals the following relationship between these variants
of revenue:
1. TR = AR×Q or ⅀MR
2. AR= TR/Q
3. MR=TRn-TRn-1
4. When TR is increasing at constant rate, MR should be constant.
5. When TR is increasing at diminishing rate, MR should be diminishing.
6. When TR is maximum, MR is zero.
7. When TR is diminishing, MR is negative.
8. When AR is curve is sloping downward, MR curve should be below the AR curve as in monopoly or
monopolistic competition.
9. If AR is constant, MR is equal to AR.
10. MR=AR in perfect competition, both are represented by a common horizontal line parallel to X-
axis.
A Few more relationships:
 MR is simply an addition to TR when one more unit of output is sold.
 In case price is constant (implying AR is constant), then MR should also be constant (AR being
equal to MR).
 Constant MR implies constant addition to TR when an addition unit of output is sold. This
implies that TR will increase at a constant rate.
What happens if AR is not constant?
Under monopoly and monopolistic competition, price (=AR) tends to decreases as more is sold. In such
a situation, we will have a table like the following:
Table
Total Revenue, Average Revenue, and Marginal Revenue, when AR is not constant
Output PRICE=AR TOTAL REVENUE MARGINAL
Q (RS.) TR= AR×Q REVENUE
(UNITS) (RS.) MR=TRn-TR n-1
(RS.)
1 10 10 10(=10-0)
2 9.5 19 9(=19-10)
3 9 27 8(=27-19)
4 8.5 34 7(=34-27)
Check table for the following relationships:
 In case AR is not constant, but declining, MR is also declining.
 When AR is declining by RS. 0.5, MR is declining by RS. 1. This proves that under monopoly
and monopolistic competition MR declines, and declines faster than AR. So, that AR > MR.
 When MR is declining, we are adding less and less to TR increases only at diminishing rate.
Can MR be zero or negative?
Yes, MR can be zero or negative. It is clear from the following illustration:

Table
A Situation of Zero and Negative MR
Average revenge or Output (UNITS) Total Revenue (RS.) Marginal revenue (RS.)
price (RS.)
100 1 100 100(=100-0)
80 2 160 60(=160-100)
40 4 160 0(=160-160/2)
30 5 150 -10(=150-160)
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 69

Check table for the following relationship:

 MR can be zero or even negative, but only when price is declining as under monopoly or
monopolistic competition.
 TR stops increasing when MR=0,so that TR is maximum when MR=0.
 TR starts declining when MR is negative.
 When MR is declining, less and less is added to TR for every additional unit sold. Accordingly,
TR increases only at a diminishing.

Y
TR is Maximum
(A) B

Output(units) X

Y (B)

TR

Zero AR
0 M X
-VE
MR
Output (units)

Up to point B, TR curve is increasing at a decreasing rate. This is because MR= is decreasing. At point
B, TR is maximum. This is because, MR=0. Beyond point B, TR starts declining. This is because MR
is negative. In a situation of zero price, AR touches X- axis. Accordingly, TR also touches X-axis.
When the diminishing marginal revenue (MR) become zero, as it indicated in fig. by point M, total
revenue (TR) will be maximum as indicated by point B in fig.
example: free medicines given in government hospitals.
Firm’s revenue curve in different markets:
Broadly, markets are of three types:
 Perfect competitive market
 Monopoly market, and
 Monopolistic competitive market.
Firm’s revenue curves are different in different markets.
These are discussed as under:
 Revenue curves under perfectly competitive market or perfect competition: Under perfect
competition, a firm is a price taker. It cannot influence / change the market price. It can sell any
number of units of output at the prevailing price, it will lose all its customers.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 70

Table 4: Firm’s revenue under perfect competition

Output/sales Average revenue= Total revenue Marginal revenue
Q price (RS.) TR=AR×Q MR=TRn-TRn-1
(units) (RS.) (RS.)
1 5 5 5
2 5 10 5
3 5 15 5
4 5 20 5
Firm’s revenue curves under perfect competition.
Y

D D
P=AR=MR

Revenue

o Output (units) X
Firm’s price line or revenue curve under perfect competition is a horizontal straight line. AR and MR
coincide with each other. This is because, under perfect competition, a firm is a price taker. At the
given price, it can sell any quantity of output.
 Revenue curves under monopoly: under monopoly, the average revenue curve and marginal
revenue slope downwards from left to right. It means that if a monopolist desires to sell more,
he has to reduce price of the product. A monopolist, by definition is a price maker. Being a
single seller of the product in the market, he can fix whatever price he wishes to. But, he can
sell more only if he lowers the price of his product. Thus, there is negative relationship between
price of the product and demand for the product in a monopoly market. Accordingly, firm’s
demand curve or AR curve (or price line) slopes downward.
Table firm’s revenue under monopoly
Output/sales Average revenue Total revenue Marginal revenue
Q AR= TR/Q=price TR=AR×Q MR=TRn-TRn-1
(units) (RS.) (RS.)
1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 71

Firm’s revenue curves under monopoly

Y

Revenue
(RS.)
AR
MR
o Output (units) X
AR curve slopes downward. It shows that monopoly firm must lower price (AR) of the product in case
it wants to sell more of it. If AR falls, and in such a situation MR<AR.
 Revenue curves under monopolistic competition: Revenue curves under monopolistic
competition are similar to monopoly as illustrated by:
Table 6 Firms revenue under monopolistic competition
Output/sales Average revenue Total revenue Marginal revenue
Q AR=TR/Q TR=AR × Q MR=TRn-TRn-1
(units) =Price (RS.) (RS.)
(RS.)
1 10 10 10
2 9.5 19 9
3 9 27 8
4 8.5 34 7

Revenue(rs.)
AR

MR

o Output(units) X
Like under monopoly, AR curve for a firm under monopolistic competition also slopes downward.
However, the difference is that AR curve under monopolistic competition is more elastic than under
monopoly.
Reason: lack of close substitutes for the monopoly product, and availability of close substitutes for a
firm under monopolistic competition.
Firm’s revenue curve or demand curve in different market situation- A Comparative look:
Fig. offers a comparative glimpse of producer’s revenue curve or demand curve or demand curve under
different market situation.
1. DP is demand curve under perfect competition. It is perfectly elastic.
2. DM is demand curve under monopoly. It is relatively less elastic.
3. DMC is demand curve under monopolistic competition. It is relatively more elastic.
[Note: producer’s demand curve or revenue curve is also called producer’s price line.]

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 72

A
Monopolistic competition

P DP
Revenue (RS.)
Perfect Competition
DMC
DM

o output(units) X

Firms demand curve is perfectly elastic under perfect competition; it is relatively less elastic under
monopoly, and more elastic under monopolistic competition.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 73

CHAPTER-9
PRODUCER’S EQUILIBRIUM
Producer’s Equilibrium mean
Producer's equilibrium refers to a situation where a firm or a producer is able to maximize the profit or
minimize losses and has no tendency to change the level of output.
Producer's equilibrium can be studied under two approaches.
i. Total Revenue - Total Cost Approach
ii. Marginal Revenue - Marginal Cost Approach
Profit is generally calculated as the difference between TR (total revenue) and TC (total cost).
= −

Here, = profit
TR= Total revenue
TC= Total cost

Producer’s equilibrium is struck at that level of output where is maximized.

We know,
TC=TVC+TFC
Since, TFC is constant, we can state is maximized when the difference between TR and TC is
maximized or when the difference between TR and TVC is maximized. However, it must be noted that
while the difference between TR and TC yield net profit, the difference between TR and TVC yield
gross profit.
Gross and net profit:
Gross profit = TR-TVC
Net profit = TR-(TVC+TFC)
= TR-TC
You must know it
In economics, the concept of profit has three aspects, VIZ.
1. Abnormal profits or extra- normal profits, when
TR>TC
TR > TC
Q Q
AR>AC
We know TR=AR, TC=AC
Q Q
2. Normal profits, when:
TR = TC
TR = TC
Q Q
AR = AC
3. Sub- normal profits (or losses) when:
TR<TC
TR<TC
Q Q
AR<AC
A situation of normal profit (when TR= TC) is somewhat confusing. A doubt may come to your mind:
Where are normal profits when TR and TC are equal to each other? Where are normal profits
when the producer is only covering his total cost of production? Here, is an answer. In economics
normal profits are a part of TC. Normal profits are defined as the minimum return that the producer
expects from his capital invested in the business. If this minimum return is not available, he will
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 74

withdraw his capital from the existing use and shift it to the next best alternative use. Normal profits are
a part of TC.
Normal profits
Normal profits are defined as the minimum return that the producer expects from his capital invested in
the business. If this minimum return is not available, he will withdraw his capital from the existing use
and shift it to the next best alternative use. Normal profits are a part of TC.
Conditions of Producers Equilibrium in terms of Marginal Revenue and Marginal Cost
Approach:
Producer’s equilibrium is often explained in terms of marginal revenue (MR) and marginal cost (MC)
of production. Profit is maximized (or a producer strikes his equilibrium) when two conditions are
satisfied: 1. MR=MC, and 2. MC is rising (or MC is greater than MR beyond the point of equilibrium
output). Let us understand the significance of these condition with reference to table
Table1. MR, MC and producer’s Equilibrium
Q MR MC
(Units of output) (Rs.) (Rs.)
1 12 15
2 12 12
3 12 10
4 12 9
5 12 8
6 12 7
7 12 8
8 12 9
9 12 10
10 12 12
11 12 15

In table, MR=MC, in two situations (1) when 2 units of output are produced, and (2) when 10 units of
output are produced. However, while in situation 1 (when output =2 units) MC is falling, while in
situation 2 (when output = 10 units) MC is rising. As noted earlier, a producers will strike his
equilibrium only when MC is rising. Implying that the equilibrium will be struck when 10 units of
output are produced, not when 2 units of output are produced. Reason is simple. Give the price, falling
MC only increases the difference between TR and TVC (recall, ƩMC= TVC, and ƩMR= TR). So that
TR-TVC tends to rise, or that profits tends to rise in a situation of falling MC.
Situation 1: when output = 2 (and MR=MC, and MC is falling)
TR= ƩMR=12+12=24
TVC = ƩMC = 15+12=27
= − = 24 − 27 = −3
Situation 2: when output = 10 (and MR= MC, and MC is rising)
TR=ƩMR
= 12+12+12+12+12+12+12+12+12+12
=120
TVC =ƩMC
=15+12+10+9+8+7+8+9+10+12=100
= −
120-100=20
Thus, we find that the difference between TR and TVC tends to rise, as output is increased from 2 to
10. In fact, it is only when output=10 that the value or (profit) is maximum. If output is increased
beyond 10 units, will be reducing. Thus, if 11 units of output are produced, ƩMR=132, while
ƩMC=115, so that = TR-TVC=132-115=17 (which is less than 20 when output= 10). Finally, the
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 75

conclusion emerge that it is only when MR=MC, and when MC is rising that a producer will reach the
point of his equilibrium, maximizing his profit.
Diagrammatic illustration: illustrates producer’s equilibrium in terms of MR and MC approach.
In fig. AR=MR=OP and is assumed to be constant as under perfect competition. Accordingly, AR (and
MR) line is drawn as a horizontal straight line parallel to X-axis. MC curve is shown to be U-shaped, as
usual. MR is equal to MC under 2 situations:
1. At point Q1 when output= OL1, and
2. At point Q2 when output = OL2. In situation 1, MC is falling but in situation 2, MC is rising.
We know, TR=area under MR corresponding to a given level of output.
This is equal to OL1Q1P in situation 1.
TVC= area under MC corresponding to a given level of output.
This is equal to OL1Q1R in situation 1.
Evidently, area OL1Q1R >area OL1Q1P.
Implying that in situation 1, the firm is not covering even its variable costs. This is not a viable
situation for a firm to undertake production.
Corresponding to situation 2, when MC is rising, at point Q2, when find that:
TR = OL2Q2P, and
TVC = OL2Q2R
Evidently, TR > TVC
Thus, of the two situations, TR-TVC is maximized in situation 2 when output = OL2 and MC is
rising.
Y MC
R

Q1 Q2
P AR=MR

Revenue
and
Cost

o L1 output L2 X

Fig. is drawn on the assumption that AR is constant for a firm and is equal to OP. it is as in a situation
of perfect competition. Constant AR implies constant MR. accordingly, AR=MR, and both are
indicated by a horizontal straight line, parallel to X-axis.

What happen when a unit more or a unit less is produced than OL2 units of output?
Answer is that in both the situations will be less compared to the situation when OL2 units of output
are produced.
In case OL3 units of output are produced (as in fig.)
Additional to TVC = area L2L3TQ2
Additional to TVC = area L2L3Q3Q2
Additional to TVC is greater than addition to TR. Additional TVC exceed additional TR by the area
Q2TQ3. So that TR-TVC will tend to shrink.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 76

Y
When output is beyond the point of equilibrium

MC
Revenue
and Q2 Q3
cost P T AR=MR

o Output L2 L3 X
Area L2L3TQ2 (additional revenue) < Area L2L3Q3Q2 (additional cost).
In case OL1 units of output are produced (as in fig.)
TR reduces by the area L1L2Q2Q1.
TVC reduces by the area L1L2Q2T.
Thus, reduction in TVC is less than the reduction in TR. Or, that the loss of TR is greater than the
reduction in TVC.
Accordingly, TR-TVC will tend to shrink.
Thus, any departure from the state of equilibrium (when MR= MC, and MC is rising) would only mean
that the difference between TR and TVC will tend to shrink, or that the profit will not be maximized.

Y
When output is reduced below the point of equilibrium

MC

Q1 Q2
P AR=MR

o Output L1 L2 X

Area L1L2Q2Q1 (loss or TR) > area L1L2Q2T (reducing in TVC).

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 77

CHAPTER-10
THEORY OF SUPPLY
Concept of Supply
Ask a producer: how much quantity of a commodity he is willing to sell? ‘Depends on price’ should be
his obvious reply. At higher price, he should be willing to sell more, while at a lower price, he should
be willing to sell less. Accordingly, supply of a commodity that the producers are willing to sell at
different possible prices of that commodity at a point of time.
Supply refers to the quantity of a commodity the firm or a seller is willing to sell in a market at a given
price in a given period of time.
 It is the amount of a commodity that is available for sale in the market at a given price, whereas
the actual amount sold at that price may be different.
 Supply is different from the stock as:
 Stock refers to total quantity of the commodity available with the seller at a point of time, and
 Supply is the part of stock which a seller offers for sale at a particular price and time.
Supply
Supply of a commodity refers to a schedule (or a table) showing various quantities of a commodity that
the producers are willing to sell at different possible prices of the commodity at a point of time.
Supply and quantity supplied are different concepts
There is a different between the term’s supply and quantity supplied quantity supplied refers to a
specific price of the commodity. Supply, on the other hand, refers to various quantities offered for sale
at different possible prices of the commodity.
Supply and Quantity supplied
Supply refers to the entire schedule showing various quantities of the commodity offered for sale at
different possible prices of that commodity. Quantity supplied refers to a specific amount offered for
sale at a specific price of the commodity.
Supply Schedule
Supply schedule it is a tabular presentation of the relationship between price and quantity supplied of a
commodity other things remaining constant. It has two aspects:
1. Individual supply schedule.
2. Market supply schedule.
Individual supply schedule
Individual supply schedule refers to supply schedule of an individual firm in the market. It shows
different quantities supplied be a firm at different prices of a commodity.
Table individual supply schedule
Prices of ice cream Quantity supplied
(Rs.) (units)
5 0
10 10
15 20
20 30
It is clear from this table that as the price rises, supply extends. At Rs.5 per ice cream, the firm is not
willing to sell any unit. When price is Rs.10 then supply is of 10 units and when it rises to Rs.20, the
supply also extends to 30 units.
Individual supply or individual schedule is a table showing various
Market Supply Schedule
Market supply schedule refers to supply schedule of all the firms in the market producing a particular
commodity.sum total of the firms producing a particular commodity is called ‘industry’’ thus, market
supply schedule of the industry as a whole.
Table 2 is a market supply schedule. It is based on the assumption that there are only two firms (A and
B) supplying commodity-X in the market.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 78

Table 2 market supply schedule

Price of Supply by Supply by Market
ice cream firm ‘A’ firm ‘B’ Supply
(RS.) (units) (Units) (units)
5 0 0 0
10 10 5 10+5=15
15 20 10 20+10=30
20 30 20 30+20=50
Table shows that when price of ice cream is Rs. 5, the firm will not supply and quantity. When price
increases to Rs.10, firm ‘A’ supplies 10 units and firm ‘B’ supplies 5 units. thus, the market supply is
(10+5) units= 15 units. As the price rises, market supply also increases.
Market supply or market supply schedule is a table showing various amount of a commodity that all
the firms in the industry are willing to sell at different possible prices of that commodity.
Supply Curve
Supply curve is a graphical presentation of supply schedule, showing various quantities of a commodity
offered for sale at different possible prices of that commodity. It shows the positive relationship
between price of a commodity and its quantity supplied. Higher quantity is offered at higher price of
the commodity. Supply curve has two aspects:
1. Individual supply curve
2. Market supply curve
Individual Supply Curve: it is a graphic presentation of supply schedule of an individual firm in the
market. Sloping upwards, it indicates positive relationship between price of a commodity and its
quantity supplied, as SS curve in fig.
This figure is drawn on the basis of individual supply schedule of table. SS curve has a positive slope,
showing that quantity supplied increases in response to a increase in own price of the commodity, and
its decreases in response to a decreases in price. Thus, if price is Rs. 5, the firm is not prepared to sell
any quantity of the commodity. When price is Rs.15, the firm is ready to sell 20 units of the
commodity. And, when price is Rs. 20, the quantity supplied increases to 30 units.
Individual Supply Curve
Individual supply curve is a graphical representation of the relationship between price and quantity
supplied by an individual firm. It shows the different quantities of a commodity that a firm is willing to
offer for sale at different prices, other things remaining same.

Y Individual supply curve

S

20

15
Price(RS.)
10

o X
10 20 30
Quantity (units)
Supply curve (SS) slopes upward. It shows that more of a commodity is supplied at a higher price. It is
drawn as a straight line for the sake of simplicity.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 79

Market Supply Curve: Market supply curve is a graphic presentation of market supply schedule. It is
supply curve of the industry as a whole. It is derived by way of horizontal summation of supply curves
of all firms in the industry.
Market Supply Curve:
Market supply curve is a graphical representation of the relationship between price and quantity
supplied by all the firms. It shows the different quantities of a commodity that all the firms together are
willing to offer for sale at different prices, other things remaining same. It is derived by the horizontal
summation of individual supply curves.

Y (A) Y (B)
A’s supply curve S B’s supply curve S
20 20

15 15
Price(Rs.) Price (Rs.)
10 10

5 5
S S
o 10 20 30 X o 5 10 15 20 X
Quantity (units) Quantity (units)

30

25

20 S

15
Price(RS.)
10

5
S
X
o 5 10
15 20 25 30 35 40 45 50
Quantity (units)
Market supply curve is a horizontal summation of individual supply curves. It shows various quantities
of a commodity that all the firms in the market are ready to sell at different possible prices of that
commodity.
Market supply curve is a horizontal summation of the individual supply curves of the various firms
producing a particular commodity in the market.

Supply function: supply function studies the functional relationship between supply of a commodity
and its various determinants. The supply of a commodity mainly depends on the goal of the firm, price
of the commodity, price of related goods, price of factors of production and state of technology. In
other words, supply of a commodity is a function of several factors as expressed in the following
equation:
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 80

S x= F (Px, Pr, Np, G, Pf, T, E x, Gp )

(Here, Sx= supply of commodity-X, F= functional relation; P x= price of commodity –x; Pr= price of
factor of production; T= technology; Ex = expected future price; Gp = government policy.)
following is a brief explanation of the various determinants of supply of a commodity:
 Price of the commodity: there is a direct relationship between price of a commodity and its
quantity supplied. Generally, higher the quantity supplied, and lower the quantity supplied.
 Price of related goods: the supply of a goods depends upon the price of related goods.
Example: consider a firm selling tea. If price of coffee rises in the market, the firm will be
willing to sell less tea at its existing price. Or, it will be willing to sell the same quantity only at
a higher price.
 Number of firms: market supply of a commodity depends upon number of firms in the market.
Increases in the number of firms implies increases in market supply, and decreases in the
number of firms implies decreases in market supply of a commodity.
 Goal of the firm: if goal of the firm is to maximize profits, more quantity of the commodity
will be offered at a higher price. On the other hand, if the goal of the firm is to maximize sales
(or maximize output or employment) more will be supplied even at the same price.
 Price of factors of production: supply of a commodity is also affected by the price of factors
used for the production of the commodity. If the factor price decreases, cost of production also
reduces. Accordingly, more of the commodity is supplied as its existing price. Conversely, if
the factor price increases cost of production also increases. In such a situation less of the
commodity is supplied at its existing price.
 Change in technology: change in technology also affects supply of the commodity.
Improvement in the technique of production reduces cost of production. Consequently, more of
the commodity is supplied at its existing price.
 Expected future price: if the producer expects price of the commodity to rise in the near
future, current supply of the commodity will reduce. If, on the other hand, fall in the price is
expected, current supply will increase.
 Government policy: ‘taxation and subsidy’ policy of the government affects market supply of
the commodity. Increases in taxation tend to reduces supply. On the other hand, subsidies tend
to reduces supply. On the other hand, subsidies tend to increases supply of the commodity.
Law of Supply:
Law of supply states that, other things remaining constant; there is a positive relationship
between price of a commodity and its quantity supplied. Thus, more is supplied at higher price
and less at the lower price.
In other words, there is positive relation between the price and quantity supplied.
The law of supply states that other things remaining constant, quantity supplied of a commodity
increases with increases in the price and decreases with a fall in its price.
Explanation:
Law of supply is explained with the help of supply schedule of table

Table: supply schedule

Px (Rs.) Sx (RS.)
10 100
11 200
12 300
Show that quantity supplied increases from 100 to 200 units when price increases from Rs. 10 to Rs. 11
per unit. Likewise, quantity supplied increases from 200 to 300 units when price increases from Rs. 11
to rs 12 per unit. Implying that there is a positive relationship between price and quantity supplied of a
commodity. Fig. offers diagrammatic explanation of the law of supply.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 81

P1 S

price S

o X
Quantity L L1

SS slopes upward from left to right. It shows positive relationship between price of the commodity and
its quantity supplied: as price rises quantity supplied also rises.
Supply curve slopes upward. It shows increases in quantity supplied in response to increases in price of
the commodity. Thus, quantity supplied increases from OL to OL1, when price rises from OP to OP1.

Assumptions of the Law of Supply

 There is no change in the prices of the factors of production.
 There is no change in the technique of production.
 There is no change in the goal of the firm.
 There is no change in the price of related goods.
 There is no change in business expectations.

Exception to the Law of Supply:

The positive relationship between price and quantity supplied of a commodity may not always hold
good, or many not firmly hold good in certain situation, as under:
 The law of supply does not apply strictly to agricultural products whose supply is governed by
natural factors. If due to natural factors. If due to natural calamities, there is a fall in the
production of wheat, then its supply will not increases, however high the price may be.
 Supply of goods having social distinction will remain limited even if their price tends to rise.
 At a given point of time, sellers may be willing to sell more of a perishable commodity even at
a lower price.

Movement along a supply curve and shifts in supply curve: movement along a supply curve
refers to extension or contraction of supply in response to change in own price of the
commodity, other determinants of supply remaining constant. Shifts in supply curve refer to
situation of increases or decreases in quantity supplied even own price of the commodity
remains constant. These are caused by factors other than own price of the commodity (or other
determinants of supply, other than own price of the commodity). Following is a tabular and
diagrammatic description of the concept of movements along a supply curve and shifts in
supply curve.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 82

Movements along the supply curve Extension and contraction of supply

Movement along a supply curve, caused by change in own price of the commodity are often
studied as:
1. Extension of supply.
2. Contraction of supply.
Increases in quantity supplied of a commodity due to rise in its price are called extension of
supply and decreases in quantity supplied due to fall in its price are called contraction of
supply.
Table: Extension of supply
Price of ice cream (Rs.) Quantity supplied (units) Description
1 1 Rise in price

5 5 Extension of supply
Y Extension of supply
S
5 B

3
Price (Rs.)
2

1 A
S
o 1 2 3 4 5 X
Quantity (units)
Extension of supply is shown by a movement from point A to B on the supply curve. More is supplied
in response to increase in price of the commodity.
Table: contraction of supply
Price of ice cream (Rs.) Quantity supplied (units) Description
5 5 Fall in price

1 1 Contraction of supply

Y
Contraction of supply S
5 A

3
Price (Rs.)
2

1
S

O 1 2 3 4 5 X
Quantity (units)
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 83

Contraction of supply is shown by a movement from point A to B on the supply curve. Less is supplied
in response to decreases in price of the commodity.
Shifts in supply curve: Increases and Decreases in Supply
Shifts in supply curve refer to situation of increases or decreases in supply even when own price of
the commodity remains constant. Shifts on supply curve are caused by factors, other than own price
of the commodity. These shifts are often studied as 1. Increases in supply, indicated by forward shift
in supply curve, and 2. Decreases in supply, indicated by backward shifts in supply curve.
Increases in supply occur when quantity supplied increases at the existing price of the commodity.
Diagrammatically, it means a forward shifts in supply curve or shifts in supply curve to the left.
Both, increases and decreases in supply are caused by factors other than own price of the
commodity. Following is a tabular and diagrammatic illustration of the situation of increases and
decreases in supply.
Increases in Supply:
Table and illustrate the situation of increases in supply of forward shifts in supply curve.
Table: Increases in supply
Price of ice cream Quantity supplied
(RS.) (units)
10 20
10 30
Increases in supply- forward shift in supply curve
y S1 S2

10 A B

Price(RS.)

o X
10 20 30
Quantity (units)
At the existing price of Rs.10, quantity supplied increases from 20 to 30 units of the commodity.
Accordingly, supply curve shifts forward from s1 to s2. The producer shifts from point A on the old
supply curve to point B on the new supply curve.
Causes of Increases in supply
Increases in supply may occur due to the following factors:
 Improvement in technology leading to a fall in cost of production.
 Reduction in factors prices, causing a fall in cost of production.
 Decreases in the price of a competing product.
 Increases in number of firm in the industry.
 Improvement in business expectation promoting higher investments.
 Shifts in goal of the firm from profit maximization to sales maximization.
 Decreases in taxation (like excise duty) or grant of subsidy.

Decreases in supply:
Table and illustrate the situation of decreases in supply or backward shift in supply curve.
Table: Decreases in supply
Price of ice cream Quantity supplied
(Rs.) (units)
10 30
10 20
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 84

Decreases in supply- backward shift in supply curve

Y
S2
S1
10 B A

Price(Rs.)

O 10 20 30 X
Quantity(units)
At the existing price of 10, quantity supplied decreases from 30 to 20 units of the commodity.
Accordingly, supply curve shifts backward from S1 to S2. The producer shifts from point A on the old
supply curve to point B on the new supply curve.

Causes of Decreases in Supply:

Decreases in supply occur due to the following reasons:
 Use of outdated technology, causing a fall in efficiency and rises in cost of production.
 Increases in factor prices, causing increases in cost of production.
 Increases in price of a competing product.
 Decreases in number of firms in the industry.
 Erosion of business expectations promoting a cut in investments.
 Shifts in goal of the firm from sales maximization to profit maximization.
 Increases in taxation (like excise duty) or withdrawal of subsidy.
How does change in technology affect supply curve of a firm?
Technology improvement tends to lower production. Because, better technology facilities higher output
with the same inputs (implying increases in marginal and average product). Accordingly, producers are
willing to supply more at the existing price. This implies a forward shift in supply curve, as in fig.
Initially, PK quantity was supplied at price OP. after technology improvement (and the consequent
reduction in cost of production), PT quantity is supplied at the same price. It is a situation of increase in
supply.
Technology impacts supply
Supply prior to technological
Improvement
Y

S2
•S1

Price Supply curve after

K T Technological improvement
P • •

S2

S1
O X
Quantity

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 85

When technology improves, productivity of the factor (output per unit of the factor) increases. It
implies a fall in MC and AC. Accordingly, supply curve shifts to the right which shows that the
producers are now, willing to offer more quantity of a commodity at its existing price. Thus, even when
price continues to be OP, quantity supplied increases from PK to PT.

How does change in input price affect supply curve?

Input price may increase or decrease. In case of increases in input price, marginal (and average) cost
tend to rise. Accordingly, producers will supply less of the commodity at its existing price. This implies
a backward shift in supply curve or decreases in supply. On the other hand, if input price falls, marginal
(and average) cost will decline. Accordingly, producers will supply more of the commodity at its
existing price. This implies a forward shift in supply curve or increase in supply.
Fig. illustrates these situations. S1S1 is initial supply curve. When input price increases, supply curve
shifts backward to S3S3, and when input price falls, supply curve shifts forward to S2S2.

Inputs price impacts supply

Y S3
S1
S2

P R K T Supply curve shifts forward in case of

Decreases in input price and the consequent
Decreases in production cost.

Price S3 S1 supply curve shifts backward in case of i

S2 increases in production cost.

o X
Quantity
Initially, the producer is assumed to be at point K, supplying PK quantity at OP price cause a forward
shifts in supply curve. Accordingly, the producer shifts from point K on S1S1 to point S2S2. At the
existing price (OP), quantity supplied increases from PK to PT. in case of increases in input price,
supply curve shifts from S1S1 to S3S3.at the existing price (OP), quantity supplied decreases from PK
to PR.

Exercise Tax and Supply Curve:

Exercise tax is a tax on the production of goods and services. Generally, it is levied per unit of
production of a firm. It rises marginal and average costs of the producers. In such situations, a producer
should be willing to sell less at the existing price, or he will sell the same quantity only at a higher
price. This implies a situation of decreases in supply or backward shift in supply curve, as shown in fig.
Initially, at OP price, the producer was willing to sell PT quantity. After excise tax is levied, he is
willing to sell only PK. Supply curve shifts backward from S1S1 to S2S 2.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 86

Y Supply curve after Excise tax and supply

Excise tax S2
S1
Supply curve before
P K T excise tax

Price
S2
S1

o Quantity X

When excise tax is levied, firm’s AC and MC tend to rise. Accordingly, supply curve shifts to the left,
from S1S1 to S2S2. Less quantity is supplied at the existing price of the commodity.

Price of related product and supply curve

Change in price of a substitute good causes a significant impact on the supply of a commodity. If tea,
for example, becomes expensive, the producers of coffee would hold the stocks and wait for the price
of coffee to rise. At the existing price of coffee to rise. At the existing price of coffee, they will sell less
of coffee- a situation of decreases in supply or backward shift in supply curve. On the other hand, if
price of tea reduces, the producers of coffee would like to clear their stocks as fast as possible.
Otherwise, buyers might shifts from coffee to tea. Thus, more of coffee will be offered for sale at its
existing price. This is a situation of increase in supply or forward shift in supply curve. Fig. illustrates
these situations.
Price of a related product and supply:
Supply of coffee when there is a change in the price of tea

Y S3 S1 S2

P K T R

Price (coffee) supply curve of coffee shifts to the

Right when price of the substitute
S3 S1 good (tea) decreases
S2 supply curve shifts to the left when price
o Quantity (coffee) X of the substitute good increases
A rise in price of tea will induce buyers to switch over to coffee. Owing to pressure of demand, less
quantity of coffee will be supplied at its existing price. Supply curve of coffee will shift to the left, from
S1S1 to S3S3. A fall in the price of tea, on the other hand, will cause increases in supply of coffee.
Supply curve of coffee will shift forward, from S1S1 to S2S2.

Price elasticity of Supply:

Price elasticity of supply is the measures of change in quantity supplied of a commodity due to change
in its price. Law of supply tells us the direction in which supply will change as a result of change in
price: a fall in price will lead to contraction of supply and a rise in price will lead to extension of
supply, we have to study price elasticity of supply. Price elasticity of supply measures percentage
change in quantity supplied caused by a given percentage change in price of a commodity.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 87

Price elasticity of supply is a measurement of percentage change in quantity supplied of a commodity

in response to some percentage change in its price.

Measurement of price elasticity of supply:

There are two well known methods of measuring price elasticity of supply (briefly called elasticity of
supply). These are:
1. Proportionate (or percentage) method.
2. Geometric method.

1. Proportionate method: According to this method, elasticity of supply (Es) is the ratio between
’percentage change in quantity supplied’ and ‘percentage change in price’ of the commodity.
Es= percentage change in quantity supplied
Percentage change in price
Symbolic,

ΔQ × 100 Q: Initially quantity

Q = ΔQ × P P: initially price
Es= ΔP × 100 ΔP Q ΔQ: change in quantity supplied
P ΔP: change in price of the commodity
2. Geometric method: Geometrically; elasticity of supply depends on the ‘origin’ of the supply
curve. Assuming the supply curve to be a straight line and positively sloped (sloping upward),
we can conceive three possible situations of elasticity of supply as in the following diagram:
Situation 1: Es=1, when a straight line,
Positively sloped supply curve starts from the point of origin ‘O’

Y
S

Es=1

Price

o Quantity X

No matter what angle it makes, a straight line (upward sloping ) supply curve, shooting from the origin
always shows Es=1 (refers to ability zone for proof).

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 88

Situation: 2 Es>1, when a straight line,

Positively sloped supply curve starts from Y-axis.

Price

o Quantity X

A straight line (upward sloping) supply curve, shooting from Y-axis always shows Es>1, irrespective
of the angle it makes.

Situation: 3 Es < 1, when a straight line,

Positively sloped supply curve starts from X-axis.
Y

Es<1

Price

o S Quantity X

A straight line (upward sloping) supply curve, shooting from X-axis always shows Es < 1, irrespective
of the angle it makes.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 89

Two extreme situations of E s

1. Zero elasticity of supply: It refers to a vertical straight line supply curve, showing constant supply,
no matter what the price is. Fig. illustrates this situation.
Y S
Perfectly inelastic supply curve
P2 Es= 0

Price

P1

0 S Quantity X

Es=0, when supply does not at all respond to change in price of the commodity. Supply is constant
even at a zero price.
Fig. shows that quantity supplied remains constant at OS, whether price of the commodity is OP1 or
OP2. Vertical straight line supply curve is also called a perfectly inelastic supply curve.

2. Infinite elasticity of supply: it refers to a horizontal straight line supply curve, showing infinite
supply corresponding to a particular price of the commodity. Fig. illustrates this situation.

Y
Perfectly elastic supply curve
Es=∞

S
S

Price

o Q Q1 X
Quantity
When Es= ∞, even a minute change in price will cause an infinite change in quantity. Thus, if price
falls below OS, supply of the commodity reduces to zero.
Shows that quantity supplied is infinite when price of the commodity is OS. It reduces to zero (in fact
supply curve ceases to exist) when price is slightly reduced.

Elastic, inelastic and unitary elastic supply

1. Supply is said to be elastic when Es > 1.
2. Supply is said to be inelastic when Es < 1.
3. Supply is unitary elastic when Es = 1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 90

Factors affecting elasticity of supply

Following factors affect the elasticity of supply of a commodity:
 Nature of inputs used: the elasticity of supply depends on the nature of inputs used for the
production of a commodity. If commonly available inputs are used, supply will be elastic, than,
if scarcely available inputs are used.
 Natural constraints: the elasticity of supply is also influenced by the natural constraints in the
production of a commodity. If we wish to produce more teak wood, it will take year of
plantation before it becomes usable. Supply of teak wood will therefore be less elastic.
 Risk taking: the elasticity of supply depends on the willingness of entrepreneur to take
production- related risk. If entrepreneur are willing to take risk of higher output, the supply will
be more elastic. On the other hand, if entrepreneurs are reluctant to take risk of higher output,
the supply will be inelastic.
 Nature of commodity: perishable goods are relatively less elastic in supply than durable goods,
because of limited shelf- life of perishables.
 Cost of production: elasticity of supply is also influenced by cost of production. Supply will be
less elastic in case increases in production cause substantial increases in the cost of production.
 Time factor: longer the time period, greater will be the elasticity of supply. Because, over a
long period of time, factors are easily available.
 Technique of production: supply will be less elastic in case production of a commodity
involves the use of a complex and expensive technology. On the other hand, use of a simple
technology facilitates quicker changes in output and supply.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 91

CHAPTER-11
FORMS OF MARKET
Concept of Market:
In economics, the concept of market has a special meaning. It refers to a mechanism or an arrangement
that facilitates the sale and purchase of goods. This arrangement could simply be through telephonic
communication or even through electronic mail. We are all familiar with ‘online marketing’ which is
marketing without any shopping complex.
In economics, market does not refer to any shopping complex. It refers to a mechanism or an
arrangement that facilitates contact between the buyers and sellers for the sale and purchase of goods
and services.
What is Market?
Market refers to a mechanism or an arrangement that facilitates contact between the buyers and seller
for the sale and purchase of goods and services.
Forms of Market:
Depending on the degree of competition or number of firms in the market (engaged in the sale of a
particular commodity), a market is often described as one of the following forms:
 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly
Perfect competition: perfect competition is said to exit where there is a large number of sellers and
buyers and engaged in the sale and purchase of a commodity, and no individual buyer or seller has any
control over price of the product. Price of the product is determined by the forces of market supply and
market demand.
Perfect competition is a form of the market where there is a large number of buyers and sellers
of a commodity. Homogeneous product is sold with no control over price by an individual firm.
Features of perfect competition and their implications
A perfectly competitive market exhibits the following features. Each feature is explained with
reference to its implications for the buyers and sellers of a commodity.
 Large number of small buyers and sellers of a commodity: the number of buyers is so large
that the demand by individual buyers is so large that the demand by an individual buyer remains
only a small fragment of the market demand for a commodity. Likewise, the number of sellers
is so large that the supply of an individual seller (firm) remains only a small fragment of the
market supply. Geometrically, it is indicated by a horizontal straight line as in fig. it shows that
under perfect competition, a firm can sell any amount of the commodity at the existing price.
Or, a firm is a price taker, not a price maker.
Y

Price line for a firm under perfect competition

P AR (Price Line)
AR/price

o Quantity X
A firm can sell any amount of the commodity, at the existing price.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
 Spell Classes (Get the spell of success.) ® 92

 Homogeneous product: under perfect competition, each firm sells a homogeneous product. A
product is said to be homogeneous when each unit of it is identical in size, shape, color, weight; so,
that the buyers are not able to express their preference for the product of one firm against that of the
other. It is a situation of zero degree of product differentiation. It may also called situation of the
market where buyers find products of different firms (in the industry) as perfect substitutes of each
other. When the product is homogeneous a firm, cannot exercise even a partial control over price.
Accordingly, firms under perfect competition do not have to incur ‘selling costs’.
 Perfect knowledge: buyers and sellers are fully aware of the prevailing price in the market. They
are also aware of the fact that homogeneous product is being sold in the market. Accordingly,
producers cannot make extra profit by charging different prices from different buyers. Price
discrimination are ruled out.
 Freedom of entry and exit: a firm can enter or leave the industry any time. In order to analyze the
implications of this feature we need to focus on short period and long period situations. Short
period, Entry or exit is possible only in the long period. In the case of extra normal losses, some of
the by definition, is too short for an existing firm to leave the industry or few firm to join the
industry. Existing firms will leave the industry. Market supply will decrease. Market price will
increase. Extra -normal losses will be wiped out.
Thus, during short period a firm may operate under any of the following situations:
1. Normal profits
2. Extra- normal profits
3. Extra-normal losses.
 Independent decision- making: there is no agreement between different firms regarding quantity
to be produced or, price to be charged. In other words, firms do not form ‘trusts’ or cartels.
Accordingly, perfect competition facilitates optimum level of output and lowest level of price thus,
perfect competition is credited with highest output and lowest price, compared with any other form
of the market.
 Perfect mobility: Factors of production are perfectly mobile. They will move to that industry
where they get best price. Accordingly, uniform factor price prevails in the market.
 No extra transport cost: for one price to prevail throughout the market, it is essential that there is
no extra transport cost for the consumers while buying a commodity from different sellers.

Three vital conclusions: description of characteristics features of perfect competition offers three vital
conclusion as under:
(1) A firm under perfect competition is a price taker, not a price maker
Price is determined by the forces of market demand and market supply. All the firms in the industry
sell their output at the given price. It is therefore said that a firm under perfect competition is a price
taker. This is explained in terms of three basic characteristics of perfect competition as under:
1. Large number of firms: the number of firms producing a product is so large that no individual
firm, by changing its output, can influence market supply. Obviously, then the market price cannot
be influenced by an individual firm.
2. Homogeneous product: all firms in the industry produce homogeneous product. Or, products of
all firms in the industry are perfect substitutes of each other. So that, if any firm fixes its price
higher than the existing market price, buyers would shift to other firms. The firm will simply be
driven out of the market.
3. Perfect knowledge: buyers are assumed to have perfect knowledge regarding ‘product-
availability’ and product price. Thus, a firm cannot charge its own price even on the pretext of
‘buyers ignorance’.
Thus, it is concluded that under perfect competition, it is neither possible nor desirable for an
individual firm to change price of the product. The firm is simply a price taker, not a price maker.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

 Spell Classes (Get the spell of success.) ® 93

(2) Demand curve of the firm under perfect competition is perfectly elastic: perfectly elastic demand
curve implies a situation when elasticity of demand for the firm’s product is equal to infinity (Ed=∞). It
is indicated by a horizontal straight line, as in fig. it shoes that the firm can sell any amount of the
commodity at the prevailing price. And that, even fractional increases in price would wipe out entire
demand for the firm’s product.
Fig. shows that at the given price OP, the firm can sell any quantity of the commodity it produces.
Price remains constant; no matter quantity is OA or OB, or even zero.
A perfectly elastic demand curve is simply a reflection of zero price control or zero market control of a
firm under perfect competition.
Y

Firm’s demand curve

Under perfect competition
Ed=∞
P P

Price

0 A B X
Quantity
Firm’s entire output is demanded at the price OP. this price is determined by the forces of market
supply and market demand. An individual firm cannot change it.
(3)A firm under perfect competition earns only normal profits in the long run: this is owing to the
fact that there is freedom of entry and exit under perfect competition. In situation of extra-normal
profits, new firms will be induced to join the industry. This increases market supply and lowers market
price to finally wipe out extra-normal profits. In situation of extra-normal losses, marginal firms will
quit the industry, lowering market supply and raising market price to finally wipe out extra-normal
losses.

Monopoly:
Monopoly is a market situation dominated by a single seller who has full control over the price.
Example: Railways in India are a monopoly industry of the government of India. Since there is only
one producer of a product in the market, the distinction between ‘firm’ and industry disappears.
Features of monopoly: the main features of monopoly are as follows:
 One seller and large number of buyers: under monopoly, there is a single producer of a
commodity. He may be alone, or there may be a group of partners or a joint stock company or a
state. However, there is a large number of buyers of the production.
 Restrictions on the entry of new firms: under monopoly, there are some restrictions on the
entry of new firms into the monopoly industry. Generally, there are patent right or exclusive
controls over a technique or raw material.
 No close substitute: a monopoly firm produces a commodity that has no close substitute.
Example: there is no close substitute of railways as a ‘bulk carrier’.
 Full control over price: being a single seller of the product, a monopolist has full control over
its Price. A monopolist thus, is a price maker. He can fix whatever price he wishes to fix for his
product.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 94

 Price discrimination: a monopolistic may charge different price from different buyers. It is
called price discrimination. “Price discrimination refers to the practice of charging different
prices from different buyers for the same good.’’

Monopoly is a form of the market in which there is a single seller or producer of a commodity. There
are no close substitutes of the monopoly product and there are legal, technical or natural barriers to the
entry of new firms in the monopoly market. A monopolist has complete control over price and can also
practice price discrimination.

A vital observation:
Full control over price under monopoly does not mean that the monopolist can sell any amount of the
commodity at any price. Once the monopolist fixes price of the commodity, quantity demanded will
entirely depend upon the buyers. At the higher price, quantity demanded will be low, and vice versa.
Accordingly, there is an inverse relationship between price and quantity sold by the monopoly firm.
Thus, demand curve facing a monopoly firm slopes downward, as fig.

DM: Demand curve for a monopoly firm

P1
DM

o Quantity Q Q1 X

Firm’s demand curve (Dm) under monopoly slopes downward, showing an inverse relationship
between price and quantity. The monopolist can fix whatever price he wishes to fix. But, higher the
price, lower the sale.

How does a monopoly market structure arise?

Monopoly market structure may arise in any of the following ways:
 Government licensing/ government control: the government may grant license for the
production of a particular commodity only to one producer. Accordingly, monopoly comes into
existence. Also, the government may decide to control the production of certain goods (or
services) exclusively through its departmental undertaking, like Railways in India.
 Patent rights: new products may secure patent rights. It amount to monopoly rights regarding
the shape, design or other characteristics of the product. Likewise, patent rights may be secured
on new technology by others. Accordingly, monopoly market structure emerges.
 Cartels: it refers to collective decision making by a group of firms with a view to avoiding
competition and securing monopoly control of the market. Competing firms may reach a broad
agreement on the pricing and output policy so that competition is avoided and a sort of joint
monopoly structure of the market emerges.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 95

 Natural occurrence: monopoly may emerge as a natural occurrence. The only spring of water
in an island, for example, may be under the control of one person who exercises full control
over price of water, without any competition.

Monopolistic Competition:
It is a form of the market in which there are many sellers of the product, but the product of each
seller is somewhat different from that of the other. Thus, there are many sellers, selling a
differentiated product; product differentiation is generally achieved through trademark or brand
name. Example: firms producing different brands of toothpastes, viz. colgate, close-up, pepsodent,
etc. monopolistic competition. Trademark gives monopoly power to the firms. On the other hand,
since many firms are producing a commodity (like toothpaste) there is competition in the market.
Existence of monopoly power along with competition offers the producers only a partial control
over price of their product.

Features of monopolistic competition: the main features of monopolistic competition are as under:
1. Large number of buyers and sellers: As under perfect competition, there is a large
number of buyers and sellers. Also, the size of each firm is small. Each firm is small. Each
firm has a limited share of the market.
2. Product differentiation: Product differentiation (or simply ‘differentiation’) is a distinct
feature of monopolistic competition. It is unlike perfect competition in which products of
different firms in the industry are perfect substitutes of each other. Differentiation implies
that rival firms are selling products which are not perfect substitutes but close substitutes of
each other.
Focus of Attention
Both under monopoly and monopolistic competition, firm’s demand curve tends to slopes
downward, left to right. But, under monopolistic competition, it exhibits a much greater degree of
price elasticity than under monopoly. This is owing to the fact that a large number of close
substitutes of the product are available in monopolistic competitive market. Whereas in monopoly
market there are no close substitutes at all.
3. Non- price competition: Even when product differentiation allows the firms to pursue their
independent price policy, they often avoid getting into price-war. Instead they focus on non-
price competition.
Non-price Competition
Non-price competition is a market strategy adopted by a firm to increases its market share by
highlighting distinct quantities of its product or promoting the product through advertisement.
Essentially, it involves high promotional expenditure to make the product popular. Example-
Getting the product promoted through celebrities.
Sponsoring entertainment programmes in schools and colleges showing brand- loyalty.
Offering better ‘after-sale service’.
4. Freedom of entry and exit: Firms are free to enter the industry or leave it. However, new
firms have no absolute freedom of entry into industry. Product of some firms may be legally
patented. New firms cannot produce identical products. Example: no rival firm can produce
/sell a patented item like woodland shoes.
5. Lack of perfect mobility: Factors of production, goods and services lack perfect mobility.
Accordingly, different prices prevail for the same factor or the same product.
6. Lack of perfectly knowledge: Sellers and buyers of the products also lack perfect
knowledge about the market. Because of product differentiation, it is not even possible to
have perfect knowledge about a variety of products in the market. This allows a scope for
consumer exploitation owing to his ignorance. Lack of knowledge also makes labour
vulnerable to exploitation.
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 96

Oligopoly:
It is a form of the market in which there is a few large firms. Two important forms of oligopoly are:
collusive oligopoly and non- collusive oligopoly.
In collusive oligopoly, firms form a cartel to avoid competition. In non- collusive oligopoly there is a
cut- throat competition and a high degree of interdependence between the firms.
Oligopoly market is also categorized as perfect oligopoly and imperfect oligopoly. Under perfect
oligopoly, homogeneous product is produced, while under imperfect oligopoly, firms produce
differentiated products.
Example: There are only a few car- producers in the global market. Toyota, ford, GM, Audi, BMW
and Volkswagen are some well known brands.

Features of oligopoly: the principal features of oligopoly are as under:

1. Small number of big firms: Oligopoly market is the one in which a small number of big
firms dominate the market for a product. Accordingly, there is a high degree of market
concentration. Market dominance is sustained through intense advertising for the branded
products. Established brand loyalty renders demand for the product as relatively inelastic.
2. High degree of independence: Oligopoly market is characterized by a small number of big
firms in the industry. Each firm is so big in size that quit often it has global presence,
selling its product across all parts of the world. The market share of each firm is so
significant that it can pursue its independent price and output policy, but not without a
competitive reaction from the rival firms.
Important: Small number of big firms causes a high degree of interdependence with regard
to their price and output policy. Because of this interdependence, each firm has to account
for the possible reaction of other firm in the market. Whenever it plans any change in its
product price or the level of output of an oligopoly firm. Which is why there is no generally
accepted theory that explains how equilibrium is achieved by oligopolist.
3. Difficult to trace firms demand curve: It is not possible to determine firm’s demand
curve under oligopoly. Simply because, it is not possible to establish any precise
relationship between price and quantity demanded for its product may not increases,
because the rival firms may lower the price proportionately greater.
4. Formation of cartels: With a view to avoiding competition, oligopoly firms are often
driven to form cartels. A cartels is a formal agreement among the firms to collude and avoid
competition. It is a situation of collusive oligopoly. Under it, output quotas and prices are
fixed by the various firms as a group.
Sometimes, leading firm in the market is accepted by the cartels as a ‘price leader’. All
firms in the cartel choose the same price as set by the price leader.
Collusive oligopoly is like a monopoly form of the market. Cartels take full control of the
market and exploit it like a monopolist.
5. Entry barriers: There are various barriers to the entry of new firms. These are created
largely through patent right and are almost similar to those under monopoly. because of
these barriers, the existing firms are seldom worried about the possible erosion of demand
in the near future. They continue to earn extra-normal profits even in the long run.
6. Non- price competition: Under oligopoly, firm tend to avoid price competition. Instead,
they focus on non-price competition. Example: in India both coke and Pepsi drinks sell at
the same price. However, in order to enhance its share of the market, each firm takes to
aggressive non-price competition. Example: coke and Pepsi sponsor different games and
sports; they also offer lucrative schemes when bulk purchases are made on regular basis.
Perfect and Imperfect Oligopoly: If oligopoly firms are producing homogeneous products, it is a
situation of perfect oligopoly. On the other hand, if oligopoly firms are producing differentiated
products, it is a situation of imperfect oligopoly.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 97

Principal basis of market classification: You can now sum up your understanding of different forms
of the market by identifying the following factors as the principal basis of market classification:
1. Number of buyers and sellers: When there is a large number of buyers and sellers of
homogeneous commodity, it is a situation of perfect competition.
- When there is a large number of buyers and sellers, but the commodity is not
homogeneous, it is a situation of monopolistic competition.
- When there is one seller but a large number of buyers of a commodity, it is situation of
monopoly.
2. Nature of the commodity: In a perfectly competitive market, commodity must be
homogeneous, while in monopolistic competition, the commodity is always differentiated
(product differentiation). In monopoly, the product may or may not be homogeneous.
3. Degree of price control: perfect competition is said to exist when the producer has no control
over price. In contrast, the monopolist has full control over price. Monopolistic competition is
characterized by partial control over price.
4. Knowledge of the market: in case of perfect competition, buyers and sellers have perfect
knowledge of the market. In other forms of the market, there is imperfect knowledge of the
market.
5. Mobility of factors: perfect mobility of the factors is another unique characteristic of perfect
competition. It is not an essential feature of other forms of the market.

Perfect competition, monopolistic competition and monopoly- some differences

S.No. Reference Perfect competition Monopolistic Monopoly
competition
1. Number of sellers and Large Large One seller, but large
buyers number of buyers.
2. Product Homogeneous Product Homogeneous or
differentiation differentiation
3. Price Uniform Not uniform Not uniform because
because of product of price
differentiation discrimination
4. Entry of firm Free entry Not absolute Not possible
freedom
5. Mobility Perfect mobility Imperfect mobility Imperfect mobility
6. Knowledge of market Perfect knowledge Imperfect Imperfect knowledge
condition knowledge
7. Firms demand curve Perfectly elastic Relatively more Relatively less
elastic elastic
8. Slope of firms demand Horizontal straight Slopes downward Slopes downward
curve line (AR=MR) with high elasticity with low elasticity
(AR>MR) (AR>MR).
9. Selling costs Not required Very significance Not required
10. Degree of price control No control over price Partial control over Full control over
price price
11. Level of profit in long AR=AC AR=AC AR> AC
run =normal profits = normal profits =extra- normal
profits

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 98

CHAPTER-12
MARKET EQUILIBRIUM UNDER PERFECT COMPETITION AND EFFECT OF SHIFTS IN
DEMAND AND SUPPLY
Concept of Market Equilibrium:
Market equilibrium is a situation of the market in which demand for a commodity is exactly equal to its
supply, corresponding to a particular price. Thus, in a state of equilibrium, the market clear itself, as
market demand= market supply of a commodity (Dx=Sx); there is neither excess demand nor excess
supply.
Market equilibrium implies:
1. Equilibrium Price: Which corresponds to the equality between market demand and market
supply of a commodity, and
2. Equilibrium Quantity: Which corresponds to the equilibrium price in the market.
Determinants of market equilibrium under perfect competition:
Under perfect competition, market equilibrium is determined by the forces of
1. Market demand, and
2. Market supply.

1. Market Demand: Market demand refers to the sum total of demand for a commodity by all the
buyers in the market.
2. Market supply: Market supply refers to the sum total supply of a commodity by all the firms in the
market.
In the context of market equilibrium when we talk of market demand and market supply, we are in fact
referring to market demand schedule a market supply schedule.
Market demand schedule is a showing different amounts of a commodity that the buyers are ready to
buy corresponding to different possible prices of the commodity.
Market supply schedule is a table showing different amounts of a commodity that the sellers or firms
are willing to sell corresponding to different possible prices in the market.
Market equilibrium is struck when, at the prevailing price in the market, quantity demanded is exactly
equal to quantity supplied.

Table: Market Equilibrium Under Perfect Competition

Price of commodity -x Quantity supplied of commodity –x Quantity demanded of
(dozen) commodity-x
(dozen)
5 50 10 excess supply
4 40 20
3 30 30 market equilibrium
2 20 40
1 10 50 excess supply

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 99

Y
D surplus (excess supply) S
5 A B

4
Equilibrium price
Price (Rs.) 3 •E

2 C D

1 S D
Shortage (excess demand)

o 10 20 30 40 50 X
Quantity (dozen)
Equilibrium is struck at point E:
Here: equilibrium price=Rs.3; equilibrium quantity=30 dozen.
If price happens to be Rs.5, there is excess demand = CD.

Three basic assumptions of market equilibrium under perfect competition:

These are that:
1. Price and quantity supplied are positively related or that supply curve of a commodity slopes upward
from left to right.
2. Price and quantity demanded are negatively related, or that demand curve of a commodity slopes
downward from left to right.
3. Forces of supply and demand operate freely without any government intervention.
Effects of shifts in demand and supply on market equilibrium: How chain effect works?
OR
How market absorbs the impact of shifts in demand and supply of a commodity?
Chain effect of shifts in demand:
Shifts in demand may mean increases in demand or decreases in demand. It occurs owing to change in
determinants of demand, other than own price of the commodity. Example: demand increases when
there is an increase in income of the buyers, and decreases when there is decreases in income, (other
things remaining constant) of the buyers. We know in a situation of increases in demand for a
commodity, demand curve shifts to the right, while in a situation of decreases in demand for a
commodity, demand curve shifts to the left.
(A) How market absorbs the impact of increases in demand.
Y
D2
D1 S
P1 K
E
P2 F

S D2
price D1

o Q1 Q2 X
Quantity
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 100

1. Increase in demand: demand curve shifts from D1D1 to D2D2.

2. Excess demand= EF.
3. Rise in price induces extension of supply from E to K, and contraction of demand from F to K.
4. K: The point of new equilibrium. New equilibrium price= OP2; equilibrium quantity = OQ2.

(B) How market absorbs the impact of decreases in demand.

Y
D1
D2 S
P1 F E

P2 K
D1
S
Price D2

o X
Quantity Q2 Q1
1. Decreases in demand: demand curve shifts from D1D1 to D2D2.
2. Excess supply = EF.
3. Fall in price induces extension of demand from F to K, and contraction of supply from E to K.
4. K: The point of new equilibrium. New equilibrium price=OP2; equilibrium quantity =OQ2.

Chain effect of shifts in supply: As in case of demand, shifts in supply may mean, increases in supply
or decreases in supply. It occurs due to change in determinants of supply, other than own price of the
commodity. Example: supply increases when production cost falls owing to fall in input prices, and
decreases when production costs rises owing to rise in input prices (other things remaining constant).
(supply may increases also when the government pursues the policy of liberalization and allows new
firms to enter the industry, particularly when the existing firms are making extra- normal profits) we
known, in a situation of increases in supply of a commodity, supply curve shifts to the right, while in a
situation of decreases in supply of a commodity, supply curve shifts to the left.

(A) How market absorbs the impact of increases in supply

Y

S1
D S2
E
P1 F
P2 K

S1 D
S2
Price

o Quantity Q1 Q2 X
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 101

1. Increases in supply: supply curve shifts from S1S1 to S2S2.

2. Excess supply= EF.
3. Fall in price induces extension of demand from E to K, and contraction of supply from F to K.
4. K: the point of new equilibrium. New equilibrium price= OP2; equilibrium quantity=OQ2.

(B) How market absorbs the impact of decreases in supply

Y

D S2
K
P2 S1
F
P1 E
S2 D

Price S1

o Quantity Q2 Q1 X

1. Decreases in supply: supply curve shifts from S1S1 to S2S2.

2. Excess demand = EF.
3. Rise in price induces contraction of demand from E to K, and extension of supply from F to K.
4. K: the point of new equilibrium. New equilibrium price= OP2; New equilibrium quantity=OQ2.

Change in demand and equilibrium price:

Some exceptional situations
Let us consider how increases and decreases in demand affect equilibrium price in two exceptional
situations:
(1) When supply of the commodity is perfectly elastic.
(2) When supply of the commodity is perfectly inelastic.

(1) When supply is perfectly elastic: Increases or decreases in demand for a commodity do not
causes any change in its price in case supply of the commodity is perfectly elastic. Only the
equilibrium quantity tends to change.

(A) Increases in demand

Y
D1
D

P E E1 S

Price D1
D

0 X
Quantity Q Q1
Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA
Spell Classes (Get the spell of success.) ® 102

Shows increases in demand when supply is perfectly elastic. Price remains unaffected. Equilibrium
quantity increases from OQ to OQ1.

(B) Decreases in demand

Y
D
D2

S E2 E S
P

Price
D2 D

o Quantity Q2 Q X

Shows decrease in demand when supply is perfectly elastic. Here also, price remains unaffected.
Equilibrium quantity decreases from OQ to OQ2.

(2) When supply is perfectly inelastic

In a situation of perfectly inelastic supply (or constant supply), increases or decreases in
demand causes a change in price of the commodity. Equilibrium quantity remains constant
simply because supply is perfectly inelastic.

(A) Increases in Demand:

Y

D1 S
P1 D E1
Price
P2 E D1

0 Quantity Q X

Shows constant supply (=OQ).In such a situation, forward shifts in demand curve (from DD to D1D1)
causes an increases in price from OP to OP1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 103

(B) Decreases in Demand

Y
D
D2
P E

P2 E2 D

Price D2

0 Quantity Q X

Shows constant supply (=OQ). Here, demand curve shifts to the left (from DD to D2D2). Equilibrium
price reduces from OP to OP2.

Change in supply and equilibrium price:

Some Exceptional Situations
Let us consider how increases and decreases in supply affect equilibrium price in two exceptional
situations;
(1) When demand for the commodity is perfectly elastic; and
(2) When demand for the commodity is perfectly inelastic.

(1) When demand is perfectly elastic: Increases or decreases in supply of a commodity does not
cause any change in its price in case demand for the commodity is perfectly elastic. Only the
equilibrium quantity tends to change.

(A) Increases in supply

Y
S S1

P E E1 D

S S1
Price

0 Q Q1 X
Quantity

Shows a situation of increase in supply when demand is perfectly elastic. Price remains unchanged at
OP. equilibrium quantity increases from OQ to OQ1.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 104

(B) Decreases in supply

Y
S2
S

P E2 E D

Price
S2 S

o Quantity Q2 Q X

Shows a situation of decreases in supply when demand is perfectly elastic. Again, price remains
unchanged at OP. however, equilibrium quantity decreases from OQ to OQ2.

(2) When demand is perfectly inelastic: In a situation of perfectly inelastic demand (or constant
demand) increases or decreases in supply causes a full impact on price of the commodity. Of
course, equilibrium quantity remains constant, simply because demand is constant.

(A) Increase in supply

D S

P E S1

P1 E1
S
Price S1

O Quantity Q X

Shows a situation of increase in supply when demand is perfectly inelastic. Equilibrium price reduces
from OP to OP1.Equilibrium quantity remains constant at OQ.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 105

(B) Decreases in demand

Y
S2
D
E2 S
P2

P E
S2
Price S

O Quantity Q X

Shows a situation of decreases in supply when demand is perfectly inelastic. Equilibrium price
increases from OP to OP2. Equilibrium quantity remains constant at OQ.

Simultaneous change in demand and supply and market equilibrium

1. Simultaneous increases in demand and supply: Simultaneous increases in demand
and supply must cause increases in equilibrium quantity of the commodity. But would
there be any change in price or not depends on whether demand increases more than,
equal to, or less than supply. Consequently, there can be three situations in this respect.
These are diagrammatically illustrated through
(A)
Y
D2
S1
D1 S2
P2
T

P1 S
D2

Price S1S2 D1

O Quantity Q1 Q2 X

Increase in demand is greater than increases in supply. Due to greater pressure of demand, equilibrium
price tends to rise from OP1 to OP2. Equilibrium quantity increases from OQ1 to OQ2.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 106

(B) Y
D2 S1
D1
S2

D2
Price S1
S2 D1

X
O Quantity Q1 Q2

Increase in demand is exactly equal to increase in supply. Accordingly, there is no change in

equilibrium price. Equilibrium quantity increases from OQ1 to OQ2.

(C) Y D2
D1 S1

P1 S S2

P2 T
S1 D2
Price
S2 D1

o Q1 Q2 X
Quantity

Increase in supply is greater than increases in demand. Due to greater pressure of supply, equilibrium
price tends to fall from OP to OP2. Equilibrium quantity increases from OQ1 to OQ2.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 107

Simultaneous decrease in supply and demand: Fig. illustrates the effect of simultaneous decreases in
demand and supply on price and quantity.
(A)
Y
D1
D2
P1

P2
D1

Price S2 S1 D2

O Q2 Q1 X
Quantity

Decrease in demand is greater than decreases in supply. It is a situation of excess supply. Accordingly,
equilibrium price tends to fall from OP1 to OP2, equilibrium quantity decreases from OQ1 to OQ2.

S2
(B) Y D1
D2 S1

P1

D1
D2
S2
S1
0 X
Quantity Q2 Q1

Decrease in demand is exactly equal to decreases in supply. Accordingly, there is no change in

equilibrium price. Equilibrium quantity reduces from OQ1 to OQ2.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 108

(C)

Y
D2 D1 S2

P2 S1

P1
D1
S2 D2
Price
S1

0 Q2 Q1 X
Quantity

Decrease in supply is greater than decreases in demand. It is situation of excess demand. Accordingly,
equilibrium price increases from OP1 to OP2. Equilibrium quantity decreases from OQ1 to OQ2.

Effect of excess demand on price of the commodity:

In a situation of excess demand, consumers are willing to buy greater amount of a commodity than
what the producers are willing to sell at the existing price. Accordingly, price of the commodity will be
pushed up. This will cause extension of supply and contraction of supply and contraction of demand.
This process will continue till DX=SX and the equilibrium is struck in the market. The market will reach
the point of equilibrium at a higher price than in a situation of excess demand.

Y
D Excess Supply S
10

6 SX=DX

4
Price (Rs.)
2 S Excess D
Demand

0 20 40 60 80 100 X
Quantity (units)

Effect of Excess Supply on Price of the Commodity:

In a situation of excess supply, producers are willing to sell greater amount of a commodity than what
the consumers are willing to buy at the existing price. Accordingly, price of the commodity will be
pushed down. This will cause contraction of supply and extension of demand.
Simple application of tools of demand and supply curves:

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 109

The present section studies some simple applications of the tools of supply and demand curves. The
study focuses on two cases of government intervention in the commodity market, viz.
1. Price Ceiling
2. Price Floor.
1. Price Ceiling: Ceiling means maximum limit. Price ceiling means maximum price of a commodity
that the sellers can charge from the buyers. Often, the government fixes this price much below the
equilibrium market price of a commodity, so that it becomes within the reach of the poorer sections of
the society.
Price Ceiling
Y

MSb

P Q

P* a b ceiling price

MDb
Price

0 L1 L L2 X
Quantity
Equilibrium price = OP
Equilibrium Quantity= OL
Ceiling price= OP*
Excess Demand = ab=L1L2

Price Floor: Floor means the lowest limit. Price floor means the minimum price fixed by the
government for a commodity in the market. It seems paradoxical, but it true that the government in
most countries fixes floor-price for most agricultural products, food grains in particular. The following
real life situation should make this point clear.
Y price Floor

MSw
P* a b Floor price

p Q

price
MSw

0 L1 L L2 X
Quantity
Equilibrium price = OP
Equilibrium Quantity= OL
Floor Price= OP*
Excess Supply= ab=L1L2

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 110

CONSUMER’S EQUILIBRIUM

1. MUn = TUn – TUn-1 OR MU = ∆TU

∆Qx

2. Equilibrium in case of one commodity X occurs where:

MUx = MUM
Px

3. Equilibrium in case of two commodities X and Y occurs where :

MUx = MUY = MUM

Px PY

OR

MUx = Px = MUM
MUY PY

Here, TU = Total Utility; MU = Marginal Utility;

Px = Price of X; PY = Price of Y;
MUx = Marginal Utility of X; MUY = Marginal Utility of Y.

ELASTICITY OF DEMAND

1. Total Expenditure OR Total Outlay Method:

A. If rise or fall in price of a commodity makes no change in its total expenditure, then Elasticity of
Demand is UNITARY (Ed = 1).

B. If with fall in price of a commodity, total expenditure increases and with rise in its price, total
expenditure decreases, then Elasticity of Demand is GREATER THAN UNITARY ELASTIC (Ed > 1).

C. If with fall in price of a commodity, total expenditure decreases and with rise in its price total
expenditure increases, then Elasticity of Demand is LESS THAN UNITARY ELASTIC (Ed < 1).

2. Percentage Method:

Ed = (–) Percentage Change in Quantity

Percentage Change in Price

# Percentage Change in Quantity = Change in Quantity X 100

Initial Quantity

# Percentage Change in Price = Change in Price X 100

Initial Price

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 111

3. Proportionate Method:
E d = (–) ∆Q X P
∆P Q

Here, ∆Q = Q1 – Q; ∆P = P1 – P;
Ed = Price Elasticity of Demand;
Q = Initial Demand; Q1 = New Demand;
P = Initial Price; P1 = New Price;
∆Q = Change in Demand; ∆P = Change in Price.

4. Geometric Method:
Ed = Lower segment of the demand curve
Upper side segment of the demand curve

OR

Ed = Right hand side segment

Left hand side segment

# There are five degrees of Ed

1. Perfectly inelastic demand (Ed= 0)
2. Inelastic demand (0 < Ed< 1)
3. Unitary elastic demand (Ed= 1)
4. Elastic demand (1 < Ed< ∞)
5. Perfectly elastic demand (Ed= ∞).

CONCEPTS OF COST

1. TC = TFC + TVC

2. ATC = TC OR AC = AFC + AVC

Q

3. AFC = TFC
Q

4. AVC = TVC
Q

5. MC n = TCn – TCn-1 OR MC n = TVCn – TVCn-1 OR MC n = ∆TC

∆Q
Note: On Zero Unit :- TC = TFC
On One Unit :- TC = ATC & TFC = AFC & TVC = AVC & TVC = MC

Here, TC = Total Cost; TFC = Total Fixed Cost; TVC = Total Variable Cost;
ATC = Average Total Cost; AFC = Average Fixed Cost; AVC = Average Variable
Cost;
MC n = Marginal Cost; ∆TC = Change in TC; ∆Q = Change in Quantity.

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA

Spell Classes (Get the spell of success.) ® 112

CONCEPTS OF REVENUE

1. Revenue / Sales = Cost + Profit

2. TR = Quantity X Price OR Q X AR

3. AR = TR
Q
4. MR = TRn – TRn-1 OR MR = ∆TR
∆Q

Note: On One Unit :- TR = AR = MR

Here, TR = Total Revenue; MR = Marginal Revenue; AR = Average Revenue;

∆TR = Change in TR; ∆Q = Change in Quantity.

THEORY OF SUPPLY

1. Percentage Method:

ES = Percentage Change in Quantity

Percentage Change in Price

# Percentage Change in Quantity = Change in Quantity X 100

Initial Quantity

# Percentage Change in Price = Change in Price X 100

Initial Price

2. Proportionate Method:
E S = ∆Q X P
∆P Q

Here, ∆Q = Q1 – Q; ∆P = P1 – P;
ES = Price Elasticity of Supply;
Q = Initial Supply; Q1 = New Supply;
P = Initial Price; P1 = New Price;
∆Q = Change in Supply; ∆P = Change in Price

Contact Numbers: 9893044064-46 314, SAPPHIRE SQUARE, TOWER CHOURAHA