UNIT-1

Economic is a study about how individuals, businesses and governments make choices on

allocating resources to satisfy their needs. These groups determine how the resources are

organised and coordinated to achieve maximum output. They are mostly concerned with the

production, distribution and consumption of goods and services.

Economics is divided into two important sections, which are: Macroeconomics & Microeconomics

Macroeconomics deals with the behaviour of the aggregate economy and Microeconomics focuses

on individual consumers and businesses.

What is Microeconomics?

Microeconomics is the study of decisions made by people and businesses regarding the allocation

of resources and prices of goods and services. The government decides the regulation for

taxes. Microeconomics focuses on the supply that determines the price level of the economy.

It uses the bottom-up strategy to analyse the economy. In other words, microeconomics tries to

understand human’s choices and allocation of resources. It does not decide what are the changes

taking place in the market, instead, it explains why there are changes happening in the market.

The key role of microeconomics is to examine how a company could maximise its production and

capacity, so that it could lower the prices and compete in its industry. A lot of microeconomics

information can be obtained from the financial statements.

The key factors of microeconomics are as follows:

 Demand, supply, and equilibrium

 Production theory
 Costs of production
 Labour economics

Microeconomics Macroeconomics

                                                                             Meaning

Microeconomics is the branch of Economics that is Macroeconomics is the branch of Economics that deals
related to the study of individual, household and firm’s the study of the behaviour and performance of the econ
behaviour in decision making and allocation of the in total. The most important factors studied in
resources. It comprises markets of goods and services macroeconomics involve gross domestic product (GDP
and deals with economic issues. unemployment, inflation and growth rate etc.

                                                                         Area of study
Microeconomics studies the particular market segment Macroeconomics studies the whole economy, that cove
of the economy several market segments

                                                                             Deals with

Macroeconomics deals with various issues like nationa

Microeconomics deals with various issues like demand,
income, distribution, employment, general price level,
supply, factor pricing, product pricing, economic
money, and more.
welfare, production, consumption, and more.

                                                          Business Application
It is applied to internal issues. It is applied to environmental and external issues.

   

                                                                                 Scope
It covers several issues like demand, supply, factor
It covers several issues like distribution, national incom
pricing, product pricing, economic welfare, production,
employment, money, general price level, and more.
consumption, and more.

                                                                              Significance

It is useful in regulating the prices of a product It perpetuates firmness in the broad price level, and
alongside the prices of factors of production (labour, solves the major issues of the economy like deflation,
land, entrepreneur, capital, and more) within the inflation, rising prices (reflation), unemployment, and
economy. poverty as a whole.

                                                                             Limitations

It has been scrutinised that the misconception of

It is based on impractical presuppositions, i.e., in
composition’ incorporates, which sometimes fails to
microeconomics, it is presumed that there is full
prove accurate because it is feasible that what is true f
employment in the community, which is not at all
aggregate (comprehensive) may not be true for
feasible.
individuals as well.

Examples: Individual demand, and price of a product.

What is Macroeconomics?

Macroeconomics is a branch of economics that depicts a substantial picture. It scrutinises itself with

the economy at a massive scale, and several issues of an economy are considered. The issues

confronted by an economy and the headway that it makes are measured and apprehended as a

part and parcel of macroeconomics.

Macroeconomics studies the association between various countries regarding how the policies of

one nation have an upshot on the other. It circumscribes within its scope, analysing the success

and failure of the government strategies.

In macroeconomics, we normally survey the association of the nation’s total manufacture and the

degree of employment with certain features like cost prices, wage rates, rates of interest, profits,

etc., by concentrating on a single imaginary good and what happens to it.

The important concepts covered under macroeconomics are as follows:

1. Capitalist nation
2. Investment expenditure
3. Revenue

Examples: Aggregate demand, and national income.

Importance of Microeconomics

Following are the importance / Use / Roles of Microeconomics.

1. Helpful to understand the working of the economy:

Microeconomics is very useful to study how on who economy functions. Hence, it tells us how
millions of consumers and producers make decisions about the allocation of resources among
goods and services. Similarly, Who to produce, how much to produce, how to produce, etc.

2. Formulation of economic policy

Microeconomic tools are useful in designing price policies, taxation policies, investment policies,
etc. Similarly, it also helps to formulate sectoral policies such as tourism, trade, industry, and
others.

3. Helpful in efficient allocation of resources.

Microeconomics explains how maximum social welfare can be achieved. According to
microeconomics, maximum social welfare is achieved through efficiency in consumption,
production, and distribution. Therefore, Maximum allocation of resources results in maximum
production without waste of resources.

4. Helpful in the study of Human Behaviours

Microeconomics studies many forms of human behaviors with the help of the law of diminishing,
marginal utility, equilibrium utility, indifference curve, etc.

5. Solution of Contemporary economic problems

Microeconomics is also used in practical aspects of economics such as public finance, international
trade, etc. Hence, it can be used to solve contemporary problems such as issues faced by
consumers, and the effects of government while formulating sectorial policies.

6. Helpful in Decision making

Microeconomics is also helpful in business decision-making. Hence, it helps business executives in

making productions plan and taking decisions. Similarly, it also helps business firms to take
decisions regarding their production and pricing.

7. Useful in international trade

Microeconomics is also useful and helpful to estimate the benefits of international trade. Similarly, it
also helps in the determination of foreign exchange rates.

The microeconomic deals with individual economic variables and there are three types of such
analysis as given below;

1. Micro Static Analysis

It is that part of the microeconomic analysis in which an equilibrium point of microeconomic

variables is attained at a given point in time as shown in the following diagram.

types of microeconomics

The graph/diagram clearly indicates that at point E there is a microstatic point where EQ is the price
and OQ is the quantity demanded and supplied.

2. Micro Comparative Static Analysis

It deals with the comparison of two micro static points of two different points in time.

The following diagram/graph shows:

types of microeconomics

The micro comparative static analysis where E and E1 points are comparative points under the
micro static analysis showing EQ and E1Q1 prices and OQ and OQ1 quantity demanded and
supplied with supply curve (SS) and original demand curve (DD) with the change in the demand
curve (D1D1).

3. Micro Dynamic Analysis

This type of microeconomic analysis explains the process of change between an initial or original

equilibrium and a new equilibrium.

types of microeconomics
 The graph or diagram shows that the initial or original equilibrium was at point E was EQ was the
price and quantity demanded and supplied.

The new equilibrium is at point E1 where the new demand curve is D1D1 and the price is E1Q1
while the demand and supply are OQ1.

The change in the equilibrium from E to E1 is not a sudden change. But the process of change has
been caused by several variables.

Types of Microeconomics:

1. Consumer Economics: Consumer economics examines the decision-making process of individual

consumers and their behavior in the market. It analyzes how consumers allocate their income
among different goods and services, their preferences, and the factors that influence their choices,
such as prices, income levels, and advertising.
2. Producer Economics: Producer economics, also known as the theory of the firm, focuses on the
behavior and decision-making of individual producers or firms. It studies how firms make production
decisions, choose input combinations, and maximize their profits by considering factors like costs,
technology, market conditions, and competition.
3. Market Economics: Market economics analyzes the interaction between buyers and sellers in
various market structures. It studies the forces of supply and demand, price determination, market
equilibrium, and the effects of market interventions such as taxes, subsidies, and regulations.
Market economics also examines market failures and the role of government in correcting them.
4. Welfare Economics: Welfare economics evaluates the efficiency and equity of economic outcomes.
It examines how resources are allocated and whether the distribution of goods and services
maximizes social welfare. Welfare economists study concepts like consumer surplus, producer
surplus, efficiency, and equity to assess the overall welfare implications of economic policies and
interventions.
5. Labor Economics: Labor economics focuses on the behavior of workers, employers, and labor
markets. It analyzes factors such as wages, employment levels, labor supply and demand, human
capital investments, and the impact of labor market policies on employment and income distribution.
6. Public Economics: Public economics examines the role of government in the economy. It studies
how governments make decisions regarding public spending, taxation, and the provision of public
goods and services. Public economics also analyzes the effects of government policies on resource
allocation, income redistribution, and market outcomes.
micro economics model: concepts, assumptions and application
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Microeconomic models are simplified representations of economic behavior that help economists
understand and analyze the decision-making processes of individuals, firms, and markets. These
models are built upon certain concepts and assumptions to provide a framework for studying
economic phenomena. Here are some key elements of microeconomic models:

Concepts:

1. Demand and Supply: The concepts of demand and supply form the foundation of microeconomics.
Demand refers to the quantity of a good or service that consumers are willing and able to purchase
at different prices. Supply represents the quantity of a good or service that producers are willing and
able to offer at various prices. The interaction between demand and supply determines the
equilibrium price and quantity in a market.
2. Utility: Utility refers to the satisfaction or value that individuals derive from consuming goods and
services. Microeconomic models often assume that individuals seek to maximize their utility when
making consumption choices.
3. Production and Costs: Production concepts focus on how firms transform inputs (such as labor and
capital) into outputs (goods or services). Costs associated with production, including factors like
labor, raw materials, and capital, are considered in analyzing firm behavior and output decisions.
4. Market Structures: Microeconomic models analyze different market structures, such as perfect
competition, monopoly, oligopoly, and monopolistic competition. These structures determine the
level of competition, entry barriers, pricing strategies, and market outcomes.

Assumptions:

1. Rationality: Microeconomic models often assume that individuals and firms are rational decision-
makers who aim to maximize their utility or profit. Rationality assumes that economic agents have
consistent preferences and make decisions based on available information.
2. Ceteris Paribus: Ceteris paribus, meaning "other things being equal," is a common assumption in
microeconomic models. It simplifies analysis by holding all factors constant except for the specific
variables under consideration.
3. Perfect Information: Microeconomic models often assume that individuals and firms have perfect
information about prices, product quality, and market conditions. This simplifies decision-making
processes in the models.

Applications: Microeconomic models are used in various real-world applications, including:

1. Pricing Decisions: Microeconomic models help businesses determine optimal pricing strategies
based on market conditions, costs, and demand elasticity.
2. Policy Analysis: Microeconomic models are used to analyze the effects of government policies,
such as taxes, subsidies, and regulations, on market outcomes, consumer welfare, and producer
behavior.
3. Consumer Behavior: Microeconomic models help understand consumer choices and behaviors,
such as purchasing decisions, demand for goods, and responses to price changes or advertising.
4. Market Efficiency: Microeconomic models help assess the efficiency of markets, identify market
failures, and analyze the impact of market interventions on resource allocation and social welfare.
5. Production Optimization: Microeconomic models assist firms in making production decisions,
determining the optimal input combinations, and analyzing cost structures to maximize profits.
goals of microeconomics policy
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The goals of microeconomic policy are aimed at promoting efficiency, equity, and the overall
welfare of individuals, firms, and markets at the micro level. Here are the primary goals of
microeconomic policy:

1. Allocative Efficiency: Microeconomic policy aims to achieve allocative efficiency, which means
resources are allocated in a way that maximizes overall societal welfare. Policies should strive to
ensure that goods and services are produced and distributed in quantities and at prices that reflect
consumer preferences and demand.
2. Productive Efficiency: Microeconomic policy seeks to promote productive efficiency, which involves
producing goods and services at the lowest possible cost. Policies should encourage firms to use
their resources efficiently, minimize wasteful production practices, and adopt technologies that
enhance productivity.
3. Market Competition: Microeconomic policy aims to foster and maintain competitive markets.
Competitive markets encourage efficiency, innovation, and consumer welfare by providing a level
playing field for firms and promoting lower prices, better quality, and greater choice for consumers.
Policies may focus on preventing anti-competitive behavior, enforcing antitrust laws, and removing
barriers to entry and exit.
4. Consumer Protection: Microeconomic policy aims to protect consumer interests and ensure fair and
transparent market practices. Policies may include regulations that promote consumer safety,
prevent fraud and misleading advertising, and enhance consumer rights and access to information.
5. Income Distribution: Microeconomic policy may address issues of income distribution and equity.
Policies could focus on reducing income inequality, providing social safety nets, implementing
progressive tax systems, and promoting equal opportunities for individuals to participate in
economic activities.
6. Externalities and Market Failures: Microeconomic policy aims to address market failures and
externalities—situations where the free market fails to allocate resources efficiently. Policies may
involve implementing corrective measures, such as taxes or subsidies, to internalize external costs
or benefits, ensuring that economic agents consider the full social costs and benefits of their
actions.
7. Sustainable Development: Microeconomic policy increasingly emphasizes the importance of
sustainable development. Policies may promote environmentally friendly practices, encourage the
adoption of clean technologies, and address issues related to natural resource management and
pollution control.

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The Law of Demand states that there is an inverse relationship between the price of a good or
service and the quantity demanded, ceteris paribus (all other factors remaining constant). In simple
terms, as the price of a product increases, the quantity demanded by consumers decreases, and
vice versa.

The demand function is a mathematical representation of the relationship between the price of a
good or service and the quantity demanded. It provides a quantitative expression of the demand for
a product based on its price and other factors that influence consumer behavior. The general form
of a demand function is as follows:

Qd = f(P, Y, T, Pr, A, O, E...)

Where:

 Qd represents the quantity demanded of the product.

 P denotes the price of the product.
 Y represents the income of consumers.
 T refers to the tastes and preferences of consumers.
 Pr signifies the prices of related goods (substitutes and complements).
 A represents advertising and promotional efforts.
 O denotes other factors such as consumer expectations, demographics, and cultural factors.
 E... represents additional variables that may influence demand.

The specific functional form of the demand function can vary depending on the characteristics of the
product and the preferences of consumers. Common functional forms include linear, logarithmic,
and power functions. These functions capture the relationship between price and quantity
demanded, along with the influence of other factors affecting demand.

By estimating the parameters of the demand function through empirical analysis or using economic
theory, economists can quantify the responsiveness of quantity demanded to changes in price and
other variables. This helps in predicting how changes in prices or other factors will impact the
demand for a particular good or service.

The demand function is a fundamental tool in microeconomics, as it provides a systematic way to

analyze and understand consumer behavior and market outcomes. It assists businesses in pricing
decisions, forecasting demand, and developing effective marketing strategies.
 explain with movement along a demand curve and shift demand curve with their types
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Certainly! Let's discuss movements along a demand curve and shifts of the demand curve, along
with their types.

1. Movement Along a Demand Curve: A movement along a demand curve occurs when there is a
change in the quantity demanded of a good or service in response to a change in its price, while
other factors remain constant. It illustrates the impact of price changes on quantity demanded,
assuming that other determinants of demand remain unchanged. A movement along the demand
curve does not shift the curve itself but represents a different point on the existing curve
.
 Expansion of Demand: An expansion of demand refers to an increase in the quantity demanded of
a good or service due to a decrease in its price. As the price decreases, consumers are willing and
able to purchase larger quantities of the product, resulting in a movement along the demand curve
to the right.

 Contraction of Demand: A contraction of demand refers to a decrease in the quantity demanded of

a good or service due to an increase in its price. As the price increases, consumers reduce their
purchases, leading to a movement along the demand curve to the left.

Movement of the Demand Curve

When there is a change in the quantity demanded of a particular commodity, because of a change

in price, with other factors remaining constant, there is a movement of the quantity demanded along
the same curve.

The important aspect to remember is that other factors like the consumer’s income and tastes along
with the prices of other goods, etc. remain constant and only the price of the commodity changes.

In such a scenario, the change in price affects the quantity demanded but the demand follows the
same curve as before the price changes. This is Movement of the Demand Curve. The movement can
occur either in an upward or downward direction along the demand curve.

We know that if all other factors remain constant, then an increase in the price of a commodity
decreases its demand. Also, a decrease in the price increases the demand. So, what happens to the
demand curve?
In Fig. 1 above, we can see that when the price of a commodity is OP, its demand is OM (provided
other factors are constant). Now, let’s look at the effect of an increase and decrease in price on the
demand:

 When the price increases from OP to OP”, the quantity demanded falls to OL. Also, the demand
curve moves UPWARD.

 When the price decreases from OP to OP’, the quantity demanded rises to ON. Also, the
demand curve moves DOWNWARD.

The shift of the Demand Curve

 When there is a change in the quantity demanded of a particular commodity, at each possible
price, due to a change in one or more other factors, the demand curve shifts. The important
aspect to remember is that other factors like the consumer’s income and tastes along with the
prices of other goods, etc., which were expected to remain constant, changed.
 In such a scenario, the change in price, along with a change in one/more other factors, affects
the quantity demanded. Therefore, the demand follows a different curve for every price change.
 This is the Shift of the Demand Curve. The demand curve can shift either to the left or the right,
depending on the factors affecting it.
 Let’s look at an example which captures the effect of a change in consumer’s income on the
quantity demanded.

Quantity demanded when the Quantity demanded when the

Price (Rs.) average household income is Rs. average household income is Rs.
4000 5000

5 10 (A) 15 (A1)

4 15 (B) 20 (B1)

3 20 (C) 25 (C1)

2 35 (D) 40 (D1)

1 60 (E) 65 (E1)

 The demanded quantities are plotted as demand curves DD and D’D’ as shown below:
 
 From Fig. 2 above, we can clearly see that if the income changes, then a change in price shifts
the demand curve. In this case, the shift is to the right which indicates that there is an increase
in the desire to purchase the commodity at all prices.
 Hence, we can conclude that with an increase in income the demand curve shifts to the right.
On the other hand, if the income falls, then the demand curve will shift to the left decreasing the
desire to purchase the commodity.


determinant of demand supply

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Determinants of Demand: The determinants of demand are factors that influence the quantity of a
good or service that consumers are willing and able to purchase at various price levels. These
determinants include:

1. Price of the Good or Service: The price of the product itself has an inverse relationship with
demand. Typically, as the price increases, the quantity demanded decreases, and vice versa.
2. Income: The income of consumers plays a crucial role in determining their purchasing power and,
thus, the demand for goods and services. As income increases, the demand for normal goods
tends to increase, while the demand for inferior goods may decrease.
3. Prices of Related Goods: The prices of related goods, including substitutes and complements,
impact the demand for a particular product. A rise in the price of a substitute good may lead to an
increase in demand for the original product, while a rise in the price of a complement may decrease
the demand for the original product.
4. Consumer Preferences and Tastes: Consumer preferences and tastes, influenced by factors such
as advertising, trends, cultural shifts, and individual preferences, can significantly affect the demand
for a product.
5. Expectations: Consumer expectations about future changes in price, income, or other factors can
influence present demand. For example, if consumers anticipate a future increase in the price of a
product, they may increase their current demand.
6. Demographics: Factors such as age, gender, income distribution, population size, and composition
can impact the demand for certain goods and services. Different demographic groups may have
varying preferences and needs.

Determinants of Supply: The determinants of supply are factors that influence the quantity of a good
or service that producers are willing and able to provide at different price levels. These
determinants include:

1. Price of the Good or Service: The price of the product itself has a positive relationship with supply.
As the price increases, producers are generally motivated to supply more of the product, aiming for
higher profits.
2. Input Prices: The prices of inputs required for production, such as labor, raw materials, energy, and
capital, affect the cost of production. Changes in input prices can impact the profitability of
producing a good or service, thereby influencing supply.
3. Technology: Technological advancements can enhance production efficiency, reduce costs, and
increase supply. Improved technology often leads to increased productivity and higher levels of
output.
4. Number of Sellers: The number of firms or sellers in the market can affect the overall supply. More
sellers entering the market may increase supply, while a decrease in the number of sellers can
result in decreased supply.
5. Expectations: Producer expectations about future changes in price, input costs, or market
conditions can influence present supply. If producers anticipate a future increase in prices, they
may reduce current supply to take advantage of potential higher profits in the future.
6. Government Policies and Regulations: Government policies, taxes, subsidies, and regulations can
impact the costs of production and the ability of firms to supply goods and services. Changes in
policies can affect supply conditions in various industries.

law of supply supply function with types

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Law of Supply: The law of supply states that, all else being equal, as the price of a good or service
increases, the quantity supplied by producers will also increase, and vice versa. In other words,
there is a positive relationship between price and quantity supplied. This law reflects the basic
economic principle that suppliers are generally willing to offer more of a product at higher prices, as
they can earn higher profits.

Supply Function: The supply function is a mathematical representation of the relationship between
the quantity supplied of a good or service and the factors that determine it. It is typically expressed
as an equation or formula. The general form of a supply function is:

Qs = f(P, Ps, Pc, T, N, Tc, S, E, ...)

 Where: Qs = Quantity supplied P = Price of the product Ps = Prices of inputs or factors of
production Pc = Prices of related goods (substitutes or complements) T = Technology N = Number
of firms or producers Tc = Taxes and subsidies S = State of nature (weather conditions, natural
disasters, etc.) E = Expectations of producers

The supply function takes into account various factors that influence the quantity supplied. These
factors can include input costs, production technology, market conditions, government policies, and
expectations.

Types of Supply:

1. Individual Supply: Individual supply refers to the quantity of a good or service that an individual
producer is willing and able to supply at different price levels. It represents the supply behavior of a
single producer or firm in the market.
2. Market Supply: Market supply refers to the total quantity of a good or service supplied by all
producers in a specific market at various price levels. It is derived by summing up the individual
supplies of all producers in the market.
3. Short-run Supply: Short-run supply refers to the supply of a good or service in the short run, where
some factors of production are fixed and cannot be easily changed. In the short run, producers can
adjust their output levels by varying variable inputs but cannot make significant changes to fixed
inputs, such as capital or technology.
4. Long-run Supply: Long-run supply refers to the supply of a good or service in the long run when all
factors of production can be adjusted. Producers have the flexibility to change both variable and
fixed inputs, such as expanding production facilities or adopting new technologies.

Movements and shifts in demand and supply curves

Movements and shifts
When the price of a product changes it will result in a movement along either a demand or supply
curve.

When a non-price determinant of demand or supply changes (assuming price is constant) it will
cause a shift in the position of the demand or supply curve.
 Determinants of Supply

 Price of a good: Other things remain constant when the relative price of a commodity is high, it is
supplied in great quantity, as firm produces the commodity to earn profit and the profit of the firm
increases with an increase in its price.
 Price of related goods: When the price of other goods, i.e. competing or complementary goods
rise, it becomes comparatively profitable to the firm to produce and offer the other good than the
good in question. For instance: A farmer produces two crops tea and coffee and if the price of tea
increases, then in such a situation, it will be more profitable for the farmer to produce more tea.
Therefore, the farmer may shift his resources from the coffee production to that of tea. In this way,
the supply of tea may increase and coffee will fall.
 Price of inputs: The price of factors of production (inputs), i.e. land, labor, capital, entrepreneur
also affects the supply of the commodity, in a way that if there is an increase in the price of a factor
of production, then the cost of producing a commodity which uses that particular factor in excess
will be more in comparison to the commodity, which uses the same factor in less quantity.
 State of the art technology: Innovations in the product, usually make the product better than
before, and also better than its competitors, with the limited resources which the company possess.
Thus the company will increase the supply of the products with state of the art technology and
reduce the supply of the product which is displaced.
 Taxes and subsidies: Goods and services tax is levied on goods, which increases the overall cost
of production and so the supply of the commodity will increase only when the price of the
commodity rises. Conversely, government subsidies usually decrease the cost of production and
hence it is beneficial to the firm to increase the supply of goods.
 Nature of competition: When there is a cut-throat competition between firms in the market, the
firm wants to increase their share to the maximum, for which they supply more of the commodity.
Further, when there is a new entry to the industry, it also increases the supply of the existing goods
in the market.
 Firm’s business objective: The primary objective of the firm, i.e. profit maximization or sales
maximization or the combination of the two, also influence the market supply of the commodity. So,
when the firm wants to increase the profit, it will decrease the supply of the commodity, which can
help the firm in increasing the price when there is a high demand for it. In contrast, when the firm
wants to increase its sales, it will simply raise the supply.

Elasticity of Demand

 Elasticity of Demand, on the other hand, specifically measures the effect of change in an
economic variable on the quantity demanded of a product. There are several factors that
affect the quantity demanded for a product such as the income levels of people, price of the
product, price of other products in the segment, and various others. 
  Let’s begin our blog with a definition of Elasticity of Demand and then we will explore the
different types of Elasticity of Demand. 

1. Price Elasticity of Demand (PED)

 
Any change in the price of a commodity, whether it’s a decrease or increase, affects the quantity
demanded for a product. For example, when there is a rise in the prices of ceiling fans, the quantity
demanded goes down.  
 
This measure of responsiveness of quantity demanded when there is a change in price is termed as
the Price Elasticity of Demand (PED).
 
The mathematical formula given to calculate the Price Elasticity of Demand is: 

 
  PED = % Change in Quantity Demanded % / Change in Price
 
The result obtained from this formula determines the intensity of the effect of price change on the
quantity demanded for a commodity. 
 
 
2. Income Elasticity of Demand (YED)
 
The income levels of consumers play an important role in the quantity demanded for a product. This
can be understood by looking at the difference in goods sold in the rural markets versus the goods
sold in metro cities. 
 
The Income Elasticity of Demand, also represented by YED, refers to the sensitivity of quantity
demanded for a certain good to a change in real income (the income earned by an individual after
accounting for inflation) of the consumers who buy this good, keeping all other things constant. 
 
Speaking of inflation, you can also take a look at our blog on what is inflation.
 
The formula given to calculate the Income Elasticity of Demand is given as:
 
YED = % Change in Quantity Demanded% / Change in Income 
 
The result obtained from this formula helps to determine whether a good is a necessity good or a
luxury good. 
 
 
3. Cross Elasticity of Demand (XED)
 
In a market where there is an oligopoly, multiple players compete. Thus, the quantity demanded for
a product does not only depend on itself but rather, there is an effect even when prices of other
goods change. 
 
Cross Elasticity of Demand, also represented as XED, is an economic concept that measures the
sensitiveness of quantity demanded of one good (X) when there is a change in the price of another
good (Y), and that’s why it is also referred to as Cross-Price Elasticity of Demand. 
 
The formula given to calculate the Cross Elasticity of Demand is given as: 
 
XED = (% Change in Quantity Demanded for one good (X)%) / (Change in Price of another Good
(Y))

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What is the Law of Variable Proportions?

The Law of variable proportion states that when only one production element is allowed to
increase keeping all other elements constant, the production firstly increases, then the
output will decrease and finally there will be a negative production.
This law is also known as the law of equality. According to this law when the dynamic value goes
up, it can lead to a negative product value of a third-party product.
When the dynamic factor increases while all other factors remain constant, initially the price of the
product will rise. However, in subsequent phases, there will be a decrease in output. Finally, with
additional input of dynamic factor, there will be a negative output of production.
For example, Let’s say a farmer has 1 acre of land (i.e., fixed factor) and wants to use labour
(i.e., variable factor) to improve the production of rice there. The output increased initially at an
increasing rate, then at a decreasing rate, and finally at a negative rate as he employed more and
more units of labour. The below table displays the output behaviour in this case.
TP
Fixed Factor Variable Factor (units MP
(Land) (Labour) ) (units) Phase

1 1 5 5 Phase I: Increasing Returns to a Factor

 TP
Fixed Factor Variable Factor (units MP
(Land) (Labour) ) (units) Phase

1 2 20 15

1 3 32 12

1 4 40 8 Phase II: Decreasing Returns to a Factor

1 5 40 0

1 6 35 -5 Phase III: Negative Returns to a Factor

Phase I: Increasing Returns to a Factor (TP increases at an increasing rate):

In the initial stage, each additional variable component raises the total production by an
increasing amount. This indicates that each variable’s MP rises and that TP rises at an increasing
rate.
 It occurs as a result of the initial variable input quantity being too small in comparison to the
fixed input. Due to the division of labour, efficient use of the fixed input during manufacturing
increases the productivity of the variable input.
 One labour generates 5 units, as shown in the schedule and diagram, whereas two labours
produce 20 units. It means that MP rises until it reaches its maximum point at point P, which
signifies the end of the first phase, while TP rises at an increasing rate (up to point Q).
Point of Inflexion: A point from where the slope of TP curve changes is known as point of
inflexion. Till the point of inflexion, TP increases at an increasing rate, and from this point
downwards, it increases at a diminishing rate. 
Phase II: Decreasing Returns to a Factor (TP increases at a decreasing rate):
Every extra variable in the second phase increases the output by a less and smaller amount. This
indicates that when the variable factor increases, MP decreases, and TP rises at a decreasing
rate. This stage is known as the diminishing returns to a factor.
 This occurs as a result of pressure on fixed inputs that results in a decline in variable input
productivity after a certain level of output.
 When MP is zero (point S), and TP is at its maximum (point M) at 40 units, the second phase
comes to an end.
 The second phase is highly important because a rational producer will always try to produce
during this time because MP and TP are both positive for each variable factor.
Phase III: Negative Returns to a Factor (TP falls):
The third phase shows a decline in TP due to the use of more variable factors. MP has now
become negative. As a result, this stage is referred to as negative returns to a factor.
 It occurs when the amount of variable input exceeds the fixed input by a great difference,
which causes TP to decrease.
 The third phase in the above graph begins after points S on the MP curve and M on the TP
curve.
 In the third phase, MP for each variable factor is negative. Therefore, no company would
deliberately decide to operate at this phase.

What Is an Isoquant and Its Properties?

An isoquant is a concave-shaped curve on a graph that measures output, and the trade-off
between two factors needed to keep that output constant. Among the properties of isoquants:

 An isoquant slopes downward from left to right

 The higher and more to the right an isoquant is on a graph, the higher the level of output it
represents
 Two isoquants can not intersect each other
 An isoquant is convex to its origin point
 An isoquant is oval-shaped
 What Is The Marginal Rate Of Technical Substitution (MRTS)?
 The Marginal Rate of Technical Substitution (MRTS) is an economic concept that measures
the rate at which one input can be substituted for another while keeping the level of output
constant. The purpose of the Marginal Rate of Technical Substitution is to analyze the
efficiency and optimal allocation of resources in production processes.
 

Formula

The formula for the Marginal Rate of Technical Substitution (MRTS) is:

MRTS = ΔQ/ΔL divided by ΔQ/ΔK

Where:

 MRTS is the Marginal Rate of Technical Substitution.

 ΔQ/ΔL represents the change in output (Q) divided by the change in labor (L) quantity.
 ΔQ/ΔK represents the change in output (Q) divided by the change in capital (K) quantity

product transformation curve

A graphical representation of the alternative combinations of the amounts of two goods or services
that an economy can produce by transferring resources from one good or service to the other. This
curve helps in determining what quantity of a nonessential good or a service an economy can afford
to produce without jeopardizing the required production of an essential good or service. Also called
the production possibility curve/frontier.

Properties of the Production Possibility Curve (PPC):

1. Scarcity: The PPC assumes that resources, such as labor, capital, and technology, are limited or
scarce. This scarcity means that an economy cannot produce an unlimited quantity of both goods
simultaneously.
2. Efficiency: The points on the PPC represent maximum efficiency, where an economy allocates its
resources optimally to produce a specific combination of goods. Any point inside the curve indicates
inefficiency, meaning the economy is not utilizing its resources fully.
3. Trade-offs: The PPC illustrates the concept of trade-offs. Since resources are limited, producing
more of one good requires reducing the production of another good. This trade-off is represented by
the negative slope of the PPC.
4. Opportunity Cost: The opportunity cost of producing one more unit of a good is the quantity of the
other good that must be given up. The opportunity cost is reflected in the slope of the PPC.
5. Constant vs. Increasing Opportunity Cost: The shape of the PPC can be either concave (bowed-
outward) or linear. A concave curve indicates increasing opportunity costs, meaning that the more
of one good produced, the higher the opportunity cost in terms of the other good. A linear curve
suggests a constant opportunity cost, where the trade-off remains the same regardless of the
quantities produced.
6. Unattainable Points: Points beyond the PPC represent combinations of goods that are unattainable
given the current resources and technology of the economy.
7. Economic Growth: Economic growth is represented by an outward shift of the PPC, indicating that
an economy can produce more of both goods due to an increase in resources or technological
advancements.
Producer’s Equilibrium
Economic production is the result of the output we produce by employing factors like land, labour,
capital, and entrepreneurship. It is possible to determine the optimum amount of production possible
considering different combinations of these inputs. Such a determination is called the producer’s
equilibrium.

Producer’s Equilibrium

The value of all assets used for production is limited. Hence, the producer has to use such a
combination of inputs as would provide him with maximum output and profits. This optimum level of
production, also called producer’s equilibrium, is achieved when maximum output is derived from
minimum costs.

In order to achieve this, producers first have to classify their resources into different combinations.
Each combination would provide production in different quantities. The combination that provides the
highest amount of produce at the least amount of costs is the optimum level of production.

What is the Production Function?

The production function of an organization or enterprise is an association between inputs
used and the utmost amount of outputs that can be manufactured. In other words, the
production function is the relationship that shows the relationship between inputs and outputs for
any given amount of inputs invested and the maximum amount of outputs obtained in the
production process.
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profit

Economic Profit is defined as the difference between total revenue and total cost of inputs.
Revenue is the amount derived from the sale of goods or the delivery services .

For example, assume a company needs to make significant changes in their business
model in order to survive in the market and beat the competition. After a review of their
business model, the manager suggests that the company can survive if it adopts either of
two feasible options: cost-cutting or the introduction of new product lines.

profit refers to the financial gain or advantage that a business or individual acquires after deducting
all expenses and costs from the total revenue generated. It is a measure of profitability and reflects
the surplus money earned by a business or an individual beyond the costs incurred in conducting
their operations.

Profit can be calculated at different levels, including gross profit, operating profit, and net profit.
Here's a brief explanation of each:

1. Gross profit: It is calculated by subtracting the cost of goods sold (COGS) from total revenue. Gross
profit indicates the profitability of a company's core operations before considering other expenses
like operating expenses, taxes, and interest.
2. Operating profit: Also known as operating income or operating earnings, it is derived by deducting
operating expenses (including salaries, rent, utilities, marketing costs, etc.) from gross profit.
Operating profit reflects the profitability of a company's primary business activities.
3. Net profit: Net profit is the final measure of profitability and represents the amount left after
subtracting all expenses, including operating expenses, taxes, interest, and other non-operating
costs, from the total revenue. It provides a comprehensive view of the overall profitability of a
business.

Dynamic Theory of Profit

The Dynamic Theory of Profit is associated with the name of an American Economist J. B. Clark.
In the world of reality, according to J. B. Clark profit arises only in a dynamic economy.

An economy is said to be dynamic when there is a change in the population growth or change in the
method of production or a change in the consumer’s wants etc. A society which is without these
changes is called a static society. In static society only monopoly profits continue to exist. All other
economic profits are gradually eliminated by competition.

In a dynamic society an entrepreneur is always confronted with continuous unpredictable changes

in demand for his product. The variation in demand may take place due to change in fashions,
tastes, standard of living, distribution of income, population, new inventions, international
repercussions and technological advances etc. A prudent entrepreneur will always keep an eye on
future demand for his products. If he succeeds in increasing his sales by lowering the cost of
production or by adopting an innovation, then he can secure profits. 

Thus we find that profits are reward of progress. Schumpeter calls it reward of innovation. In
dynamic economy, if an entrepreneur produces a new thing and creates demand for his products,
then he is likely to obtain big profits. But profits of the entrepreneur can not continue to exist for long
period. The other entrepreneurs also adopt innovation and produce similar products. A total output
increases, the profits gradually comedown. Thus we find that perpetual profits are the result of
perpetual successful innovations.

Criticism

Professor Knight has criticized the Clarkian theory of profit on the ground that it is wrong to attribute
all profits to dynamic changes. According to him, there are certain changes which are of a recurring
and calculable nature. They can be anticipated and the output can be adjusted according to that.
The profits do not arise on those regular changes but on those which are unforeseen or
unpredictable. He thus observes that “It is not dynamic changes, not only changes as such which
cause profits but the divergence of actual conditions from those which have been expected and on
the basis of which business arrangements have been made.”

Advantages

 The dynamic theory of profit is more realistic than the static theory of profit. This is because
it takes into account the fact that economies are constantly changing and evolving.

 The dynamic theory of profit can help to explain why some businesses are more successful
than others. This is because it takes into account the role of innovation, entrepreneurship,
and risk-taking in economic growth.

 The dynamic theory of profit can help to guide economic policy. This is because it can help
policymakers to understand the factors that contribute to economic growth and how to
promote these factors.
 Disadvantages

 The dynamic theory of profit is more complex than the static theory of profit. This can make
it difficult to understand and apply.

 The dynamic theory of profit is based on a number of assumptions that may not be accurate.
For example, it assumes that businesses are always willing to take risks and innovate.

 The dynamic theory of profit does not take into account all of the factors that can affect
economic growth. For example, it does not take into account the role of government policy
or the natural environment.

innovation theory of profit,

The innovation theory of profit, also known as the Schumpeterian theory of profit, is an economic
theory developed by the economist Joseph Schumpeter. It focuses on the role of innovation and
technological progress in generating profits for firms and driving economic growth. According to this
theory, profit is primarily derived from successful innovations rather than from static market
conditions or competitive forces alone.

Key elements of the innovation theory of profit include:

1. Entrepreneurship: Schumpeter emphasizes the role of entrepreneurs as drivers of innovation and

profit. Entrepreneurs are individuals who introduce new ideas, products, processes, or business
models into the market. They take risks and invest resources in pursuing innovative ventures.
2. Creative Destruction: Schumpeter's theory emphasizes the concept of creative destruction,
whereby new innovations disrupt existing industries and markets, replacing old products and
processes with new and more efficient ones. This process of creative destruction creates
opportunities for entrepreneurial firms to earn significant profits.
3. Technological Progress: The innovation theory of profit highlights the importance of technological
progress as a key driver of innovation and profit. Technological advancements enable firms to
introduce new and improved products, lower production costs, enhance efficiency, or create entirely
new markets.
4. Monopoly Power: The theory suggests that successful innovators can enjoy temporary monopoly
power and earn above-average profits as a result. When firms introduce truly groundbreaking
innovations, they may gain a competitive advantage and capture a significant market share,
allowing them to set higher prices and earn substantial profits until competitors catch up or new
innovations emerge.
5. Entrepreneurial Profits and Risk: Schumpeter argues that the pursuit of innovation and
entrepreneurship involves taking risks. Not all entrepreneurial ventures will succeed, and some may
even result in losses. However, successful innovations that generate profits compensate for the
risks and uncertainties associated with entrepreneurial activities.

Explain Modern Theory of Rent

The modern theory of rent is an amplified and modified form of Ricardian theory. This theory was
explained by Mrs Robinson Marshall, William Stanley Jevons, etc. According to Modern
Economists, rent is a surplus that is not related to land alone, it can be part of the income of labour,
capital and entrepreneur also.
According to Modern Economists, “Rent is the difference between actual earning and
transfer earning of a factor.”

Rent = Actual Earning – Transfer Earning

Actual Earning: It is that earning which is a factor gets in its present occupation.
Transfer Earning: Transfer earning of a factor is that part of its income which it could get in its next
best alternative use. Thus, it is the earning which must be paid to a factor to keep it in its present
use.
Determination of Rent
According to the modern theory of rent, rent is determined where the demand for factor equals the
supply of factor. Modern economists define rent in two ways:

1. It is a payment for the use of land only.

2. It is a surplus or difference between actual earning and transfers earning.
1. Determination of Rent of Land:
Rent is the payment for the use of land. According to the modern economist, rent arises due to
scarcity of land. It is determined by the demand and the supply of land.

 Demand for Land

 Supply of Land
i. Demand for Land
The demand for land is derived from the demand. It means that demand for land depends upon
agricultural products, e.g., if the population increases, the demand for food will increase, resulting in
increased demand for land and vice-versa. Demand for land is influenced by its marginal
productivity. That is why the demand curve DD as shown in fig. slopes downward from left to right.

ii. Supply of Land

The supply of land is fixed for an economy. It is perfectly inelastic; it means its supply is
independent of what it earns. Rent is determined at an appointment where the demand curve of
land and supply curve of land intersects each other.

Supply of Land.
In the figure, DD is the demand curve and SS is the supply curve. E is the point of equilibrium. In
this position, OR is rent. If the demand for land increases, the demand curve shifts upwards and
becomes D1D1, then the new equilibrium will be E1 and therefore, rent will rise to OR1. If demand
decreases DD to D2D2, then the new equilibrium point will be E2 and at this, rent will fall to OR2.
Thus, rent is like the price of other goods and is determined by the equilibrium between demand for
the supply of land. Rent is paid because of the scarcity of land.

2. Rent as the difference between Actual Earning and Transfer Earning:

According to modern theory, rent arises because there is a difference between actual earning and
transfer earning. How much rent a factor of production will get, depending on its elasticity of supply?
Supply of a factor can be of three types:

 Perfectly elastic supply

 Perfectly inelastic supply
 Less elastic supply
i. Rent When the Supply of a Factor is Perfectly Elastic
The supply of a factor is perfectly elastic when at the existing rate, supply of the factor can be
increased up to any extent. Such a factor is not scary. The actual earning of this factor is equal to
transfer earning. Thus, there is no difference between actual earning and transfer earning so rent is
zero as shown in the below figure.

In this figure, units of factors are shown on OX-axis and price is on OY-axis. E is the point of
equilibrium and therefore, at OP price, ON units of factor are employed. When demand for factor
increases to D1D1, then the new equilibrium point is E1. This equilibrium point shows that when
demand for factor increases, its supply also increases. Due to this, the price factor remains the
same. In this case, nor rent arises.

Actual Earning = OPE1N1

Transfer Earning = OPE1N1
Actual Earning = Transfer Earning

Rent = OPE1N1 – OPE1N1 = Zero

ii. Rent When the Supply of Factor is Perfectly Inelastic
Supply of a factor of perfectly inelastic when increases or decreases in its demand does not affect
its supply. In this case, transfer earning if the factor is zero and whatever the actual earning it gets
is called rent as shown in the figure below.
Rent = Actual Earning (Since Transfer Earning is zero)

In this figure, SS is the supply curve and DD is the demand curve of the land. E is the point of
equilibrium. At this point, the actual earning of land is OP and transfer earning is zero and rent is
OPES. When demand for land increases to D1D1, the actual earning also increase OP to OP1 and
transfer earning zero. Thus, the entire earning of this factor is called rent.

iii. Rent When the Supply of Factor is Less Elastic

Supply of a factor is less elastic when increases in its demand id followed by less increase in its
supply. Therefore, the actual earning of the factor exceeds its transfer earning which is called rent.
It is shown with the help of this figure.

In this figure, SS is a less elastic supply curve and DD is the demand curve. E is the point of
equilibrium. At this point, the ON factor is employed at OP price. SS supply curve of factor indicates
that the minimum supply price or transfer earning is OS while its actual earning is OP. hence, rent
will be PES.

3. When the Supply of factors of production is less than perfectly elastic:

When the Supply of a factor of production is less than perfectly elastic, the Supply of the factor is
limited but not fixed. In this case, the owner of the factor will earn some portion of the economic
Rent, as the price of the factor will be determined by the market demand for the factor and the
Supply of the factor. The formula to calculate Rent in this scenario is:
Rent = Price of Factor – Opportunity Cost of Factor x (1 – Elasticity of Supply)
Where:
Price of Factor = The market price of the factor
Opportunity Cost of Factor = The cost of the next best alternative use of the factor
The elasticity of Supply = The responsiveness of the Supply of the factor to changes in the market
price of the factor
 The graph above has labor on the X-axis and price on the Y-axis. The supply curve, SS, predicts
how much of the factor will be available at different prices while still having some elasticity. When
the price is OK, the transfer earnings of the first unit of factor X are AK 1. AL represents the surplus
or rent. The other units also similarly earn extra income or rent.
The transfer earnings of each unit are less than its price, except for the final unit Kg. This means
that all units, except the final one, earn more than their transfer earnings, resulting in economic rent.
OK6EK represents the total transfer earnings and overall earnings. If we subtract the transfer
earnings, we are left with KES, the surplus or rent.
In these formulas, Rent represents the amount of economic Rent earned by the owner of the factor
of production, Price of Factor represents the market price of the factor, and Opportunity Cost of
Factor represents the cost of the next best alternative use of the factor. The elasticity of Supply
represents the responsiveness of the Supply of the factor to changes in the market price of the
factor.

Features of Modern theory of Rent:

The modern theory of Rent also referred to as the neo-classical theory of Rent, differs from other
economic theories in several significant ways:

1. Focus on scarcity: The modern theory of Rent is based on the idea that land is a scarce resource
and that its price is determined by the demand for and Supply of that land. The theory focuses on
the role scarcity plays in allocating resources in the market.
2. Concept of economic Rent: The modern theory introduces the concept of economic Rent, which
refers to the payment made for the use of a piece of land that is more than what is necessary to
bring the land into production.
3. The distinction between differential and absolute Rent: The modern theory makes a distinction
between differential Rent, which refers to the extra Rent earned due to differences in the quality or
location of a piece of land, and absolute Rent, which refers to the Rent earned simply due to the
scarcity of the land itself.
4. Emphasis on Supply and demand: Modern theory strongly emphasizes the role of Supply and
demand in determining the price of land and the allocation of resources in the market.
5. Microeconomic focus: The modern theory of Rent is a microeconomic theory that focuses on the
behaviour of individuals and firms in the market.
6. Simplifying assumptions: The modern theory of Rent is based on several simplifying
assumptions, including the assumption of perfect competition, rational behaviour, and no
government intervention, which allow for a straightforward analysis of the market economy.

Interest

interest refers to the cost or price of borrowing funds or the return earned on lending or
investing money. It is a fundamental concept in financial markets and plays a significant role
in various economic activities.

Liquidity Preference Theory

Definition: Liquidity Preference Theory implies that Interest is an economic event determined by
two factors, i.e. the Demand for Money and the Supply of Money. The great economist Lord
Keynes gave this theory for Interest rate determination.

Conventionally, classical theorists suggested that people only use the money for transaction
motives. They keep the money to meet their daily needs and acquire goods and services.

In contrast, as per Keynes, people store some cash besides spending money on necessities.
And this money is later used for investment with the motive to earn some reward.

They maintain liquid money to invest it in the capital market instruments like Bonds. He emphasized
that money is used for exchange and is also used for Saving and Investment.

According to him, people store their wealth in the form of:

 Money
 Bond
 Government Securities
 Debentures

Diagrammatic Representation of Liquidity Preference Theory

The diagram below explains the determination of interest rate with supply and demand.
Where,

 The Interest rate lies on the x-axis.

 The y-axis shows the different quantities of money.
 L is the Demand for Money curve.
 M shows the Supply of Money curve.
 E is the point where L and M intersects. It is the situation of market equilibrium.
 r1 is the determined Interest rate.

Liquidity Trap

A liquidity trap is when people prefer liquidity over investment in the capital market. Because,
there is a fall in the interest rates that makes people indifferent between cash and capital market
instruments.

People will continue to prefer liquidity until they expect an increase in interest rates. As they invest
to earn a specific reward on their principal amount.

Liquidity Trap- Theory of Liquidity Preference

According to Keynes, there comes a situation when the interest rates are considerably low. Here,
people prefer absolute liquidity in place of investment in Bonds.

The people prefer absolute liquidity to hold money and invest at increasing interest rates in the
future.

Here,

 The money demand becomes perfectly elastic.

 The interest rates cannot be decreased further by increasing the money supply.
 The monetary policy turns out as ineffective.
 It is a situation of severe economic depression.

The liquidity trap is an excellent contribution to economics by Lord Keynes in this theory.

Graphical representation of Liquidity Trap:

 The loanable funds model explains the determination of interest rates through the relationship
between supply and demand for loanable funds in an economy. In this model, the supply of funds
comes from savings, while the demand for funds comes from investment opportunities.

In essence, the loanable funds theory explains how lenders and borrowers interact to determine the
equilibrium interest rate, which is the rate at which the quantity of funds supplied equals the quantity
of funds demanded.

According to Loanable Funds Theory, the interest rate in an economy is determined by

1. Demand for Loanable Funds

2. Supply of Loanable Funds

Loanable Funds
The funds available with banks for lending and borrowing are called "loanable funds."

1. Demand for Loanable Funds

The willingness and ability of borrowers to get loans is called the demand for loanable funds.

Households, firms, and the government demand loanable funds.

 Households demand loanable funds for expensive purchases, e.g., houses, cars, etc. This demand
for loanable funds is interest-elastic.
 Firms demand loanable funds for investment. This demand for loanable funds is also interest-
elastic.
 The government demands loanable funds to finance its budget deficit. This demand for loanable
funds is interest-inelastic.

There is a negative or inverse relationship between the quantity demanded of loanable funds and
the interest rate as shown in the following graph of the demand curve.
 A graph illustrating the downward sloping demand curve of loanable funds.

Factors Affecting the Demand for Loanable Funds

The demand for loanable funds is affected by various factors, including the level of economic
growth, the state of consumer confidence, and the availability of alternative sources of financing,
such as equity markets.

2. Supply of Loanable Funds

The willingness and ability of banks (lenders) to give loans is called the supply of loanable funds.

Banks supply loanable funds from the amounts deposited by households and firms.

 As savers, the households save money in banks.

 Firms keep their excessive profits and capital in banks.

There is a positive, or direct, relationship between the quantity supplied of loanable funds and
interest rate as shown in the following graph of the supply curve.

v
A graph illustrating the upward sloping supply curve of loanable funds.

Factors Affecting the Supply of Loanable Funds

The supply of loanable funds is primarily influenced by two key factors: the willingness of
households to save and the level of government borrowing. When households are more willing to
save, the supply of loanable funds increases, and interest rates decrease. Conversely, when the
government borrows more money, the supply of loanable funds decreases, and interest rates
increase.
What is wage differential?

It’s the discrepancy in earnings between similarly skilled workers within various industries or
locations. It also applies to the pay difference between various levels of experienced workers in the
same industry or locations.
Factors affecting wage differentials

There are five major factors that affect the level of pay among groups:

 Occupational: These are roles that’ll need employees with diverse skills within an
organisation. The roles, responsibilities and skill set of all staff members will differ. So, it’s
only right that the difference in skill is also reflected in their pay.

The variance in occupational pay can act as a motivator for your staff. It encourages them to
undertake more challenging jobs or seek education and training to develop their abilities.

 Regional: This alteration occurs when employees work in similar roles but at alternate
locations. The most common factor that impact regional wage differential is the difference
in the cost of living.

For example, an HR specialist in London might receive a way more than an HR specialist in
Manchester with the same skill set and level of experience.

 Personal: Differences in pay also occurs on a personal level. Staff members with similar
skills might receive different salary offers in the same organisation. This could be
because although they have the same qualification, they might have acquired dissimilar
levels of skills. The personal wage differential is more likely to happen if you adopt a skill-
based pay system.

 Organisational: On this level, businesses offer different salaries to workers with similar

backgrounds. It involves similar industries and geographical locations.

Causes include:

 Organisational policies.
 Quality of labour.
 Available technology.
 Financial capability.
 Company size.
 unit-10

General Equilibrium Theory Explained

General equilibrium definition refers to a theory explaining how demand and supply become equal
in an economy with various markets working simultaneously. It tries to explain how price, demand,
and supply work in an economy, not in a particular or single market.

The concept links cause and effect sequences of the alterations in prices and quantities of products
and services concerning the entire economy. The theory holds only if all prices are in equilibrium. In
other words, every consumer must spend their income in a way that yields maximum satisfaction.
The demand and supply of factors of production must balance each other at equilibrium prices.
Moreover, all firms in every industry must be in equilibrium at all output levels and prices.

Diagram

Let us look at a diagrammatic representation of general equilibrium.

As one can observe from the above figure, at price and output levels P1 and Q1, demand and supply
balance each other, and general equilibrium exists.

Example

Let us look at a general equilibrium example to understand the concept better.

Suppose there are two sectors only in A’s economy — business and household. The nation’s
economic activity involves products, services, and money flowing between these two sectors.
Consumers buy products and services in the goods market, and producers receive money from
them in the factor market.

In other words, consumers pay producers for purchasing their offerings. In return, producers pay
consumers for the services provided to the business, the wages paid for labor, etc. Hence, there is
a circular flow of payments between consumers and producers. That said, products and services
flow in the opposite direction. Products flow to the household sector from the business sector, and
services flow to the business sector from the household sector. Factor and product prices link these
two flows.

An economy is in general equilibrium when the volume of income flow from the producers to
consumers balances the volume of expenditures from the consumers to producers at certain prices.

General Equilibrium vs Partial Equilibrium

There are two approaches to the study of equilibrium — partial and general. Both concepts have
crucial contributions to economic analysis. Hence, individuals must have a clear idea of the
differences between them. Let us look at them.

General Equilibrium Partial Equilibrium

Analyzes the economy as a whole. Analyzes single markets.

The impact of several variables is taken into Its derivation involves considering the impact of two
account simultaneously to derive it. variables; all other variables remain constant.

Considers interdependence and the

Ignores interdependence between variables.
interrelations of many variables.

Forms the basis of macroeconomic analysis. Forms the basis of microeconomic analysis.

The theory of general equilibrium

The theory of general equilibrium is a macroeconomic theory that explains how in markets, there
is a dynamic interaction between supply and demand, which eventually culminates in a price
equilibrium. In economics, economic equilibrium is when the quantity supplied and the quantity
demanded are equal. Therefore, this theory aims to identify precisely the set of circumstances that
must be in place for the equilibrium price to be very likely to reach stability.

Graph of the equilibrium theory generates

This is a market system where the consumption of goods and services are closely related because
varying the price of one good affects the price of other goods. In that sense, the basic questions
in general equilibrium analysis concern the conditions under which equilibrium will be efficient,
what equilibria can be reached, the existence of an equilibrium guaranteed, and when the
equilibrium will be unique and stable.

Demand Vs Supply
Resource allocation is rooted in how societies seek to balance limited resources such as land and
working capital against the needs of their members through various mechanisms, the best-known
allocation mechanisms being the household, business and government.

For example, when the real price is above the equilibrium price, many producers will be
interested in offering the product, so the quantity offered will increase. Still, because prices are so
high, there will be less demand leading to excess supply.

Excess supply in general equilibrium theory

In the opposite case, when the real price is below the equilibrium price, there will be fewer
producers offering the product and more demanders willing to buy it, which will lead to excess
demand.  

social welfare function (SWF)

The social welfare function (SWF) is a sort of social indifference map consisting of the social
indifference curves (SICs). An SIC gives the various combinations of utilities of the two
individuals that comprise the society, that result in the same level of social welfare (W). To
show this diagrammatically, let us denote the utilities of the two consumers by U I and UII

The SWF then is:

W = f(UI, UII).
The SICs have been shown in Fig. 21.7. Each of them shows the different combinations of
UI and UII that give a particular level of social welfare (W). SICs are negatively sloped because
as I is made better off, II must be made worse off, to give us the same W.

If, at the initial (U I, UII) combination, both the individuals, or any one of them, are made better
off, the utility level of the other remaining the same, then that would result in a higher level of W
and the society would move to a higher SIC. In Fig. 21.7, W 2 represents a higher level of social
welfare than W 1.

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Let us note that the SICs need not be convex or concave to the origin. For there is no rule here
that as U I increases U II would fall at a diminishing or at an increasing rate. Once we formulate
the SWF and the SICs, we are well equipped to compare different policies and find out the
policies that maximise social welfare subject to the available economic resources.

But how are we to obtain, or who is to determine, the combinations of U I and UII that would give
the society the same level of welfare, or, who is to determine the combinations that would not
give the same—but a lower or higher—level of social welfare? In a dictatorship, the dictator
performs this function. Here the SWF and SICs reflect the value judgements of the dictator.

In a democracy, the value judgements must be determined collectively by the members of the
society. The individuals can express their value judgements by means of voting. But Arrow
pointed out that social welfare could not be evaluated by a democratic vote. This is known as
Arrow’s Impossibility Theorem.

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According to Arrow, the social welfare choices should be transitive, i.e., if situation A is
preferred to situation B and B is preferred to C, then A is preferred to C. Given the transitivity
assumption, let us now consider the following rankings of three policies A, B and C by three
individuals I, II and III (the lower number indicating a higher rank).

From the above rankings we obtain: Individuals I and II prefer the policy A to policy B. Thus, a
majority vote between the policies A and B will lead to the choice of A. Again I and III prefer B to
C. So a majority vote between B and C will lead to the choice of B. Thus, we obtain A is
preferred to B and B is preferred C. This would imply, because of transitivity, that A is preferred
to C.

Therefore, if transitivity holds, we obtain A is preferred to B and A is preferred to C. Therefore,

democratic vote gives us that A is the policy that should be selected. However, when we
consider A and C, we find that both II and III prefer C to A.
So, the majority vote between A and C will lead to a choice of C, and transitivity will not hold.
Thus, democratic votes lead to the choice of all the three policies, i.e., here we arrive at what is
known as the voting paradox.

The above method of voting by ranks is paradoxical and confusing, and we may come out of it,
if account is taken of the intensity of the preferences of different individuals, and a scheme of
compensation is made use of. This is actually the idea behind the compensation principle.

For example, if the consumer I and II’s preference for A is very intense and it is worth, say, Rs
1000 to each, and consumer I and Ill’s preference for B, and II and Ill’s preference for C, are not
so intense, it is worth Rs 100, say, for each of them, then certainly a compensation scheme
might be worked out and policy A might be implemented.

However, the criterion of SWF and also the Kaldor-Hicks compensation criterion based on
potential and not actual compensation, requires an assumption of omniscience on the part of
the individuals evaluating the different policies.

But such an assumption is totally unrealistic, because individual’s utilities are highly subjective,
and it is very difficult for others to evaluate them. Only actual compensation will help an
evaluation. In many instances, however, it is not clear to whom compensation is to be made.

unit-7

Monopoly Definition

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

Features of a Monopoly

After monopoly definition, let’s take a look at the features of a monopoly:

Single seller and several buyers

The primary feature of a monopoly is a single seller and several buyers. Also, in a monopoly, there is
no difference between the firm and the industry.

This is because there is only one producer and/or seller. Therefore, the firm’s demand curve is the
industry’s demand curve. Since there are several buyers, an individual buyer cannot affect the price in
a monopoly market.

No close substitute
 In a monopoly, the product that the monopolist produces has no close substitute. If a close substitute
exists, then the monopoly cannot exist.

Remember, a monopoly can only exist when the cross-elasticity of the product that the monopolist
produces is zero. Therefore, the monopolist can determine the price of his own choice and refuse to
sell below the determined price.

Strong barriers to the entry of new firms

Even if the monopolist firm is earning super-normal profits, new firms face many hurdles in trying to
enter the industry. There are many reasons for this like legal barriers, technology, or a naturally
occurring substance which others cannot find. Sometimes, the monopolist works in a small market
making it economically challenging for new firms to enter.

Types of Monopoly

The different types of monopolies are discussed as follows:

#1 – Simple monopoly

A simple monopoly charges uniform prices for its product (or service) from all the buyers. In this, the
monopolist firm usually operates in one market and its consumers are price takers.

#2 – Pure monopoly

A pure monopoly is the rarest form wherein the product (or service) being sold has no close
substitutes. Moreover, competitors are discouraged from entering the market often due to high
initial costs.

#3 – Natural monopoly

A natural monopoly depends on unique raw materials or sophisticated technology to manufacture

its products. In this, the monopolist firm utilizes its copyright and patents to prevent competition. In
addition, such firms usually provide public utilities (like electricity, gas, etc.), adhere to government
regulations, and incur high costs on research and innovation.

#4 – Legal monopoly

A legal monopoly is one wherein the monopolist firm reserves the right to manufacture a product by
way of a patent, trademark or copyright. Since the monopolist is the inventor of such a product (or
process), it is the exclusive supplier in the market. Patents allow time to firms to recover the high
costs of development and research.

#5 – Public or industrial monopoly

A public monopoly is set up by the government to supply important products and services. The
government creates such monopolies for the following reasons:

 The costs associated with production and deliveries are too high.
 The presence of a sole supplier is considered to be more reliable and beneficial for the general
public.
Public monopolies are created when the government nationalizes certain industries to serve the
interest of the people.

Characteristics

The features of a monopoly are listed as follows:

#1 – Maximizes profits

The monopolist firm aims to maximize its profits owing to no rivalry and lack of consumer choices.
This is the major reason a monopolist firm wants to continue enjoying its monopoly. The monopolist
firms strive to earn abnormal (or supernormal) profits.

#2 – Sets prices

The single manufacturer has the power to set the prices of its products or services. The monopolist
firm (price maker) may or may not charge the same price from all its consumers. The consumers
(price takers) have to accept the prices set by the firm unless the government intervenes to impose
a maximum price.

#3 – Poses high entry barriers

The new entrants have to face several challenges while trying to enter a monopolist market. Such
challenges include high startup costs, specialized technologies, high government restrictions,
complex business contracts, restricted purchase of raw materials, etc.

#4 – Lacks close substitutes

There are no products (or services) that match the offerings of the monopolist firm. The absence of
close substitutes makes the demand for monopolist products relatively inelastic. The demand is
inelastic when it does not change much with a change in the price of the product. Inelastic demand
makes it easier to make profits in the market.

#5 – Becomes the industry

The single firm, being the sole supplier, becomes synonymous with the industry. This implies that
the difference between a firm and an industry ceases to exist in the case of a monopoly.

Price and output determination under monopoly in Short-run: 

Short-run refers to that period in which a monopolist cannot change the fixed factors. However, the
monopolist is free in determining price due to lack of competition. A monopolist has control over the
market supply. So, he/ she is the price maker. His/ her price and output determination is motivated
by profit as well as sales maximization. Therefore, he/ she will adjust the output in such a way that
the marginal cost and marginal revenue are equal.
 In short run equilibrium whether the firm makes an abnormal profit, normal profit or loss, it depends
on the level of AC and AR which can be shown as follows:-

1. If AR=AC, the firm receives a normal profit.

2. If AR> AC, the firm receives abnormal profit.
3. If AR< AC, the firm bears the loss.

The following conditions must be fulfilled in order to attain equilibrium under monopoly:-
1. MR must be equal to MC
2. MC must intersect MR from below.

The equilibrium position of a monopoly firm can be graphically presented as follows:-

In the above figures, the three different possibilities of profit and loss situation in the short run under
monopoly firm are shown. These possibilities are explained as follows:-

1. Abnormal profit:-
In the first figure, we see that the equilibrium point is 'E' when MC cuts MR from below. The
equilibrium level of output is determined at OQ. The level of revenue earned is OP and the cost
incurred is OC. Since Revenue is greater than cost, the firm earns abnormal profit equal to the
shaded area (ABPC).

2. Loss:-
In the second figure, point E is the equilibrium point where MC intersects MR from below. The
equilibrium level of output is OQ. The cost incurred is OC and the revenue earned is OP. Since cost
is higher than revenue, the firm bears loss equal to the shaded area (ABCP).

3. Normal profit:-
In the third figure, we can see that the equilibrium point is at 'E' where the conditions for equilibrium
are fulfilled. The equilibrium level of output is OQ. The revenue and cost are at the same level (OP).
The firm earns just a normal profit to sustain its business in this case.
 Price and output determination under monopoly in the long run/ Long run equilibrium/
Equilibrium of a monopoly in the long run: 
Long-run is that time period in which all the fixed and variable factors of production can be altered.
The firm can change the size of plant and machinery and can determine the level of output to
maximize its profit. Because of this, the firm does not suffer loss. Likewise, the entry of new firms is
restricted somehow and the monopolist earns abnormal profit in the long run due to lack of
competition.

      The following conditions must be fulfilled to attain equilibrium under monopoly in the long run:

i) MR must be equal to LMC.

ii) LMC must intersect MR from below.
       The equilibrium of a monopoly, in the long run, can be graphically presented as follows:-

            In the above figure, LAC and LMC represent long-run average cost curve and Marginal cost
curve. AR and MR represent Average and Marginal Revenue. The equilibrium point is determined
at ‘E’ where LMC intersects MR from below. The equilibrium level of output is determined at OQ.
The cost incurred is OC and the revenue earned is OP. Since revenue is higher than cost (AR>
AC), the monopolist earns abnormal profit in the long-run.

What is Price Discrimination?

Discriminating monopoly’ or ‘price discrimination’ occurs when a monopolist charges the same
buyer different prices for the different units of a commodity, even though these units are in fact
homogeneous. Such a situation is described as “perfectly discriminating monopoly”. It is
more usual, however, to find that a monopolist sells identical products to different buyers at
different prices.

Discrimination between buyers is more usual than discrimination between units of a

homogeneous commodity. In general, it can be said that price discrimination occurs when a
producer sells a commodity to different buyers at two or more different prices for reasons not
associated with differences in costs. It may be either systematic (i.e., discrimination
systematically and persistently) or unsystematic (i.e., discrimination frequently or casually).

In the simplest case, there is one identical good going to two buyers (or groups of buyers).
Then:

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Price of buyer 1/Cost ≠ Price of buyer 2/Cost

For example, buyer 1 might be retail purchasers of a medical drug (low elasticity of demand),
while buyer 2 is a group of large hospitals (high elasticity). Cost might be Re 1 per bottle.

Price discrimination refers to a pricing strategy that charges consumers different prices for identical
goods or services.

Price discrimination is a competitive pricing strategy used by businesses and sellers. Price

discrimination involves the use of different prices charged to various customers for the same
product or service. It is commonly used by larger, established businesses to profit from differences
in supply and demand from consumers.

 Different Types of Price Discrimination

1. First Degree Price Discrimination

Also known as perfect price discrimination, first-degree price discrimination involves

charging consumers the maximum price that they are willing to pay for a good or service. Here,
consumer surplus is entirely captured by the firm. In practice, a consumer’s maximum willingness to
pay is difficult to determine. Therefore, such a pricing strategy is rarely employed. 

2. Second Degree Price Discrimination

Second-degree price discrimination involves charging consumers a different price for the amount or
quantity consumed. Examples include:

 A phone plan that charges a higher rate after a determined amount of minutes are used
 Reward cards that provide frequent shoppers with a discount on future products
 Quantity discounts for consumers that purchase a specified number of more of a certain
good 

3. Third Degree Price Discrimination

Also known as group price discrimination, third-degree price discrimination involves charging
different prices depending on a particular market segment or consumer group. It is commonly seen
in the entertainment industry.

For example, when an individual wants to see a movie, prices for the same screening are different
depending on if you are a minor, adult, or senior.
 welfare cost of monopology

The welfare cost of monopoly is measured by the area on a graph between the demand
curve and the marginal cost curve for the units that, due to monopoly output limitations, are no
longer traded. The welfare cost of monopoly signifies:

 The net gains from trade

 The difference between the marginal values of the products shown by the demand curve,
and
 The marginal cost of manufacturing those goods from goods that are no longer traded, due
to the restricted output of the monopoly

Monopolistic Competition
Monopolistic competition describes a scenario in which multiple companies compete by selling
products that are different from each other and therefore not perfect substitutes. Product
differentiation can be due to brand, product quality, location, or marketing strategy. Monopolistic
competition describes an industry in which multiple companies offer products or services that are
similar (but not perfect) substitutes.
Monopolistic competition combines elements of monopoly and perfect competition, a theoretical
market state in which companies sell similar products and have the same market share. The term
was first used in the 1930s by economists Edward Chamberlain and Joan Robinson to describe
the competition that existed between companies with similar (but not identical) products.
Characteristics of Monopolistic Competition
1. A Large number of sellers and buyers: There are a large number of buyers in the market. All
buyers have their unique preferences. These buyers are divided into selling companies based on
their preferences. For example, different companies sell shampoos to wash hair. Each company
advertises its shampoo based on its unique properties, such as a dandruff-controlling shampoo, a
root-strengthening shampoo, etc. Buyers buy these shampoos based on their needs.

2. Different prices of products: For example, a leather jacket made by the PUMA brand can
cost up to $400, while a good locally produced leather jacket can cost less than $50. Therefore, in
monopolistic competition, the same product can have different prices.
3. Seller control over the Price of the Product, but not over the Market:  A seller has control
over the price of the products produced by his company. Unlike perfect competition, he is not
required to maintain the same as other vendors. For example, the PUMA brand sells its jackets at
high prices for its brand name.
4. Product Variation: Product variation is an essential feature of monopolistic competition. For
example, different tea brands like Tata Tea, Tetley Tea, Society Tea, and Brooke Bond Taj Mahal
Tea sell tea at different prices by promoting different characteristics of the tea.
5. Freedom of Entry and Exit: Take the example of a coffee shop in a shopping mall. People
enjoy coffee as long as it provides services to people. But, if one day for some reason the owner
of the coffee shop wants to close the business. This won’t make a big deal out of the mall coffee
business. Initially, people will be surprised and soon move to another nearby coffee shop.
Therefore, the entry and exit of a firm from the trading market do not create turbulence as it does
in a monopoly market.
6. Incomplete mobility of products: This means that all products are available everywhere,
regardless of their origin. For example, in monopolistic competition, it is difficult for companies to
change the price of the product by moving it to a different location to sell it. However, companies
often move products to a perfectly competitive market.
7. Incomplete knowledge: Organizations use the lack of customer knowledge as a marketing
tool. They use advertising to convey any information about their product. The only reason is to
maximize sales by attracting more customers.
8. More elastic demand: The demand for the products varies according to the season and the
requirement. As a result, the selling company’s revenue generation is not constant and continues
to change frequently.
For example, the demand for moisturizers increases during the winter season, while the demand
for sunscreen creams increases during the summer season.
9. Advertising: Products are heavily advertised in monopolistic competition. In monopolistic
competition, the products produced by different sellers are not the same. They come in different
sizes, shapes and different prices. Therefore, sellers need to use advertising to attract customers
and promote sales of their products. Due to advertising, each selling company has a different
share of the market.
Take the example of an advertisement for bath soap. The sole function of all soaps is to lather
and cleanse your body. But the companies assure their buyers that their soaps can perform
various functions, such as moisturizing the skin, improving skin radiance, and making skin look
younger.
10. Independent decision making: In monopolistic competition, sellers have the right to make
important product decisions, such as product size, product size, product colour, and product
price, independently. For this reason, different companies in the organization sell similar products
at different prices.
For example, the price of an Apple smartphone is much higher than the price of a OnePlus
smartphone. Both smartphones serve the same basic purpose but are sold at different prices due
to their unique features.
11. Competition without a price: In monopolistic competition, there is also non-price competition
between different firms. Companies compete with each other based on brand name, features,
size, and shape of products. All of these competing features are unpriced features, and the
seller’s company advertises these features to promote sales. These are also known as imaginary
differences. There is no difference between the two products, but buyers are led to believe that
there is a difference with the help of advertising.
12. Cost of Transportation: Transportation costs play an important role in monopolistic
competition. Similar products are sold at different prices due to the cost of transportation in the
mobility of the products. The cost of transportation becomes part of the final price of the product.

What is Monopolistic Competition?

Monopolistic competition is a type of market structure where many companies are present in an
industry, and they produce similar but differentiated products. None of the companies enjoy a
monopoly, and each company operates independently without regard to the actions of other
companies. The market structure is a form of imperfect competition.

The characteristics of monopolistic competition include the following:

 The presence of many companies

 Each company produces similar but differentiated products
 Companies are not price takers
 Free entry and exit in the industry
 Companies compete based on product quality, price, and how the product is marketed

Companies in a monopolistic competition make economic profits in the short run, but in the long
run, they make zero economic profit. The latter is also a result of the freedom of entry and exit in
the industry. Economic profits that exist in the short run attract new entries, which eventually lead to
increased competition, lower prices, and high output.

Such a scenario inevitably eliminates economic profit and gradually leads to economic losses in the
short run. The freedom to exit due to continued economic losses leads to an increase in prices and
profits, which eliminates economic losses.
In addition, companies in a monopolistic market structure are productively and allocatively
inefficient as they operate with existing excess capacity. Because of the large number of
companies, each player keeps a small market share and is unable to influence the product price.
Therefore, collusion between companies is impossible.

In addition, monopolistic competition thrives on innovation and variety. Companies must

continuously invest in product development and advertising and increase the variety of their
products to appeal to their target markets. Competition with other companies is thus based on
quality, price, and marketing.

Quality entails product design and service. Companies able to increase the quality of their products
are, therefore, able to charge a higher price and vice versa. Marketing refers to different types of
advertising and packaging that can be used on the product to increase awareness and appeal.

Industries Exhibiting Features of Monopolistic Competition

Examples of industries in monopolistic competition include the following:

 Clothing and apparel

 Sportswear products
 Restaurants
 Hairdressers
 PC manufacturers
 Television services

 Short-Run Decisions on Output and Price

The short-run equilibrium under monopolistic competition is illustrated in the diagram below:

 Profits are maximized where marginal revenue (MR) is equal to marginal cost (MC). The point
determines the company’s equilibrium output. The price is determined at a point where the
imaginary line from the equilibrium output passes through the point of intersection of the MR, and
MC curves and meets the average revenue (AR) curve, which is also the demand curve.

Total profit is represented by the cyan-colored rectangle in the diagram above. It is determined by
the equilibrium output multiplied by the difference between AR and the average total cost (ATC).
Companies in monopolistic competition determine their price and output decisions in the short run,
just like companies in a monopoly.

Companies in monopolistic competition can also incur economic losses in the short run, as
illustrated below. They still produce equilibrium output at a point where MR equals MC in which
losses are minimized. The cyan-colored rectangle shows the economic loss incurred.

Long-Run Decisions on Output and Price

In the long run, companies in monopolistic competition still produce at a level where marginal cost
and marginal revenue are equal. However, the demand curve will have shifted to the left due to
other companies entering the market. The shift in the demand curve is a result of reduced demand
for an individual company’s products due to increased competition.

Such action reduces economic profits, depending on the magnitude of the entry of new players.
Individual companies will no longer be able to sell their products at above-average cost.

 
Companies in monopolistic competition will earn zero economic profit in the long run. At this stage,
there is no incentive for new entrants in the industry.

Monopolistic Competition vs. Perfect Competition

Companies in monopolistic competition produce differentiated products and compete mainly on

non-price competition. The demand curves in individual companies for monopolistic competition are
downward sloping, whereas perfect competition demonstrates a perfectly elastic demand schedule.

However, there are two other principal differences worth mentioning – excess capacity and mark-
up. Companies in monopolistic competition operate with excess capacity, as they do not produce at
an efficient scale, i.e., at the lowest ATC. Production at the lowest possible cost is only completed
by companies in perfect competition.

Mark-up is the difference between price and marginal cost. There is no mark-up in a perfect
competition structure because the price is equal to marginal cost. However, monopolistic
competition comes with a product mark-up, as the price is always greater than the marginal cost.

Inefficiencies in Monopolistic Competition

 The equilibrium output at the profit maximization level (MR = MC) for monopolistic
competition means consumers pay more since the price is greater than marginal revenue.
 As indicated above, monopolistic competitive companies operate with excess capacity. They
do not operate at the minimum ATC in the long run. Production capacity is not at full
capacity, resulting in idle resources.
 Monopolistic competitive companies waste resources on selling costs, i.e., advertising and
marketing to promote their products. Such costs can be utilized in production to reduce
production costs and possibly lower product prices.
 Since companies do not operate at excess capacity, it leads to unemployment and social
despondency in society.
 Inefficient companies continue to exist under monopolistic competition, as opposed to
exiting, which is associated with companies under perfect competition.
 Another scope of inefficiency for monopolistic competitive markets stems from the fact that
the marginal cost is less than the price in the long run.
 Monopolistic competitive market structures are also allocatively inefficient. Their prices are
higher than the marginal cost.

Limitations of Monopolistic Competition Market Structure

 Companies with superior brands and high-quality products will consistently make economic
profits in the real world.
 Companies entering the market will take a long time to catch up, and their products will not
match those of the established companies for their products to be considered close
substitutes. New companies are likely to face barriers to entry because of strong brand
differentiation and brand loyalty.

Excess Capacity Under Monopolistic Competition

Excess capacity is more defined under monopolistic competition due to the nature of the market
structure.

Unlike perfectly competitive markets where the demand curve is horizontal, monopolistic
competitive markets show a downward sloping demand curve. The demand curve cannot be
tangential to the LAC at its minimum point.

Conditions of equilibrium are reached at E, where LMC = LAC at the minimum point of the latter.
Firms in monopolistic competition are likely to see excess capacity, as there is no incentive to
produce optimum output at a higher long-run marginal cost (LMC) that is greater than marginal
revenue (MR).

Firms in monopolistic competition operate below optimum capacity; hence, they are smaller in size,
large in terms of population, and work under conditions of excess capacity.

Firms under monopolistic competition operate at the equilibrium point E1, where output OQ1 is
produced, and the demand curve is tangent to the LAC at point A. It is the point where the LMC
curve intercepts with the MR curve.

Firms do not operate at equilibrium (E), where the LMC curve intercepts the LAC curve at its lowest
point, and optimum output (OQ) is produced. Beyond OQ1, firms will start making losses as LMC is
greater than MR. Thus, excess capacity is created as represented by Q1Q.

The graph also reveals that in the long run, output is lower, and price is higher under monopolistic
competition, compared to perfectly competitive markets where output is higher and price is lower.

Role of Advertising in Monopolistic Competition

Monopolistic competition is characterized by multiple firms that sell differentiated products.

Advertising is a technique used by firms in monopolistic competition to create product
differentiation. The goal of product differentiation and advertising in monopolistic competition is to
make sure the the market is under control, and as a result, charge a higher price. Excessive
advertising will serve to inform consumers about the physical difference in the product, and the
perceived difference will lead to increased product differentiation.
If advertising in the long run convinces customers that the product is superior to the competitor’s,
then the firm would charge a higher price (Arnold 241).

What role does advertising play for monopolistically competitive firms? Advertising will increase
demand and reduce demand elasticity. As seen from the short-run equilibrium graph, Q gives the
current profit-maximizing output at a price P. Therefore, advertising will increase the quantities of
the product the consumers are willing to purchase, leading to a shift or a move in the demand curve
to a higher level. The new demand curve will correspond to higher levels of quantity demanded and
the prices given by Q1 and P1 (Arnold 245). As such, the role of advertising in monopolistic
competition is monumental.

In monopolistic competition, the firm faces a comparatively elastic demand, and this limits the prices
that can be charged on the product. To reduce demand elasticity, the demand curve will be
relatively steeper, implying that consumers are likely to change their quantity demanded as a result
of a change in price. As illustrated in the diagram, the firm can now charge a slightly higher price P1
for the same quantity, and this means the firm can collect more revenues for the same quantity Q
sold at a profit-maximizing level of output (McConnell and Brue 494).

Advertising in monopolistic competition is excessive, and as long as revenues per product are more
in comparison to an increase in average cost per product, it may not result in loses. One of the
characteristics of monopolistic competition is relatively easy entry. Firms in a monopolistic
competition market will use advertising to maintain their profits because advertising affects the
products of the firm by increasing its demand.

Monopoly vs Oligopoly Infographic

 Key Differences Between Monopoly and Oligopoly

 There is a single seller of goods in the market in a monopoly. In an oligopoly, there are few sellers in the market.
 There is no competition among the sellers in a monopoly as they are the only ones in the market. In contrast, there are few sellers in the
market in an oligopoly, and there is intense competition.
 In an oligopoly, the customer has various product choices and is mainly driven by the price, customer preference, and brand loyalty. In
contrast, the customer has no option or alternative to pick among the goods in a monopoly.
 In an oligopoly, the demand curve of the market is kinked. While, in a monopoly, the demand curve is downward sloping.
 In the long run, in an oligopoly market structure, the seller ends up making the normal profit in the
industry as any change in the price will be counter-set by the subsequent fall in the cost of the rival
firm. Whereas, in the case of monopoly, there is a possibility that the seller can earn
abnormal profits in the long run.
 The price set by the monopoly is generally controlled or monitored by the government to protect the
customers’ interests. For example, electricity is an example of a monopoly market where there is
only one producer of goods. On the other hand, oligopoly is driven by private players in the market.
For example, a brand of toothpaste has many closely related substitutes, which is an example of
an oligopoly market.

Comparative Table

Monopoly Oligopoly

A market structure where numerous sellers

A market structure is dominated by a single seller of the
sell close substitutes of the goods. Large
goods and the services.
industries generally dominate the market.

The competition in the market determines

The seller controls the price as there is no competition in
the price and keeps in mind the
the market.
competitor’s actions.

This market structure is a high barrier to entry and exit as

In this market structure, the barrier of entry
the industry is generally capital intensive. There are also
is generally high because of the economies
economic, institutional, or legal restrictions on this kind of
of scale in the industry.
industry.

A firm is a price maker. A firm is a price taker.

The demand curve of the market is

The demand curve of the market is kinked.
downward-sloping.

Electricity, railways, and water are examples of the FMCG and automobiles are examples of
monopoly market. an oligopoly industry.

No competition exists as there is a single seller of the Intense or high competition among the
goods. sellers.

unit-6

What is Perfect Competition?

A market situation where a large number of buyers and sellers deal in a homogeneous product at
a fixed price set by the market is known as Perfect Competition. Homogeneous goods are
goods of similar shape, size, quality, etc. In other words, in a perfectly competitive market, the
sellers sell homogeneous products at a fixed price determined by the industry and not by a single
firm. In the real world, the situation of perfect competition does not exist; however, the
closest example of a perfect competition market is agricultural goods sold by the farmers. Goods
like wheat, sugarcane, etc., are homogeneous in nature and their price is influenced by the
market. 

Features of Perfect Competition

1. Homogeneous Product: The products offered by firms for sale under perfect competition are
homogeneous. It means that the goods are identical in every respect such as size, shape, colour,
quality, etc. As the goods are identical, these can be easily substituted for each other, which
results in zero specific preference of the buyer from any particular seller. As the products are
homogeneous, the buyers are willing to pay the same price only for the products of every firm of
the industry. It also means that an individual firm cannot charge a higher price for their product,
ensuring uniformity in price in the market. 
As the products under perfect competition are homogeneous, the purchase of a good is not a
matter of choice, but a matter of chance. 
2. Very large number of Buyers and Sellers: The number of buyers and sellers in a perfect
competition market is very large. It means that the number of buyers in a perfect competition
market is so large that the total share of one single buyer is insignificant to the total purchase;
therefore, a single buyer cannot influence the price of a product in the market. Similarly, the
number of sellers is so large that the share of one single seller is insignificant to the total supply
of the economy; therefore, a single seller cannot influence the price of a product in the market.
Because of the large number of buyers and sellers, the firms under perfect competition are just
price-takers. It means that the firms do not have any option over the price of a product and have
to just sell the products at the price determined by the industry. In the same way, the buyers are
also just price-takers and cannot influence the price of a product in the market by changing their
demand. 
3.  Freedom of Entry and Exit: The sellers under the perfect competition market have the
freedom of entry and exit in/from the industry. It means that there are no artificial restrictions or
barriers to the entry of a new firm or exit of an existing firm. This feature of a perfect competition
market ensures that abnormal profits and abnormal losses do not exist in the long run. 
Freedom of Entry of the new firms under a perfect competition market indicates that there are no
barriers for the new firms to enter the industry. When the existing firms in the industry are making
abnormal profits from their business, it attracts new firms to enter for profit, which in result
increases the market supply of goods, ultimately resulting in the reduction in market price and
profits. Hence, the entry of new firms into the industry only happens until every firm in the industry
is earning normal profits only. 
Freedom of Exit of the existing firms under a perfect competition market indicates that there are
no barriers for the existing firms to leave the industry. Firms generally exit the industry when they
are facing losses, and their exit decreases the market supply of goods resulting in an increase in
the market price of those goods. However, their exit also reduces the losses, and hence the firms
exit the industry until all the losses are wiped out from the industry and each of the existing firms
earns normal profits. 
A short period in this case is too short for a firm to exit from the industry or a new firm to enter into
the industry. Similarly, a long period is too long for a firm to exit the industry or for a new firm to
enter into the industry. 
Normal Profits:
The minimum profit required by a firm to run the business is Normal Profit. Normal profits are
included in the total production costs of a firm.
Abnormal Profits:
The excess amount of earnings of a firm over its total production cost is known as Abnormal
Profit.
Abnormal Losses:
The shortage in the amount of earnings of a firm over its total production cost is known
as Abnormal Losses. 
4. Perfect Mobility of Factors of Production: The factors of production such as land, labor,
capital, and entrepreneurship under a perfect competition market are perfectly mobile. There is no
occupational and geographical restriction on the movement of factors of production, i.e., they are
free to move to the industry with the best price. 
5. Perfect Knowledge among Buyers and Sellers: Under a perfect competition market, the
buyers and sellers have complete knowledge about the market price of the products. It means
that no firm/seller can charge a different price from the customers and no buyer will pay a higher
price than the price in the market. In other words, it results in uniformity in the market price of a
product. Besides, the sellers of the product have perfect knowledge regarding the input markets.
It means that each firm has equal access to the inputs and technology used for the production of
goods, resulting in a uniform cost structure. Also, as the price and cost of a product is uniform, the
profits earned by the firms are also uniform. 
6. Absence of Selling Costs: Selling cost is the cost of the advertisement of a product. As the
goods under perfect competition are homogeneous, they do not include selling costs. The perfect
knowledge of the buyers and sellers regarding the product, makes it easy for the firms to sell the
goods without selling cost. 
7. Absence of Transportation Costs: To ensure uniformity in the price of goods, it is assumed
that there is no transportation cost under perfect competition. In other words, it is assumed that a
manufacturer can sell the product at any place, and the buyers can purchase the product from
any place of their choice. 

A. Short Run Supply Curve

(i) Short Run Supply Curve of a Firm:

Short run is a period in which supply can be changed by changing only the variable factors,
fixed factors remaining the same. That way, if the firm shuts down, it has to bear fixed costs.
That is why in the short run, the firm will supply commodity till price is either greater or equal to
average variable cost. Thus a firm will continue supplying the commodity till marginal cost is
equal to price or average revenue. Under perfect competition average revenue is equal to
marginal revenue, so the firm will produce up to that point where marginal revenue and marginal
cost are equal.

Short run supply curve of a perfectly competitive firm is that portion of marginal cost curve
which is above average variable cost curve. According to C.E. Ferguson, “The short run supply
curve of a firm in perfect competition is precisely its Marginal Cost Curve for all rates of output
equal to or greater than the rate of output associated with minimum average variable cost.”
Prof. Bilas has defined it in simple words, “The Firm’s short period supply curve is that portion
of its marginal cost curve that lies-above the minimum point of the average variable cost curve.”
However, short run supply curve of a firm can be shown with the help of fig. 1.

From fig. 1 it is clear that there is no supply if price is below OP. At price less than OP, the firm
will not be covering its average variable cost. At OP price, OM is the supply. In this case, firms’
marginal revenue and marginal cost cut each other at A, OM is equilibrium output. If price goes
up to OP1, the firm will produce OM1 output. This firm’s short run supply curve starts from A
upwards i.e., thick line AB.

(ii) Short Run Supply Curve of an Industry:

An industry is a blend of firms producing homogeneous goods. That way, supply curve of an
industry is a lateral summation of all firms. This can be made clear with the help of a Fig. 2.

Here, we have assumed that different firms in the industry are producing identical products.

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Each firm at OP price is producing OM output. It is because all firms have identical costs. At OP
price, supply of industry is 100 x M = 100M.

Similarly at OP1 price, all the firms of industry are producing 100 xM 1 =100M 1 quantity of output.
These quantities will be called supply or output of industry. SS is the supply curve of industry.
Point E shows that at OP price firm’s supply is OM and an industry’s total supply is 100 × M =
100M.

At OP1 price, firm’s supply is OM1 and industry’s supply is 100M). We get industry’s supply
curve by joining points E and E 1.

Thus, under perfect competition, lateral summation of that part of short run marginal cost curves
of the firms which lie above the average variable cost constitutes the supply curve of the
industry. According to Stonier and Hague, “short run supply curve of a competitive industry will
always slope upwards since the short run marginal cost curve of the industrial firms always
slope upward.”

B. Long Run Supply Curve:

Long run supply curve can also be analyzed from firm and industry’s point of view:
1. Long Run Supply Curve of a Firm:
Long run is a period in which supply can be changed by changing all the factors of production.
There is no distinction between fixed and variable factors. In the long run, firm produces only at
minimum average cost. In this situation, long run marginal cost, marginal revenue, average
revenue and long run average cost are equal i.e., LMCMR (= AR)LAC (minimum). The firm is
enjoying only normal profits.

So that position of marginal cost curve will determine the supply curve which is above the
minimum average variable cost. The point where minimum average cost is equal to marginal
cost is called optimum production. Thus Long Run Supply Curve of a firm is that portion of its
marginal cost curve that lies above the minimum point of the average cost curve.

In figure 3 the firm is in equilibrium at point E where MRLMC (=AR). AC is minimum

corresponding to this point. This point E is also called optimum point because at this point
MR=LMCAR minimum LAC. That portion of LMC which is above E is called long run supply
curve.

2. Long Run Supply Curve of an Industry:

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In the long run, industry’s supply curve is determined by the supply curve of firms in the long
run. Long run supply curve in the long run is not lateral summation of the short run supply
curves. Industry’s long run supply curve depends upon the change in the optimum size of firms
and change in the number of firms.

It is on account of two reasons:

(i) In the long run, firms continue to enter into and exit from the industry,

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(ii) Firms get economies and diseconomies of scale. This displaces the long run marginal cost
(LMC).

Due to these reasons, long run supply curve of industry is not the lateral summation of supply
curve of firms. In reality, long run supply curve of industry can be known from the long run
optimum production of firms multiplied by the number of firms in an industry.

LRSi, = Q x N
Where LRS 1 is long run supply curve of industry. Q is the optimum output of a firm and N, the
number of firms.

Short-run Equilibrium of the Firm: Graphical Analysis

Below graph shows the Short-run Equilibrium of the Firm.

Short run Equilibrium of the Firm in perfect competition

In the short, the firm is in equilibrium at point e. At this point,

MR=MC
MR= MC as the first-order condition. At this point, the second-order condition is also satisfied.
That is, at point e slope of the MC curve is greater than the slope of the MR curve.
The slope of the MC > Slope of the MR curve

Since MC is always positive, at equilibrium MR also positive. The equilibrium price is P1 and the
quantity is Q1.

What happens in the short-run perfect competition?

The total revenue of the firm is equal to the area of 0P1eQ1 and the total cost is equal to the area
of 0abQ1. The revenue of the firm is higher than the cost. Hence, the profit of the firm equal to the
area of P1eba. It is an excess profit or profit larger than normal profit.

The total revenue of the firm= 0P1eQ1

Total cost= 0abQ1
Profit of the firm= P1eba

This implies that in the short-run, a perfectly competitive firm can make an excess profit. However,
it does not mean that the firms necessarily earn excess profit in the short-run. It depends on the
level of the SAC (short-run average cost) in the short-run equilibrium.

If the SAC is below the price at the equilibrium, the firm earns an excess profit. But, if the SAC
is higher than the price at the equilibrium, the firm makes losses.
Producing with losses in the short-run perfect competition

Closing down point in short run: perfect competition

Although the firm makes a loss in the short-run it will continue to produce. However, if it cannot
cover its variable cost the firm will close down since by closing down the firm is better off. The point
at which the firm covers its variable cost is called ‘the closing down point’. The closing down point
is denoted by point w.

If the price falls below the Pw, (this price is equal to the minimum variable cost) the firm cannot
cover all its variable cost, and hence, it will close down whereby minimizing the losses.

Supply Curve of the Firm and Industry

The supply curve of the firm can derive associate with the MC curve and demand curve of the firm.
When the market price increases gradually it causes an upward shift in the demand curve of the
firm. Since the firm’s demand curve is the MR curve, the firm reaches the equilibrium at the points
where the successive demand curve cuts the MC curve.

Supply Curve of the Firm and Industry

The quantity supplied by the firm increases as price rises. If the price falls below Pw, the firm will
not supply any quantity. The firm will close down when the price falls Pw.

If we transfer the successive points of interaction of the MC curve and the demand curves to the
separate graph, the supply curve of the firm can be formed which is identical to its MC curve to the
right of the closing down point ‘w’.
The supply curve of the industry is the horizontal sum of the supply curves of individual firms.  The
total market supply at each price is the sum of the quantities supplied by each firm at that price.

Short-run Equilibrium of the Industry

S
hort run Equilibrium of the Industry

Given the market demand and supply, the industry is in equilibrium at the price that ‘clears the
market’. At that price, market demand is equal to the market supply. As shown in figure
equilibrium price and quantity are P0 and Q0, respectively. This will be a short-run equilibrium.

Under the prevailing market price, the firms can make excess profit or losses. So the firms that
make losses in the short-run will make necessary adjustments. Otherwise, they will close down the
firm in the long-run. The firms that earn excess profit will expand the size of the firms to maximize
their profit.

Long-run equilibrium in perfect competition

In the long-run, firms can make the necessary adjustment to their capacity. Accordingly, they will
adjust their capacity to produce at the minimum point of the long-run average cost (LAC) curve,
which is tangent to the demand curve defined by the market price. In the long-run equilibrium, firms
will earn just a normal profit which includes in the LAC (long average cost).

What happens in the long-run perfect competition?

If the existing firms are making an excess profit, new firms will enter the industry. Then the market
price will fall down due to the increase of market supply with the new entrants’ supply. This will lead
to shifting the demand curve down. Simultaneously, the cost curves will shift upward due to an
increase in factor prices. These changes will continue until the LAC is tangent to the demand curve.

If the firms make losses inside the long-run they may go away the industry. As a result, the price will
rise and the demand curve will shift upward. The cost will go down and price curves shift downward.
These changes will continue until the remaining corporations attain the minimum factor of the LAC
curve.

The below graph shows the firm which earns excess profits.
 Long
run Equilibrium of the Firm: perfect competition

In the long-run equilibrium, firms adjust their capacity to produce at the minimum point of LAC,
given the technology and factor prices.
At the equilibrium, SMC = LMC = LAC = P = MR
In the long-run equilibrium, both short-run and long-run equilibrium conditions coincide. When
satisfying this condition the firm is working it’s optimal and no excess capacity and the resources
are fully utilizing.

Long-run Equilibrium of the Industry

In the long-run, industry is in equilibrium when there is no tendency to expansion or contraction. So

all the firms should be earned just a normal profit. In this situation, all firms will be operating at the
minimum point of the LAC curve.

Long run Equilibrium of the Industry

At the market price P1, firms are producing at their minimum cost, earning just normal profit. Hence
there is no further entry to or exit from the industry. At the equilibrium point,

LMC = SMC = MR = P. This equality ensures that the firm maximize its profit.

unit-5

What Is a Market?

A market is a place where parties can gather to facilitate the exchange of goods and services. The
parties involved are usually buyers and sellers. The market may be physical like a retail outlet,
where people meet face-to-face, or virtual like an online market, where there is no direct physical
contact between buyers and sellers. There are some key characteristics that help define a market,
including the availability of an arena, buyers and sellers, and a commodity that can be purchased
and sold
KEY TAKEAWAYS

 A market is a place where buyers and sellers can meet to facilitate the exchange or
transaction of goods and services.
 Markets can be physical like a retail outlet, or virtual like an e-retailer.
 Other examples include illegal markets, auction markets, and financial markets.
 Markets establish the prices of goods and services that are determined by supply and
demand.
 Features of a market include the availability of an arena, buyers and sellers, and a
commodity.

Features of a Market

There are certain features that help define a market. These are necessary in order for the market
to function. The following are the most basic characteristics that shape a market:

 Arena: This is the platform where transactions are conducted between buyers and sellers.
Keep in mind that this doesn't necessarily mean a physical location. It can also mean the
area in which all parties involved are spread out.
 Buyers and Sellers: In order for the market to function, there must be buyers and there
must be sellers. The market can't exist if someone isn't buying something that someone
else is selling. These entities can be businesses, individuals, or even governments, and
they can execute their transactions physically or virtually, thanks to the internet.
 One Commodity: A single market is dependent on a single commodity, so in order for a
market to operate, a related commodity must be present. For instance, wheat is the
commodity bought and sold in the wheat market. Electronics make up the electronics
market en masse but can be broken down into subcategories.

There are other features, including competition, pricing, and the freedom to buy and sell goods and
services.

Types of markets

1. बस्तुको आधारमा
2. परिमाणको आधारमा
3. क्षेत्रको आधारमा
4. प्रतिस्पर्धाको आधारमा
5. समयको आधारमा

https://www.microeconomicsnotes.com/revenue/relationship-between-total-revenue-
average-revenue-and-marginal-revenue/15891

cost curve
 a cost curve is a graph of the costs of production as a function of total quantity produced.
In a free market economy, productively efficient firms optimize their production process by
minimizing cost consistent with each possible level of production, and the result is a cost
curve. Profit-maximizing firms use cost curves to decide output quantities. There are various
types of cost curves, all related to each other, including total and average cost curves;
marginal ("for each additional unit") cost curves, which are equal to the differential of the
total cost curves; and variable cost curves. Some are applicable to the short run, others to
the long run.
verage and Marginal Cost

Marginal cost is the change in total cost when another unit is produced; average cost is the total
cost divided by the number of goods produced.

LEARNING OBJECTIVES
Distinguish between marginal and average costs

KEY TAKEAWAYS
Key Points

 The marginal cost is the cost of producing one more unit of a good.
 Marginal cost includes all of the costs that vary with the level of production. For example, if a
company needs to build a new factory in order to produce more goods, the cost of building the
factory is a marginal cost.
 Economists analyze both short run and long run average cost. Short run average costs vary in
relation to the quantity of goods being produced. Long run average cost includes the variation
of quantities used for all inputs necessary for production.
 When the average cost declines, the marginal cost is less than the average cost. When the
average cost increases, the marginal cost is greater than the average cost. When the average
cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.

Key Terms

 marginal cost: The increase in cost that accompanies a unit increase in output; the partial
derivative of the cost function with respect to output. Additional cost associated with producing
one more unit of output.
 average cost: In economics, average cost or unit cost is equal to total cost divided by the
number of goods produced.

Marginal Cost
In economics, marginal cost is the change in the total cost when the quantity produced changes by
one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs
that vary with the level of production. For example, if a company needs to build a new factory in
order to produce more goods, the cost of building the factory is a marginal cost. The amount of
marginal cost varies according to the volume of the good being produced. Economic factors that
impact the marginal cost include information asymmetries, positive and negative externalities,
transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of
calculating marginal cost is: the production of one pair of shoes is $30. The total cost for making
two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.

Average Cost
The average cost is the total cost divided by the number of goods produced. It is also equal to the
sum of average variable costs and average fixed costs. Average cost can be influenced by the time
period for production (increasing production may be expensive or impossible in the short run).
Average costs are the driving factor of supply and demand within a market. Economists analyze
both short run and long run average cost. Short run average costs vary in relation to the quantity of
goods being produced. Long run average cost includes the variation of quantities used for all inputs
necessary for production.

Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:
 Cost curve: This graph is a cost curve that shows the average total cost, marginal cost, and
marginal revenue. The curves show how each cost changes with an increase in product price and
quantity produced.

 When the average cost declines, the marginal cost is less than the average cost.
 When the average cost increases, the marginal cost is greater than the average cost.
 When the average cost stays the same (is at a minimum or maximum), the marginal cost
equals the average cost.

What is revenue?

Revenue is the earning that an enterprise has from its normal business pursuits, usually from the
sale of commodities, and services to consumers. Revenue is also mentioned and referred to as
turnover or sales. A few companies get revenue from royalties, other fees, or interests.

An enterprise believes that it can sell as many quantities of the commodity as it requires by setting
a cost price less than or equivalent to the market cost price. In such a case, there is no logic to set
a cost price lower than the market cost price. In other words, the enterprise should sell some
amount of the commodity so that the cost price it sets is exactly equivalent to the market cost price.

Types of revenues

Total revenue: Total revenue is the total receipts a vendor can procure from selling commodities or
services to the customers. It can be mentioned as P × Q, which is the cost price of the commodities
multiplied by the amount of the commodities sold. So, the total revenue (TR) of an enterprise is
defined as the market cost price of the commodity (p) multiplied by the enterprise’s output (q).

Hence,

                                                                   TR = p × q

Average revenue: Average revenue is the revenue initiated per unit of the output sold. It plays a
vital role in deciding an enterprise’s profit. Per unit of the profit is the average (total) cost subtracted
by the average revenue. An enterprise usually prefers to manufacture the amount of output that
maximises profit.

                                                           AR = TR/q = p × q/q = p
Marginal revenue: Marginal revenue is referred to as the revenue earned from the sale of an
additional product or unit. It is the revenue that the company generates when there is a sale of an
additional unit. It is used by the management in analysing the demands of the customers, planning
the production schedules, and setting the product prices.

Marginal revenue remains constant till a certain level of output, and slows down with an increased
output by following the law of diminishing returns.

                                                 MR = Change in total revenue/Change in quantity

What is revenue?

Revenue is the earning that an enterprise has from its normal business pursuits, usually from the
sale of commodities, and services to consumers. Revenue is also mentioned and referred to as
turnover or sales. A few companies get revenue from royalties, other fees, or interests.

An enterprise believes that it can sell as many quantities of the commodity as it requires by setting
a cost price less than or equivalent to the market cost price. In such a case, there is no logic to set
a cost price lower than the market cost price. In other words, the enterprise should sell some
amount of the commodity so that the cost price it sets is exactly equivalent to the market cost price.
Basic Concepts of Revenue

Revenue, in simple words, is the amount that a firm receives from the sale of the output. According to
Prof. Dooley, ” The Revenue of a firm is its sales receipts or income.‘ In a firm, revenue is of three
types:

1. Total Revenue

2. Average Revenue

3. Marginal Revenue
Let’s look at each one of them in detail:

Total Revenue

This is simple. The Total Revenue of a firm is the amount received from the sale of the output.
Therefore, the total revenue depends on the price per unit of output and the number of units sold.
Hence, we have

TR = Q x P

Where,

 TR – Total Revenue

 Q – Quantity of sale (units sold)

 P – Price per unit of output

Average Revenue

Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold.
Therefore, you can get the average revenue when you divide the total revenue with the total units sold.
Hence, we have,

AR=TRQ

Where,

 AR – Average Revenue

 TR – Total Revenue

 Q – Total units sold

Marginal Revenue

Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In
other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence, we
have

MR = TRn – TRn-1

Or

MR=ΔTRΔQ

Where,

 MR – Marginal Revenue

 ΔTR – Change in the Total revenue

 ΔQ – Change in the units sold

 TRn – Total Revenue of n units

 TRn-1 – Total Revenue of n-1 units

MR pertains to a change in TR only on account of the last unit sold. On the other hand, AR is based on
all the units that the firm sells. Therefore, even a small change in AR causes a much bigger change in
MR. In fact, when AR reduces, MR reduces by a far greater margin.

Similarly, when AR increases, MR increases by a greater extent too. AR and MR are equal only when
AR is constant. It is also important to note that the firm does not sell any unit if the TR or AR becomes
either zero or negative. However, there are times when the MR is negative (especially if the fall in price
is big).

The relationship between TR, AR, and MR

In order to understand the basic concepts of revenue, it is also important to pay attention to the
relationship between TR, AR, and MR. When the first unit is sold, TR, AR, and MR are equal.

Therefore, all three curves start from the same point. Further, as long as MR is positive, the TR curve
slopes upwards.

However, if MR is falling with the increase in the quantity of sale, then the TR curve will gain height at a
decreasing rate. When the MR curve touches the X-axis, the TR curve reaches its maximum height.

Further, if the MR curve goes below the X-axis, the TR curve starts sloping downwards.

Any change in AR causes a much bigger change in MR. Therefore, if the AR curve has a negative
slope, then the MR curve has a greater slope and lies below it.

Similarly, if the AR curve has a positive slope, then the MR curve again has a greater slope and lies
above it. If the AR curve is parallel to the X-axis, then the MR curve coincides with it.
Here is a graphical representation of the relationship between AR and MR:

In the left half, you can see that AR has a constant value (DD’). Therefore, the AR curve starts from
point D and runs parallel to the X-axis. Also, since AR is constant, MR is equal to AR and the two
curves coincide with each other.

In the right half, you can see that the AR curve starts from point D on the Y-axis and is a straight line
with a negative slope. This basically means that as the number of goods sold increases, the price per
unit falls at a steady rate.

Similarly, the MR curve also starts from point D and is a straight line as well. However, it is a locus of
all the points which bisect the perpendicular distance between the AR curve and the Y-axis. In the
figure above, FM=MA.

Relationship between Total Revenue, Marginal Revenue and Average Revenue Under
Imperfect Competition

The relationship among total, average and marginal revenues under imperfect competition (all
market forms other than pure and perfect completion are cover here) can be explained with the help
of a table given below:
Exactly the same information is given by the total revenue (TR), average revenue (AR) and
marginal revenue (MR) curves in Fig. 12.1. These curves have been plotted from the figures in

In the first two columns, we have the data for the demand (or AR) curve. We notice that AR curve is
downward sloping, i.e., as price (or AR) falls, quantity demanded and sold increases. In other
words, the producer has to reduce the price to sell the additional units of the product.

It can be observed from Table 12.2 and Fig. 12.1 that when AR falls, MR curve lies below it. It
means that MR declines at more rapid rate than AR, so that, the gap between AR and MR becomes
wider with the increase in output.

Each additional unit sold adds less to the total revenue than the price received for it, since price on
all the units must be lowered in order to sell this unit. Thus, the marginal revenue (MR) is equal to
the price of the extra unit sold minus the loss from selling all previous units at the new lower price,
i.e., MR =Pn+ 1 – (Pn – Pn+1) Qn, where Pn and Qn are the price and quantity sold before the fall in
price. Pn +1 is the reduced price. It is evident that at all prices, MR is smaller than AR (price), given
that Qn and (Pn– Pn+1) are positive. This is clear from the figures given in the table.
ADVERTISEMENTS:

As per Table 12.2, TR is zero, when no unit is sold. Further, one unit is sold at a price of Rs. 10.
Now, the total revenue of two units is Rs. 9 x 2 = Rs. 18 and the total revenue from the first unit is
Rs. 10. Hence, marginal revenue (i.e., addition to total revenue) of the second unit is Rs. 18-Rs. 10
= Rs. 8.

Alternatively, the loss of revenue of Rs. 1 on first unit can be deducted from the price at which the
second unit is sold, to get its marginal revenue. This loss is due to the fall in price as a result of the
sale of one additional unit. Marginal revenue is, therefore, Rs. 9 – Rs. 1 = Rs. 8. Further, when price
declines to Rs. 8, only 3 units are sold and TR increases to Rs. 24.
The increase in TR by selling this unit is Rs. 6, which is the MR of the third unit. Alternatively, MR of
the third unit can be obtained by subtracting Rs. 2 (total loss of revenue on first two units) from Rs.
8 (the price of the third unit).

Again, MR is the same, i.e. Rs. 6. In the same way, MR of the other units can be calculated. We,
thus, observe that with the increase in sales, price falls and marginal revenue is less than the price
(or AR). That is why, the MR curve lies below the AR curve and declines at a faster rate.

ADVERTISEMENTS:

It is important to note that the falling MR curve bisects the distance on the X-axis between the point
of origin and the point, where the AR curve touches the X-axis in two equal parts. But, this
relationship will not hold true, if the AR curve is not a straight line that slopes downward.

It may be further observed that so long as the TR is increasing, MR is positive. In Fig. 12.1, MR is
positive for the first five units. Thus, TR curve starting from the origin continues to increase up to
five units. TR does not change between fifth and sixth unit.

When TR is unaffected by the increase in quantity, MR is equal to zero. TR is maximum

corresponding to zero MR at the sixth unit. Beyond sixth unit, TR falls and MR becomes negative.
MR of the seventh unit is – 2 and that of eighth unit is – 4. Thus, while AR is always positive. MR
can be positive, zero or even negative.

The relationship among TR, AR and MR can be summarised as follows:

(i) Initially, TR (i.e., price x units of the commodity sold) increases at a diminishing rate with
increase in the units of output, since more units of the commodity can only be sold at a lower price,
such that MR is positive and is downward sloping.

(ii) When TR is maximum MR becomes equal to zero.

(iii) MR becomes negative, when TR decreases with increase in the units of output.

(iv) MR falls with the fall in AR, but, the rate of decrease in MR is much higher than that in AR.

(v) MR may be positive, negative or zero, but AR is always positive (since negative price is absurd)

The above relationship holds true in case of all forms of imperfect competition that is, monopoly,
duopoly, oligopoly, monopolistic competition, etc. Under imperfect competition, as a firm lowers the
price, the quantity demanded goes up and average revenue curve slopes downward as a result.

What is Cost?
Cost refers to the total expenditure made on inputs that are used for the production of final goods
or services. The cost is the sum of the Explicit Cost and Implicit Cost.
 Explicit Cost: The actual expenditure made on the inputs or the payments made to the
outsiders to hire their factor services is known as Explicit Cost. For example, wages paid to
the workers, payment for land, payment for raw materials, etc.
 Implicit Cost: The estimated value of the inputs supplied by the owners along with the normal
profits is known as Implicit Cost. For example, estimated rent on own land, imputed salary for
the entrepreneur’s services, etc.

Short Run Costs

In the short run, some of the factors are fixed, while other factors are variable. In the same way,
the short-run costs are also categorised into two different kinds of cost; viz., Fixed
Costs and Variable Costs. The sum total of these costs is equal to the total cost.
1. Total Fixed Cost (TFC) or Fixed Cost (FC)
The costs on which the output level does not have a direct impact are known as Fixed Costs. For
example, salary of staff, rent on office premises, interest on loans, etc. Other names of fixed
costs are Supplementary Cost, Overhead Cost, Unavoidable Cost, Indirect Cost, or General
Cost. Fixed cost is the cost spent on fixed factors such as land, building, machinery, etc. The
amount spent on these factors cannot be changed in the short run. Also, the payment made on
these factors remains the same whether the output is small, large, or zero.
Example:

 
  

In the above graph, X-axis represents the Units of Output and Y-axis represents the Fixed Cost.
TFC is the fixed cost curve formed by plotting the points in the above schedule. The TFC curve
makes an intercept with Y-axis equal to ₹10 Fixed Cost. It is a horizontal straight line parallel to
the X-axis. It is because, at all output levels (even at zero level), TFC remains the same.
2. Total Variable Cost (TVC) or Variable Cost (VC)
The costs on which the output level has a direct impact are known as Variable Costs. For
example, fuel, power, payment for raw materials, etc. Other names of variable costs are Prime
Cost, Avoidable Cost, or Direct Cost. In other words, variable cost is the cost spent on variable
factors such as power, direct labour, raw material, etc. The amount spent on these factors
changes with the change in output level. Also, these costs arise till there is production and
become zero at zero output level.
Example:

In the above graph, X-axis represents the Units of

Output and Y-axis represents the Variable Cost. TVC is the total variable cost curve formed by
plotting the points in the above schedule. It can be seen in the above graph, the TVC curve starts
from the origin, which means that at zero level of output, the variable cost is also zero. TVC is
an inversely S-shaped curve because of the Law of Variable Proportion. It means that the TVC
curve firstly increases at a decreasing rate (due to better utilisation of fixed factors and an
increase in the efficiency of variable factors) and then increases at an increasing rate (due to a
fall in the efficiency of the variable factors as there is a limitation of fixed factor).
3. Total Cost (TC)
The total expenditure incurred by an organisation on the factors of production which are required
for the production of a commodity is known as Total Cost. In simple terms, total cost is the sum of
total fixed cost and total variable cost at different output levels.
TC = TFC + TVC
As the Total Fixed Cost remains the same at all output levels, the change in Total Cost
completely depends upon Total Variable Cost.
Example:

In the above schedule, TC and TFC are equal at zero output level; i.e., ₹10 because TVC at this
level is zero. TFC at 1 unit of output also remains the same; i.e., ₹10, but TVC increases to ₹5,
which makes TC = 10 + 5 = ₹15. In the same way, TC at 2, 3, 4, and 5 output levels will be
calculated.

In the above graph, the TC curve is obtained by adding TVC and TFC curves. As TFC remains
the same at all output levels, the change in TC is solely due to TVC. Therefore, the distance
between the TC curve and the TVC curve always remains the same. Just like the TVC curve, the
TC curve is also inversely S-shaped because of the Law of Variable Proportion.

Average Costs

Average costs are the per unit costs which explain the relationship between the cost and output in
a realistic manner. These per-unit costs are obtained from Total Fixed Cost, Total Variable Cost,
and Total Cost. The three different types of per-unit costs are as follows:
1. Average Fixed Cost (AFC)
The per unit fixed cost of production is known as Average Fixed Cost. The formula for calculating
Average Fixed Cost is:

With an increase in the output, Average Fixed Cost falls. It is because the total fixed cost remains
the same at all output levels. 
Example:

It can be seen in the above schedule that with the increase in output level, AFC falls. It is because
the constant TFC; i.e., ₹10 is divided by the increasing output.

In the above graph, the AFC curve is formed by plotting the points shown in the above schedule.
AFC will keep on falling because of the increasing output level; however, it can never be equal to
zero. Therefore, the AFC curve is a rectangular hyperbola. It means that AFC is a curve in
which any rectangle formed under the curve will have the same area. 
AFC curve does not touches X-axis and Y-axis.
AFC is a rectangular hyperbola and hence approaches both the axes. The curve gets near to the
axes, but never touches them. It means that AFC can neither touch X-axis (because TFC can
never be zero) nor Y-axis (because TFC is positive at zero output level and if we divide any value
by zero, it will be an infinite value).
2. Average Variable Cost (AVC)
The per unit variable cost of production is known as Average Variable Cost. The formula for
calculating Average Variable Cost is:

Initially, Average Variable Cost falls with an increase in output. Once the output increases till the
optimum level, the average variable cost starts to rise.
Example:

It can be seen in the above schedule that initially, AVC falls with an increase in output level, and
once it reaches its minimum level: i.e., ₹4, it starts to rise.

In the above graph, the AVC curve is obtained by plotting the points shown in the above
schedule. AVC curve is a U-shaped curve because of the Law of Variable Proportion. In the
beginning, the AVC curve falls (because of the increasing returns to a factor with better utilisation
of fixed factors and variable factors), and after reaching its minimum level; i.e., optimum output
level, it starts on increasing with every additional output (because of diminishing returns to factor).
3. Average Total Cost (ATC) or Average Cost (AC)
The per unit total cost of production is known as Average Total Cost or Average Cost. The
formula for calculating Average Total Cost i

Another way to define Average Total Cost is by the sum of Average Fixed Cost and Average
Variable Cost; i.e., AC = AFC + AVC. 
Just like Average Variable Cost, average cost also initially falls with an increase in output. Once
the output increases till the optimum level, the average cost starts to rise.
Example:

In the above schedule, AC is determined by adding AFC and AVC.

In the above graph, the AC curve is a U-shaped curve, which means that initially, AC falls
(Phase 1), and after reaching its minimum point (Phase 2), it starts to rise (Phase 3). 
Phase 1: When AFC and AVC both fall (till 2 output level), AC also falls (till point A).
Phase 2: From 2 units of output to 3 units of output, AFC continues to fall; however, AVC remains
the same; i.e., ₹4, and because of this AC falls till it reaches its minimum point (Point B). From 3
units of output to 4 units of output, the fall in AFC is equal (approx) to the rise in AVC; therefore,
AC remains the same.
Phase 3: Now, after 4 units of output, the rise in AVC; i.e, by ₹1 is more than the fall in AFC; i.e.,
₹0.5; therefore, AC starts to rise.
AC, AVC, and AFC Curve

Some important observations about AC, AVC, and AFC

1. AC curve will always lie above the AVC curve (as seen in the above graph). It is because, at
levels of output, AC includes both AVC and AFC.
2. AVC curve reaches its minimum point; i.e., point B, at an output level that is lower than AC;
i.e., point A. It is because when AVC is at its minimum point, AC is still falling due to falling
AFC.
3. As the output level increases, the gap between AC and AVC curves starts to decrease;
however, these curves never intersect each other because the vertical distance between these
two curves is AFC, which can never be zero.

Marginal Cost

The additional cost incurred to the total cost when one more unit of output is produced is known
as Marginal Cost. For example, if the total cost of producing 2 units is ₹400 and the total cost of
producing 3 units is ₹600, then the marginal cost will be 600 – 400 = ₹200.
MCn = TCn – TCn-1
Where,
n = Number of units produced
MCn = Marginal cost of the nth unit
TCn = Total cost of n units
TCn-1 = Total cost of (n-1) units
Another way to calculate Marginal Cost:
When the change in the units produced is more than one unit, then the previous formula of
calculating MC will not work. In that case, the formula for calculating Marginal Cost will be:

For example, if the total cost of producing 5 units is ₹700 and the total cost of producing 3 units
is ₹250, then the marginal cost will be:

Marginal Cost = ₹225

Marginal Cost is affected by Fixed Costs
Marginal Cost is the additional cost to Total Cost when one more unit of the output is produced.
Also, TC is the sum of TFC and TVC. Now, as TFC does not change with the change in output,
Marginal Cost is independent of Total Fixed Cost and is affected by TVC only.
The following mathematical derivation can easily explain this concept: 
MCn = TCn – TCn-1 ……….(1)
TC = TFC + TVC …………..(2)
Now, by putting the value of (2) in (1), we get
MCn = (TFCn + TVCn) – (TFCn-1 + TVCn-1)
= TFCn – TFCn-1  + TVCn – TVCn-1 ………….(3)
As TFC is same at all output levels, TFCn = TFCn-1
Therefore, (3) becomes
MCn = TVCn – TVCn-1 
Example:

In the above schedule, MC is determined in two ways; using TC and TVC.

In the above graph, the MC curve is formed by plotting the points shown in the above schedule.
MC is a U-shaped curve because of the Law of Variable Proportions. In the beginning, the units
of the variable factor are employed along with the fixed factors, yielding increasing returns to
factor and reducing MC. It pushes down the MC curve. Now, when more variable factors are
employed, it results in diminishing returns and increasing MC after it reaches its minimum level.
Therefore, the MC curve falls to its minimum level and then increases, making the short-run MC
curve, U-shaped.

unit-3

What is an Ordinal Utility?

Ordinal Utility states that the satisfaction a consumer gets after consuming a good or service cannot
be scaled in numbers, whereas, these things can be arranged in the order of preference. Two
English economists, John Hicks and R.J. Allen 1930 argued that the consumer behavior theory
should be introduced based on Ordinal Utility. According to the ordinal approach, utility is a
psychological phenomenon like happiness, satisfaction, and welfare. The ordinal theory is highly
subjective and differs across individuals. Therefore, it cannot be measured in quantifiable terms.

The function that represents utility of a product according to its preference, but does not provide any
numerical figure, is known as an Ordinal Utility. In simpler words, this theory affirms that it is
relevant to ask which item is better as compared to others instead of how good is that product. For
example, a BMW car is favored more than a Toyota car, but it cannot be determined by what
percentage.

Apart from showing a mathematical function, a consumer’s preference can be demonstrated

graphically through indifference curves. It becomes easy when there are two types of commodities
x and y. Each indifference curve provides coordinates (x,y) when (x1, y1) and (x2, y2) lie on the
same curve line and (x1, y1) ~ (x2, y2).

This is an example of an indifference curve map where the preference of goods are shown but not
their quantity. Each of the curves represents a combination of two services or goods. The
consumers are equally satisfied with the goods and services. The more distant a curve is from the
origin, the higher its utility level.

The utility according to this approach can be measured in relative terms such as less than and
greater than. This approach states that consumer behavior can be explained in terms of
preferences or rankings. For example, a consumer may prefer soft drinks over hard drinks. In such
a case, the soft drink would have 1st rank, while 2nd rank would be given to hard drinks

Therefore, as per the Ordinal Utility approach, a consumer observes different pairs of two
commodities which would provide him/her the same level of satisfaction. Among these pairs, he/she
may prefer one commodity over the other based on how he/she ranks them in order of utility. This
implies that utility can be ranked qualitatively rather than quantitatively.

Do you know: In 1934 John Hicks and Roy Allen produced the first paper which declared Ordinal
Utility.
(Image will uploaded soon)

What is Cardinal Utility?

According to classical economists, utility is a quantitative concept that can be measured in terms of
a number. Hence they introduced the concept of measuring utility using a cardinal approach.
According to this concept, the utility can be expressed similarly to how weight and height are
expressed. However, the economists lacked a precise unit for utility. Hence, they derived a
psychological unit termed as ‘Util’. Util is not regarded as a standard unit because it varies from
person to person, place to place, and time to time. For example, if a person assigns 30 utils to a
pizza and 20 utils to a chowmein, we can understand that the pizza has double the capacity to
satisfy what humans want.

As util is not a standard unit for measuring utility, many economists, including Alfred Marshall
suggested measurement of utility in terms of money that consumers are willing to pay for a
commodity. If each rupee is equal to 1 util, a pizza worth Rs 30 has 30 utils and a chow min worth
Rs 20 has 20 utils. Hence, the consumer who consumes burgers will yield utility of 30 utils and
those who consume chow min will yield utility of 20 utils.
The supply and demand of a product decide its price. Moreover, a person’s desire for a product
depends on these three factors:

 Price of the item

 Income of a person
  The cost of other related items

Application of Cardinal Utility

Following are the different applications of Cardinal Utility: 

Welfare Economics: Under this structure, the production of goods and providing services are
judged by the personal wealth of an individual. This means that it presents a way to comprehend
the “greatest good to the greatest number of persons”. For example, by this act, a person’s utility
decreases by 75 utils and increases two other persons each by 50 utils. However, the overall
increase is 25 utils which is a positive offering.

Marginalism: In cardinal theory, a product’s marginal utility sign is alike for all the mathematical
forms, but its magnitude is not the same. This applies to the second derivative of a differentiable
utility as well.

Expected Utility Theory: This framework works for settlements that are to be made under risks.
Suppose there are a few lottery tickets that will provide outcomes. Here, it is possible to plot
preferences in real numbers so that numerical representation can be done.

Intertemporal Utility: In various representations of utility, where people deduct the upcoming
values of utility, cardinality comes into play. With the use of this, it is feasible to generate proper
utility functions.

Meaning of Indifference Curve

An indifference curve is the locus of all those combinations of two goods that yields the same
level of utility (satisfaction) to the consumer so that the consumer is indifferent to purchase the
particular combination s/he selects.

Such a situation arises because a consumer consumes a large number of goods and services.
Often he finds that one commodity serves as a substitute for another. This allows him to substitute
one commodity for another. In this case, he can make various combinations of two goods that give
him the same level of satisfaction. 

When a consumer faces such combinations of goods, he/she would be indifferent between the
combinations. When such combinations are plotted graphically, it gives a curve. This curve is
known as the indifference curve. It is also called the iso-utility curve or equal utility curve.
According to Anna Koutsoyaiannis, “An indifference curve is the locus of points-particular
combination or bundles of goods, which yields the same utility (i.e, satisfaction) to the consumer so
that he is indifferent as to the particular combination he consumes”.

Indifference Schedule:

A table that shows the various combinations of two goods that yield the same level of satisfaction to
the consumer is called indifference schedule. The table below is an example of an indifference
schedule that shows 5 different combinations A, B, C, D, and E of two goods X and Y. All these
combinations yield the same level of satisfaction to the consumer. Therefore, the consumer is
indifferent between them.

Indifference schedule:
Combinations Commodity-X Commodity-Y
 A 1 14
B 2 10
C 3 7
D 4 5
E 5 4

Indifference Curve/ Diagram/ Graph:

All the combinations of X and Y showed in the table above, give the same level of satisfaction to the
consumer. The indifference schedule, when plotted on a graph, gives an indifference curve as
shown in the figure below:

In the above figure, commodity X is measured on X-axis and commodity Y is measured on Y-axis.
IC represents an indifference curve. Points A, B, C, D, and E show combinations of X and Y
commodities that give the same level of satisfaction to the consumer. If we join these points, we get
a smooth, convex, and continuous negative sloped curve which is called the indifference curve.
Properties or Characteristics of Indifference Curve

The properties or characteristics of the indifference curve are as follows:

1. Indifference curve has a negative slope: 

An indifference curve slopes downward from left to right, ie, it has a negative slope. A negative
slope implies that the two goods are substitutes for one another. Therefore, if the quantity of one
commodity decreases, the quantity of the other commodity must increase if the consumer has to
stay at the same level of satisfaction.
In the above figure, when the consumer moves from point A to B, the quantity of Y decreases from
Y1 to Y2. At the same time, the quantity of X increases from X1 to X2 keeping the level of
satisfaction the same. The same thing happens as the consumer moves from point B to C. But the
decrease in Y i.e. Y2Y3 is less than Y1Y2 and the increase in X, ie. X2X3 is equal to X1X2.

2. Indifference Curve is Convex to the origin: 

Indifference curves for normal goods are convex to the origin. This implies that the two goods are
imperfect substitutes for one another and the marginal rate of substitution between the two goods
decreases as a consumer moves along an indifference curve. Diminishing marginal rate of
substitution means that as the quantity of X is increased by an equal amount then that of Y
diminishes by a smaller amount.

In the above figure, the indifference curve is convex to the origin. Convexity of indifference curve
implies diminishing slope because consumer gives up less and fewer units of Y to have an equal
additional unit of X. The slope of the IC curve measures the marginal rate of substitution
(MRS). Therefore, MRS also diminishes.
3. Indifference curves neither Intersect nor become tangent to one another: 

If two indifference curves intersect or are tangent to each other, it means that an indifference curve
indicates two different levels of satisfaction. If two indifference curves intersect, it violates
consistency or transitivity assumption.

Let us suppose that the two indifference curves IC1 and IC2 intersect to each other at point C. Point
C lies on both indifference curves where points A and B lie on IC1 and IC2 curves respectively.
Points A, B, and C represent three different combinations of commodities X and Y. Combination C
is common to both the indifference curves. It implies that in terms of utility;

Level of satisfaction at A = Level of satisfaction at C     ...... (i)

Again, level of satisfaction at B = level of satisfaction at C     ......(ii)

From (i) and (ii), Level of satisfaction at A = Level of satisfaction at B.

If A = B, OM of X + AM of Y = OM of X+ BM of Y.

More Precisely,

In IC1, A = C

In IC2, B = C

Then, A = B, which is absurd because A ≠ B. They are different points on different

indifference curves which yield different level of satisfaction.

Since OM of X is common to both the curves, it means that AM of Y is equal to BM of Y. But this is
not so in reality because of AM > BM. Therefore, combinations A and B cannot be equal in terms of
utility. Therefore, the intersection violates the transitivity assumptions.
4. Higher indifference curve represents a higher level of satisfaction than the lower ones: 

A higher indifference curve represents a higher level of satisfaction than the lower one. The reason
is that an upper indifference curve contains a larger quantity of one or both goods than the lower
one. 

Let us consider three indifference curves IC1 and IC2 and IC3. IC2 is a higher indifference curve
than IC1 and IC3 is a higher indifference curve than IC2. Every point that lies on IC2 gives higher
satisfaction than that of IC1. Every point that lies on IC3 gives higher satisfaction than that of IC2
because they contain more quantity of both goods (X and Y) than the combinations on lower ICs.
Hence, by the assumption of non-satiety, the consumer prefers IC3 to IC2. Similarly, we will prefer
any other combination that lies on IC2 than on IC1.

5. Indifference curves are not necessarily parallel: 

Another important property of the indifference curve is that Indifference curves are not necessarily
parallel. Though indifference curves are falling, negatively sloped to the right, yet the rate of fall will
not be the same for all indifference curves. In other words, the diminishing marginal rate of
substitution between the goods is not the same in the case of all indifference schedules. Therefore,
it is not necessary to be parallel between two indifference curves.
The starting point of IC1 and IC2 is very near in the above figure. When ICs are nearer to X-axis
their gap becomes higher and higher. The diminishing marginal rate of substation between X and Y
commodity is not equal so IC and IC2 are not parallel.

6. Indifference curve does not touch either of the axes: 

If indifference curve IC2 touches X-axis as shown in the figure below at M, the consumer will be
having OM of goods X and no Y. Similarly, if an indifference curve IC touches the Y-axis at N, the
consumer will be having only ON of good Y and no X. Such curves violate the assumption that the
consumer buys two goods in a combination. Therefore, indifference curves do not touch either of
the axes.

7. An indifference curve may not necessarily be a straight line:

An indifference curve is not linear or straight-line because the diminishing marginal rate of

substitution between two goods may not be the same. One individual may not be giving up the
same units of X goods to obtain the same units of goods Y. 

An indifference curve may not take the shape as shown in the figure above.

8. Combinations that lie on an indifference curve give the same level of satisfaction:

All the combinations that lie on an indifference curve give the same level of satisfaction. When a
consumer consumes a large number of goods and services, he finds that one commodity serves as
a substitute for another. This allows him to substitute one commodity for another one. In this case,
he can make various combinations of two goods that give him the same level of satisfaction.
In the above figure, all the combination points A, B, C, D, and E yield the same level of satisfaction
to a consumer. Furthermore, any combination along this IC gives the same satisfaction as that of
combinations A, B, C, D, and E.

9. Two indifference curves include more indifference curves between their gap:

There can be as many indifference curves between the gap or the open space between the
indifference curves IC1 and IC2 as shown in the figure below:

What is the Marginal Rate of Substitution?

The marginal rate of substitution (MRS) is the quantity of one good that a consumer must sacrifice
in order to increase the consumption of another good by one unit while maintaining the same level
of total satisfaction.

It is the slope of the negative sloping indifference curve and is an important tool to understand
consumer behaviour.

MRS Formula

The marginal rate of substitution formula can be expressed as:

 

MRS = (Change in the quantity of Good X / Change in the quantity of Good Y)

An image showing the formula of the marginal rate of substitution.

Calculation Example

Suppose a consumer is willing to give up three units of Good X for one unit of Good Y while
maintaining the same level of total satisfaction. In that case, the MRS would be 3.

Marginal Rate of Substitution and the Indifference Curves

Indifference Curve
An indifference curve is a curve that shows possible combinations of two goods that a consumer
can consume to get the same total satisfaction. Hence, the consumer will be indifferent.

The assumption here is that the consumer is rational.

 Graphical Representation
The MRS is represented by the slope of the indifference curve.

Let’s consider the following data table and graph.

An image showing the data table and graph of the indifference curve.

Let's take the example of a consumer who has a choice between two substitute goods: X and Y.
Each axis of the graph represents the quantity of one good. The X-axis (horizontal axis) shows the
quantity of good X and the Y-axis (vertical axis) shows the quantity of good Y. The consumer's
preferences can be represented by an indifference curve that shows all possible combinations of X
and Y that yield the same level of satisfaction. The slope of the indifference curve at any point
represents the MRS between the two goods at that point.

As shown in the above data table and standard convex shaped curve, each point on the
indifference curve represents a combination of two goods that yields the same level of total utility or
total satisfaction to the consumer. Points A, B, C, and D give the same total utility. So the consumer
is indifferent.

 All the points on the same indifference curve give the same total utility.
 All points below an indifference curve show inferior combinations because they give lower total
utility.
 All points above an indifference curve show superior combinations because they give higher total
utility.

The last column of the above table shows the marginal rate of substitution, which is decreasing.

The indifference curve is bowed inward (convex to the origin) because of the decreasing marginal
rate of substitution (MRS).  The diminishing marginal rate of substitution is due to the law
of diminishing marginal utility.

For example, suppose the consumer is initially consuming 1 unit of good X and 10 units of good Y,
represented by point A on the indifference curve. If the consumer gives up 5 units of good Y and
gets 1 more unit of good X, he/she would be at point B on the indifference curve, where the level of
satisfaction is the same as at point A. The slope of the indifference curve at point B (the MRS
between X and Y at point B) represents the rate at which the consumer is willing to substitute X for
Y.

The slope of the indifference curve is steeper at point B than at point C, which indicates that the
consumer is willing to give up more units of Y at point B for an additional unit of good X, and the
MRS is higher at point B (5) than at point C (3).

From point A to point B, MRS = 5, which means that five units of good Y give the same utility as the
second unit of good X. Hence, the second unit of good X is equal to five units of good Y in terms of
utility.

From Point B to Point C, MRS = 3, which means that three units of good Y give the same utility as
the third unit of good X. Hence, the third unit of good X is equal to three units of good Y in terms of
utility.

From Point C to D, MRS = 1, which means that 1 unit of good Y gives the same utility as the fourth
unit of good X. Hence, the fourth unit of good X is equal to one unit of good Y in terms of utility.
The value of 1 unit of X decreases with an increase in its quantity. This is according to the law of
diminishing marginal utility. Due to this reason, MRS decreases, and the indifference curve is
bowing inward. MRS will be constant for perfect substitutes, and the indifference curve will be a
straight line.

The Importance of Marginal Rate of Substitution

MRS is an important concept in economics because it helps us understand how consumers make
trade-offs between goods. By understanding MRS, economists can make predictions about how
consumers will react to changes in prices or incomes.

Limitations of Marginal Rate of Substitution

MRS has some limitations. One limitation is that it assumes that the consumer has perfect
information and can make rational decisions. However, in reality, consumers may not always have
perfect information and may make irrational decisions.

Budget line definition

The budget line, also known as the budget constraint, exhibits all the combinations of two
commodities that a customer can manage to afford at the provided market prices and within the
particular earning degree.

The budget line is a graphical delineation of all possible combinations of the two commodities that
can be bought with provided income and cost so that the price of each of these combinations is
equivalent to the monetary earnings of the customer.

It is important to keep in mind that the slope of the budget line is equivalent to the ratio of the cost of
two commodities. The slope of the budget constraint possesses distinctive importance.

In other words, the slope of the budget line can be described as a straight line that bends
downwards and includes all the potential combinations of the two commodities which a customer
can purchase at market value by assigning his/her entire salary. The concept of the budget line is
different from the Indifference curve, though both are necessary for consumer equilibrium.

The two basic elements of a budget line are as follows:

 The consumer’s purchasing power (his/her income)

 The market value of both the products
Read link: Deriving a Demand Curve from Indifference Curves and Budget Constraints

Equation of a Budget Line

To understand the concept of a budget line in a detailed manner, it is important to understand the
mentioned equation. The equation of the budget line equation can be represented as follows:

M = Px × Qx + Py × Qy

Where,

Px is the cost of product X.

Qx is the quantity of product X.

Py is the cost of product Y.

Qy is the quantity of product Y.

M is the consumer’s income.

Additional Reading: What is the Government Budget?

Example of a Budget Line

Radha has ₹50 to buy a biscuit. She has a few options to allocate her income so that she receives
maximum utility from a limited salary.

Budget schedule

Combination Cream biscuit Plain biscuit Budget allocation

(@ ₹10 per packet) (@ ₹5 per packet)

A 0 10 10 × 0 + 5 × 10 =
50

B 1 8 10 × 1 + 5 × 8 = 50

C 2 6 10 × 2 + 5 × 6 = 50

D 3 4 10 × 3 + 5 × 4 = 50

E 4 2 10 × 4 + 5 × 2 = 50

F 5 0 10 × 5 + 5 × 0 = 50

To get an appropriate budget line, the budget schedule given can be outlined on a graph.
The budget set indicates that the combinations of the two commodities are placed within the
affordability margin of a consumer.

Also, read: What is a Budget Set?

Features of Budget Line

Some of the properties of the budget line are as follows:

Negative slope: If the line is downward, it shows a reverse correlation between the two products.

Straight line: It indicates a continuous market rate of exchange in individual combinations.

Real income line: It denotes the income and the spending size of a customer.

Tangent to indifference curve: It is the point when the indifference curve meets the budget line.
This point is known as the consumer’s equilibrium.

What Is the Income Effect?

The income effect, in microeconomics, is the resultant change in demand for a good or service
caused by an increase or decrease in a consumer's purchasing power or real income. As one's
income grows, the income effect predicts that people will begin to demand more (and vice-versa).

So-called normal goods will exhibit this typical pattern. Inferior goods, on the other hand, may see
their demand actually fall as income increases. An example of such an inferior good could be
store-brand items: as people become wealthier they may opt instead for more expensive name
brands,

What Is Substitution Effect?

The substitution effect is the decrease in sales for a product that can be attributed to consumers
switching to cheaper alternatives when its price rises. A product may lose market share for many
reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price,
some consumers will select a cheaper alternative.

Difference between Substitution Effect and Income Effect

Basis Substitution Effect Income Effect

The practice of substituting one

The effect on demand that occurs when a
commodity with another when it
consumer’s real income changes as a result
Meaning becomes comparably less
of a change in the price of a
expensive is known as Substitution
given commodity is known as Income Effect.
Effect.

It is caused by a change in the price It is caused by a change in the consumer’s

Cause of the commodity with respect to the purchasing power when there is a change in
price of substitute commodities. the price of the given commodity.

Type of Substitution effect works for both

Income effect only works for normal goods.
Good normal and inferior goods.

Due to substitution effect, a

Due to income effect, when the price of a
consumer replaces the expensive
Result commodity falls, a consumer buys more of it
product with its substitute which is
as it increases his purchasing power.
available at a lower price.

Substitution effect works when there

Income effect works when a large number of
is at least one close substitute of the
Availability the same commodity is available in the
given commodity available in the
market.
market.

Substitution effect is reflected by the

Reflected Income effect is reflected by the movement
movement along the price-
by along the income-consumption curve.
consumption curve.

In the case of a normal good, higher real income leads to an increase in quantity demanded; this
complements the increase due to the substitution effect. This change is shown in the diagram
below.
In the case of an inferior product, the income effect leads to a fall in the quantity demanded, which
will work against the substitution effect. In the following diagram the substitution effect is Q2 Q5; the
income effect is Q5 Q4. However, the substitution effect outweighs the income effect and overall
the quantity demanded rises. The overall change in quantity demanded results in an increase of Q2
Q4. This means the demand curve is downward-sloping, because a price fall increases the quantity
demanded.

When a good is inferior and the income effect outweighs the substitution effect, it is called a Giffen
good. This is, however, unlikely, because the substitution effect is almost always stronger than the
income effect.

Another exception is the case where an increase in price

causes an increase in demand. This results in an
upward-sloping demand curve, and the good is called
a Veblen good.
One possible justification for a Veblen good is that people associate higher prices with status,
luxury, and quality, so that a higher price might increase the perceived value of a good.
 Ordinary demand curve

A consumer’s ordinary demand curve for a good, also called a Marshallian demand curve, gives
the quantity of the good he will buy as a function of its price.

The shape of the ordinary demand curve for a good depends upon the properties of the
consumer’s utility function, viz., diminishing marginal utility (dMU) in the case of Marshallian
utility theory and the diminishing marginal rate of substitution (dMRS) in the case of the
indifference curve theory.

For a non-giffen good, the ordinary demand curve would be negatively sloped. The ordinary
demand curve may be negatively sloped even in the case of an inferior good if the magnitude of
the substitution effect of a change in the price of the good is greater than that of the income
effect. A negatively sloped ordinary demand curve for any good, X, has been shown in Fig.

6.35.
 Meaning of Consumer's Surplus

A consumer’s surplus is also known as a buyer’s surplus. Professor Boulding named it ‘Buyer’s
surplus.’ Let us look at an example to understand the concept of consumer surplus. Suppose there
is a commodity called ‘X’ in the market. You would like to buy commodity X, as you deem that the
commodity is very useful.

The important point here is that commodity X does not have alternatives. When it comes to the
price of the commodity, you are willing to pay $10. However, when you inquire in the market, the
seller says that the price of the commodity is $5. Therefore, the difference between what you are
willing to pay and the actual price ($10 - $5 = $5 in our example) is called consumer’s surplus.

unit-8

demandc curve for single input variable input and serveral input variable in competitive market
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In a competitive market, the demand curve shows the relationship between the price of a product or
service and the quantity demanded by consumers. The shape of the demand curve depends on
whether the market is for a single-input variable or several input variables.

1. Demand Curve for Single Input Variable: In a single-input variable market, the demand curve is
usually downward sloping, which means that as the price of the product decreases, the quantity
demanded increases, and vice versa. This is the typical demand curve for most goods and services
in competitive markets.

The demand curve is represented as D(p) = Q(p), where:

 D(p) is the quantity demanded at a given price p,

 Q(p) is the demand function, which shows the relationship between price and quantity demanded.

Graphically, the demand curve is a downward-sloping line, with price on the y-axis and quantity
demanded on the x-axis.

2. Demand Curve for Several Input Variables: In a market with several input variables, the demand
curve can be more complex and can vary based on the prices of multiple related goods or services.

For example, in the case of complementary goods, where the demand for one product is influenced
by the price of another product, the demand curve may shift based on changes in the price of the
complementary good. Similarly, in the case of substitute goods, where consumers can choose
between two similar products, changes in the price of one product can affect the demand for the
other.

The demand curve for several input variables can be represented as D(p1, p2, ..., pn) = Q(p1,
p2, ..., pn), where p1, p2, ..., pn represent the prices of the respective input variables, and Q(p1, p2,
..., pn) represents the quantity demanded based on those prices.

Graphically, the demand curve may not be a simple line, but a more complex shape that changes
based on the interactions of the input variables.
 Overall, the concept of the demand curve remains the same in both cases – it illustrates how the
quantity demanded changes in response to changes in price or other relevant input variables.
However, in markets with several input variables, the demand curve can become more intricate due
to the interdependencies between the various goods or services

effects of minimum wage law on empolyment

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The effects of minimum wage laws on employment are a topic of ongoing debate among
economists and policymakers. There are both positive and negative impacts that can occur as a
result of implementing or increasing minimum wage laws. Here are some of the key effects:

1. Positive Effects on Employment:

 Higher wages can lead to increased motivation and productivity among workers, potentially
reducing turnover and absenteeism, which can benefit employers.
 When the minimum wage is raised, workers with low incomes may experience an improvement in
their financial situation, leading to increased consumer spending. This can boost demand for goods
and services, potentially leading to job creation in some industries.
2. Negative Effects on Employment:
 One of the main concerns about minimum wage laws is the potential for job losses, especially in
industries that rely heavily on low-wage labor. Employers may respond to higher labor costs by
reducing their workforce or cutting back on hiring new employees.
 Some small businesses, in particular, may find it challenging to absorb the increased labor costs
associated with higher minimum wages. This could lead to business closures or reduced working
hours for employees.
 In response to minimum wage increases, employers may seek alternative methods of production,
such as automation, to reduce reliance on labor. This automation could further impact employment
levels in certain industries.
3. Impact on Different Demographic Groups:
 Minimum wage increases can have a disproportionate effect on certain demographic groups, such
as teenagers and low-skilled workers. These groups may face reduced job opportunities and
increased competition for available positions.
 On the other hand, minimum wage laws can benefit certain vulnerable groups, such as low-income
families, by improving their overall standard of living.
4. Regional and Industry Differences:
 The effects of minimum wage laws can vary based on regional differences in the cost of living and
the prevailing wage rates in different areas.
 Certain industries, like fast food or retail, may be more affected by minimum wage increases due to
their reliance on low-wage labor.

determinant of employment
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Employment, the number of people who are currently employed in the labor market, is influenced by
a variety of factors. These determinants can be broadly categorized into demand-side factors and
supply-side factors:

Demand-Side Factors:

1. Economic Growth: Strong economic growth generally leads to increased demand for goods and
services, which, in turn, drives businesses to expand and hire more workers to meet the rising
demand.
2. Business Investment: Higher levels of business investment can lead to the creation of new
businesses or expansion of existing ones, resulting in more job opportunities.
3. Consumer Spending: When consumers spend more, businesses may need to increase production
and hire additional workers to meet the demand.
4. Government Spending: Government spending on infrastructure projects, public services, and other
programs can create employment opportunities directly and indirectly.

Supply-Side Factors:

1. Labor Force Participation: The size and composition of the labor force, which includes people who
are actively seeking employment, impact employment levels.
2. Workforce Skills and Education: The skills, qualifications, and education levels of the workforce
influence the types of jobs they are eligible for and their employability.
3. Demographics: Population growth, aging, and changes in family structures can affect the availability
of workers in the labor market.
4. Labor Market Regulations: Employment regulations, including minimum wage laws, labor union
influence, and employment protection laws, can affect the ease of hiring and firing workers.

Other Factors:

1. Technological Advancements: Technological innovations can lead to job displacement in certain

industries but also create new job opportunities in emerging sectors.
2. Globalization: Global trade and international competition can influence employment levels in various
industries, affecting the demand for labor.
3. Government Policies: Various policies, such as taxation, monetary policies, and fiscal measures,
can have implications for employment levels.
4. Seasonal and Cyclical Factors: Some industries may experience fluctuations in demand due to
seasonal variations or economic cycles, impacting employment.

determination of equilibrium price of factors and employment

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The determination of the equilibrium price of factors (such as labor) and employment is a crucial
aspect of labor market analysis. In a competitive labor market, the equilibrium wage (price of labor)
and level of employment are determined by the interaction of labor demand and labor supply. The
process can be explained as follows:

1. Labor Demand: Labor demand represents the number of workers that businesses or employers are
willing to hire at different wage levels. Several factors influence labor demand, including:
 Product Demand: Higher product demand leads to increased production, requiring more labor to
meet the demand.
 Labor Productivity: Higher productivity makes hiring additional labor more profitable for businesses.
 Technology and Automation: Technological advancements and automation can affect labor demand
by replacing some tasks previously performed by workers.
 Input Costs: If the cost of labor is relatively lower than other inputs, businesses may prefer to hire
more workers.
2. Labor Supply: Labor supply represents the number of workers willing and able to work at different
wage levels. The labor supply is influenced by factors such as:
 Population Size: A larger population usually means a larger labor force.
 Workforce Participation: The proportion of the population actively participating in the labor market
affects the labor supply.
 Education and Skills: The level of education and skills of the workforce impacts their employability
and wage expectations.
 Government Policies: Policies such as unemployment benefits and labor market regulations can
influence labor force participation.
3. Equilibrium Wage and Employment: The equilibrium wage and employment occur at the point
where the quantity of labor demanded by employers matches the quantity of labor supplied by
workers. At this equilibrium point:
 If the wage is above the equilibrium level, there is excess labor supply (unemployment). In this
case, there are more workers willing to work at the higher wage, but employers do not require that
many workers, leading to unemployment.
 If the wage is below the equilibrium level, there is excess labor demand. There are more job
openings at the lower wage, but there are not enough workers willing to work at that wage, leading
to labor shortages.