7550100920 Professoracademy.

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 Professor Academy
Consumer Behavior

Introduction, Theory of Consumer Behaviour and

Theory of Production
Economics – A Humble Introduction:
Economy is the social activity where people come together to produce, stock, distribute,
trade and facilitate consumption of goods and services. The entire activity is meant for the
market- that is for selling. Goods and services may either be exchanged for other goods
and services (barter) as it used to happen as a practice in primitive economies or they are
exchanged for money which is the practice for contemporary economies in the world.
Economics as a term comes from Greek- oikos means family, household, or estate and
nomos stands norm or law.
The origin of the term itself is revealing. Be it household or village or a nation-state, the
universally acknowledged reality is that people have limitless needs and the available
resources to meet the needs are limited. What is the norm at the micro level (household)
is true for the macro economy as well- be it at the national or even global level. The need
for the field of economics as a branch of social science becomes relevant to balance the
needs with resources.
Study of rational management of scarce resources is the substance of economics.
Rationality is choosing the right means for the chosen end. Since last century, economic
rationality which started with the study of production, distribution and consumption, has
come to include equity and sustainability as well.

The Big Four Definition:

Classical Version - Smith’s Wealth Definition:

In the third quarter of the 18th century, with the publication in 1776 of An
Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith, Classical
Economics was born. Britain was beginning to experience the Industrial Revolution.
Smith emphasized Division of Labour or Specialization as the source of productivity or
efficiency in factories contributing aggregative to the nation’s wealth or prosperity. He
explains how a nation’s wealth is created and increased. He considers that the individual
in the society wants to promote his own gain and, in this process, he is guided and led by
an “invisible hand”.

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Neo- Classical Version - Marshall’s Welfare Definition:

Marshall’s Principles of Economics (1890), the pioneering work of Neo-

Classical tradition, provided the following definition of Economics: "a study of mankind
in the ordinary business of life; it (Economics) examines that part of individual and social
action which is most closely connected with the attainment and with the use of the
material requisites of wellbeing. Thus, it is on one side a study of wealth; and on the
other, and more important side, a part of the study of man." This definition established
the character of the subject as for a long time to come. Economics studied human beings
as they go about their everyday life.

New Age Version - Robbins’s Scarcity Definition:

In 1932, in Lionel Robbins’ Essay on the Nature and Significance of

Economic Science, Lionel Robbins highlighted another aspect of the subject, choice
under conditions of scarcity. "Economics is a science which studies human behaviour as
a relationship between ends and scarce means which have alternative uses."

Modern Age Version - Samuelson’s Growth Definition

Paul Samuelson published a book "An Introductory Analysis" in 1948. He

defines Economics as “the study of how men and society choose, with or without the use
of money, to employ scarce productive resources which could have alternative uses, to
produce various commodities over time, and distribute them for consumption, now and in
the future among various people and groups of society”.

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Economics Law – Law of Demand – Utility Analysis:

The law of demand states that, other things remaining the same, the quantity demanded of
a commodity increases when its price falls and decreases when the price rises.
There is a definite inverse relationship between the price of the good and the quantity
demanded of that good.
Symbolically, D = f(P) Ceteris Paribus

Assumptions of the Law of Demand:

(1) The prices of the related goods remain the same.
(2) The income of the consumers remains unchanged.
(3) Commodity should be a normal commodity.
(4) All the units of the goods are homogeneous.
(5) Tastes and preferences of the consumer remain the same.

Reasons behind Downward Slope of the Demand Curve

The demand curve obeys the law of demand which states that there is an inverse
relationship between price and quantity demanded of a good.
That is why demand curve slopes downward to the right. The reasons behind downward
slope of the demand curve are:
(a) Law of Diminishing Marginal Utility. This law was formulated by Alfred Marshall
and it states that as the consumer has more and more of a good its marginal utility to him
goes on declining. A consumer is not interested in buying more units of the same
commodity at the same price. Instead, he is ready to pay a price equal to its marginal
utility and marginal utility goes on diminishing.
(b) Substitution Effect. The substitution effect is the effect that a change in relative prices
of substitute goods changes the quantity demanded. When the price of a good rises (other
things being same) the consumer prefers to buy its substitute goods which have become
relatively cheaper.
(c) Income Effect. Change in demand on account of change in real income resulting from
change in the price of a commodity is known as income effect. In other words, due to fall
in the price of a good, consumers' real income or purchasing power rises and he demands
more units of the goods.
(d) New Consumers Creating Demand. A fall in the price of a commodity leads to an
increase in quantity demanded by the existing consumers due to income and substitution
effect. As price of a commodity falls, new consumer class appears, who can now afford
the commodity thus the total demand for the commodity increases.

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Exceptions to the Law of Demand

There are certain exceptions to the law of demand. In certain cases, an increase in the
prices of some goods leads to an increase in their demand. Alternatively, as their prices
fall their demand also falls. Thus, we set direct relation, between price and quantity So
this. is the exact opposite of the law of demand. Conditions under Which this unusual
behaviour of demand is found are as follows.

1. Giffen Goods:
Sir Robert Giffen (1837-1910) observed that in early 19th, a fall in the
price of bread, reduced the demand for bread. Even in our country we find that
when the price of coarse cereals like jowar and bajra falls, the consumers have a
tendency to spend less on them and shift over superior cereals like wheat and rice.
Similarly, when the price of coarse cloth falls the consumers are likely to purchase
more cloth of belter quality and reduce the consumption of coarse cloth.
Therefore, in the case of course cereals and course cloth, demand is likely to move
in the same direction as price, these are called Giffen goods. Giffin goods are
those inferior goods on which the consumer spends a large part of his income and
demand for which falls with a fall in their price.

2. Expectation of Future Rise in Price:

When the price of a commodity is increasing and consumer expect a further
rise in its price, they will try to store more and more quantities of that commodity.
Therefore, even though the price has increased, the demand will increase instead
of falling.

3. Demand for Goods Conferring Social Prestige:

If the price of a commodity relating social prestige declines its demand also
shows a tendency to diminish. On the other hand, if its price increases its demand
also increases, because of the prestige associated with their ownership. Therefore,
the well to do people purchase more of diamonds and precious Stones when their
prices increase. So, such goods are known as articles of conspicuous consumption.

4. Change in Fashions:
The demand for the new fashion. dress will increase even if the seller of
this new dress increases. its price.

5. Emergencies:
Law of demand may not hold good during, emergencies like war, famines
etc. At such times, consumers behave-in an abnormal way. If they expect shortage
of goods, they would buy and hoards goods even at high prices during such
periods. On the other hand, during depression they will buy less even at low
prices.

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Movement vs Shift of Demand Curve:
Movement Along the Demand Curve
A movement along the demand curve is caused by a change only in the price of the good
other things remaining constant. If is also called change in quantity demanded of the
commodity.

Movement is always along the same demand curve and is of following types:

(i) Expansion of Demand.

It refers to rise in demand due to fall in the price of the goods. When the quantity
demanded of a commodity rises due to fall in its price, other things remaining the same, it
is called 'rise in quantity demanded or expansion of demand'.
(ii) Contraction of Demand.
It refers to fall in demand due to rise in the price of the goods. It refers to fall in
quantity demanded of a commodity as a result of rise in its price other things remaining
the same.

II. SHIFT (INCREASE OR DECREASE) IN DEMAND

When the quantity purchased of commodity rises or falls because of changes in
factors other than the price of the commodity, it is called change in demand. A shift of the
demand curve is caused by changes in factors other than price - of the good.
These factors are
(i) Consumer's income
(ii) Prices of other goods
(iii) Consumers' tastes and preferences

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A change in any of these factors causes shift of the demand curve. It is also called change
in demand. In a shift a new demand curve is drawn. A shift of the demand curve can
bring:
(i) increase in demand
(ii) decrease in demand.

(a) Increase in Demand: Increase in demand refers to the situation when the consumer
buy a large quantity of commodity at the same price.
It refers to more demand at a given price or same demand at a higher price
The causes of increase in demand are
(a) Increase in the income of the consumers.
(b) Increase in the price of substitute goods.
(c) Fall in the price of complementary goods.
(d) Consumers' taste becoming stronger in favour of that goods.
(e) Expectation of rise in price
(f) Increase in population

(b) Decrease in Demand: It refers to a situation when the consumers buy a smaller
quantity of the commodity at the same price. It refers to less demand at the given price or
same demand at a lesser price due to unfavourable changes in factors other than price of
the goods.

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The causes of decrease in demand
(a) Fall in the income of the consumers.
(b) Fall in the prices of the substitute goods.
(c) Rise in the prices of complementary goods.
(d) Consumers' taste becoming unfavourable towards the good.
(e) Expectation of fall in price.
(f) Decrease in population.

Utility:
DEFINITION OF UTILITY
Total Utility: Total utility refers to the total satisfaction derived by the consumer from
the consumption of a given quantity of commodity. It is the aggregate of the utility that a
consumer derives from the consumption of a certain amount of commodity.
Mathematically, TU can be obtained by the summation of the marginal utilities from the
consumption of different units of the commodity
TUn = MU1+MU2+………. + MUn

Marginal Utility: It is the additional utility derived from consumption of an additional

unit of a commodity. In other words, it is the utility from the last unit of a commodity
consumed. Additional unit is known as marginal unit and the utility from the additional
unit is called marginal utility.

Marginal Utility = Utility of the Last Unit

Marginal Utility = (TUn – TUn-1)

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Cardinal Approach: Origin Theories
Gossen's First Law is the concept of diminishing marginal utility itself, namely that
increasing consumption of a good yields a smaller additional satisfaction.
Gossen's Second Law is the Equi -Marginal principle, that when faced with limited
budget (Gossen uses time), a person maximizes his utility when he allocates his
expenditure among various goods so that he obtains the same amount of satisfaction from
the last unit of each good consumed
Assumptions:
Rationality: A consumer is always rational i.e.; he always prefers more of goods and
services to derive maximum utility. Thus, he always buys the commodity which gives
him maximum utility first and then he buys the least utility giving commodity at the end.
Cardinal utility: The utility derived from the consumption of each good is measurable in
terms of utils which is in turn equal to the money a consumer is willing to pay for it i.e. 1
util= utility of 1 unit of money.
Constant marginal utility of money: The utility of each unit of money spent on buying
the good remains the same.
Diminishing marginal utility: According to this, utility derived from the consumption of
each successive unit of the good diminishes.
Additive utility: According to this, the utility derived from the consumption of all goods
and services is additive in nature.

THE LAW OF DIMINISHING MARGINAL UTILITY (LDMU)

This law can be traced back to the writings of Gossen and Bentham. According to this
law, as a person purchases more and more units of a commodity its marginal utility
declines. In simple terms it means that the more of a thing we have the less we want it.

The law of diminishing marginal utility is universal in character. It is based on the

common consumer behaviour that as more and more units of a commodity are provided to
him; the utility of additional units (MU) goes on decreasing successively. This is due to
the reason that the moment a person begins consumption of a commodity to satisfy his
want, its intensity starts diminishing and the commodity that is being consumed becomes
less and less useful. If this process continues for sometimes, a stage is reached where the
consumer fails to derive any satisfaction from the consumption of additional units.

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LAW OF EQUI-MARGINAL UTILITI: CONSUMER'S EOUILBRIUM

Marshall states the law as, “If a person has a thing which he can put to several uses, he
will distribute it among these uses in such a way that it has the same marginal utility in
all. For, if it had a greater marginal utility in one use than another, he would gain by
taking away some of it from the second use and applying it to first”.
The law of Equi-marginal utility states that the consumer will distribute his money
income between the goods in such a way that the utility derived from the last rupee spent
on each good is equal. In other words, consumer is in equilibrium position when marginal
utility of money expenditure on each good is the same. The marginal utility of money
expenditure on a good or the utility of the last rupee spent on the good is equal to the
marginal utility of the good divided by the price of that good. In Symbols,
MUE = MUX/PX
Where is marginal utility of money expenditure, Mux is the marginal utility of the good x
and Px is the price of X.
Consumer will be in equilibrium in respect of the purchase of two goods x and y when,
MUX MUY
------- = ------ = MUE
Px Py

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Thus, with several goods to buy with a given money income the consumer will be
maximising utility and be in equilibrium when the following condition prevails.
Consumer's equilibrium can be depicted graphically:

ELASTICITY OF DEMAND
Elasticity of demand is a technical term used by economists to describe the degree of
responsiveness in the demand for' a commodity to a change in its price.

Alfred Marshall introduced the concept of elasticity of demand into economic theory. He
said that elasticity of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price and diminishes much or tittle
for a given rise in price.
Price Elasticity is defined as the ratio of percentage change in quantity demanded of a
good to a percentage change in its price. It may be defined as the degree of
responsiveness of quantity demanded of a commodity in response to change in its price.

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Different Types of Price Elasticity of Demand.
In terms of the degree of elasticity there are five types of price elasticity of demand.

(i) Perfectly Inelastic Demand:

When the demand of a commodity does not change as a result of change in its price, the
demand is said to be perfectly inelastic i.e., zero. The perfectly inelastic demand curve is
a vertical line parallel to Y axis.

(ii) Perfectly elastic demand: When consumers are prepared to purchase all that they can
get at a particular price but nothing at all at a slightly higher price, then the price elasticity
of demand for a commodity is said to be infinite. When the demand for a commodity rises
or falls to any extent without any change in price, the demand for the commodity is said
to be perfectly elastic. The perfectly elastic demand curve is a Horizontal line parallel to
X axis.

(iii) Unitary Elastic Demand: When the given percentage change in demand is equal to
the percentage change in price, the demand for the commodity is said to be unitary
elastic.

(iv) Elastic Demand: When a small change in price leads to a more than proportionate
change in demand, the demand is said to be elastic or more than unit elastic. The
coefficient of elasticity of demand is greater than unity.

(v) Inelastic Demand: Demand is inelastic when the percentage change in quantity
demanded of commodity is less than the percentage change in its price. When a
considerable change in price leads to less thar proportionate change in demand, the
demand is said to be less elastic or inelastic.

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Important methods for calculating price elasticity of demand are as follows:
(I) Total Outlay Method: Total outlay method for measuring elasticity of demand was
originally suggested by Alfred Marshall. According to this method, the price elasticity of
demand can be measured on the basis of change in total outlay or total expenditure in
response to a change in price of the commodity. Marshall maintains that elasticity of
demand can be of three types.

(i) Unitary Elasticity (ep=1) If small changes in price leave total outlay unaffected, price
elasticity of demand is unity.

(ii) Elastic Demand (ep>1) If a small reduction in price, increases total outlay or if small
increase in price reduces total outlay, demand is elastic.

(iii) Inelastic Demand (ep<)1 Demand is inelastic when, with fall in price total outlay
also falls or, with rise in price, total outlay also rises.

(2) Point Method or Geometrical (or graphical) Method:

The point method of measuring elasticity of demand was developed by Prof. Marshall.
Elasticity measured at a point on a demand curve is known as point elasticity of demand.
Point Elasticity on a straight-line demand curve can be calculated by the help of the
following formula:
Ep= Lower Segment of the demand curve/ Upper Segment of the demand curve
Thus, the price elasticity of the demand at different points if the demand curve will be
different.

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(3) Arc Method: When elasticity of demand is measured over a finite range or 'arc' of a
demand curve, it is called arc elasticity of demand. Arc elasticity is an average reaction or
the average responsiveness.

In terms of demand curve, when we have to measure the price elasticity over an arc of the
demand curve such as between points A and B on the demand curve DD in the following
figure, the point elasticity formula will not yield the true and correct measure of price
elasticity.

For measuring price elasticity in such cases when the changes in price are somewhat large
or the price elasticity over an arc of the demand curve is to be measured, is used. We take
the average of the two prices (original and subsequent) and average of the two quantity
figures (original and subsequent). Thus, the formula for measuring arc price elasticity of
demand is:
Ep = Δq * P1+P2
---- ---------
Δp q1+q2

Income Elasticity of demand:

Income elasticity of demand is the responsiveness of demand to the change in Income. It
measures the degree of responsiveness of quantity demanded of a commodity to changes
in income of the consumers. It is defined as: -

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Income elasticity is positive for most of the goods i.e., an increase in income increases the
quantity demanded and vice-versa. Some economists define goods as normal, superior
and inferior on the basis of income elasticity of demand.

(I) If 1 <ey< ∞ then good is superior.

(II) If 0<ey<1 Then the good is normal.
(III) ey < 0 The good is inferior.

Cross Elasticity of Demand:

Cross elasticity of demand measures the responsiveness of the change in quantity
demanded of one commodity due to a change in the price of another commodity. Let X
and Y be two commodities Px and Py their prices, the cross elasticity of demand can be
defined as; varies from minus infinity to plus infinity. Complementary goods have
negative cross elasticities and substitute goods have positive cross elasticities.

i.e., For Substitute goods 0 <ec<∞

For Complementary Goods - ∞ < ec <0

Consumer Surplus:

The Marshallian Surplus: The concept of consumer's surplus was introduced by Marshall
which pronounces the difference between the amount of money that a consumer actually
pays to buy a certain quantity of a commodity X, and the amount that he would be willing
to pay for this quantity rather than go without it. Marshall maintained that this concept
can be measured in monetary terms. Graphically the consumer's surplus may be depicted
by his demand curve for commodity X and the current market price which he cannot
affect by his purchases of this Commodity.

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Consumer surplus is infinite when the demand curve is inelastic and zero in case of a
perfectly elastic demand curve.

HICKSIAN INDIFFERENCE CURVE ANALYSIS:

The theory of consumer behavior based on the ordinal approach was propounded by J.R.
Hicks and R.G.D. Allen in 1934.
According to this approach, utility cannot be measured in any quantifiable number.
It could only be measured by giving order, ranks or preferences. Hence the ordinal utility
means consumers preferences or choice for one commodity or for a basket of goods over
the other.
Here, the preferences could be expressed in terms of ‘more’ or ‘less’ preferable.
Indifference curves were originally invented by F.Y. Edgeworth and later developed by
Vilfredo Pareto, Johnson and E.E. Slutsky. But we owe it to two English economists,
Prof. Allen and Prof. J.R. Hicks for providing us with a first systematic treatment of
indifference curve technique as an approach to the theory of demand. Prof. Hicks worked
further on it. Hicks' two works 'Value and Capital' (1939) and 'A Revision of Demand
Theory' (1965) deserve credit for the common popularity of this technique among the
micro economists.

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ASSUMPTIONS
(1) Rationality: The consumer is assumed to be rational.

(2) Utility is Ordinal: It is taken as axiomatically true that the consumer can rank his
preference according to the satisfaction of each unit. He need not know precisely the
amount of satisfaction.

(3) Diminishing Marginal Rate of Substitution: Preference are ranked in terms of

indifference curves, which are assumed to be the convex to the origin. Convexity of
indifference curves is based on the axiom of diminishing marginal rate of substitution.

(4) The total utility of the consumer depends on the quantities of the commodities
consumed.

U=f (q1, q2,…qx)

(5) Consistency and Transitivity of Choice: It is assumed that the consumer is

consistent in his choice, that is, if in one period he chooses combination of A over B, he
will not choose B over A in another period if both combinations are available to him. The
consistency assumption may be symbolically written as follows:

If A>B, Then B ≯ A

Similarly, it is assumed that consumer's choices are characterised by transitivity. If A

combination A is preferred to B and B is preferred to C, then Combination A, is preferred
to C. Symbolically we may write the transitivity assumption as follows:

If A > B, and B > C, then A>C

6. Non – Satiety:

Consumer is not over supplied with either good that is he prefers to have more of
commodity X or Y.

MEANING OF AN INDIFFERENCE CURVE

An indifference curve is the locus-of points, indicating particular combinations of goods
from which the consumer derives the same satisfaction and, as a result, he is indifferent as
to the particular combination he consumes.
Symbolically an indifference curve is given by the equation:
U=f (X1, X2, X3………Xn) =K

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Indifference curve is shown in the following figure. It is assumed that the Commodities Y
and X can substitute one another to a certain extent but are not perfect substitutes. The
negative of the slope of an IC at any one point is called the marginal rate of substitution
of the two commodities X and Y and is given by the slope of the tangent at that point.

The marginal rate of substitution of x for y is defined as the number of units of

commodity y that must be given up in exchange for an extra unit of commodity X so that
the consumer maintains the same level of satisfaction.
The Concept of marginal utility is implicit in the definition of MRS.

INDIFFERENCE MAP
A set of IC is called indifference map. Indifference map is a group or set of Indifference
curves each one of which represents a given level of satisfaction. In other words, an
indifference map is a collection of indifference curves corresponding to different levels of
satisfaction. Such a map has been drawn in the following figure.

ICIII > ICII > ICI

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PROPERTIES OF INDIFFERENCE CURVE
Indifference curves possess the following properties-
(i) Indifference Curves Slope Downwards from Left to Right. An indifference curve
slopes downward from left to right i.e., it has a negative slope. The reason underlying this
property is that if the consumer has to stay at the same level of satisfaction the quantity of
one commodity must decrease when the quantity of the other commodity is increasing.

(ii) Indifference Curves are Convex to the Origin: This property of indifference curves is
due to the tendency of diminishing marginal rate of substitution.

(iii) Indifference Curves Cannot Intersect Each Other: Two indifference curves can never
intersect one another, because they represent two different sets of combinations of two
commodities providing unequal amount of satisfaction.

The IC need not to be parallel to one another. This is due to two reasons: firstly,
indifference curve is not based on measurable utility and secondly, the MRS for two
commodities need not be the same on different IC.

(iv) Higher Indifference Curve Yield Higher Satisfaction: Higher indifference curve
represents those combinations which yield more satisfaction than the combinations on the
lower indifference curve. A combination on a higher indifference curve will give more
satisfaction than a combination on the lower indifference curve since the former will be
giving us more amount of one commodity or the other or more amount of both the
commodities.
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BUDGET EQUATION OR BUDGET LINE
Income acts as a constraint in the attempt for maximizing utility. Income constraint is
represented by budget line. Budget line, in the case of two commodities, X and Y with
prices Px and Py respectively, may be written as Y = Pxqx + Pyqy
Budget line can be depicted by a straight line A B shown in the following figure:

CONSUMER'S EQUILIBRIUM
Every rational consumer wants to maximise his satisfaction. In order to explain how the
consumer achieves maximum satisfaction or reaches equilibrium he will have to bring
together these two tools-the indifference maps and the price line (budget line).
An indifference map describes the preferences of the consumers and the price line
describes the combinations open to the consumer given his income and the prices of the
commodities.
MRS = Price ratios of two goods

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The price line on the indifference map has been superimposed since the consumer acts
rationally. He will try his best to move to the highest possible indifference curve. In doing
so he will act within an area imposed by a price line. The consumer will be in equilibrium
when he reaches the highest possible indifference curve with the given price line. The
consumer is in equilibrium at point E because this combination gives the consumer the
maximum satisfaction since it is on the highest indifference curve IC2 to which his
money income can take him. He will not choose any other point than E on IC2. He will
not choose F on IC3 though it yields him more satisfaction than E, because F is beyond
his price or budget line AB.

CONDITIONS OF CONSUMER'S EQUILIBRIUM

1st Order Condition (Necessary Condition): -

At the point of equilibrium, the budget (price) line should be tangent to the indifference
curve. At the tangency point, the slopes of the budget line and indifference curve are
equal, i.e.

MRSxy = Px/Py = MUx/MUy

2nd Order Condition (Sufficient Condition):

The second order condition is that at the point of equilibrium indifference curve must be
convex to the origin. In other words, the MRSxy must be falling at the point of
equilibrium.

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7550100920 [Link]
 THEORY OF PRODUCTION

MEANING OF PRODUCTION
The act of production involves the transformation of inputs into outputs. The word
production in economics is not merely confined to effecting physical transformation in
the matter, it is creation or addition of value. Therefore, production in economics also
covers the rendering of services such as transporting, financing, marketing.
The resource utilised for production were classified into four factors of production-Land,
Labour Capital and Entrepreneur.
Land and Labour are regarded as the primary factors of production because they are not
the products of any economic activity. Capital represents the produced means of
production. Hence it is treated as a secondary factor of production.

PROUUCTION FUNCTION
The production function is a purely technical relation which connects factor inputs and
outputs. It describes the law of production, i.e., the transformation of factor inputs into
outputs at any particular time period. The production function includes all the technically
efficient methods.

Mathematically, a production function can be written as:

Y = f (L, K, R, S, V, r)
where, Y is output, L is labour input, K is capital input, R is raw material, S holds for
land, V is Returns to Scale and r is efficiency parameter.

The production function is purely a technical relation. Prices of factor do not enter into
the production function.

TOTAL AVERAGE AND MARGINAL PRODUCTS

I. TOTAL PRODUCT (TP):

Total product refers to aggregate output resulting from the, use of total quantities of all
inputs. In the case of production with one variable input, total product refers to the
aggregate output resulting from the use of a given amount of a fixed input and a certain
quantity of the variable input.

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II. AVERAGE PRODUCT (AP):
Average product of an inputs is defined as the total product divided by the amount of
input used to produce it.
Thus: APL = Q/L
Were,
APL = Average Product of Labour
Q = Total Output
L = Amount of Labour

III. MARGINAL PRODUCT (MP):

The marginal product of an input is defined as the change in total output due to the
change in the amount of an input. Thus
MPL = ΔQ/ΔL
Were,
MPL = Marginal product of labour
ΔQ = Change in Output
ΔL = Change in labour

RELATIONSHIP BETWEEN TP, AP AND MP.

(1) AP curve is the slope of the straight line from the origin to each point on the TP

curve. MP curve is the slope of the TP curve at each point.

(2) When AP is Maximum, MP = AP

(3) When TP is maximum, MP = 0

(4) When TP is falling, MP is negative

(5) As long as TP is positive, AP is positive

(6) Both AP and MP curve are inverted U shaped

(7) When MP > AP, this means that AP is rising

(8) When MP=AP, this means that AP is constant

(9) When MP < AP this means that AP is falling.

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LAW OF VARIABLE PROPORTION:
Since not all inputs can vary in the short-run, the proportion at which inputs are combined
vary. Thus, the-name returns to variable proportions is given to one input-output
relationship depicted by the short-run production function. The long-run production
function describes the input-output relationship all inputs can be freely varied when all
inputs on be freely varied
This law is also known as the "law of non-Proportional return " or the law of the
diminishing marginal return." Mosh the earlier economists talked of the law of
diminishing return the field of production. Famous Malthusian theory of produce and the
celebrated Ricardian theory of rent are based on "the of diminishing returns".

ASSUMPTIONS OF LAW
(1) State of technology remains the same.
(2) All units of the variable factors are homogeneous
(3) There must always be some fixed input which cannot increased in the short-term.
(4) Only one factor is variable and the other factor are kept constant
(5) It is possible to vary the proportions in which the variables input are combined.

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THREE STAGES OF PRODUCTION

Stage I.

Stage I is characterized by increasing average product; until the maximum average

product is utilised every additional unit of labour employed results in an increase in
average productivity. It is to the benefit of the firm to continue to employ more and more
units of labour. So, it is not advisable to stop before maximum average output is achieved.

Stage II.
During the Stage II, both average product and marginal product are declining though
positive.
Stage III.
The Stage III begins from point of the maximum total product. Beyond that point the total
product declines and marginal product becomes negative.
The Stage of Actual Operation. A rational producer will never choose to produce in stage
III where the Marginal product of variable factor is negative.

A rational producer will also not choose to produce in stage I where the marginal product
of fixed factor is negative. A producer producing in stage I means that he will not be
making the best use of the fixed factor and further he will not be utilizing fully the
opportunities. of increasing production and increasing quantity of the variable factor
whose average product continues to rise throughout the stage [. Thus stages 1 and III
represent non-economic region in production function. A rational producer will always
seek to produce in stage II where both marginal product and average product of variable
factor are diminishing. The stage II represents range of rational production.

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LAWS OF RETURNS TO SCALE
The term 'returns to scale' refers to the response of total output to changes in all inputs by
the same proportion. The laws of 'returns to scale' refers to the effects of scale
relationship.

THREE STAGES OF RETURNS TO SCALE

1. Stage I: Increasing Returns to Scale - It occurs when the increase in output is more than
proportional to increase in inputs. The first stage starts from the point of origin and
continues till the average product is maximum.
2. Stage II: Constant Returns to Scale - It occurs when the increase in output is
proportional to the increase in input.
3. Stage III: Decreasing Returns to 'Scale - It occurs when the increase in output is less
than proportional to the increase in inputs.

PRODUCER'S EQUILIBRIUM
In any business, the producer wants to maximize his satisfaction which comes with
more profit. The producer must reach a level of output where his profits are maximized.
By having an optimal combination of factors, a producer can reach a producer’s
equilibrium if his profits are maximum. The producer’s equilibrium is also referred to as
profit maximization condition. To reach this state of equilibrium, the following 2 things
have to be achieved.
 Costs are minimized for a given level of output.
 Outputs are maximized for a given amount of cost.

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Consumer and Producer Equilibrium
The consumer and producer equilibrium are different from each other as outlined below.

 A consumer’s equilibrium refers to the point where he or she derives maximum

satisfaction by spending money on the consumption of goods and services.

 A producer’s equilibrium refers to the state where the combination of price and
output gives maximum profit to the producer. By producing any more goods than
the equilibrium state, the producer’s profit would begin to decline.

Methods of Determining Producer’s Equilibrium

There are mainly 2 methods utilized in determining the producer’s equilibrium for any
firm.
1. TR - TC Approach - This is the total revenue total cost approach. The producer
equilibrium formula in this is based on the difference between TR and TC. The
equilibrium happens when TR minus TC is positive and maximum. Beyond this point, the
producer has no incentive to either increase or decrease the output. In case the producer
increases his output, the profits would start falling. Hence the 2 important conditions to be
met under this approach are as follows.

a. TR-TC is positively maximized.

b. Profits fall after this level of output.

Two situations can arise in this case.

 Price remains constant - This happens in a perfect competition where price

remains the same at all levels of output. We will explain this with the following
example.

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In the table above we can mark that profit rises first and then becomes a maximum at
Rs.10 with 3 and 4 units produced. After that, profit begins to decline. Hence, in this case,
the maximum profit is reached at 3 or 4 units of production. However, the producer’s
equilibrium would be said to reach at 4 units of production because both conditions stated
above (TR-TC is maximum and profits fall after this point) should be met.

2. MR - MC Approach - This is the marginal revenue and marginal cost approach. The
producer’s equilibrium formula for this approach is given by the following 2
fundamentals.

a. MR = MC. So till the point, MC is less than MR, the producer would keep
producing till she or he hits the level of equal MR and MC.

b. MC > MR after the MC = MR output level is reached. MC = MR is not a

sufficient condition to reach the producer’s equilibrium. For any additional unit of
production, MC must exceed MR to realize the producer’s equilibrium for output level.

Here, MR is an additional amount earned over and above TR (total revenue) when more
than 1 unit of product is sold. MC is an additional cost incurred over and above TC when
more than 1 unit of product is produced. We will now examine this approach with the
following 2 situations.

 When price remains constant - When the price is fixed, firms can sell any amount
of product. In this case, revenue from each additional unit, i.e., MR is equal to AR
or the price. AR and MR curves would be the same in this scenario. So this would
mean that price is equal to MC at all levels of output. Producers would aim to
produce to a point where MC = MR and MC > MR after it reaches MC = MR
output level.

 When the price falls with output increase - The MR curve would slope downward
if there is no fixed price and there is a fall in price when output increases. In this
case, producers would aim to produce to a level where MC = MR and MC curve
cuts the MR curve from below.

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PRODUCER’S SURPLUS
The producer surplus is the difference between what the producer sells its goods for and
the minimum price it would be willing to sell for. In other words, because the producer is
selling at a higher price than they would accept, a ‘producer surplus’ is created. The
surplus itself is the difference between the two values.
The producer surplus refers to the area between price and the supply curve. If we look at
the graph below, this is the area shaded in grey. This refers to the total producer surplus –
so the surplus for all businesses in the market.
The producer surplus can therefore be calculated using the formula:

Producer Surplus = Final Price – Marginal Cost

INTERNAL AND EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE

OF PRODUCTION
Economies of scale may be defined as the cost advantages that can be achieved by an
organisation by the expansion of their production in the long run. Therefore, the
advantages of large-scale expansion are known as Economies of Scale. The lower average
cost per unit achieves the advantage in cost.

Economies of Scale are a long-term concept which is achieved when there is an increase
in the sales of an organisation. Due to the lowering of production cost, the organisation
can save more and invest it on buying a bulk of raw materials which can again be
obtained at a discount.

These are the benefits of Economies of Scale. When there is a massive expansion in an
organisation, the cost per unit may increase with the increase in output. Diseconomies of
Scale may arise due to internal issues resulting from technical, organisational, or resource
constraints.

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Types of Economies of Scale
The Economies of Scale may be divided into two categories- 1) Internal Economies and
2) External Economies.
1. Internal Economies: Internal Economies are the real economies which arise from
the expansion of the organisation. These economies are the result of the growth of
the organisation itself.
2. External Economics: External Economics are the economies that originate from
factors outside the organisation. These economies result in the increase in the main
organisation by the increase in the quality of factors outside the organisation like
better transportation, better labour, infrastructure, etc. Due to the betterment of
these external factors, the cost of production per unit of an item in the organisation
decreases.

Types of Diseconomies of Scale

When there is a massive expansion in an organisation, the cost per unit may increase with
the increase in output. Diseconomies of Scale may arise due to internal issues resulting
from technical, organisational, or resource constraints.

Similar to the Economies of Scale, Diseconomies of Scale is of two types- Internal

Diseconomies of Scale and External Diseconomies of Scale.

Internal Diseconomies of Scale: Internal Diseconomies of Scale are the Diseconomies

resulting from the internal difficulties within the organisation. The Internal Diseconomies
are the factors which raise the cost of production of an organisation like lack of
supervision, lack of management and technical difficulties.

External Diseconomies of Scale: External Diseconomies of Scale are the external factors
which result in the increase in the production per unit of a product within an organisation.
The external factors that act as a restrain to expansion may include the cost of production
per unit, scarcity of raw materials, and low availability of skilled labours.

COST AND REVENUE:

The term 'cost of production' means expenses incurred in the production of a commodity.
This refers to the total amount of money spent on the production of a commodity. The
determinants of cost of production are: the size of plant, the level of production, the
nature of technology used, the quantity of inputs used, managerial and labour efficiency.
Thus the cost of production of a commodity is the aggregate of prices paid for the factors
of production used in producing a commodity. which may arise due to price decisions,
output, product variation etc. Entrepreneurs claim profit as rewards for undertaking these
non-insurable risks or uncertainties. According to Knight uncertainty in production can be
thought of as factor of production like other factors say land, labour, capital etc. The price
for undertaking this uncertainty is, therefore, considered as part of cost of production.
Like other factors there exist supply price of uncertainty. This supply price is known as

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profit. In the production process since entrepreneurs supply the uncertainty factor, they
enjoy profit. It should be noted that in Knight’s theory in the midst of uncertainty, if
producers’ anticipations regarding output and price decisions are found correct, then they
enjoy profits otherwise they incur losses.

Cost function
The cost function expresses a functional relationship between costs and output that
determine it. Symbolically, the cost function is
C = f (Q)
Where C = Cost
Q = Output

Short run cost Curves:

Short Run Cost refers to a certain period of time where at least one input is fixed while
others are variable.

In the short-run period, an organisation cannot change the fixed factors of production, such as
capital, factory buildings, plant and equipment, etc. However, the variable costs, such as raw
material, employee wages, etc., change with the level of output.

Example: If a firm intends to increase its output in the short run, it would need to hire more
workers and purchase more raw materials. The firm cannot expand its plant size or increase
the plant capacity in the short run.

Similarly, when demand falls, the firm would reduce the work hours or output, but cannot
downsize its plant. Therefore, in the short run only variable factors are changed, while the
fixed factors remain unchanged.

Short Run Total Cost

The total cost refers to the actual cost that is incurred by an organisation to produce a given
level of output. The Short-Run Total Cost (SRTC) of an organisation consists of two main
elements:
Total Fixed Cost (TFC): These costs do not change with the change in output. TFC remains
constant even when the output is zero. TFC is represented by a straight line horizontal to the
x-axis (output).

Total Variable Cost (TVC): These costs are directly proportional to the output of a firm.
This implies that when the output increases, TVC also increases and when the output
decreases, TVC decreases as well.

SRTC = TFC + TVC

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As the TFC remains constant, the changes in SRTC are entirely due to variations in TVC.
Figure depicts the short run cost curve of a firm:

Short run average cost curves

Average Fixed Cost (AFC)

The average fixed cost is the fixed cost per unit of output. It is obtained by dividing the total
fixed cost by the number of units of the commodity produced.
Symbolically AFC = TFC / Q
Where AFC = Average fixed Cost
TFC = Total Fixed cost
Q = number of units of output produced
Suppose for a firm the total fixed cost is Rs 2000 when output is 100 units, AFC will be Rs
2000/100 = Rs 20 and when output is 200 units, AFC will be Rs 2000/200 = Rs10/- Since
total fixed cost is a constant quantity, average fixed cost will steadily fall as output increases;
when output becomes very large, average fixed cost approaches zero.

Average Variable cost (AVC):

Average variable cost is the variable cost per unit of output. It is the total variable cost
divided by the number of units of output produced.
AVC = TVC / Q
Where AVC = Average Variable Cost
TVC = Total Variable Cost
Q = number of units of output produced
Average variable cost curve is 'U' Shaped. As the output increases, the AVC will fall upto
normal capacity output due to the operation of increasing returns. But beyond the normal
capacity output, the AVC will rise due to the operation of diminishing returns.

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Average Total Cost or Average Cost :
Average total cost is simply called average cost which is the total cost divided by the number
of units of output produced.
AC = TC / Q

where AC = Average Cost

TC = Total Cost

Q = number of units of output produced

Average cost is the sum of average fixed cost and average variable cost. i.e. AC = AFC+AVC
The average cost is also known as the unit cost since it is the cost per unit of output produced.
The following figure shows the shape of AFC, AVC and ATC in the short period.

From the figure, it can be understood that the behaviour of the average total cost curve
depends on the behaviour of AFC and AVC curves. In the beginning, both AFC and AVC
fall. So ATC curve falls. When AVC curve begins rising, AFC curve falls steeply ie fall in
AFC is more than the rise in AVC. So ATC curve continues to fall. But as output increases
further, there is a sharp increase in AVC, which is more than the fall in AFC. Hence ATC
curve rises after a point. The ATC curve like AVC curve falls first, reaches the minimum
value and then rises. Hence it has taken a U shape.

Short Run Marginal Cost

Marginal cost is the addition made to the cost of production by producing an additional unit
of the output. In simpler words, it is the total cost of producing n units instead of n-1 units.
Let’s look at an example to understand this better:
A firm produces 5 units at a total cost of Rs. 200. For some reasons, it is required to produce
6 units instead of 5 and the total cost is Rs. 250. Therefore, the marginal cost is Rs. 250 – Rs.
200 = Rs. 50.

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Symbolically, MCn = TCn - TCn-1
Where MCn = Marginal cost
TC n = Total cost of producing n units
TC n-1 = Total cost of producing n-1 units
The marginal cost curve is given below

The marginal cost curve is 'U' shaped. The shape of the cost curve is determined by the law of
variable proportions. If increasing returns (economies of scale)is in operation, the marginal
cost curve will be declining, as the cost will be decreasing with the increase in output. When
the diminishing returns (diseconomies of scale) are in operation, the MC curve will be
increasing as it is the situation of increasing cost.

From the below table, we can make the following observations:

 Since the fixed cost does not change with the output, the average fixed cost decreases
as the output increases.
 The average variable cost does not always increase in proportion to an increase in the
output.
 Marginal costs also come down until 44 units are produced after which they start
rising.

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The following Table outlines the behaviour of all these costs:

Relationship between Average Cost and Marginal Cost

a. If the average cost falls due to an increase in the output, the marginal cost is less than
the average cost.
b. If the average cost rises due to an increase in the output, the marginal cost is more
than the average cost.
c. Marginal cost is equal to the average cost when the marginal cost is minimum. You
can see in Fig. 1 that the MC curve cuts the ATC curve at its minimum or optimum
point.

Long Run Cost curve

The long run refers to that time period for a firm where it can vary all the factors of
production. Thus, the long run consists of variable inputs only, and the concept of fixed
inputs does not arise. The firm can increase the size of the plant in the long run. Thus, you
can well imagine no difference between long-run variable cost and long-run total cost, since
fixed costs do not exist in the long run.

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Long Run Total Costs
Long run total cost refers to the minimum cost of production. It is the least cost of producing
a given level of output. Thus, it can be less than or equal to the short run average costs at
different levels of output but never greater.
In graphically deriving the LTC curve, the minimum points of the STC curves at different
levels of output are joined. The locus of all these points gives us the LTC curve.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC curve or the cost per
unit of output in the long run. It can be calculated by the division of LTC by the quantity of
output. Graphically, LAC can be derived from the Short run Average Cost (SAC) curves.
While the SAC curves correspond to a particular plant since the plant is fixed in the short-
run, the LAC curve depicts the scope for expansion of plant by minimizing cost.

Derivation of the LAC Curve

Note in the figure, that each SAC curve corresponds to a particular plant size. This size is
fixed but what can vary is the variable input in the short-run. In the long run, the firm will
select that plant size which can minimize costs for a given level of output.
You can see that till the OM1 level of output it is logical for the firm to operate at the plat size
represented by SAC2. If the firm operates at the cost represented by SAC2 when producing an
output level OM2, the cost would be more.
So in the long run, the firm will produce till OM1 on SAC2. However, till an output level
represented by OM3, the firm can produce at SAC2, after which it is profitable to produce at
SAC3 if the firm wishes to minimize costs.

Thus, the choice, in the long run, is to produce at that plant size that can minimize costs.
Graphically, this gives us a LAC curve that joins the minimum points of all possible SAC

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curves, as shown in the figure. Thus, the LAC curve is also called an envelope curve or
planning curve. The curve first falls, reaches a minimum and then rises, giving it a U-shape.
We can use returns to scale to explain the shape of the LAC curve. Returns to scale depict the
change in output with respect to a change in inputs. During Increasing Returns to
Scale (IRS), the output doubles by using less than double inputs. As a result, LTC increases
less than the rise in output and LAC will fall.

 In Constant Returns to Scale (CRS), the output doubles by doubling the inputs and
the LTC increases proportionately with the rise in output. Thus, LAC remains
constant.

 In Decreasing Returns to Scale (DRS), the output doubles by using more than
double the inputs so the LTC increases more than proportionately to the rise in output.
Thus, LAC also rises. This gives LAC its U-shape.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit of the
output in the long-run i.e., when all inputs are variable. The LMC curve is derived by the
points of tangency between LAC and SAC.
Note an important relation between LMC and SAC here. When LMC lies below LAC, LAC
is falling, while when LMC is above LAC, LAC is rising. At the point where LMC = LAC,
LAC is constant and minimum.

Concepts of Revenue

The amount of money, which the firm receives by the sale of its output in the market, is
known as its revenue.

Total Revenue

Total Revenue refers to the total amount of money that a firm receives from the sale of its
products.

Mathematically TR = P*Q
where TR = Total Revenue;

P = Price; Q = Quantity sold.

Suppose a firm sells 10000 units of a product at the price of Rs 100 each, the total revenue
will be 10000 x Rs 100 = Rs 10,00,000/-

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Average Revenue

Average revenue is the revenue per unit of the commodity sold. It is calculated by dividing
the total revenue by the number of units sold.
AR = TR / Q
Where AR = Average Revenue
TR = Total Revenue
Q = Quantity sold
Eg: Average Revenue = Rs 10,00,000 / 10000 = Rs 100 / −
Thus, average revenue means price of the product.

Marginal Revenue

Marginal Revenue is the addition made to the total revenue by selling one more unit of a
commodity.
For example, if 10 units of a product are sold at the price of Rs 15 and 11 units are sold at
Rs14, the marginal revenue will be:
MRn = TRn - TRn-1
Rs (11x 14) - Rs (10x 15)
Rs 154 – 150
Rs 4/-

Relationship between AR and MR curves

When the average revenue (price) remains constant, the marginal revenue will also remain
constant and will coincide with the average revenue.
Constant AR and MR
No. of Units Price or AR(Rs) TR(Rs) MR(Rs)
Sold
1 10 10 10
2 10 20 10
3 10 30 10
4 10 40 10
5 10 50 10
6 10 60 10

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A firm can sell large quantities only at lower prices. In that case, the average revenue (price)
of the product falls. When AR falls MR will also fall. But fall in MR will be more than the
fall in the AR. Hence the marginal revenue curve will lie below the average revenue curve as
shown in the below figure.
Downward sloping AR and MR
[Link] Units Sold Price or AR(Rs) TR(Rs) MR(Rs)
1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0

Measurement of Profit

A firm's profit may be defined as the difference between its total revenue and its total cost.
i.e., Profit = Total Revenue - Total Cost
The aim of any firm is to maximise its profit i.e. to maximise the positive difference between
the Total Revenue (TR) and Total Cost (TC). At that point the producer will be in
equilibrium.

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 Maximising Profits
Output (Units) Total Revenue (Rs) Total Cost (Rs) Total profit (Rs)
1 40 45 -5
2 80 70 10
3 130 90 40
4 175 105 70
5 210 130 80
6 240 155 85
7 265 200 65
8 285 255 30
9 290 270 20
10 300 310 -10

From Table it can be understood the firm will earn maximum profit of Rs 85 when it
produces 6 units of output. Thus, the firm will be in equilibrium by producing 6 units of
output.

Its profit is the maximum at OM level f output where the distance between the TR curve and
the TC curve is the maximum. When the firm produces OL level of output, and OH level of
output, total revenue just equals total cost (TR=TC). At these points, the firm is making
neither profits nor losses. Thus, the points S and Q are called Break-even points.

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PRICE DETERMINATION UNDER DIFFERENT MARKET STRUCTURES:
Market structure, in economics, refers to how different industries are classified and
differentiated based on their degree and nature of competition for goods and services. It is
based on the characteristics that influence the behavior and outcomes of companies
working in a specific market.

Perfect Competition:
Perfect competition is a market structure where many firms offer a homogeneous product.
Because there is freedom of entry and exit and perfect information, firms will make normal
profits and prices will be kept low by competitive pressures. In perfect market, goods are
bought and sold under perfect competition. Following are the characteristics or conditions of
perfect market or competition.

Characteristics of Perfect competition:

 Large number of buyers and sellers: There is a large number of buyers and sellers
exist in the perfect market. Therefore, neither sellers nor buyers can influence the
market price. Consequently, the market price remains unchanged. If the price of a
good increases by a single seller, the buyer will immediately move to another seller.
 Homogeneous products are being traded: Under perfect market or competition all
the firms produce identical goods having same quality and features. The products are
perfectly substituted. A buyer can buy a product from any seller in the market.
 Free entry and exit of firms: There is no legal, social or market restrictions on entry
and exit of the firm. Any firm can enter and leave the industry.
 Perfect awareness of market conditions: All the buyers and sellers know the
prevailing price of the good and its availability in the market. So, by having perfect
awareness of the market conditions, no one can sell or buy the product at a higher
rate.
 Factors of production are perfectly mobile: All factors of production (land, labor,
capital and organization) are freely mobile. Land can be bought or rented. Labor and
capital can be moved from one firm to another. In the same way, any organization can
enter or leave the industry.

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  Free from government interference: There is no government interference in the
market. A seller can sell his product to any buyer in any quantity.
 Absence of transport cost: Under perfect competition, a commodity is sold at
uniform price throughout the market. If transport cost is incurred, the firms nearer to
the market will change a low price than the firms far away. Hence it is assumed that
there is no transport cost.

Examples of perfect competition

In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect
knowledge’ and ‘perfect information’. However, some industries are close.
1. Agricultural markets. In some cases, there are several farmers selling identical
products to the market, and many buyers. At the market, it is easy to compare prices.
Therefore, agricultural markets often get close to perfect competition.

Perfect Competition Short Run

In the diagram above, the firm is making supernormal profits. The total cost to the firm is in
blue, and the profit is in the red. We can intuitively tell it makes a profit because its average
costs are lower than the average revenue. To calculate the cost, see where the quantity hits the
average cost line, and then draw a horizontal line to the Y-axis. Whatever area is above the
cost is the profit or the loss. Since we assume that all individual firms are profit maximizers,
we take MC = MR for profit maximization. If a company is loss-making, the rule still applies,
so the loss is minimized. Similarly, the least Total Cost is taken to maximize profit or
minimize loss.

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Perfect Competition Long Run Equilibrium

In the long run, with the entry of new firms in the industry, the price of the product will go
down as a result of the increase in supply of output and also the cost will go up as a result of
more intensive competition for factors of production. The firms will continue entering the
industry until the price is equal to average cost so that all firms are earning only normal
profits.

The short-run cost curves that lie at the lowest point of the long run average cost curve has no
incentive to leave the industry.

The firms will continue leaving the industry until the price is equal to average cost so that the
companies remaining in the field are making only normal profits. Normal Profits, also known
as the break-even or zero economic profit, includes the profit paid to the entrepreneur
(included in the total cost, for bringing in scarce resources and taking on risk), and the total
cost is equal to total revenue. A firm making normal profits will remain in the industry.

In the Perfect Competition Long Run, the loss-making firms will exit the industry, and new
firms will enter the market. Losses are the key to establishing Long Run equilibrium.

In the long run equilibrium, firms enjoy market efficiencies, which leads to scarce resources
not being wasted.

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Perfect Competition Long-Run Profit Maximization Formula

Where Long Run Marginal Cost (Long Run MC) = Short Run Marginal Cost (SMC)
= Marginal Revenue (MR)

1. Productive Efficiency: When the firm produces at the lowest short-run average cost, they
can achieve productive efficiency, where price equals the minimum average total costs.
Therefore, any firm that cannot produce at the minimum Average Total Cost will be forced to
leave the industry.

2. Technical Efficiency: Technical Efficiency is when the firm produces the maximum
average product. This efficiency is also a consequence of productive efficiency.

3. Allocative Efficiency: Allocative Efficiency is when the price is equal to marginal cost.
The firm achieves the greatest allocative efficiency when there is no other combination of
goods and services that would be more desired by society.

MONOPOLY DEFINITION
The term monopoly means a single seller (mono = single and poly = seller). In economics, a
monopoly refers to a firm which has a product without any substitute in the market.
Therefore, for all practical purposes, it is a single-firm industry.

Monopoly definition by Prof. A.J. Braff – ‘Under pure monopoly, there is a single seller in
the market. The monopolist’s demand is the market demand. The monopolist is a price maker.
Pure monopoly suggests a no substitute situation.

Characteristics of Monopoly

 Single Seller: There is only one seller; he can control either price or supply of his
product. But he cannot control demand for the product, as there are many buyers.
 No close Substitutes: There are no close substitutes for the product. The buyers have
no alternatives or choice. Either they have to buy the product or go without it.
 Price: The monopolist has control over the supply so as to increase the price.
Sometimes he may adopt price discrimination. He may fix different prices for
different sets of consumers. A monopolist can either fix the price or quantity of
output; but he cannot do both, at the same time.
 No Entry: There is no freedom to other producers to enter the market as the
monopolist is enjoying monopoly power. There are strong barriers for new firms to
enter. There are legal, technological, economic and natural obstacles, which may
block the entry of new producers.
 Firm and Industry: Under monopoly, there is no difference between a firm and an
industry. As there is only one firm, that single firm constitutes the whole industry. .

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Causes for Monopoly

1. Natural: A monopoly may arise on account of some natural causes. Some minerals are
available only in certain regions. For example, South Africa has the monopoly of
diamonds; nickel in the world is mostly available in Canada and oil in Middle East.
This is natural monopoly.
2. Technical: Monopoly power may be enjoyed due to technical reasons. A firm may have
control over raw materials, technical knowledge, special know-how, scientific secrets
and formula that enable a monopolist to produce a commodity. e.g., Coco Cola.
3. Legal: Monopoly power is achieved through patent rights, copyright and trade marks
by the producers. This is called legal monopoly.
4. Large Amount of Capital: The manufacture of some goods requires a large amount of
capital or lumpiness of capital. All firms cannot enter the field because they cannot
afford to invest such a large amount of capital. This may give rise to monopoly. For
example, iron and steel industry, railways, etc.
5. State: Government will have the sole right of producing and selling some goods. They
are State monopolies. For example, we have public utilities like electricity and railways.
These public utilities are undertaken by the State.

A Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s Equilibrium in
Monopoly. These are:
1. The firm earns normal profits – If the average cost = the average revenue
2. It earns super-normal profits – If the average cost < the average revenue
3. It incurs losses – If the average cost > the average revenue

Normal Profits
A firm earns normal profits when the average cost of production is equal to the average
revenue for the corresponding output.

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In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point
E. Also, the AC curve touches the AR curve at a point corresponding to the same point.
Therefore, the firm earns normal profits.

Super-normal Profits
A firm earns super-normal profits when the average cost of production is less than the
average revenue for the corresponding output.

In the figure above, you can see that the price per unit = OP = QA.
Also, the cost per unit = OP’. Therefore, the firm is earning more and incurring a lesser cost.
In this case, the per unit profit is
OP – OP’ = PP’
Also, the total profit earned by the monopolist is PP’BA.

Losses
A firm earns losses when the average cost of production is higher than the average revenue
for the corresponding output.

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A Firm’s Long-run Equilibrium in Monopoly

In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium
of the firm, we need only two cost curves – the AC and the MC. Further, since the
monopolist exits the market if he is operating at a loss, the demand curve must be tangent to
the AC curve or lie to the right and intersect it twice.

As you can see above, there are two alternative cases for the determination of Equilibrium in
Monopoly:
 With normal profits
 With super-normal profits

We have not taken the loss scenario here because if the monopolist incurs losses in the long-
run, he will stop operating.

Case 1
The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve
lies to the left of the AC curve, then the monopolist is unable to recover his costs and closes
down.
However, if the AR curve is tangent to the AC curve, then the monopolist can recover his
costs and stay in the market.
Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the
MR curve are concurrent at point A.
Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM
quantity and sells it at a price of EM per unit which covers its average costs + normal profits.

Case 2
The marginal revenue curve MR2 cuts the MC curve from below at point B. The
corresponding height of the AR2 curve is E’M1.
Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra
profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer
firms entering the industry.

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Methods of Controlling Monopoly

 Legislative Method: Government can control monopolies by legal actions. Anti-

monopoly legislation has been enacted to check the growth of monopoly. In India, the
Monopolies and Restrictive Trade Practices Act was passed in 1969. The objective of
this Act is to prevent the unwanted growth of private monopolies and concentration of
economic power in the hands of a small number of individuals and families.
 Controlling Price and Output: This method can be applied in the case of natural
monopolies. Government would fix either price or output or both.
 Taxation: Taxation is another method by which the monopolistic power can be
prevented or restricted. Government can impose a lump-sum tax on a monopoly firm,
irrespective of its level of output. Consequently, its total profit will fall.
 Nationalization: Nationalizing big companies is one of the solutions. Government
may take over such monopolistic companies, which are exploiting the consumers.
 Consumer's Association: The growth of monopoly power can also be controlled by
encouraging the formation of consumers associations to improve the bargaining
power of consumers.

What is Monopolistic Competition?

Prof. Leftwitch’s answer to what is Monopolistic Competition:
‘Monopolistic competition is a market situation in which there are many sellers of a particular
product but the product of each seller is in some way differentiated in the minds
of consumers from the product of every other seller.’

Therefore, in this market structure, each seller is a monopolist of his ‘differentiated product’.
The buyers can get the specific product only from him. Having said that, there are several
close substitutes available in the market too. Therefore, buyers compare the prices of the
products along with the perceived quality of each. Hence, there is competition between
sellers for the market share. So you can see that in this market structure, a group of firms
compete against each other while remaining monopolists of their own products.

Features of a Monopolistic Competition

1. In Monopolistic Competition, a buyer can get a specific type of product only from one
producer. In other words, there is product differentiation.
2. The firms have to incur selling expenses since there is product differentiation.
3. There is a large number of sellers with inter-dependent demand and supply
conditions. Sellers are price-makers and the demand curve for the product of an
individual seller is downward sloping. The demand is not perfectly elastic.
4. The firm can improve or deteriorate the quality of its products too. Improving the
quality helps in increasing the demand and price of the product. On the other hand,
deteriorating the quality helps reduce the average cost of production.

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 5. The firms compete for inputs too. Also, they need to operate within a given
technological range. Therefore, no firm can produce a better quality product at a
lower average cost.
6. Firms are expected to know its demand and cost conditions. Further, they must use
this knowledge to maximize its expected profit income.
7. Any firm can leave the group of firms belonging to a specific product group. Also,
new firms can enter the group and produce close substitutes of the existing products in
the group. This ensures that no firm incurs losses or earns super-normal profits.
8. In Monopolistic Competition, every firm must pursue the goal of profit maximization.
9. It is assumed that all firms in this market structure have identical cost and demand
conditions.

Two features which form the foundation of Monopolistic Competition are –

product differentiation and selling expenses. Let’s look at them a little further.

Product Differentiation

Product differentiation covers all aspects which help in distinguishing the product of one firm
from that of the other. This differentiation can be real (technical) or imaginary (non-
technical).
The real differentiation refers to the technical features like the product’s technical life and
performance, durability, cost of operation and maintenance, etc.

On the other hand, the non-technical differentiation may take the form of brand names,
trademark, packing, shape, size, etc. The non-technical differentiation adds a subjective
appeal to a product inducing buyers to increase its demand or pay more for it.

In reality, however, the two forms of differentiation are intertwined to the extent that it is
impossible to separate them. No matter which differentiation a firm adopts, it expects to
increase the demand of the product in doing so. Firms use the differentiation to tell buyers
why their product’s quality and price combination is better than their competitors.

In Monopolistic Competition, a firm is not a price-taker and its demand curve has an inverse
relationship with the price of the product. Therefore, it can raise the price of its product and
lose some customers or drop the price to sell more. The demand curve is downward sloping
and not parallel to the X-axis. Since in Monopolistic Competition, products are close
substitutes of each other, they have high positive cross-elasticities. The market for the
product of one firm is not separate from the markets of its rival firms. A firm can lose the
market share of its products due to its price decisions or the price decisions of its rivals.
Further, selling expenses also play a major role in determining the demand conditions for the
product of a firm.

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Selling Expenses

Selling expenses are all the costs that a firm incurs to create and/or increase the demand for
its products. The firm tries to shift the demand curve of the advertised product to the right so
that buyers are willing to pay more for the same quantity or buy more quantity at the same
price. They include advertisement through media, showrooms, selling campaigns, discounts,
and incentives to buyers, etc. They also include informative and educative campaigns where
the buyer is informed about the benefits of using their product over something else. These
expenses also neutralize the perceived impact that the selling campaigns of the rival
companies create. Many firms increase their selling expenses to capture a bigger market share
as well.

Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product

differentiation is a key element of the business. There are relatively low barriers to
entry in setting up a new restaurant.

 Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.

 Clothing. Designer label clothes are about the brand and product differentiation

 TV programmes – globalization has increased the diversity of tv programmes from

networks around the world. Consumers can choose between domestic channels but
also imports from other countries and new services, such as Netflix.

Equilibrium under Monopolistic Competition

The two types of demand curves of a firm under monopolistic competition are due to the
following reasons:
 When a firm revises the price of its product, the rival firms don’t always increase the
prices of their products too. Therefore, the demand curve has a smaller slope and the
demand for the product is more elastic.
 If the rival firms follow the price revision by the first firm, then the demand for its
product becomes less elastic. In such cases, the firm needs to slash its prices further to
achieve an increase in demand. In this case, the demand curve has a steeper slope.

A Firm’s Short-Run Equilibrium under Monopolistic Competition

Under Monopolistic Competition, the revenue curves are downward sloping (like under
Monopoly). This is because, in order to sell more, the firm has to decrease the price.
A firm under Monopolistic Competition can either earn normal profits, super-normal profits,
or incur losses. Also, like under Monopoly, a firm earns super-normal profits if the demand
for its product is very high.

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Also, in the short-run, new firms cannot enter the group and enhance the supply of the
product group. Therefore, they cannot compete away the super-normal profits of the
firm. Also, in the short-run, a firm faces certain fixed costs. These can include production as
well as selling costs.

In the figure above, you can see that the AR and MR curves of the firm have negative slopes.
Further, the AVC curve includes the production costs as well as the variable components of
selling expenses. Furthermore, the MC curve cuts the AVC curve at its lowest point. Also,
the ATC curve represents the average of the total cost of the firm including the fixed selling
expenses.
The MC curve intersects the MR curve from below at point I. Hence, the firm decides to
produce a quantity of OM and charge a price of EM per unit.
By doing so, the firm earns a profit of EK per unit and the entry of rival firms do not compete
it out. However, based on the relative location of the cost and revenue curves, it is possible
that the firm is in equilibrium with:
 Only normal profit
 Covering a part of fixed costs. Therefore, incurring a loss less than its fixed costs
 Loss equal to the fixed costs (where AR is tangent to the AVC curve)

A Firm’s Long-Run Equilibrium under Monopolistic Competition

To discuss a firm’s long-run equilibrium under Monopolistic Competition, it is important to

remember the following points:
 There are no fixed costs in the long-run. The firm can vary its inputs as well as its
selling costs. Further, the firm can choose between various product qualities.
 There is no compulsion on a firm to operate at a loss. It can leave the industry
whenever it wants. When a firm leaves the industry, the absolute market shares of the

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 remaining firms, increase. Further, their demand curve shifts right and upwards. This
continues until other firms can produce without incurring a loss.
 On the other hand, if the demand is so strong that the existing firms make super-
normal profits, then new firms can enter the group.
 They produce close substitutes of the existing products and increase the total product
supply. Therefore, the demand shares of the existing firms reduce. Hence, the demand
curve of a firm cannot stay above its long-run average cost curve.
 All firms operating under Monopolistic Competition can make a choice between
combinations of:
o Product quality
o Product Differentiation
o Selling costs

 A firm must consider the fact that any variation of price on its part can attract a
reaction from its rivals. Therefore, it faces a much steeper demand curve.

Therefore, under Monopolistic Competition, a firm is exposed to constant interaction with the rest
of the firms in the group. Its decisions are not independent of the decisions of the other firms.
Further, the firm’s demand curve depends on its actions AS WELL AS on the actions of its
rivals. Therefore, it must consider different combinations of its cost components pertaining to
the product quality and its selling expenses, etc. This helps the firm estimate the slope and
position of the demand curve.

Let’s say that the LAC curve in Fig. I represent the product quality and selling expenses that
a firm selects. This has a corresponding long-term MC curve (LMC) which intersects the MR
curve from below at point I.
Therefore, the firm decides to produce a quantity of OM and sell it a per unit price of EM.
This gets a profit of EK per unit. However, soon new firms enter the market and start offering
close substitutes and bring the profit down.
Therefore, there is a reduction in the market shares of the existing firms. The firm’s AR curve
shifts left until it becomes tangent to the LAC curve at point E as shown in Fig. ii. This
ensures that the firm earns only normal profit. Once this stage is reached, there is no incentive
for new firms to enter the market.

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This results in the firm’s long-term equilibrium under Monopolistic Competition. The
equilibrium is given by the point of tangency between the firm’s AR curve and LAC curve,
which is at point E in Fig. ii. Therefore, in the long-run, under monopolistic competition,
firms earn only normal profits.

OLIGOPOLY
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’
meaning ‘to sell’.

Definition and Meaning

Oligopoly is defined as a market structure with a small number of firms, none of which can
keep the others from having significant influence.

An Oligopoly market situation is also called ‘competition among the few’. In this article, we
will look at Oligopoly definition and some important characteristics of this market structure.

Example : -
Oligopoly in India exists in the aviation industry where there are just few players, such as
Kingfisher, Air India, Spice Jet Indigo, etc. All these airlines depend on each other for setting
their pricing policies. This is because the prices are affected by the prices of the competitors’
products.

Oligopoly characteristics

 Existence of few sellers: One of the primary features of oligopoly is the existence of a
few sellers who dominate the entire industry and influence the prices of each other,
greatly. In addition, the number of buyers is also large. Moreover, in oligopoly, there are
a large number of buyers.
 Identical or differentiated products: An important characteristic of oligopoly is the
production of identical products or differentiated products. This implies that organizations
may either produce homogenous products, such as cement, asphalt, concrete and bricks,
or differentiated products, such as an automobile. If organizations produce homogenous
products, it is said to be pure oligopoly.
 Impediments in entry: Another important characteristic of oligopolistic competition is
that organizations cannot easily enter the market; nor can they make an exit from the
market. The reasons for difficult entry in the market are various legal, social and
technological barriers. This also implies that the existing organizations have a complete
control over the market.
 Enhanced role of government: Under oligopolistic market structure, the government has
a greater role as it acts as a guard to anti-competitive behaviour of oligopolists. It is often
observed that oligopolists may engage in the illegal practice of collusion, where they
together make production and pricing decisions. Oligopolists may start acting as a single
organization and further increase prices and profits. Thus, in such an environment, the
government requires to keep a watch on such activities to curb the illegal practices.

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 Mutual interdependence: Under oligopoly market structure, mutual interdependence
refers to the influence that organizations create on each other’s decisions, such as pricing
and output decisions. In oligopoly, a few numbers of sellers compete with each other.
Therefore, the sale of an organization is dependent on its own price of products, as well as
the price of its competitor’s products. Thus, in oligopoly, no organization can make an
independent decision.
 Existence of price rigidity: Under oligopolistic market, organizations do not prefer to
change the prices of their products as this can adversely affect the profits of the
organization. For instance, if an organization reduces its price, its competitors may reduce
the prices too, which would bring a reduction in the profits of the organization. On the
other hand, the increase in prices by an organization will lead to loss of buyers.

How firms compete in oligopoly

There are different possible ways that firms in oligopoly will compete and behave this will
depend upon:
 The objectives of the firms; e.g., profit maximization or sales maximization?

 The degree of contestability; i.e., barriers to entry.

 Government regulation.

There are different possible outcomes for oligopoly:

1. Stable prices (e.g., through kinked demand curve) – firms concentrate on non-price
competition.
2. Price wars (competitive oligopoly)
3. Collusion- leading to higher prices.

The kinked demand curve model

This model suggests that prices will be fairly stable and there is little incentive for firms to
change prices. Therefore, firms compete using non-price competition methods.

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  This assumes that firms seek to maximise profits.
 If they increase the price, then they will lose a large share of the market because they
become uncompetitive compared to other firms. Therefore, demand is elastic for price
increases.
 If firms cut price, then they would gain a big increase in market share. However, it is
unlikely that firms will allow this. Therefore, other firms follow suit and cut-price as
well. Therefore, demand will only increase by a small amount. Therefore, demand is
inelastic for a price cut.
 Therefore, this suggests that prices will be rigid in oligopoly

The diagram above suggests that a change in marginal cost still leads to the same price,
because of the kinked demand curve. Profit maximization occurs where MR = MC at Q1.

Evaluation of kinked demand curve

 In the real world, prices do change.

 Firms may not seek to maximise profits, but prefer to increase market share and so be
willing to cut prices, even with inelastic demand.
 Some firms may have very strong brand loyalty and be able to increase the price
without demand being very price elastic.
 The model doesn’t suggest how prices were arrived at in the first place.
Price wars
Firms in oligopoly may still be very competitive on price, especially if they are seeking to
increase market share. In some circumstances, we can see oligopolies where firms are
seeking to cut prices and increase competitiveness.
A feature of many oligopolies is selective price wars. For example, supermarkets often
compete on the price of some goods (bread/special offers) but set high prices for other goods,
such as luxury cake.
Collusion
 Another possibility for firms in oligopoly is for them to collude on price and set profit
maximizing levels of output. This maximizes profit for the industry.

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In the above example, the industry was initially competitive (Qc and Pc). However, if firms
collude, they can agree to restrict industry supply to Q2, and increase the price to P2. This
enables the industry to become more profitable. At Qc, firms made normal profit. But, if they
can stick to their quotas and keep the price at P2, they make supernormal profit.
 Collusion is illegal, but tacit collusion may be hard to spot.

 For collusion to be effective, there need to be barriers to entry.

 A cartel is a formal collusive agreement. For example, OPEC is a cartel seeking to

control the price of oil.

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