HUM 701 : Principles of Economics

Theory Related Question

1.​ What are the shutdown conditions of a firm under perfect competition? Show graphically and
explain.
2.​ Define supply function
3.​ What are the factors that influence the shifting of the demand curve?
4.​ What are the exceptions to the law of demand? Explain.
5.​ Show that price elasticity of demand varies from zero to infinity along any straight line demand
curve. Explain graphically.
6.​ How is price determined in an economy under competition? Explain graphically.
7.​ What do you understand by division of labour? Explain different types of division of labour
8.​ What are the advantages and disadvantages of division of labour? Explain

Economics: Part A
Definition:

Economics is the study of how societies use scarce (olpo) resources to produce valuable goods and
services and distribute them among different people.

What Economics Studies:

1.​ Institutions & Technology Impact​

How society’s institutions and technology affect prices and resource allocation.​
Example: How advances in technology like smartphones affect the price and demand for
computers.
2.​ Financial Markets​
Behavior of financial markets, interest rates, and stock prices.​
Example: How changes in interest rates influence the stock market.
3.​ Income Distribution & Poverty​
How income is distributed and ways to help the poor without harming the economy.​
Example: Evaluating tax policies to help low-income families without discouraging business
investment.
4.​ Business Cycles & Monetary Policy​
Study of economic ups and downs and how central banks use monetary policy to control
unemployment and inflation.​
Example: Lowering interest rates to reduce unemployment during a recession.​
International Trade​
Patterns of trade between countries and effects of trade barriers like tariffs.​
Example: How tariffs on steel imports affect domestic prices and industries.
5.​ Growth in Developing Countries​
Ways to promote efficient resource use and economic growth in developing nations.​
Example: Encouraging investments in education and infrastructure in a developing country.
 6.​ Government Policy & Economic Goals​
How governments use policies to promote growth, resource efficiency, full employment, price
stability, and fair income distribution.​
Example: Minimum wage laws to reduce poverty while keeping unemployment low.​

Two Main Branches of Economics:

1. Macroeconomics (From Greek macro = large)

Focuses on the whole economy — aggregate variables like total output, unemployment, inflation, and
economic growth.

●​ Studies banking and monetary systems.

●​ Examines gross national product (GNP), inflation, unemployment.

Common macroeconomic goals:

●​ Full employment
●​ Price-level stability
●​ Economic growth

2. Microeconomics (From Greek micro = small)

Focuses on individual parts of the economy — households, firms, and specific markets.

●​ Allocation of resources.
●​ Prices, production, and income distribution for specific goods/services (e.g., butter, cars,
haircuts).

Aspect Microeconomics Macroeconomics

Focus Individual parts of the economy The whole economy and large-scale economic
(households, firms, markets) factors

Focus Specific goods and services (e.g., cars, Total output, employment, inflation, GDP
clothes)

Key Supply and demand for specific products, Aggregate demand and supply, unemployment,
Concepts price determination, resource allocation inflation, economic growth

Examples Why does the price of coffee rise? How do Why is unemployment high? What causes
wages in one company get set? inflation?

Goal Understand behavior of consumers and Manage the economy to ensure growth, low
firms, optimize individual markets unemployment, price stability
 Key Concepts in Macroeconomics:

●​ Aggregate Demand: Total spending in the economy by:

○​ Consumers (households)
○​ Foreign buyers (exports)
○​ Government
○​ Firms (capital equipment, raw materials)​

●​ Aggregate Supply: Total output of goods and services produced nationally.

Wants and Needs:

●​ Economics is about satisfying material wants (what people desire), not necessarily needs
(basic survival).
●​ People work to earn income to buy what they want, which may exceed what they strictly need.​

Example: A person works extra hours to buy a new smartphone (a want), not just to buy food and
shelter (needs).

Want Need

Something people desire to have for comfort or Something essential for survival or basic living.
pleasure.

Unlimited and vary from person to person. Limited and generally the same for everyone (food,
water, shelter).

Example: A new smartphone, designer clothes, Example: Food, clean water, basic clothing, shelter.
eating at a restaurant.

People work and earn income mainly to satisfy Needs must be met for people to survive and function.
their wants.

Scarcity:

●​ Scarcity means resources are limited compared to people's unlimited wants.

●​ It's a relative concept, depending on how much people want versus how much is available.​

Example: There may be limited water in a drought-affected area, making water a scarce resource.

Resources (Factors of Production):

 1.​ Land (Natural Resources):
○​ Free gifts of nature: land, forests, minerals.​
Example: Oil fields or agricultural land.​

2.​ Labour (Human Resources):​

Human mental and physical effort.​
Example: Factory workers, teachers.​

3.​ Capital:
○​ Man-made tools and buildings used in production (not consumed themselves).​
Example: Machinery, factories, computers.​

4.​ Entrepreneurship:
○​ The ability and willingness to take risks and innovate.​
Example: A business owner launching a new product or service.

Collectively these are factors of production.

Production & Consumption:

●​ Production: Making goods and services by transforming inputs into outputs to earn profit.​
Example: A car factory assembling vehicles.
●​ Consumption: Using goods and services to satisfy wants, usually through purchasing.​
Example: Buying and driving a car.

Aspect Production Consumption

Definition The act of making goods and services. The act of using goods and services to satisfy
wants.

Process Transforming inputs (like labor, raw Using or purchasing goods and services to fulfill
materials) into finished products. desires or needs.

Who does Firms or producers who create products to Consumers or households who buy and use the
it? earn profit. products.

Purpose To create output for sale or use. To satisfy wants and needs.

Example A factory assembling cars. Buying and driving a car.

Types of Economic Statements:

1.​ Positive Statements:

 ○​ Deal with facts and can be tested true or false.​
Examples:​
"Britain is an island."
○​ "British coal employs 50,000 workers."
○​ "Abdullah obtained grade A in economics."
○​ Disagreements can be settled by checking facts.​

2.​ Normative Statements:​

○​ Express opinions, what ought to be.

○​ Based on values or moral judgments, not verifiable by facts.​
Examples:
○​ "Britain should leave the European Union."
○​ "Income should be distributed more equally."
○​ "We ought to give more aid to underdeveloped countries."
○​ Settled by debate or voting, not by fact-checking.

Positive vs. Normative Economics:

●​ Positive Economics: Describes how the economy works.​

Examples:
○​ Why do doctors earn more than rickshaw pullers?
○​ Does free trade raise wages?​

●​ Normative Economics: Involves ethical questions and policy recommendations.​

Examples:
○​ Should poor people work to get government aid?
○​ Should the government break up Microsoft for antitrust?

Normative questions have no objectively right or wrong answers, only political or ethical debate.

The Three Problems of Economic

Organization
Because resources are scarce, societies must make important choices about how to use them. There
are three main categories of choices that every society faces:

1. What to produce, and in what quantities?

A society must decide which goods and services to produce and how much of each.

●​ Should we produce more consumption goods (things people use now, like pizzas, clothes, or
smartphones)?
 ●​ Or should we produce more investment goods (things that help produce more in the future,
like machines to make pizzas or factories)?

Example:​
Should a country produce more cars for people to buy now, or invest in machines and factories to
produce even more cars later?

2. How to produce goods and services?

There are usually multiple ways to produce the same thing. Society must decide:

●​ What resources to use and in what amounts?​

Which production techniques to adopt?

Example:​
Should cars be made mostly by robots (automation) or by assembly line workers?​
Should electricity come from coal, oil, nuclear power, or renewable sources like solar and wind?

3. For whom to produce?

This means deciding who gets the goods and services produced, or how the nation’s income is
distributed.

●​ Is wealth shared fairly or unequally?

●​ Are many people poor while few are rich?

Example:​
Should essential goods like food and healthcare be affordable to everyone, or only to those who can
pay more?

Demand in Economics
What is Demand?

●​ Demand for a commodity means the quantity that consumers are willing and able to buy at
various prices during a specific period of time (e.g., per day, week, month, or year).

For a commodity to have demand, three conditions must be met:

1.​ Willingness to buy it.

2.​ Ability (means) to buy it (enough money or resources).
3.​ The demand relates to a specific time period (like per month or per year).​
Example:​
If people want to buy ice cream but don’t have enough money, the demand isn’t effective because they
lack the ability to pay.

Quantity Demanded

●​ The quantity demanded is the amount consumers wish to purchase at a certain price.
●​ It is a desired quantity — how much consumers want to buy, not necessarily how much they
actually buy.

Example:​
If the price of a car drops, more people may want to buy it, so quantity demanded increases.

Demand Function

●​ A demand function is an equation showing the mathematical relationship between the

quantity demanded of a good and the factors affecting it.
●​ It expresses how different factors influence the demand for a commodity.

Demand Function Expression:

QD=f(Px,P1,...,Pn,Y,T,S)

Where:

●​ QDx = Quantity demanded of commodity X

●​ Px = Price of commodity X
●​ P1,...,Pn = Prices of related commodities (substitutes or complements)
●​ Y = Consumer’s income and wealth
●​ T = Consumer’s tastes or preferences
●​ S = Sociological factors (like culture, social trends)

Example of Factors Affecting Demand:

●​ If the price of tea (a substitute for coffee) rises, demand for coffee may increase.
●​ If people’s income rises, they may buy more clothes (normal goods).
●​ If a celebrity promotes a product, tastes (T) may shift, increasing demand.

Demand Schedule, Demand Curve & Law of

Demand
Demand Schedule

●​ A demand schedule is a table showing the relationship between the price of a good and the
quantity demanded at those prices.
 ●​ It lists specific prices and how much the consumer would buy at each price.

Example: Individual’s Demand Schedule for Carrots

Reference Price (Tk per kg) Quantity Demanded (kg per month)

A 1 80

B 2 60

C 3 40

D 4 30

E 5 20

F 6 10

Explanation:​
At price Tk 4 per kg (point D), the consumer demands 30 kg per month.

Demand Curve

●​ A demand curve is a graph showing the same relationship as the demand schedule —
between price (vertical axis) and quantity demanded (horizontal axis).
●​ The curve slopes downward, showing that as price falls, quantity demanded rises.

Each point on the curve corresponds to a price-quantity pair from the demand schedule.

Law of Demand

●​ The Law of Demand states:​

“Other things being equal (ceteris paribus), as the price of a product falls, the quantity
demanded increases; and as the price rises, the quantity demanded decreases.”
 ●​ This negative relationship between price and quantity demanded is why the demand curve
slopes downward

Determinants of Demand
Demand for a good depends on several factors that influence how much consumers want and are able
to buy. These factors can cause the demand curve to shift.

1. Price
●​ Higher price → lower quantity demanded
●​ Lower price → higher quantity demanded

2. Taste and Preferences

●​ The more desirable a good, the higher the demand.
●​ Influenced by advertising, fashion, health concerns, social trends, and past experience.

3. Price and Availability of Substitute Goods

●​ If the price of substitutes rises, demand for the goods increases.
●​ Example: If coffee gets expensive, demand for tea rises.

4. Price and Availability of Complementary Goods

●​ Complementary goods are used together (e.g., cars & petrol).
●​ If the price of a complement rises, demand for the related goods falls.
●​ Example: If cigarette prices rise, demand for matches falls.

5. Income
●​ Rising income increases demand for normal goods (demand curve shifts right).
●​ Rising income decreases demand for inferior goods (demand curve shifts left).
●​ Example: People buy more branded clothes (normal goods) but less cheap margarine (inferior
goods) as income rises.

6. Distribution of Income
●​ Redistributing income from poor to rich increases demand for luxury goods.
●​ Poorer people may buy more inferior goods, increasing their demand.

7. Expectations of Future Price Changes

●​ If prices are expected to rise, people buy more now, increasing current demand.

8. Advertising
●​ Successful advertising makes products more attractive, shifting the demand curve to the right.

9. Availability of Credit
 ●​ Easier credit increases demand for durable goods (cars, appliances, furniture, houses).
●​ Changes in loan terms affect demand significantly.

10. Population Changes

●​ Changes in population size and age distribution affect total demand and what kinds of goods are
demanded.
●​ Example: More elderly people increase demand for healthcare and residential homes.

11. Sociological Variables

●​ Social changes affect demand patterns.
●​ Example: Fewer children reduce demand for children’s goods; earlier retirement increases
demand for leisure products.

Shifts in the Demand Curve

A shift in the demand curve means the entire curve moves either right or left, showing a change in
demand at every price.

Increase in Demand (Demand curve shifts right, from D0 to D1​)

More quantity is demanded at every price. Causes include:

1.​ The price of substitutes rises (people switch to this good).

2.​ The price of complements falls (related goods get cheaper).
3.​ Income changes:
○​ Income rises → demand for normal goods increases.
○​ Income falls → demand for inferior goods increases.
4.​ Income redistribution toward groups who prefer the good.
5.​ Change in taste favoring the good.
6.​ Increase in number of buyers.
7.​ Expectations of lower future prices or income.
Decrease in Demand (Demand curve shifts left, from D0​to D2​)

Less quantity is demanded at every price. Causes include:

1.​ The price of substitutes falls (people switch away).

2.​ The price of complements rises (related goods get more expensive).
3.​ Income changes:
○​ Income falls → demand for normal goods decreases.
○​ Income rises → demand for inferior goods decreases.
4.​ Income redistribution away from groups who prefer the good.
5.​ Change in taste disfavors the good.
6.​ Decrease in number of buyers.
7.​ Expectations of higher future prices or income.

Change in Quantity Demanded

●​ Movement along the demand curve is called a change in quantity demanded, also known
as extension (increase) or contraction (decrease) of demand.
●​ When price decreases (from OP to OP1​), quantity demanded increases (from OQ to OQ1​).
This is called an extension or increase in quantity demanded.
●​ When price increases (from OP1 to OP​), quantity demanded decreases (from OQ to OQ1​).
This is called a contraction or decrease in quantity demanded.​
Moving down the demand curve = increase in quantity demanded.
●​ Moving up the demand curve = decrease in quantity demanded.

Movements Along Demand Curves vs. Shifts

in Demand
●​ A rise in demand means the demand curve shifts right (from D0 to D1​), so more is bought at
every price.
●​ Originally, at price P00​, the quantity demanded is Q0​(Point A).
●​ After demand increases, at the same price P0​, quantity demanded rises to Q1 (Point B).
What happens if price changes after the demand shift?

●​ Suppose the price now rises above P0.​

This causes quantity demanded to fall along the new demand curve D1​, below Q1
●​ The final quantity demanded depends on the price level:
○​ At price P2​, quantity demanded is Q2​(Point C), which is still higher than the original
Q0
○​ But if the price rises further to P3​, quantity demanded falls to Q3​(Point D), which is less
than the original Q0

Reasons Why the Demand Curve Slopes

Downward
1.​ Diminishing Marginal Utility:
○​ As people buy more, each extra unit gives less satisfaction.
○​ So, they buy more only if the price goes down.

2.​ More Buyers at Lower Prices:

○​ When prices fall, new buyers enter the market.
○​ When prices rise, some buyers stop purchasing.

3.​ Income Effect:

○​ Lower prices increase consumers’ real income, letting them buy more.
○​ Higher prices reduce buying power, so they buy less.

4.​ Substitution Effect:

○​ If a good’s price falls, people buy it instead of costlier alternatives.
○​ If the price rises, they switch to substitutes.

5.​ Most Buyers Are Price-Sensitive:

○​ The majority of consumers have low income and buy more when prices drop.
○​ Rich consumers’ buying doesn’t change much with price.

6.​ Different Uses of Goods:

 ○​ When prices rise, goods are used only for essential needs.
○​ When prices fall, people use goods for more purposes.

Exceptions to the Law of Demand

Sometimes, demand increases when price rises (upward sloping demand curve). Here are the main
exceptions:

1.​ War
○​ Fear of shortage leads people to buy more and hoard goods even at higher prices.
2.​ Depression
○​ Prices are low but demand is also low because people have little money.
3.​ Habit
○​ People addicted to a product keep buying it even if the price rises.
4.​ Giffen Paradox
○​ For essential goods (like wheat), if the price rises, people buy more because they cut
back on expensive foods but still need the cheap staple.
○​ Example: In poor economies, when maize price falls, people buy less maize and more
wheat (superior goods).
5.​ Demonstration Effect
○​ People buy more expensive, status goods (like diamonds) when prices rise, to show off
wealth.
6.​ Ignorance Effect
○​ Buyers mistake expensive goods for better quality due to misleading labels and buy
more at higher prices.
7.​ Speculation
○​ Speculators buy more as prices rise, expecting to sell later at a profit, causing demand to
rise with price.
8.​ Very Rich People
○​ Wealthy buyers purchase regardless of price changes, so the law of demand doesn’t
apply to them.

Market Demand
●​ Definition: The total quantity of a commodity demanded by all buyers in the market at different
prices over a certain time period.
●​ Depends on:
1.​ Factors affecting individual demand (price, income, tastes, etc.)
2.​ Number of buyers in the market

How it is calculated

●​ Found by adding the quantities demanded by all individuals at each price.

●​ This is called the horizontal summation of individual demand curves.
Example:

If three people (A, B, C) buy a product:

●​ At Tk 6/kg → A buys 15 kg, B buys 20 kg, C buys 22 kg → Market demand = 57 kg

●​ At Tk 1/kg → A buys 60 kg, B buys 70 kg, C buys 70 kg → Market demand = 200 kg

Demand Equations (Demand Functions)

Definition:​
A demand equation (or demand function) is a mathematical formula showing the relationship between
quantity demanded (Qd) and its determinants (such as price, income, etc.).

Basic Form:

When only price (P) is considered:

Qd=a−bP

●​ a = maximum quantity demanded when price is 0

●​ b = slope (change in Qd for each unit change in
price)
●​ P = price of the commodity

Example (Individual Demand)

For commodity X: QdX​=8−PX​(ceteris paribus)

Market Demand from Individual Demand

If there are 1000 identical buyers:
Individual demand: QdX​=8−PX
Market demand: QdX​=1000(8−PX)
 QdX​=8000−1000PX

Estimated demand equations

The demand for butter (Qd​) can be estimated using a linear demand equation. This equation shows
the relationship between the quantity of butter demanded and several key factors: the price of butter
(Pb​), the price of margarine (Pm​), and consumer income (Y).
Based on the provided values, the general form of the demand equation is:

Qd​= 2000000 − 50000Pb ​+ 20000Pm​+ 0.01Y

Given:

●​ Pb=50 pence
●​ Pm=35 pence
●​ Y=200,000,000

Substitute the values:

Qd=2,000,000 − (50,000×50) + (20,000×35) + (0.01×200,000,000)
Qd​=2,000,000−2,500,000+700,000+2,000,000
Qd​=2,200,000

Factors Affecting Demand for Butter

1.​ Taste & Preferences
○​ Advertising can increase demand.
○​ Health concerns (e.g., cholesterol scares) can reduce demand.
2.​ Price of Substitutes
○​ If margarine’s price increases, people may switch to butter → demand for butter
rises.
3.​ Price of Complements
○​ If bread’s price increases, people may buy less bread → less butter is bought.
4.​ Income Levels
 ○​ Higher incomes → people may choose butter over margarine or use more of it.
5.​ Income Distribution​
If wealth shifts away from lower-income groups, they may buy cheaper margarine or use less
butter.
6.​ Expectations of Future Prices
○​ If butter prices are expected to rise soon, consumers may buy more now and store it.

Supply: Definition & Concepts

●​ Supply: The amount of a product that producers are willing and able to sell under various
conditions during a given period.
●​ Quantity Supplied: The specific amount producers are willing to sell at a particular price and
time.
●​ Supply is a desired flow — it’s about how much producers want to sell per period, not
necessarily how much they actually sell.

Supply Schedule & Supply Curve

●​ Supply Schedule:​
A table showing different quantities of a good that producers are willing and able to supply at
various prices over a given time period.
○​ Can be for an individual producer or for all producers in the market.​

●​ Supply Curve:​
A graph plotting price against quantity supplied.
○​ Shows a direct (positive) relationship between price and quantity supplied.

Supply Function
The supply function shows the mathematical relationship between the quantity supplied of a
commodity and the factors affecting it.

Simple Form (Ceteris Paribus – other factors constant):

QsX=(PX)

Where:

●​ QsX= Quantity supplied of commodity X

●​ PX = Price of commodity X

This form considers only the price of the commodity, keeping other factors constant.

Complex Form (all factors included):

QsX=f(PX,Pinputs​, Pother​,T,Tax)

Where:

●​ PX = Price of commodity X
●​ Pinputs = Price of inputs/raw materials
●​ Pother= Price of other commodities
●​ T = Technology
●​ Tax/Subsidy = Government charges or incentives

Example:​
If the supply function is:

QsX=−40+20PX

This means:

●​ When PX increases, QsX increases (positive relationship).

●​ When PX is too low, supply can be zero or negative (not possible in practice). The relationship
between price and quantity supplied is direct and positive.

Law of Supply
The law of supply states that, other things being equal, the quantity supplied of a commodity varies
directly with its price.

●​ When the price rises, the quantity supplied increases.

●​ When the price falls, the quantity supplied decreases.

"Other things being equal" means that all other factors affecting supply are assumed to remain
constant.

Reasons why supply increases with price:

1.​ Rising production costs – Beyond a certain level of output, costs increase rapidly, so firms are
willing to supply more only at higher prices.
2.​ Higher profitability – At higher prices, producing goods becomes more profitable, encouraging
firms to shift from less profitable products to this one.
3.​ New producers – If prices stay high, new firms will enter the market, increasing total supply.

Supply Schedule & Curve:​

A supply schedule lists the quantities of a commodity offered for sale at different prices over a given
time. This can be shown using a table (schedule) and a graph (supply curve).

Example: A hypothetical supply schedule for apples.

Factors Influencing Supply
1.​ Goals of the Firm
○​ If producers aim to sell as much as possible (even at lower profits), supply will be higher.
○​ If producers are risk-averse, they will produce less, especially for risky goods.
○​ Basic assumption in economics: Firms aim to maximize profits.

2.​ Price of the Commodity

○​ Ceteris paribus (other things constant), higher price → higher profitability → greater
quantity supplied.

3.​ Prices of Other Commodities

○​ If the price of other commodities increases, producers may shift resources to produce
them instead.
○​ This can reduce the supply of a commodity whose price has not risen.

4.​ Prices of Factors of Production

○​ A rise in the price of a factor (e.g., land, labor, capital) affects costs differently depending
on how much of that factor the good requires.
■​ Example: Higher land prices greatly raise wheat production costs but have little
effect on car production.
○​ Changes in factor prices alter the relative profitability of goods, changing supply patterns.

5.​ State of Technology

○​ Advances in science and production methods increase efficiency and lower costs.
○​ Examples:
■​ Chemistry → cheaper production of paints, creation of plastics and synthetic
fibers.
■​ Electronics → transistors enabling TV, computers, guidance systems.
■​ Future possibilities: atomic energy for large-scale construction or desalination.
○​ Over time, new knowledge changes what is produced and how it’s produced.

Shifts in the Single Producer’s Supply Curve

1. What is a Shift in Supply?

●​ When other factors (kept constant in the supply schedule) change, the entire supply curve
shifts.
●​ This is called a change in supply.
●​ Important: A shift in supply is different from a change in quantity supplied (which is a
movement along the same supply curve caused only by a price change).
 1.​ QSx = Original (normal) supply schedule.
2.​ QSx′ = New supply schedule after input prices increased.​
This shifts the entire supply curve upward → decrease in supply.

Explanation of Changes

(a) Plotting the Curves

●​ On a graph: Price ($) on vertical axis, Quantity supplied on horizontal axis.​

Plot both QSx and QSx′ to get two curves: Sx (original) and Sx′ (shifted up).

(b) Price rises from $3 to $5 before the shift in supply

●​ Movement along the same supply curve (Sx).

●​ Quantity supplied increases from 30 → 40 units.
●​ This is point A → point B on Sx.

(c) Price of $3 before and after the shift

●​ Before shift (Sx): 30 units (point A).

●​ After shift (Sx′): 10 units (point C).
●​ This is a decrease in supply.

(d) Price rises from $3 to $5 at the same time supply decreases

●​ Movement from point A → point D (on Sx′).​

Quantity supplied is 10 units less than before the changes.

Summary

●​ Movement along a supply curve = change in quantity supplied due to price change.
●​ Shift in supply curve = change in supply due to other factors (e.g., input prices).
●​ Upward shift → decrease in supply (less supplied at same price).
●​ Downward shift → increase in supply (more supplied at same price).

Increase in Supply Due to Technology Improvement

1. What Happens?

●​ Improved technology → lower production costs.

●​ The supply curve shifts downward → called an increase in supply.
 ●​ At the same price, the producer can supply more units per time period.

2. Supply Functions

●​ Before improvement:​
QSx=−40+20Px
●​ After improvement:​
QSx′=−10+20Px

4. Graph

●​ Sx = old supply curve (before improvement).

●​ Sx′ = new supply curve (after improvement).
●​ Sx′ lies below and to the right of Sx (increase in
supply).

5. Example at Price $4

●​ Before improvement: 40 units supplied.

●​ After improvement: 70 units supplied.
●​ Increase in supply: 30 extra units at the same
price.

Key Points

●​ Movement along a curve = price change only

●​ Shift of the curve = caused by other factors (here, technology).
●​ Downward shift = more supplied at the same price (increase in supply).

Market Equilibrium
●​ Equilibrium means the point of rest or balance.
●​ Market equilibrium refers to a stable state in which supply and demand are in balance.
●​ Market equilibrium occurs when the quantity of a commodity demanded in the market per unit
of time equals the quantity of the commodity supplied to the market over the same time period.
●​ Equilibrium Price = the price at which this balance occurs.
●​ Equilibrium Quantity = the quantity bought and sold at this price.

Equilibrium is found at the intersection of the commodity’s market demand curve and market supply
curve.
Example with Hypothetical Data

Let’s take a hypothetical market demand curve and a market supply curve for commodity X:

From the curves, we can determine that:

●​ When the price of X is $4, sellers will sell exactly the same quantity as buyers will buy.
●​ This is the equilibrium market price ($4) and equilibrium market quantity.

Adjustment Process

Case 1 – Price Higher than Equilibrium ($5)

●​ Sellers offer 6000 units of X.

●​ Buyers will buy only 3000 units.
●​ This creates a surplus of 3000 units (unsold stock).
●​ To sell the excess, sellers must lower the price.

Case 2 – Price Lower than Equilibrium ($3)

●​ Buyers want to buy 5000 units of X.

●​ Sellers offer only 2000 units.
●​ This creates a shortage of 3000 units (unsatisfied
buyers).
●​ The shortage pushes the price up to $4,
encouraging sellers to bring more X to the market.

Graphical Illustration

●​ In the figure (Fig. 1-1), the demand curve and supply curve intersect at Point P.
●​ PP′ is the market price ($4), where:
○​ Quantity demanded = Quantity supplied = 4000 units.
●​ This intersection shows how market price is fixed and how market equilibrium is established.
​
​
The Measurement of Elasticities
●​ From the theory of demand, the amount of a commodity purchased per unit of time depends
on:
1.​ Price of the commodity
2.​ Money incomes
3.​ Prices of other (related) commodities
4.​ Tastes
5.​ Number of buyers in the market
●​ A change in any of these factors will change the amount purchased per unit of time.
●​ Elasticity of demand measures the relative responsiveness of the quantity purchased per
unit of time to a change in one of these factors, while keeping all others constant.

Price Elasticity of Demand

●​ The coefficient of price elasticity of demand (e) measures the percentage change in the
quantity of a commodity demanded per unit of time resulting from a given percentage change
in the price of the commodity.
●​ Since price and quantity demanded are inversely related, e is a negative number.
●​ To avoid negative signs, a minus is included in the formula for e.

Formula

Let:
●​ ΔQ= change in quantity demanded
●​ ΔP = change in price

Types of Price Elasticity

●​ Elastic demand → e>1

●​ Inelastic demand → e<1
●​ Unitary elastic demand → e=1
 ’

Point Elasticity of Demand

●​ Elasticity tells us how sensitive quantity demanded is to price changes.
●​ Point elasticity means we measure that sensitivity at one specific point on the demand curve
(instead of over a range of prices).

Think of it like zooming in with a microscope on one spot of the curve.

Income Elasticity of Demand
●​ It measures how much your demand for a product changes when your income changes.
●​ In other words:​
“If I earn more or less money, how much more or less of this product will I buy?”

The Formula

Where:
●​ Q = quantity demanded
●​ M = income
●​ ΔQ = change in quantity
●​ ΔM = change in income

So it's the percentage change in quantity ÷ percentage change in income.

The Signs & Meanings

●​ eM>0 → Normal good: you buy more when you have more income.
○​ If eM>1 → Luxury (demand rises faster than income).
○​ If 0<eM<1→ Necessity (demand rises slower than income).
●​ eM<0 → Inferior good: you buy less when you earn more​
(e.g., cheap noodles, low-quality bus travel — replaced by better alternatives when income
grows).

Why It Can Change Over Time

A good’s income elasticity isn’t fixed — it depends on how rich you are:

●​ At low income: a motorbike might be a luxury ( eM>1 ).

●​ At middle income: the same motorbike becomes a necessity ( 0<eM<1).
●​ At high income: it might become inferior ( eM<0 ) if you switch to cars.

You’ve got a table (Table 1.3) that tracks how a person’s income changes and how much of
commodity X they buy at each income level.

●​ Column (1) → Income level.

●​ Column (2) → Quantity of commodity X bought per year.
●​ Column (5) → eM value (income elasticity) for each income jump.
●​ Column (6) → Classification: luxury, necessity, or inferior good — based on the eM​from column
(5).

Cross Elasticity of Demand ( exy)

●​ It measures how much the quantity demanded of commodity X changes when the price of
commodity Y changes.
●​ In other words, it shows the percentage change in the amount of X bought per unit time due to
a percentage change in the price of Y.

Formula

Where:

●​ Qx= quantity demanded of commodity X

●​ Py = price of commodity Y
●​ ΔQx= change in quantity demanded of X
●​ ΔPy = change in price of Y
Interpretation of exy

●​ If exy>0→ Substitutes
○​ When the price of Y goes up, demand for X goes up.
○​ Example: Butter and margarine. If margarine gets expensive, people buy more butter.
●​ If exy<0 → Complements
○​ When the price of Y goes up, demand for X goes down.
○​ Example: Tea and sugar. If sugar gets expensive, people buy less tea.
●​ If exy=0 → Independent goods
○​ The price of Y doesn’t affect demand for X.
○​ Example: Shoes and bread — unrelated products.
Main Factors That Affect Income Elasticity of Demand
1.​ Type of Need the Good Fulfills
○​ As income grows, people spend a smaller share of their money on essentials like food.
This idea is called Engel’s Law. It helps show how well people are doing and how
developed an economy is.
2.​ Starting Income Level of a Country
○​ The same good can be seen differently depending on how wealthy a country is. For
example, a TV is a luxury in poor countries but becomes a necessity in richer ones
where people expect to own one.
3.​ Time Period
○​ Buying habits don’t change overnight. Over time, people may start to see goods they
once considered luxuries as necessities. So income elasticity changes as consumption
patterns adjust.
4.​ Influence of Others (Demonstration Effect)
○​ People’s tastes and preferences can change because they see what others buy and
want to keep up. This social influence affects how income changes affect demand.
5.​ How Often Income Increases
○​ When incomes increase frequently, people tend to spend more on luxury and comfort
goods, leading to higher income elasticity.

Budget Line
●​ The budget line shows all possible combinations of two goods a consumer can buy if they
spend their entire income on those goods.
●​ Its slope is the negative ratio of the prices of the two goods.

Example

●​ Suppose a consumer has Rs. 50 to spend on goods X and Y.

●​ Price of good X = Rs. 10 per unit
●​ Price of good Y = Rs. 5 per unit

If the consumer spends:

●​ All Rs. 50 on X → they can buy 50/10​= 5 units of X

●​ All Rs. 50 on Y → they can buy 50/5=10 units of Y

Graphical Representation

●​ Drawing a straight line between 5 units of X (on X-axis) and 10 units of Y (on Y-axis) gives the
budget line.
●​ Points on the line (like 8Y & 1X, 6Y & 2X, 4Y & 3X) represent combinations of X and Y the
consumer can buy by spending their full income.
●​ Points above the line (like H: 5Y & 4X) are not affordable because they cost more than Rs. 50.
 ●​ Points below the line (like K: 2X & 2Y) are affordable but don’t spend all income.

What Does the Budget Line Show?

●​ The budget constraint: The limit on what the consumer can buy given their income and prices.
●​ Combinations to the right or outside the line are unattainable.
●​ Combinations to the left or inside the line are attainable but leave some income unspent.

Algebraic Equation of the Budget Line

Px⋅X+Py⋅Y= M

Where:

●​ Px= price of good X

●​ Py= price of good Y
●​ M = consumer’s money income
●​ X, Y = quantities of goods X and Y

Rearranged for Y

●​ M/Py​is the maximum amount of Y that can be bought

if the consumer buys zero units of X (vertical intercept on Y-axis).
●​ Px/Py​​is the slope of the budget line (shows the trade-off between X and Y).

Budget Space
●​ Definition:​
The budget space represents all possible combinations of
two goods that a consumer can afford to buy, given their
income and the prices of the goods.​
It includes:
○​ Combinations where the entire income is spent.
○​ Combinations where only part of the income is
spent.
●​ Condition:​
The total spending on both goods must not exceed the
given income:​
Px⋅X+Py⋅Y≤M​
or​
M≥Px⋅X+Py⋅Y​
where:
 ○​ Px= Price of good X
○​ Py​= Price of good Y
○​ M = Money income
●​ Graphical Representation:​

○​ Budget space is the shaded area under and including the budget line (BL) between the
X-axis and Y-axis.

Changes in Price and Shifts in Budget Line

1. Change in Price of Good X

●​ Price falls (income and price of Y unchanged):

○​ Consumers can buy more of X.
○​ The budget line shifts outward along the X-axis, from BL to
BL′.
○​ Point B on the Y-axis stays the same.
●​ Price rises (income and price of Y unchanged):
○​ Consumers can buy less of X.​
The budget line shifts inward along the X-axis, from BL to
BL″.
○​ Point B on the Y-axis stays the same.

2. Change in Price of Good Y

●​ Price falls (income and price of X unchanged):

○​ Consumers can buy more of Y.
○​ The budget line shifts outward along the Y-axis, from BL to
LB′.
●​ Price rises (income and price of X unchanged):
○​ Consumers can buy less of Y.
○​ The budget line shifts inward along the Y-axis, from BL to
LB″.

3. Change in Income

●​ Income increases (prices unchanged):

○​ Consumers can buy proportionately more of both goods.
○​ The budget line shifts outward parallel to the original line,
from BL to B′L′.
●​ Income decreases (prices unchanged):
○​ Consumers can buy proportionately less of both goods.
○​ The budget line shifts inward parallel to the original line,
from BL to B″L″.
Consumer's Equilibrium: Maximizing
Satisfaction
A consumer is in equilibrium when they choose a combination of goods where they have no reason
to change their buying pattern. At this point, their money is allocated between goods in a way that
maximizes satisfaction.

In the indifference curve analysis, it is assumed that the consumer aims to get the highest possible
satisfaction given their constraints.

Assumptions

1.​ Given indifference map – Shows the consumer’s preference for various combinations of two
goods, X and Y.
2.​ Fixed income – The consumer has a certain amount of money to spend entirely on these two
goods.
3.​ Constant prices – The prices of goods X and Y are given and do not change; the consumer
cannot influence them.
4.​ Goods are homogeneous and divisible – They can be split into smaller quantities without
changing their nature.
5.​ Rational consumer – The consumer aims to maximize satisfaction.

Equilibrium Explained

●​ The budget line (BL) shows all combinations of X and Y that the consumer can afford.
●​ The consumer wants to choose the combination on the budget line that is on the highest
possible indifference curve.
●​ Equilibrium occurs where the budget line is tangent to an indifference curve.

Example (Fig. 5)

●​ The budget line BL touches the indifference curve IC₃ at

point Q.
●​ Q is the highest possible point the consumer can reach given
their budget, so it gives the maximum satisfaction.
●​ Other points on BL, such as R (on IC₁) or S (on IC₂), give less
satisfaction because they lie on lower indifference curves.
●​ Points like T or H to the right of Q on BL also give less
satisfaction.
●​ Curves IC₄ and IC₅ are higher than IC₃ but unattainable
because they require more income.

Conclusion

With the given income and prices:

 ●​ Equilibrium is at point Q, where BL is tangent to IC₃.
●​ At Q, the consumer buys OM units of good X and ON units of good Y.
●​ This is the combination that maximizes satisfaction.

Second Order Condition for Consumer Equilibrium

Just because the budget line touches an indifference curve (tangency) doesn’t mean the consumer
is truly in equilibrium. That tangency is only a necessary condition — but not enough by itself.​
We also need a second condition for true equilibrium.

Second Condition

At the equilibrium point, the indifference curve must be convex to the origin.​
In other words, at that point, the Marginal Rate of Substitution (MRS) of X for Y must be falling.

In Fig. 5, at point Q, the indifference curve IC₃ is convex to the origin, and the budget line is tangent
there.​
This means:

1.​ The two goods are being exchanged at the rate the consumer prefers (MRS = Price ratio).
2.​ The satisfaction is at its highest possible level with the given budget.

So Q is the best choice and the consumer is in stable equilibrium.

When Tangency Is Not Enough

Sometimes, the budget line may still be tangent to an indifference

curve, but the curve could be concave at that point.​
Example: In Fig. 6, budget line BL is tangent to indifference curve
IC₁ at point J.​
But here the curve is concave — meaning J is not the point of
maximum satisfaction.​
The consumer could move along the same budget line to another
point (like U) and get more satisfaction.

Final Conclusion

For consumer equilibrium, two conditions must be satisfied:

1.​ Budget line tangent to an indifference curve​

→ MRS of X for Y (MRSₓᵧ) = Price ratio (Pₓ / Pᵧ)
2.​ The indifference curve is convex to the origin at the tangency point.
Indifference Curves
The indifference curve analysis explains consumer behaviour by looking at their preferences for
different combinations of two goods (say X and Y).​
It measures utility ordinally — meaning it ranks satisfaction levels, instead of measuring them in
exact numbers.

An indifference curve comes from an indifference schedule — a table showing combinations of two
goods that give the consumer the same satisfaction, so they don’t prefer one combination over
another.

Assumptions of Indifference Curve Analysis

This theory keeps some assumptions from the older cardinal theory, removes some, and adds new
ones. The main assumptions are:

1.​ A rational consumer — tries to get the maximum satisfaction possible.

2.​ Two goods only — X and Y.
3.​ Complete market information — knows the prices of both goods.
4.​ Prices are constant — prices of X and Y don’t change during analysis.
5.​ Tastes, habits, and income stay the same — no changes while analysing behaviour.
6.​ More is better — prefers more X to less Y, or more Y to less X.
7.​ Negative slope — the indifference curve slopes downward (to get more of one good, you must
give up some of the other).
8.​ Convex to the origin — shows a decreasing marginal rate of substitution.
9.​ Smooth and continuous — goods are divisible, and satisfaction changes gradually (no sudden
jumps).
10.​Scale of preference — consumers can rank combinations from most to least preferred, and
also identify combinations they feel indifferent about.
11.​Transitivity of preference and indifference —
●​ If A is preferred to B, and B to C → then A is preferred to C.
●​ If A is indifferent to B, and B to C → then A is indifferent to C.​
This ensures choices are consistent.
12.​Can compare all combinations — the consumer can rank or compare every possible
combination of the two goods.

Properties of Indifference Curves

From the assumptions given earlier, we can find these main properties of indifference curves:

1. Higher curves mean higher satisfaction

●​ A curve to the right of another shows a higher level of satisfaction.

●​ Example: In Fig. 15.3, curve I₂ is to the right of I₁.
○​ Point A on I₂ means the consumer has more of both X and Y than
point N on I₁.
 ○​ Even if only X increases and Y stays the same (like point M vs A), the consumer still
prefers the point with more X.

2. Many curves can exist between two curves

●​ Between I₁ and I₂, there can be infinite other curves, one for every possible point.

3. Curve numbers are arbitrary

●​ The labels I₁, I₂, I₃... are just names.

●​ They can be numbered in any order (e.g., 1, 2, 4, 6 or 1, 2, 3, 4).
●​ The numbers don’t affect the analysis.

4. Indifference curves slope downwards

●​ They are negative-sloping from left to right.

●​ Meaning: To get more of X, the consumer must give up some of Y.
●​ Why?
○​ If a curve sloped upward (Fig. A), both goods would increase, so the new point would be
better, not indifferent.​
If a curve were horizontal or vertical (Fig. B & C), one good could increase without
reducing the other — again, the consumer would prefer that point.

5. Curves never touch or intersect

●​ Each curve represents a different satisfaction level, so they

cannot cross.
●​ Example (Fig. 15.5A):
○​ On I₁: A = C (same satisfaction)
○​ On I₂: B = C (same satisfaction)
○​ This implies A = B, but A is preferred to B — which is
a contradiction.
●​ Even touching at a single point (Fig. 15.5B) causes the same
problem.

6. Curves cannot touch the axes

●​ If a curve touches the X-axis (point M), the consumer has only X and no Y.
 ●​ If it touches the Y-axis (point L), the consumer has only Y and no X.
●​ This goes against the assumption that the consumer buys both goods in combination.

7. Curves are convex to the origin

●​ Convexity means the marginal rate of substitution (MRS) of X for Y decreases as X

increases.
●​ Why not concave?
○​ In a concave curve (Fig. 15.7A), the consumer gives up more and more of Y for the
same increase in X (e.g., ab < cd < ef for bc = de = fg of X). This is unrealistic.
●​ Why not a straight line?
○​ A 45° line (Fig. 15.7B) means MRS is constant — the same amount of Y is always
given up for each X gained (e.g., ab = bc, cd = de).
●​ Correct case: Convex (Fig. 15.7C) — the consumer gives up less and less of Y for equal gains
in X (ab > cd > ef for bc = de = fg of X).

8. Curves are not always parallel

●​ While all curves slope downward, their rate of slope change is different.
●​ Example: In Fig. 15.8, I₁ and I₂ are not parallel because the MRS patterns
are different.

9. Shape in reality vs diagrams

●​ In reality, indifference curves are closed loops like bangles.

●​ But in theory diagrams, we show only the useful segment — the part that is
downward sloping and convex to the origin (Fig. 15.9).

Localization
Localization means when a certain industry is concentrated in a specific area, town, or region.​
It’s connected to the territorial division of labor, meaning different regions specialize in different
products.​
Examples:

●​ Switzerland → Watches
●​ Brazil → Coffee
●​ India → Tea
Causes of Localization

Industries choose their location based on many factors — mainly low production cost and low
transport cost. The key causes are:

1.​ Climatic Conditions

○​ Some places naturally suit certain products due to climate or soil.
○​ Example: Tea industry in Sylhet, Bangladesh — cheaper than trying to grow tea
elsewhere with artificial means.
2.​ Nearness to Raw Materials
○​ Important for industries using bulky raw materials that are expensive to transport and
lose weight during production.​
Example: Iron & steel industry in Bihar (close to iron ore and smelting materials).
3.​ Nearness to Power Sources
○​ Industries often set up near sources of power (coal, hydro, atomic).
○​ Example: Iron & steel near coalfields to save transport cost.
○​ Today, coal is less critical because hydro/atomic power can be transmitted far more
cheaply.
4.​ Nearness to Markets
○​ Being close to customers reduces transport costs and keeps prices competitive.
○​ If far away, selling price increases, making products less competitive.
5.​ Adequate & Trained Labour
○​ Industries cluster where skilled workers are already available.
○​ New industries also get attracted to such areas.
6.​ Availability of Finance
○​ Banking and financial facilities are essential.
○​ Capital is drawn to industrial areas, which then attract even more industries.
7.​ Momentum of an Early Start
○​ Sometimes industries grow in a place simply because they started there earlier — even
by chance or personal reasons.
○​ Example:
■​ Detroit (USA) → Motor car industry (Henry Ford’s birthplace).
■​ Oxford (UK) → Motor car industry (William Morris’s birthplace).
8.​ Political Patronage
○​ Government or rulers may support specific industries in certain areas.
○​ Example: Silk industry in Varanasi, ivory work in Delhi (supported by Hindu & Muslim
rulers).

Localization of Industry: Advantages and Disadvantages

Advantages of Localization

When an industry is concentrated in one area, it enjoys several benefits:

1.​ Reputation​
The place becomes famous for the industry, and products made there gain a good reputation.​
Examples:
 ○​ Sheffield cutlery
○​ Swiss watches
○​ Ludhiana hosiery
2.​ Skilled Labour​
Localization encourages specialization. Skilled workers gather in that area, ensuring a steady
supply of experienced labor. This attracts new firms too.​
Also, the children of skilled workers often inherit those skills.​
Examples:
○​ Watch industry in Switzerland
○​ Shawl industry in Kashmir
○​ Brassware industry in Moradabad
3.​ Growth of Facilities​
Industrial concentration encourages development of supporting facilities:
○​ Banks and financial institutions open branches
○​ Railways and transport companies offer special services
○​ Insurance companies provide coverage for risks like fire or accidents
4.​ Subsidiary Industries​
Localized industries lead to the growth of related industries that supply machinery, tools, and
other materials, and also utilize by-products.​
Example:
○​ Sugar industry localization leads to factories making sugar machinery and plants making
spirit from molasses, and poultry farms feeding on molasses.
5.​ Employment Opportunities​
More industries and subsidiaries mean more jobs in the area.
6.​ Common Problems Solved Together​
Firms in the area form associations to address shared issues, secure government support,
establish research labs, publish technical journals, and open training centers — benefiting all.
7.​ Economic Gains​
Localization lowers production costs and improves product quality by providing:
○​ Skilled labor
○​ Timely credit​
Quality raw materials
○​ Research and market intelligence
○​ Efficient transport
8.​ The region benefits through employment, the government through tax revenue, and overall
economic growth happens.

Disadvantages of Localization

However, localization also brings some problems:

1.​ Dependence​
The economy becomes reliant on products from one area.​
Risks include disruption during war, depression, or natural disasters, which can severely affect
supply and the economy.
2.​ Social Problems​
Industry concentration can cause:
 ○​ Congestion
○​ Slums
○​ Accidents
○​ Strikes
3.​ These issues reduce labor efficiency and hurt industrial productivity.​
Limited Employment Options​
Jobs are limited to specific trades in that area.​
During downturns, specialized workers may struggle to find alternative jobs.​
Strong labor unions can demand high wages, raising production costs and affecting the industry
negatively.
4.​ Diseconomies of Scale​
Over time, problems arise such as:
○​ Transport bottlenecks
○​ Power shortages
○​ Financial institutions facing credit shortages
○​ Demands for higher wages and better living conditions from labor
5.​ These issues increase costs and reduce production efficiency.
6.​ Regional Imbalances​
Concentration of industries in one region leads to uneven development.​
The region with industries attracts more businesses due to better infrastructure (power,
transport, finance, labor).​
This causes:
○​ Faster growth in income and living standards in the developed region
○​ Other regions remain backward, causing envy and social tensions
7.​ The government often needs to intervene by starting industries or encouraging private firms to
invest in backward regions with incentives.

Division of Labor
Division of labor originally began with people working in different occupations. Now, with large-scale
production and heavy machinery, the work is divided into many processes, and many people contribute
to producing one product. This is called division of labor.

Example:​
In a large ready-made garment factory:

●​ One person cuts the cloth.

●​ Another stitches the clothes with machines.
●​ Another attaches buttons.
●​ Another folds and packs the garments.

Each worker performs a specific part of the production process, which is why this is called division of
labor.

Forms of Division of Labor

Economists classify division of labor into different types:

1.​ Simple Division of Labor​

Production is divided into parts, many workers work together, but it is hard to measure each
worker’s individual contribution.​
Example: When several people carry a large log of wood, it’s difficult to know how much each
person contributes.
2.​ Complex Division of Labor​
Production is divided into different parts, and each part is done by workers specialized in that
task.​
Example: In a shoe factory:
○​ One worker makes the upper part.
○​ Another prepares the soles.
○​ Another stitches the parts.
○​ Another polishes the shoes.
3.​ Each worker focuses on a specialized task, making this complex division of labor.
4.​ Occupational Division of Labor​
When producing a commodity becomes a person’s occupation, it’s called occupational division
of labor.​
Example: Farmers, cobblers, carpenters, weavers, and blacksmiths each specialize in
producing different goods.
5.​ Geographical or Territorial Division of Labor​
Sometimes production of certain goods is concentrated in a particular place, state, or country
because that location is best suited for that product.​
This type of division happens when workers or factories specialized in a product are located in
one area.​
Examples:
○​ Assam specializes in tea production.
○​ Mumbai is famous for its textile industry.
○​ West Bengal specializes in jute production.

Merits of Division of Labor

1.​ Increase in Production​
Division of labor significantly raises total production. Adam Smith illustrated this with pins: one
worker could produce 20 pins daily, but with production divided into 18 steps performed by 18
workers, 48,000 pins can be made in a day.
2.​ Increase in Efficiency of Labor​
Repeating the same task repeatedly leads to specialization, which increases worker efficiency.
3.​ Increase in Skill​
Repetition in the same work enhances skill, enabling the worker to perform tasks better.
4.​ Increase in Mobility of Labor​
Workers become specialized in specific tasks, gaining occupational mobility. Large-scale
production attracts workers from various places, increasing geographical mobility.
 5.​ Increase in Use of Machines​
Division of labor promotes machine use both in large and small-scale production, boosting
productivity.
6.​ Increase in Employment Opportunities​
Diverse occupations and large-scale production create more job opportunities.
7.​ Work According to Taste​
Workers can choose jobs matching their skills and interests due to the division of labor.
8.​ Work for Disabled Persons​
Tasks are split into small processes, allowing disabled individuals to work with suitable
machines or parts of the process.
9.​ Best Use of Tools​
Workers only need specific tools for their specialized task, ensuring efficient and continuous
tool use.
10.​Best Selection of Workers​
Employers can easily assign workers to jobs they are best suited for, improving productivity.
11.​Saving of Capital and Tools​
Not every worker needs a full set of tools, saving capital and reducing costs.
12.​Goods of Superior Quality​
Specialization results in better quality products.
13.​Saving of Time​
Workers focus on one task without shifting, reducing downtime and increasing output.
14.​Right Man at the Right Job​
Tasks are allocated to the most suitable workers, avoiding inefficiency.
15.​Reduction in Cost of Production​
Division of labor increases output and reduces average production costs through cooperation
and better resource use.
16.​Cheap Goods​
Mass production lowers costs, resulting in cheaper goods and improved living standards.
17.​Saving Time and Expenses in Training​
Workers train only for a specific task, saving time and training costs.
18.​Spirit of Cooperation among Workers​
Working together fosters cooperation and unionism, helping workers support each other.
19.​Development of International Trade​
Countries specialize based on comparative advantage, boosting international trade.

Demerits of Division of Labor

1.​ Monotony​
Repetitive work leads to boredom and decreased job satisfaction.
2.​ Loss of Joy​
Workers do not feel pride or joy in producing a complete product, reducing motivation.
3.​ Loss of Responsibility​
When many workers contribute, it’s difficult to assign responsibility for poor quality or output.
4.​ Loss of Mental Development​
Specialization limits workers' knowledge of the overall process, hindering intellectual growth.
5.​ Loss of Efficiency​
Focusing on only one task may cause workers to lose efficiency in other skills.
6.​ Reduction in Mobility of Labor​
Specialization limits workers’ ability to find similar jobs elsewhere, restricting mobility.
7.​ Increased Dependence​
Each worker depends on others; if one is negligent, the entire production suffers.
8.​ Danger of Unemployment​
Specialized workers may struggle to find other jobs if dismissed.
9.​ Increased Dependence on Machines​
Growing machine use means workers rely heavily on machinery.
10.​Danger of Over-Production​
Large-scale production may exceed demand, leading to unsold goods and economic problems.
11.​Exploitation of Labor​
Capitalists own big factories, paying workers less than their contribution, exploiting them due to
lack of alternatives.
12.​Evils of Factory System​
Factory systems cause problems like pollution, overcrowding, bad habits, and poor living
conditions.
13.​Employment of Women and Children​
Small, simple tasks allow employment of women and children, who may be paid low wages and
exploited.
14.​Industrial Disputes​
Conflict arises between workers and employers over wages and conditions, leading to strikes
and closures.​
Economics: Part B
Costs of production
The Short Run and the Long Run
The Short Run:​
The short run can be defined as a period which is long enough to permit any desired change of output
technologically possible without altering the scale of plant, but which is not long enough to permit
any adjustment of the scale of plant.

The Long Run:​

On the other hand, the long run is a period which is sufficiently long enough to permit any desired
change of output technologically possible by altering the scale of plant, and which is long enough to
permit any adjustment of the scale of plant.

Fixed Costs
Fixed costs are the costs of all those factors of production whose amount cannot be altered quickly in
the short run. The fixed costs are mainly those costs of the fixed plant and equipment of the firm.

The clearest way to define fixed costs is to say that they are costs that continue even if the firm
temporarily shuts down producing nothing at all.

Examples of fixed costs include:

●​ Interest on investment in the plant and equipment

●​ Most kinds of insurance
●​ Property taxes
●​ Depreciation and maintenance
●​ Wages of those people who continue to be employed even in a temporary shut-down

Variable Costs
Variable costs are those costs that vary with the volume of output. They necessarily rise as the firm’s
output increases, since larger output requires larger quantities of variable resources and hence, larger
cost obligations.

Examples of variable costs include:

●​ Wages
●​ Payment for raw materials and other goods bought by the firm
●​ Payment for fuel
●​ Interest on short-term loans
Short-Run Total Cost Curves
Cost curves show the minimum cost of producing various levels of output. In the short run, one or two
factors of production are fixed in quantity.

●​ Total Fixed Costs (TFC): The total obligations incurred by the firm per unit of time for all fixed
inputs.​
Total Variable Costs (TVC): The total obligations incurred by the firm per unit of time for all
variable inputs.
●​ Total Costs (TC): Equal to TFC + TVC.

Table 1.1: Hypothetical TFC, TVC, and TC Schedules

Quantity of Output Total Fixed Cost (TFC) Total Variable Cost (TVC) Total Cost (TC)

0 60 0 60

1 60 30 90

2 60 40 100

3 60 45 105

4 60 55 115

5 60 75 135

6 60 120 180
Explanation of the Table and Curves

Suppose an entrepreneur has a fixed plant that can be used to produce a certain commodity. Further
suppose this plant costs $60. Total fixed cost is, therefore, $60 – it is constant irrespective of the level
of output.

●​ This is reflected in Table 1.1 by the column of $60 entries labeled “Total fixed cost.”
●​ It is also shown by the horizontal line labeled TFC in Figure 1-1. Both the table and the graph
emphasize that fixed cost is indeed fixed.

Variable inputs must also be used if production exceeds zero. The greater the level of variable input,
the greater the total variable cost of production.

●​ This is shown in column 3 of Table 1.1 and by the curve labeled TVC in Figure 1-1.

Summing total fixed and total variable cost gives total cost, the entries in the last column of Table 1.1
and the curve labeled TC in Figure 1-1.

From the figure:

●​ TC and TVC move together and are, in a sense, parallel.

●​ The slopes of the two curves are the same at every output point.
●​ At each point, the two curves are separated by a vertical distance of $60, the total fixed cost.

SHORT-RUN PER-UNIT COST CURVES

Although total cost curves are very important, per-unit cost curves are even more important in the
short-run analysis of the firm. The short-run per-unit cost curves that we will consider are the Average
Fixed Cost (AFC), Average Variable Cost (AVC), Average Cost (AC), and Marginal Cost (MC)
curves.

Definitions and Formulas

Average Fixed Cost (AFC):​
Average fixed cost equals total fixed costs divided by output. So,

Average Variable Cost (AVC):​

Average variable cost equals total variable costs divided by output. Thus,
Average Cost (AC):​
Average cost equals total costs divided by output. AC also equals AFC plus AVC. So,

Marginal Cost (MC):​

Marginal cost equals the change in TC or the change in TVC per unit change in output. So,

Behavior of Curves
The AFC, AVC, AC and MC schedules of Table 1.2 are plotted in Fig. 1-2.
 ●​ The AFC curve falls continuously as output is expanded.
●​ The AVC, AC, and MC curves are U-shaped.
●​ The MC curve reaches its lowest point at a lower level of output than either the AVC curve or
the AC curve.
●​ The rising portion of the MC curve intersects the AVC and AC curve at their lowest point.

PROBLEM: From the following cost functions calculate AC, MC, AVC, AFC functions and also
calculate the output when the MC will be minimum.
Monopoly
Monopoly is a market structure in which:

1.​ There is a single seller.

2.​ There are no close substitutes for the commodity it produces.
 3.​ There are barriers to entry.

Main Causes of Monopoly

1.​ Ownership of strategic raw materials or exclusive knowledge of production techniques.

2.​ Patent rights for a product or a production process.​
Government licensing or the imposition of foreign trade barriers to exclude foreign
competitors.
3.​ Market size and technology constraints:
○​ The market may not support more than one plant of optimal size.
○​ Technology may exhibit substantial economies of scale, which require only a single
plant to fully exploit.
○​ Examples include transport, electricity, communications, where large-scale output is
needed to realize economies.
○​ Such markets are termed natural monopolies.
○​ Often, the government undertakes production in these cases to prevent consumer
exploitation (e.g., public utilities).
4.​ Limit-pricing and strategic policies by existing firms:
○​ The existing firm adopts a limit-pricing policy, aiming to prevent new entry.
○​ Combined with heavy advertising or continuous product differentiation, new entry is
discouraged.
○​ This creates barriers to new competition.

Demand and Revenue in Monopoly

●​ Since there is a single firm, the firm’s demand curve = industry demand curve.
●​ The demand curve is downward sloping (Figure 6.1).
●​ For simplicity, a linear demand function is assumed:

●​ Ceteris paribus: all other factors affecting demand (income, tastes, other prices) are held
constant.
●​ Slope of demand curve:

The price elasticity of demand is

That is, elasticity changes at any one point of the demand curve.
(a) At point D the elasticity approaches infinity

(b) At point D' the elasticity is zero

(c) At the mid point C the price elasticity is unity

The total revenue of the monopolist is R = P.X

Solving the demand equation for P we may rewrite the price equation as P = b0─ b1X
Substituting into the revenue equation we find

The average revenue is equal to the price:

Thus the demand curve is also the A R curve of the monopolist.

The marginal revenue is:

That is the M R is a straight line with the same intercept as the demand curve, but twice as
steep.
The general relation between P and M R is found as follows. Given
R = P.X

The marginal revenue is at all levels of output smaller than P, given that

The relationship between M R and price elasticity e

Proof:
We know that

The price elasticity of demand is defined as

Inverting this relation we obtain

Solving for dP/dX we find

Substituting in the expression of the MR we get

Costs in Monopoly
●​ In the traditional theory of monopoly, the shapes of the cost curves are the same as in pure
competition:
○​ AVC, MC, and ATC are U-shaped.
○​ AFC is a rectangular hyperbola.
●​ The particular shape of the cost curves does not affect the determination of equilibrium,
provided that the slope of MC is greater than the slope of the MR curve.

Equilibrium of the Monopolist

Short-Run Equilibrium
The monopolist maximises short-run profits if the
following conditions are satisfied:

1.​ Marginal Cost (MC) equals Marginal Revenue

(MR).
2.​ Slope of MC is greater than the slope of MR
at the point of intersection.
●​ In Figure 6.2, the equilibrium of the monopolist
is at point E, where:
○​ MC intersects MR from below,
satisfying both conditions.
○​ Price = PM
○​ Quantity = XM
○​ Excess profits = shaded area APMCB

Note: Price is higher than MR.

Differences from Perfect Competition

 ●​ In pure competition, the firm is a price-taker, so the only decision is output determination.
●​ In monopoly, the firm faces two interdependent decisions:
○​ Setting the price
○​ Determining output
●​ Because of the downward-sloping demand curve:
○​ The monopolist cannot independently choose both price and quantity.
○​ He either:
■​ Sets a price and sells the quantity the market will buy at that price, or
■​ Produces the output defined by MC = MR, which will be sold at the
corresponding price P.
●​ The crucial condition for profit maximisation:

MC = MR and MC cuts MR from below.

A numerical example
Given the demand curve of the monopolist
Supply Curve of a Monopolist
●​ Key Point: There is no unique supply curve for a monopolist derived from his MC, unlike in
pure competition.

Why MC is Not the Supply Curve

●​ In pure competition, the MC curve above AVC serves as the supply curve.
●​ In monopoly, there is no unique relationship between price and quantity supplied.
 ●​ The same quantity may be offered at different prices, depending on the price elasticity of
demand.

Graphical Illustration
●​ Figure 6.3:
○​ Quantity X is sold at price P if demand is D.
○​ The same quantity X is sold at price P2 if demand is
D2.
○​ This demonstrates no unique price–quantity
relationship.
●​ Figure 6.4:
○​ Given the MC curve, various quantities may be
supplied at the same price, depending on market
demand and the corresponding MR curve.
○​ Example:
■​ At price P, supply is OX1 if market demand is
D1.
■​ At the same price P, supply is only OX2 if
market demand is D2.

Monopoly: Long Run

Equilibrium
In the long run, the monopolist has the flexibility to expand his plant or to use his existing plant at any
level that maximizes profit. Since entry is blocked, it is not necessary for the monopolist to reach an
optimal scale (i.e., the minimum point of the Long-Run Average Cost, LAC). Likewise, there is no
guarantee that the existing plant will be used at optimum capacity.

What is certain, however, is that the monopolist will not continue in business if he incurs losses in the
long run. Given that entry is barred, he will most probably continue to earn supernormal profits even
in the long run.

The size of his plant and the degree of utilization of any given plant depend entirely on market
demand. Therefore, the monopolist may:

●​ Reach the optimal scale (minimum point of LAC),

●​ Remain at a suboptimal scale (falling part of LAC), or
●​ Surpass the optimal scale (expand beyond the minimum LAC),depending on the prevailing
market conditions.
Case 1: Suboptimal Plant Size and Under-Utilization (Figure
6.5)

When the market size does not permit expansion to the minimum point of LAC:

●​ The plant is of suboptimal size (economies of scale are not fully exhausted).
●​ The existing plant is under-utilized.​

This occurs because, to the left of the minimum point of LAC:

1.​ The Short-Run Average Cost (SRAC) is tangent to the LAC at its falling part.
2.​ The Short-Run Marginal Cost (SRMC) must equal the Long-Run Marginal Cost (LRMC).​

Thus, equilibrium is at point r, whereas:

●​ The minimum LAC is at b.

●​ The optimal use of the existing plant is at a.
●​ Actual utilization is at c', resulting in excess capacity.

Case 2: Over-Expansion and Over-Utilization (Figure 6.6)

When the market size is very large, the monopolist, in order to maximize output, must:

●​ Build a plant larger than the optimal size and

●​ Over-utilize it.

This happens because, to the right of the minimum point of LAC:

1.​ The SRAC and LAC are tangent at a point on their positive slope.
2.​ The SRMC must equal the LAC.

As a result, the plant that maximizes profits leads to higher costs for two reasons:

●​ It is larger than the optimal size.

●​ It is over-utilized.

This situation is often observed in public utility companies operating at the national level.

Case 3: Optimal Scale and Full Capacity (Figure 6.7)

When the market size is just large enough, the monopolist can:

●​ Build the optimal plant, and

●​ Use it at full capacity.

Imposition of a Tax on a Monopolist

We will examine the effects on the equilibrium of the monopolist under three types of taxes:

1.​ Lump-sum tax

2.​ Profits tax
3.​ Specific sales tax

1. Imposition of a Lump-sum Tax (per period)

 ●​ In the case of a monopolist, we need not distinguish between the short run and the long run
(unlike in a purely competitive market).
●​ In general, the monopolist realizes excess profits in both the short run and the long run.
●​ Under these conditions, the imposition of a lump-sum tax will:
○​ Reduce the excess profits of the monopolist (since it increases his total fixed cost).
○​ Leave the marginal cost (MC) curve unaffected.
●​ Therefore, the equilibrium in the monopoly market remains unchanged in both the short run
and the long run.
●​ Exception: If the lump-sum tax exceeds the monopolist’s supernormal profits, he would be
unable to sustain production.

2. Imposition of a Profits Tax

●​ The effects of a profits tax on monopoly equilibrium are the same as a lump-sum tax:
○​ The profits tax reduces abnormal (monopoly) profits.
○​ The market equilibrium is not affected.
●​ Condition: As long as the profits tax does not reduce profits below the level of normal profit,
the monopolist continues production.
●​ If the profits tax cuts into normal profits, the monopolist will not be covering his total costs
(including normal profit) and will shut down.

3. Imposition of a Specific Sales Tax

●​ The effects of a specific sales tax on monopoly output are broadly the same as in a purely
competitive market.
●​ The imposition of a specific sales tax will:
○​ Shift the MC curve upward.
○​ Change the monopolist’s equilibrium.
○​ Lead to a new equilibrium (E′), where:
■​ The price is higher.
■​ The quantity produced is smaller than before.
●​ This outcome is the same qualitative prediction as in pure competition.

Price Effects of a Specific Tax in Monopoly

●​ The change in price may be smaller, equal, or greater than the

tax amount (as in pure competition).
●​ However, unlike in competition, we do not distinguish between
short run and long run in monopoly, since the conditions of
equilibrium are the same in both.

(i) Upward-sloping MC curve

●​ If the monopolist’s MC curve has a positive slope:

○​ The increase in price will be smaller than the specific
tax.
 ○​ The monopolist passes part of the tax to consumers.
○​ (Figure 6.14 shows ∆P < tax).

(ii) Horizontal MC curve

●​ If the monopolist’s MC curve is horizontal:

○​ The monopolist raises the price, but not by the full
amount of the tax.
○​ Even when the MC curve is infinitely elastic, the
monopolist still bears part of the tax.
○​ (Figure 6.15 shows ∆P < tax).

(iii) Complex cases

●​ Conditions under which the monopolist can:

○​ Pass the entire tax to the consumer, or
○​ Raise the price by more than the tax amount,​
are complicated and require advanced analysis.
●​ For further study, the reader is referred to textbooks on public finance and public policy.

The Multi-Plant Firm

Assume a monopolist operates two plants, A and B, each with different cost structures (figs. 6.16 &
6.17). He must make two decisions:

1.​ Total Output & Price – How much to produce altogether and at what price to sell in order to
maximize profit.
2.​ Allocation of Output – How to distribute the optimal (profit-maximizing) output between the two
plants.

The monopolist knows his market demand curve (and the corresponding MR curve) as well as the
cost structures of both plants. The total marginal cost (MC) curve of the firm is obtained by the
horizontal summation of the two plants’ MC curves:
Given MR and MC, the monopolist determines the profit-maximizing output and price at the
intersection of these two curves (point E in fig. 6.18).

Allocation Rule

The monopolist allocates output across plants according to the rule:

●​ If MC of A<MC of B​, the monopolist can increase profit by raising output in A and reducing it in
B until costs are equalized.
●​ Equilibrium is reached only when the marginal costs of both plants are equal and equal to MR.​

Graphical Explanation

●​ At equilibrium (point E, fig. 6.18), draw a horizontal line to where it intersects the two MC curves
of plants A and B (points E₁ and E₂).
●​ From E₁ and E₂, drop perpendiculars to the X-axis of figs. 6.16 and 6.17. These give the
equilibrium outputs of plants A and B.
●​ Clearly, X1+X2=X, where X is the total profit-maximizing output.

Profit Distribution

●​ Profit from plant A = shaded area abed.

●​ Profit from plant B = shaded area gfjh.
●​ Total profit = sum of both.

Perfect Competition
Definition​
Perfect competition is a market structure characterized by the complete absence of rivalry among
individual firms. In everyday language, competition means rivalry, but in economic theory, perfect
competition implies no rivalry.

Assumptions of Perfect Competition

1.​ Large Number of Buyers and Sellers

○​ The market has a large number of firms and buyers.
○​ Each firm supplies only a small fraction of the total market output.
○​ No single buyer or seller can influence the price.
○​ Hence, individual firms cannot change the market price by altering their output.​

2.​ Product Homogeneity

○​ Products of all firms are identical.
○​ If products were differentiated, firms could set prices independently.
 ○​ With homogeneity, firms are price-takers.
○​ Their demand curve is perfectly elastic, coinciding
with average revenue (AR) and marginal revenue
(MR).​

3.​ Free Entry and Exit

○​ Firms face no barriers to entry or exit.
○​ Though entry/exit may take time, movement in or
out of the industry is unrestricted.
○​ This ensures no firm can gain monopoly power.​

4.​ Profit Maximisation

○​ The sole objective of firms is to maximize profits.​

5.​ No Government Regulation

○​ No government intervention (tariffs, subsidies, rationing, etc.).
○​ Market forces operate freely.​

Additional Assumptions of Pure vs. Perfect Competition

Perfect competition requires more stringent conditions than pure competition:

6.​ Perfect Mobility of Factors

○​ Factors of production can freely move between firms and industries.
○​ Workers can switch jobs easily; skills are transferable.
○​ No monopolisation of resources, no labour union restrictions.​

7.​ Perfect Knowledge

○​ Buyers and sellers have full knowledge of present and future market conditions.
○​ Information is free, costless, and eliminates uncertainty.​

Equilibrium of the Firm in the Short Run

The firm is in equilibrium when it maximises its profits (π), defined as the difference between total
cost (TC) and total revenue (TR):

The firm is in equilibrium when it produces the output that maximises the difference between total
receipts and total costs.

There are two graphical methods to show equilibrium:

 1.​ Using TR and TC curves
2.​ Using MR and MC curves

1. Perfect Competition: TR and TC Curves

●​ In Figure 2, we show the total revenue (TR) and total cost (TC) curves of a firm in a perfectly
competitive market.​

●​ The TR curve:​

○​ A straight line through the origin.

○​ Indicates that price is constant at all levels of
output.
○​ The firm is a price-taker, meaning it can sell any
amount at the given market price.
○​ TR increases proportionately with sales.
○​ The slope of TR = Marginal Revenue (MR),
which is constant and equal to price.

Thus, under pure competition:

MR=AR=P

The TC curve:

○​ Shape reflects the U-shape of the average cost (AC) curve, based on the law of
variable proportions.
●​ Profit maximisation:​

○​ Occurs at output X* where the vertical distance between TR and TC is greatest.

○​ At outputs smaller than X* or larger than X_B, profit is reduced or negative (losses).

2. MR–MC Approach
●​ In Figure 3, we show average cost (AC), marginal cost
(MC), and the demand curve of the firm.
●​ In perfect competition:
○​ The demand curve = AR curve = MR curve.
●​ Both MC and SATC are U-shaped, reflecting the law of
variable proportions, since the plant is fixed in the short run.
●​ Equilibrium is reached at the intersection of MC and MR
(point e).

Explanation:

●​ To the left of e:
 ○​ Profit not maximised.
○​ Each unit adds more revenue (MR) than cost (MC).
○​ Firm should expand output.​

●​ To the right of e:
○​ Each unit costs more (MC) than it earns (MR).
○​ Firm should reduce output.

Summary conditions:​
(a) If MC < MR, profits not maximised → expand output.​
(b) If MC > MR, profits reduced → cut output.​
(c) If MC = MR, profits maximised.

3. Conditions for Equilibrium

The firm is in equilibrium when two conditions are satisfied:

1.​ First Condition:​

MC=MR
2.​ Second Condition:
○​ The MC must be rising at the point of
intersection.
○​ i.e., MC cuts MR from below.
○​ This means:​
slope of MC>slope of MR\text{slope of MC} >
\text{slope of MR}slope of MC>slope of MR
●​ In Figure 4:
○​ At point e′, MC = MR but MC is not rising steeply
enough.
○​ True equilibrium occurs at X* (Xe > Xe′).

4. Profit or Loss in Short-Run Equilibrium

Being in equilibrium does not guarantee excess profits. The outcome depends on the position of
ATC relative to price:

●​ If ATC < Price → Excess profits (Figure 5.5).

○​ Profit = Area PABe.
●​ If ATC > Price → Losses (Figure 5.6).
○​ Loss = Area FPeC.
 5. The Closing-Down Point
●​ If a firm incurs losses, it will continue to produce only if it
covers its variable costs.
●​ If it cannot cover variable costs, it should shut down to
minimise losses.
●​ The closing-down point is where Price = AVC.
●​ In Figure 5.7:
○​ The closing-down point is w.
○​ If Price < Pw, the firm does not cover variable costs
→ shuts down.

Supply Curve and Equilibrium under Perfect

Competition
1. Supply Curve of the Firm
●​ The firm’s supply curve is derived from the points of intersection of its MC curve with
successive demand curves.
●​ As the market price rises, the demand curve of the firm shifts upward.
●​ Since MC has a positive slope, higher demand curves intersect MC at points further to the right,
meaning higher price → higher quantity supplied.
●​ If price falls below Pw, the firm shuts down because it cannot cover its variable costs.
●​ Hence, the firm’s supply curve = MC curve (above Pw). Below Pw, supply is zero.

2. Supply Curve of the Industry

●​ The industry supply curve = horizontal summation of all firms’ supply curves.
●​ Assumptions: factor prices and technology are constant, and the number of firms is very large.
●​ At each price, industry supply = sum of all firms’ outputs.
 ●​ Shape depends on:
○​ technology
○​ factor prices
○​ firm size distribution (since all firms are not equal in size, depending on entrepreneurial
efficiency).

(slope of MR) < (slope of MC)

3. Equilibrium of the Firm in the Long Run

●​ A firm is in long-run equilibrium when it produces at the minimum point of LAC, which is
tangent to the demand curve (market price).
●​ In the long run, firms earn only normal profits (included in LAC).
○​ Excess profits → attract new firms → price falls (due to rightward shift of supply + rising
factor costs).
○​ Losses → firms exit → price rises until remaining firms cover total costs including
normal profit.
●​ Equilibrium condition:​
LMC=LAC=P
●​ At this point:​
SAC=SMC=LMC=LAC=P=MR
●​ This ensures that the plant operates at optimal capacity:
○​ LMC cuts LAC at minimum.
○​ SMC cuts SAC at minimum.
○​ Minima of SAC and LAC coincide.

4. Short-Run Equilibrium of the Industry

●​ Industry equilibrium occurs where market demand = market supply.
●​ Price at this point clears the market (Q units supplied = Q units demanded).
●​ If, at this price:
○​ Firms make excess profits → (Figure 5.11 case).
○​ Firms make losses → (Figure 5.12 case).
●​ But this is only short-run equilibrium.
●​ In the long run:
○​ Loss-making firms exit.
○​ Profit-making firms expand capacity or attract new entrants.
○​ Entry, exit, and readjustment continue until firms earn normal profit and there is no
further entry/exit.

National Income and Economic Accounting

Introduction
 ●​ National income is an uncertain term, used interchangeably with:
○​ National dividend
○​ National output
○​ National expenditure
●​ In common usage, national income refers to the total value of goods and services produced
annually in a country.
●​ It can also be described as the total amount of income accruing to a country from economic
activities within a year.
●​ It includes payments to all resources in the form of:
○​ Wages
○​ Interest
○​ Rent
○​ Profits

Concepts of National Income

Several important concepts are associated with national income, including:

●​ Gross National Product (GNP)

●​ Net National Product (NNP)
●​ Net National Income at Factor Cost
●​ Net Domestic Product at Factor Cost
●​ Personal Income
●​ Disposable Income
●​ Real Income

Each of these is explained below.

Gross National Product (GNP)

●​ Definition: GNP is the total measure of the flow of goods and services at market value resulting
from current production during a year in a country, including net income from abroad.​

●​ Components of GNP:
1.​ Consumers’ goods and services – to satisfy immediate wants of the people.
2.​ Gross private domestic investment in capital goods, consisting of:
■​ Fixed capital formation
■​ Residential construction
■​ Inventories of finished and unfinished goods
3.​ Goods and services produced by the government.
4.​ Net exports of goods and services – i.e., the difference between the value of exports
and imports, also known as net income from abroad.

Factors to Consider in Measuring GNP

 1.​ Measurement in money:
○​ All goods and services produced during a year are measured in monetary terms at
current prices, then added together.
2.​ Only final products counted:
○​ Market prices of final goods are considered.
○​ Intermediary goods are excluded to avoid double counting.
○​ Example: goods that pass through multiple production stages should only be counted
once when finally purchased by consumers.
3.​ Exclusion of free services:
○​ Goods and services rendered free of charge are not included since their market prices
cannot be correctly estimated.
○​ Examples:
■​ A mother bringing up her child
■​ A teacher tutoring his son
■​ A musician performing for friends​
A sculptor sculpting as a hobby
4.​ Exclusion of non-productive transactions:
○​ Transactions not related to current production are excluded.
○​ Examples:
■​ Sale and purchase of old goods
■​ Sale of shares, bonds, or assets of existing companies
5.​ Exclusion of capital gains/losses:
○​ Profits or losses due to fluctuations in market prices of capital assets are not included if
unrelated to current production.
6.​ Exclusion of illegal income:
○​ Income from black-market activities is excluded.
○​ Although such goods/services may satisfy demand, they are not socially useful and are
therefore omitted from GNP.

Income Approach to GNP

The income approach measures GNP as the total remuneration paid in terms of money to the
factors of production annually in a country.

Thus, GNP is the sum total of the following items:

1.​ Wages and Salaries

○​ Includes all forms of wages and salaries earned through productive activities by workers
and entrepreneurs.
○​ Covers:
■​ Basic pay
■​ Overtime
■​ Commissions
■​ Provident fund contributions
■​ Insurance payments
■​ Other allowances received or deposited during the year.
 2.​ Rents
○​ Consists of total rent from land, shops, houses, factories, etc.
○​ Includes imputed (estimated) rents of assets that are used by owners themselves.
3.​ Interest
○​ Comprises income received as interest by individuals from different sources.
○​ Also includes estimated interest on private capital invested (not borrowed) in personal
businesses.
○​ Exclusion: Interest received on government loans is excluded because it is considered
a transfer payment, not new production.
4.​ Dividends
○​ Dividends received by shareholders from companies are included.
5.​ Undistributed Corporate Profits
○​ Profits retained by companies (not distributed to shareholders) are counted as part of
GNP.
6.​ Mixed Incomes
○​ Includes incomes of:
■​ Unincorporated businesses
■​ Self-employed persons
■​ Partnerships
7.​ Direct Taxes
○​ Taxes levied on individuals, corporations, and other businesses are added to GNP.
8.​ Indirect Taxes
○​ Examples: excise duties, sales tax, etc.
○​ Though these revenues go to the government treasury (not directly to factors of
production), they are included in GNP because they raise the market prices of goods
and services.
9.​ Depreciation
○​ Corporations account for depreciation (wear and tear of machinery, plants, and
equipment).
○​ Even though this sum is not received by factors of production, it is included in GNP.
10.​Net Income from Abroad
○​ The difference between exports and imports of goods and services.
○​ If positive → added to GNP.
○​ If negative → deducted from GNP.

Formula

GNP (Income Method)= Wages and Salaries +Rents + Interest+Dividends + Undistributed

Corporate Profits + Mixed Incomes + Direct Taxes + Indirect Taxes + Depreciation + Net Income
from Abroad

Expenditure Approach to GNP

From the expenditure viewpoint, GNP is the sum total of expenditure incurred on goods and
services during one year in a country. It includes the following items:
(i) Private Consumption Expenditure (C)

●​ Covers all types of expenditure on personal consumption by individuals.

●​ Includes:
○​ Durable goods (watch, bicycle, radio, etc.)
○​ Single-use consumer goods (milk, bread, ghee, clothes, etc.)
○​ Services (fees for schools, doctors, lawyers, transport, etc.)
●​ All these are counted as final goods.

(ii) Gross Domestic Private Investment (I)

●​ Expenditure by private enterprise on:

○​ New investment
○​ Replacement of old capital
●​ Includes expenditure on house construction, factory buildings, machinery, plants, and
capital equipment.

(iii) Net Foreign Investment (X – M)

●​ Refers to export surplus (difference between exports and imports).

●​ Exports (X): Goods/services produced within the country → included in GNP.
●​ Imports (M): Goods/services produced abroad → excluded from GNP.
●​ Thus, Net Foreign Investment = X – M (positive → added, negative → deducted).

(iv) Government Expenditure on Goods and Services (G)

●​ Expenditure by Central, State, or Local governments on goods and services.

●​ Covers:
○​ Salaries of employees, police, army.
○​ Office running costs (stationery, cloth, furniture, cars, etc.).
○​ Spending on government enterprises.
●​ Excludes transfer payments (like pensions, subsidies, etc.), since they are not payments for
current goods/services.

Formula:

GNP (Expenditure Method) = Private Consumption Expenditure (C)+Gross Domestic Private

Investment (I)+Net Foreign Investment (X-M)+Government Expenditure on Goods and Services
(G) = C+I+(X-M)+ G.

Value Added Approach to GNP

●​ GNP is measured by calculating the money value of final goods and services produced at
current prices during a year.
●​ This avoids double counting of intermediate goods.
 ●​ Rule: Subtract the value of intermediate products (raw materials, fuels, semi-finished goods,
etc.) from total output.
●​ The difference between output and input at each stage = Value Added.
●​ Adding up all “value added” across industries = GNP by Value Added Method.

GNP at Market Prices

●​ Defined as:​
GNP at Market Price= Gross value of final goods and services produced annually in a
country + Net Income from Abroad

GNP at Factor Cost

●​ Defined as:​
GNP at Factor Cost= GNP at Market Prices – Indirect Taxes + Subsidies
●​ Represents income received by factors of production in return for services (wages, rents,
profits, etc.).
●​ Always less than GNP at Market Prices (since indirect taxes raise market prices).

Net National Product (NNP)

●​ Depreciation (Capital Consumption Allowance): Deducted because production uses up fixed
capital (wear/tear, damage, obsolescence).
●​ Formula:​
NNP=GNP – Depreciation

NNP at Market Prices

●​ Formula:​
NNP at Market Prices=GNP at Market Prices – Depreciation

NNP at Factor Cost (National Income)

●​ Formula:​
NNP at Factor Cost=NNP at Market Prices – Indirect Taxes + Subsidies​
Or equivalently,​
NNP at Factor Cost=GNP at Market Prices – Depreciation – Indirect Taxes + Subsidies
●​ Also called National Income.
●​ Normally, NNP at Market Prices > NNP at Factor Cost, since indirect taxes > subsidies.
●​ Exception: If subsidies > indirect taxes, then NNP at Market Prices < NNP at Factor Cost.

Per Capita Income

 ●​ Defined as:​

​
●​ Can be calculated at current prices or constant prices.

Example:

Methods of Measuring National Income

There are four methods of measuring national income. The choice of method depends on the
availability of data in a country and the purpose for which the measurement is undertaken.

1. Product Method (Output Method)

●​ This method calculates the total value of final goods and services produced in a country
during a year at market prices.
●​ To find the Gross National Product (GNP), data are collected for all productive activities, such
as:
○​ Agricultural products
○​ Wood from forests
○​ Minerals from mines
○​ Industrial commodities
○​ Contributions from transport, communications, insurance companies, and professions
(lawyers, doctors, teachers, etc.)
●​ Important Note: Only final goods and services are included. Intermediate goods and
services are excluded to avoid double counting.

2. Income Method
●​ According to this method, the net income payments received by all citizens of a country in a
particular year are added up.
●​ These include net rents, net wages, net interest, and net profits.
●​ Transfer payments (such as pensions or allowances) are not included.
●​ Data sources include:​

○​ Income tax departments (for high-income groups)

○​ Wage bills (for workers and employees)

3. Expenditure Method
 ●​ This method measures national income by summing up the total expenditure incurred by
society in a year.
●​ It includes:
○​ Personal consumption expenditure
○​ Net domestic investment
○​ Government expenditure on goods and services
○​ Net foreign investment
●​ This method is based on the assumption:​
National Income = National Expenditure

4. Value Added Method

●​ In this method, the value added by each industry at every stage of production is calculated.
●​ Formula:​
Value Added = Value of Output – Value of Inputs
●​ Adding up the value added across all industries gives the Gross Domestic Product (GDP).

Difficulties in Measuring National Income

The calculation of national income is complicated and faces the following difficulties:

1. Defining “Nation”

●​ Should include income earned by nationals both inside and outside the country.

2. Non-monetary Goods and Services

●​ Some activities are difficult to value in money terms (e.g., painting as a hobby, childcare by a
mother, services of a secretary after marriage to her employer).
●​ Excluding them underestimates national income.

3. Double Counting

●​ The biggest problem arises from failing to distinguish between final goods and intermediate
goods.
●​ Example: Flour used by a bakery (intermediate) vs. flour bought by a household (final).

4. Illegal Activities

●​ Incomes from gambling, smuggling, illicit liquor production, etc., are excluded even though
they provide goods/services.

5. Transfer Payments
 ●​ Pensions, unemployment allowances, and interest on public loans create confusion: they are
part of individual income but also government expenditure.
●​ Usually, they are excluded to avoid inflation of figures.

6. Capital Gains and Losses

●​ Fluctuations in the market value of assets (e.g., stock prices, property value) are not included
unless they arise from current productive activities.

7. Inventory Changes

●​ All inventory changes (positive or negative) are included, but firms often record them at original
cost rather than replacement cost, causing over/under-estimation.

8. Depreciation Estimates

●​ Calculating depreciation (e.g., for machines with a 50-year life) is extremely difficult, yet it must
be deducted from GNP to calculate Net National Product (NNP).

9. Price Changes (Inflation/Deflation)

●​ When prices rise, national income appears higher even if production falls.
●​ When prices fall, national income appears lower even if production increases.

10. Exclusion of Leisure

●​ National income measures money income, not real income.

●​ For example, two people may earn the same income, but one works longer hours, meaning his
true income is understated.

11. Valuation of Public Services

●​ Estimating contributions from police, military, irrigation, and power projects is very difficult
since their productivity cannot be easily expressed in money terms.

Problems of Measurement in a Developing

Economy
In developing countries, additional challenges arise due to lack of reliable data and structural issues:

1. Non-monetized Sector

●​ A large part of rural production is consumed locally or bartered (not sold in markets), making it
hard to measure.
2. Lack of Occupational Specialization

●​ Farmers are engaged in multiple activities (crop cultivation, dairying, poultry, weaving, etc.), and
their incomes are difficult to separate and record.

3. Non-market Transactions

●​ Villagers often build their own huts, tools, or garments, and urban families grow vegetables in
home gardens.
●​ These productive activities are not included in official estimates.

4. Illiteracy

●​ Many people do not maintain proper records of production, income, or expenditure, so

estimates become guesses.

5. Non-availability of Data

●​ Adequate data on agriculture, forestry, fisheries, animal husbandry, petty trade, small
enterprises, and construction work are often missing.
●​ Lack of data collection machinery makes it difficult to estimate incomes, consumption, and
investment reliably.

The Circular Flow of Income and Expenditure

The circular flow of income and expenditure describes how national income and expenditure move
in a continuous cycle within an economy. It shows how money and resources circulate between
households, businesses, government, and other sectors. The flow also includes leakages (like saving
and taxes) and injections (like investment and government spending) that keep the system balanced.

1. Two-Sector Economy (Households and Businesses)

We begin with a simple economy where there are only two sectors:
households and businesses.

●​ The household sector owns all the factors of production

(land, labor, and capital).
○​ Households provide these factors to businesses and
receive income in return.
○​ Income comes in the form of wages (for labor), rent
(for land), interest (for capital), and profit (for
entrepreneurship).
●​ The business sector consists of producers.
○​ Businesses use the factors of production to produce goods and services.
○​ These goods and services are sold to households in the product market.
So, households buy goods from businesses, while businesses pay households for factor services.

The Flow:

●​ Money flow (outer circle):​

Businesses pay households (wages, rent, profit), and households pay businesses (for goods
and services).
●​ Real flow (inner circle):​
Goods and services move from businesses to households, while factor services (labor, land,
capital) move from households to businesses.

In this way, Gross National Product (GNP) = Gross National Income (GNI).

2. The Circular Flow with Saving and Investment

In reality, the economy is not just two sectors. There are leakages and injections.

●​ Leakage: Saving (households do not spend all their income).

●​ Injection: Investment (businesses borrow money to invest in production)

To connect saving and investment, we introduce the capital or

credit market (banks, savings banks, loan institutions, stock and
bond markets, etc.).

●​ Households supply their savings to the capital market.

●​ Firms (businesses) borrow these funds from the capital
market as investments.

Thus, household income can be spent in two ways:

1.​ Directly as consumption expenditure.

2.​ Indirectly through saving, which becomes investment
expenditure by firms.​

This ensures that the total flow continues.

3. The Circular Flow in a Three-Sector Closed Economy

(Adding Government)
When we add the government sector, the model becomes a
three-sector closed economy.

Here we include:
 ●​ Taxes (T): Leakages, because they reduce household consumption and business investment.
●​ Government expenditure (G): Injections, because the government spends money on goods,
services, and social benefits.

(a) Household ↔ Government

●​ Households pay taxes (income tax, commodity tax) → leakage.

●​ The government provides services, pensions, unemployment benefits, healthcare, education,
housing, water, parks, etc. → injection.

(b) Business ↔ Government

●​ Businesses pay taxes → leakage.

●​ The government buys goods from firms, provides subsidies, and supports industries →
injection.

(c) Combined Flow

●​ Taxes reduce household consumption and business investment.

●​ But the government balances this by spending on households (services, wages) and
businesses (purchases, subsidies).
●​ This restores equality between total income and expenditure, keeping the flow in equilibrium.

4. Government Budget Effects

●​ If Government Expenditure (G) > Taxes (T) → There is a budget deficit.
○​ The government borrows from the capital market.
○​ Funds come from household savings.
●​ If Taxes (T) > Government Expenditure (G) → There is a budget surplus.
○​ The government reduces debt and puts funds into the capital market.
○​ These funds are available to businesses for investment.

Optimum Factor Combination and

Product-Mix
A profit-maximizing entrepreneur seeks to minimize cost for producing a given output, or equivalently, to
maximize output for a given level of outlay.

The choice of a particular combination of factors by an entrepreneur depends upon:

1.​ Technical possibilities of production – represented by the isoquant map.

2.​ Prices of factors used for production – represented by the iso-cost line.
Iso-Cost Line
An iso-cost line shows the various combinations of two factors that a firm can buy with a given outlay.

●​ On the X-axis we measure units of labour.

●​ On the Y-axis we measure units of capital.

We assume:

●​ Prices of factors are given and constant for the firm.

●​ The firm operates under perfect competition in
factor markets.

Example:

Suppose the firm has an outlay of Rs. 300,

●​ Price of labour = Rs. 4 per labour hour

●​ Price of capital = Rs. 5 per machine hour

Then, with Rs. 300:

●​ If the firm spends all on labour → it buys 75 units

(OB).
●​ If the firm spends all on capital → it buys 60 units (OA).

Thus, the straight line AB joining A and B represents all combinations of labour and capital the firm can
buy with Rs. 300.

Hence, an iso-cost line is the locus of all combinations of factors that a firm can purchase with a
constant outlay.​
It is also called the price line or outlay line.

Equation of the Iso-Cost Line

The total cost of production is the sum of payments to labour and capital:

C=wL+rK

Where:

●​ C = total cost (outlay)

●​ w = wage rate (price of labour)
●​ L = quantity of labour
●​ r = price of capital
●​ K = quantity of capital

Rearranging in intercept-slope form:

 ●​ Intercept on Y-axis =

●​ Slope of iso-cost line =

Slope of the Iso-Cost Line

The slope represents the factor price ratio:

Slope=

●​ Vertical intercept (OA) = C/r → quantity of capital if entire outlay spent on capital.
●​ Horizontal intercept (OB) = w/r → quantity of labour if entire outlay spent on labour.

Thus,

Slope of iso-cost line=

Shifts in the Iso-Cost Line

1. Change in the Total Outlay of the Firm

●​ If the total outlay which the firm wants to spend on the factors
increases, the iso-cost line shifts outward, remaining parallel
to the original.
●​ Example:
○​ Suppose the total outlay increases from Rs. 300 to
Rs. 400, with factor prices unchanged.
○​ The firm can now buy 100 units of labour hours
(OB′) or 80 units of capital (OA′) if it spends the
entire sum on one factor.
○​ The new iso-cost line is A′B′, parallel to the original
AB.
○​ If the outlay further increases to Rs. 500, the iso-cost
line shifts again to A″B″.
Thus, a family of parallel iso-cost lines can be drawn, each representing a different level of outlay.

●​ The higher the outlay, the higher (further from the origin)
the corresponding iso-cost line.

2. Change in Factor Prices (Outlay Constant)

The iso-cost line also shifts when factor prices change, while the
outlay remains constant.

●​ Example:
○​ Suppose the firm’s outlay is Rs. 300, with labour
priced at Rs. 4 per unit and capital at Rs. 5 per
unit.
○​ The iso-cost line is AB.

Now consider two cases:

1.​ Fall in the price of labour (from Rs. 4 to Rs. 3):

○​ With Rs. 300 and labour at Rs. 3, the firm can buy 100 units of labour (OC) if it spends
the entire outlay on it.
○​ The iso-cost line shifts from AB to AC.
2.​ Rise in the price of labour (from Rs. 4 to Rs. 6):
○​ With Rs. 300 and labour at Rs. 6, the maximum labour purchase falls.
○​ The iso-cost line shifts from AB to AD.

Similarly, if the price of capital changes (outlay and labour price remaining constant), the iso-cost line
shifts accordingly.

Key Determinants of Iso-Cost Line

The position of the iso-cost line depends on:

1.​ Prices of factors of production (w, r).

2.​ Total outlay (C).

Least-Cost Combination of Factors: Choice of

Inputs
An isoquant map represents the different combinations of two factors (labour and capital) that yield the
same level of output.​
A family of iso-cost lines represents the different levels of outlay (total cost) given factor prices.

The producer’s problem can be of two types:

 1.​ Cost minimization for a given level of output.
2.​ Output maximization for a given level of outlay.

1. Iso-Cost and Producer’s Equilibrium (Cost Minimization)

To produce a given level of output, the entrepreneur will choose
the combination of inputs that minimizes cost. Only then can he
maximize profit.

●​ Suppose the entrepreneur wants to produce 500 units of

output, represented by isoquant Q.
●​ This output (500 units) can be produced by several
combinations of labour and capital such as R, S, E, T, J,
lying on the isoquant.
●​ But the least-cost combination is at point E, where the
isoquant Q is tangent to the iso-cost line CD.

Why point E?

●​ At point E, the iso-cost line just touches the isoquant,

meaning this is the minimum cost needed to produce
500 units.
●​ Other points (R, S, T, J) on the isoquant Q lie on higher iso-cost lines, implying greater cost for
the same output.
●​ Thus, E is the optimum combination of labour and capital for producing 500 units.

Therefore, the producer will choose OM units of labour and ON units of capital (combination E).

2. Output Maximization for a Given Outlay

Now consider the opposite problem: the firm fixes a total outlay and seeks to maximize output.

●​ Suppose the firm fixes an outlay of Rs. 5000, represented

by iso-cost line AB.
●​ The firm can choose any combination of labour and capital
on line AB (such as R, S, E, T, J).

Choosing the best point:

●​ Superimpose an isoquant map (Q₁ = 200, Q₂ = 300, Q₃ =

400, Q₄ = 500).
●​ A glance at Figure 19.5 shows that factor combination E
(ON labour and OH capital) allows the firm to reach the
highest possible isoquant Q₃ (400 units) with the given
outlay.
 ●​ Other combinations (R, S, T, J) lie on lower isoquants and yield less output.

Therefore, for an outlay of Rs. 5000, the firm maximizes output by choosing factor combination E.

Summary
●​ Least-Cost Combination: Tangency between isoquant and iso-cost line → minimum cost for a
given output.
●​ Output Maximization: Tangency between isoquant and iso-cost line → maximum output for a
given cost.

Both conditions describe producer’s equilibrium, where the firm achieves efficiency in input choice.

Internal & External Economies of Scale

Meaning of Economies of Scale
●​ When increasing the scale of production (expanding output) leads to a more than
proportionate increase in output, the firm experiences economies of scale.
●​ In simple terms: producing on a large scale makes average (per unit) costs go down.
●​ These are long-run advantages of increasing size.

Economies of scale are of two main types:

1.​ Internal Economies – Benefits a firm gets by growing in size, independent of other firms.
2.​ External Economies – Benefits a firm gets when the whole industry grows, regardless of its
own size.

1. Internal Economies of Scale

These arise from within the firm itself when it expands production. They can be divided into:

(A) Plant Economies

These are benefits from expanding individual workplaces like factories or offices.

1.​ Increased Specialization

○​ Bigger firms can divide work into smaller, specialized tasks.
○​ Workers and machines become more efficient.
○​ Example: Large supermarkets use electronic fund transfer at checkout.
2.​ Indivisibility
○​ Some equipment works efficiently only at a certain minimum size (e.g., blast furnaces,
nuclear stations, car assembly lines).
○​ Small firms can’t use them fully, so costs remain high.
 3.​ Increased Dimensions (Cube Law)
○​ Doubling the length, width, and height of a cube increases surface area 4x but volume
8x.
○​ Example:
■​ A 240,000-tonne oil tanker is only twice as big in size as a 30,000-tonne tanker
but carries 8 times more oil at much lower cost.
■​ Jumbo jets carry far more passengers at lower cost than smaller planes.
4.​ Principle of Multiples
○​ Many industries need a balanced set of machines.
○​ Example:
■​ Machines A, B, C, D with capacities 50, 60, 20, and 30 units/hour.
■​ Output is limited to the slowest machine (20 units/hour).
■​ To fully utilize all machines, a balanced team producing 300 units/hour is needed.
■​ Hence, production must expand in multiples (300, 600, 900, etc.) to maintain
efficiency.
5.​ By-product Economies
○​ Large firms can sell or reuse waste products.
○​ Examples:
■​ Large stables sell manure.
■​ Oil refineries sell extracted chemicals.
■​ Tupperware became profitable as a by-product.
6.​ Economies of Linked Processes
○​ Large plants can produce multiple products together.
○​ Example: A steel plant may produce both iron and steel.
7.​ Stock Economies
○​ Large firms need relatively smaller stocks compared to sales.
○​ Customer demand fluctuations balance out across a large market.

(B) Firm Economies

These benefits arise when the whole firm grows (not just one factory).

1.​ Marketing Economies

○​ Large firms buy raw materials in bulk → lower prices.
○​ They can demand better quality and delivery terms.
○​ Example: Suppliers prefer large orders (1000 units) instead of many small ones.
○​ They can also afford expert buyers, reducing wasteful purchases.
○​ Selling costs per unit fall:
■​ Packing 100 articles in one box is cheaper than packing 10 separate boxes.
■​ Clerical/administrative costs per unit fall with larger orders.
■​ Advertising costs per unit are lower even if total spending is high.
2.​ Financial Economies
○​ Large firms are more creditworthy → can borrow at lower interest.
○​ They have access to more financial sources:
■​ Banks, financial institutions, issuing shares/debentures.
○​ Borrowing in bulk also reduces cost (like bulk buying raw materials).
3.​ Research and Development Economies
 ○​ Large firms can afford research departments.
○​ For small firms, R&D cost may be too high compared to output.
○​ For big firms, R&D cost per unit is small.
4.​ Managerial Economies
○​ Large firms can employ specialist staff (accountants, lawyers, HR, etc.).
○​ Small firms can’t keep them fully occupied, so they rely on generalists.
5.​ Risk-bearing Economies
○​ Large firms are better at handling risks due to:
■​ Law of averages – spreading risks across large operations.
■​ Diversification – producing multiple models/products reduces danger if demand
for one falls.
6.​ Plant Specialisation Economies
○​ Large firms can assign plants to different products.
○​ Example: A vehicle company may have separate plants for buses, cars, and trucks.
7.​ Staff Facilities Economies
○​ Large firms can provide canteens, sports grounds, medical care, etc.
○​ Since costs are spread over many employees, per-head cost is low.
○​ Example: Marks & Spencer offers many staff benefits.

The main internal economies of scale are shown in Figure below.

Diseconomies of Scale
1. Management Problems
As firms grow, managing them becomes more complex. Management must handle:

●​ Coordination​
Large firms need many specialized departments (production, sales, HR, finance, etc.).
Coordinating these departments becomes harder as the number grows.
●​ Control​
Management involves decision-making and making sure decisions are carried out. Large firms
have long chains of authority (managing director → director → head of division → head of
department → foreman). Ensuring that every worker is doing their job properly becomes a
difficult task.
●​ Communication​
Communication must flow both ways. Orders go down, but feedback from workers must also go
up. Lateral communication (between departments) is also needed so that everyone knows what
others are doing. In large firms, this process becomes slow and complicated.
●​ Morale​
The bigger the workforce, the harder it is to maintain morale. Workers often feel unimportant in
a huge organization and may lose identification with the firm. This can lead to apathy or even
hostility. Industrial relations are usually worse in large firms than in small ones.

2. Prices of Inputs

As firms expand, they demand more labour, materials, energy, and transport. Sometimes, supplies
are limited (e.g., skilled labour or scarce minerals). When demand increases, firms may end up bidding
up the prices of these inputs, which increases costs.

External Economies of Scale

These are the benefits that a firm gains because the industry as a whole grows, regardless of its own
size. Even small firms can benefit. These advantages are especially strong when industries are
concentrated in one area (called economies of concentration).

1. Labour

When many similar firms cluster in one area, a skilled local labour force develops. Local colleges also
design training courses for that industry (e.g., tourism courses in Cornwall and Devon, horse-related
studies in Witney).

2. Ancillary Services

Supporting industries grow to serve the main industry.

●​ Example: In Newmarket (horse racing center), there are feed suppliers, vets specializing in
horses, and blacksmiths.
●​ Even in dispersed industries, ancillary services develop. Example: Fertilizer industry supports
farmers everywhere.
3. Disintegration

In localized industries, firms often specialize in one process instead of doing everything. Example: In
Lancashire’s cotton industry, separate firms handle spinning, weaving, dyeing, and finishing.

4. Cooperation

Firms in the same region often cooperate.

●​ They may set up joint research centers (e.g., pottery in Stoke-on-Trent, footwear in East
Midlands, cotton in Lancashire).
●​ Local trade societies, journals, and informal contacts also grow more easily.

5. Commercial Facilities

Service industries in concentrated areas adapt to industry needs:

●​ Banks and insurance companies provide special services.

●​ Transport firms design specialized vehicles/containers.
●​ Better infrastructure (roads, airports) is often developed.​
All firms benefit, not because they are large, but because the industry creates demand.

6. Specialised Markets

Large industries can develop specialized markets and meeting places for buyers and sellers. Example:
Lloyd’s of London.

External Diseconomies of Scale

Just as industries create external economies, they can also create external diseconomies when they
grow too large.

●​ Labour shortages may occur, forcing firms to bid up wages.

●​ Raw material demand may push up prices.
●​ Land costs rise in concentrated areas, making expansion more expensive.
●​ Transport congestion increases, raising costs further.