Managerial Economics
UNIT – 1 : Introduction
O. S. Suguna Sheela
Meaning
O Managerial economics is economics applied
in decision making.
O It connects theory and practice
O It is based on economic analysis for
identifying problem, organizing information
and evaluating alternatives
Meaning
O Goal oriented
O Prescriptive
O Maximum achievement of objective
O Selecting best alternative choice
Definition
O Spencer and Siegelman : “Managerial economics
is the integration of economic theory with
business practice for the purpose of facilitating
decision making and forward planning by
management”
O Mc Nair and Meriam : “Managerial Economics is
the use of economic modes of thought to analyze
business situation”
O Watson : “ME is price theory in the service of
business executives”
Feature
O Concerned
O
O
O
O
with decision making of
economic nature
Goal oriented and prescriptive
Pragmatic
Conceptual and metrical
Link between traditional economics and
decision sciences
Decision Problem
Traditional
Economics
Managerial
Economics
Optimal Solution to Business Problems
Decision
Sciences
Nature of managerial economics
O
O
O
O
O
O
O
O
O
Microeconomic in nature
Work with given macro economic condition
Pragmatic
Goal Oriented
Prescriptive
Normative Science
Conceptual and metrical
Helps in decision making and forward planning
Integration of economic theory and business
practice
Scope
O
O
O
O
O
O
O
O
O
O
O
O
O
O
O
O
1. DEMAND ANALYSIS & DEMAND FORECASTING
2. PRODUCTION POLICY AND COST ANALYSIS
3. SUPPLYPOLICY
4. PRICING AND PRICE POLICY
5. RELATION OF PRICE ANDOUTPUT
6. SALES PROMOTION
7. MARKET STRUCTURE, COMPETITION AND STRATEGY
8. PROFIT MANAGEMENT AND MAXIMISATION
9. INPUT – OUTPUT ANALYSIS
10.INVENTORY CONTRIBUTION
11. INVESTMENT&CAPITAL BUDGETING
12. OBJECTIVES OF FIRM
13. GOAL SETTING AND STRATEGIC PLANNING
14. RESOURCE ALLOCATION
15. TRADITIONAL ECONOMICS
16.ECONOMIC ENVIRONMENT OF BUSINESS
Significance
Tools in Managerial Economics
Opportunity cost principle
Incremental principle
Time perspective
Discount Principle
Equi-Marginal Principle
Contribution
Risk and Uncertainty
Negotiation Principle
Opportunity cost principle:
O Benham : “The opportunity cost of anything is
the best alternative which could be produced
instead by the same factors or by an equivalent
group of factors, costing the same amount of
money”.
O W. W. Haynes : “Opportunity cost of a decision
means the sacrifice of alternatives required by
that decision “.
O Adam Smith has explained opportunity cost like
this –If a hunter finds a bear and a dear while
hunting, if he kills bear, dear is the opportunity
cost & vice versa.
Incremental principle:
O We can say incremental principle is an
extension of marginal principle.
O In the incremental concept, managerial
economists use incremental cost and
incremental revenue more.
Time perspective:
O Traditional Economists divide the time element into four
as very short run, short run, long run & very long run.
The demarcations of short run and long run is done
based on the fixed and variable input. But Managerial
economist is interested in division of time element into
two-Short run and Long run, because he is interested in
making policies for the immediate future (short run) or
remote future (long run). Definitely, effect of short run &
long run on revenue, cost, production, decision about
the plant size, etc. makes a lot of difference to him.
Time distinction is very essential in making essential
decision, particularly in deciding about size of the plant,
knowing about the stage of law of production, pricing
the full cost according to time, etc.
Discounting principle:
O Discounting principle is a continuation of time perspective &
we can say it is a corollary of time perspective.
O The old proverb “A bird in hand is better than two in the bush”
is a representative of this discounting principle. The worth of a
rupee receivable tomorrow is less than that of a rupee
receivable today. Since the future is unknown & incalculable,
also there is a lot of risk & uncertainty about the future. If the
return is same for now & future, then definitely present return
will be given importance. So the future must be discounted
both for the elements of waiting & risk of the future. Even if
one is certain that he will get some income in the future, it is
essential to make a discount in the income because he has to
wait for the future, which involves sacrifice. Moreover inflation
may reduce the purchasing power. For making a decision
regarding investment which will yield a return over a period of
time, it is important to find its net present worth. To know the
returns over a period of years to decide over an alternative
investment, it is necessary to use discounting principle.
Discounting principle:
O Suppose the bank fixed rate is 7% per annum. A person who is
O
O
O
O
O
O
O
having 1000 rupees this year can get 1070/- rupees along
with the returns. We can say 1070/- next year is worth 1000/today. This is the net present value. We can find this by using
the formula.
Present value or discounted value V = R/(1+i)
Where, i is the interest rate
V is the present value
R represents the returns i.e. Present value + interest
So we can determine the amount we have to invest now in
order to get particular amount after certain years.
The sum of present value of returns for n years would be
V = R1 / (1+i) + R2 / (1+i) 2 + ……… +R n / (1+i)n
=
n R / (1+I )k
∑
k
Equi- Marginal principle :
O
O
O
O
O
O
To make optimum allocation of resources, a firm can use equi-marginal principle.
Equi-marginal principle can be applied to the allocation of the resources between
their alternative uses with a view to maximize their profit in case a firm carries out
more than one business activity.
Equi-marginal Principle States that an input must be allocated between various
uses in such a way that the value added by the last unit of the input is the same in
all its uses.
To understand the principle, let us assume a simple example. Suppose a firm
produces two products A & B and market price of both the product is the same.
Suppose the last unit of the labor used for production of A gives rise to a marginal
product of 20 units and the last unit of the labour used in producing B gives rise
to a marginal product of 30 units, then the firm must shift the labor from
production of A to B. Firm should relocate the laborers till the Marginal product of
A = Marginal product of B of the last labourer used in both production. When
prices are different, then
MPA / PA = MPB /PB
It can be generalised as
MPA / P A = MPB /P B = MPC / PC =… ………=MPN / PN
Concept of contribution:
O
O
O
This concept takes help from both the principles of incremental reasoning and
opportunity cost. The concept of contribution tells us about the contribution of a
unit of output to overheads and profit. It helps in determining the best product mix
when allocation of scarce resources is involved. It also indicates whether it is
advantageous or not to accept a fresh order, to introduce a new product, to shut
down, to continue with the existing plant, to make or to outsource etc. Unit
contribution is the per unit difference between incremental revenue from
incremental cost. In case of a firm with excess capacity, a new product can be
introduced easily as it is likely to contribute very little to cost but significantly to
Revenue. And some contribution is better to none. On the other hand, if the firm
has a backlog of orders for the existing products, then the new product, if
introduced, will have to compete for the use of the same production facilities which
the existing products are using. In such a case the choice between clearing the
backlog orders of the existing product and introduction of a new product will
depend upon their respective contributions. Production facilities will be allocated
on the basis of which of these products can contribute more.
If the firm has only a single source which is scarce, say, the machine time
availability and rest of the resources are abundantly available should look at
contributions per machine-hour. Firm will produce that product which uses less
machine-hour.
Risk & uncertainty:
Economic theory of the firm generally assumes that the firm has
perfect knowledge of its cost and demand relationships and of its
environment. Uncertainty is not allowed to influence the decisions of
the firm.
O Yet, we know that in the real world uncertainty influences the
estimation of costs and revenues, and hence the decisions of the firm.
Since future conditions are not perfectly predictable, there is always a
sense of risk and uncertainty about the outcome of such decisions. The
major problem therefore remains how to measure the uncertainty. The
Economists have tried to take an account of uncertainty with the help
of subjective probability. It is assumed that profit expected from the
adoption of any action may assume any value within a certain range of
values, each value having an associated probability of being realized.
This requires formulation of definite subjective expectations about the
cost, revenue and the environment which is very difficult.
O
The Negotiation principle:
O Everything in real commercial world is
negotiable such as prices, terms and
conditions of payment, commissions,
payment to labourers, etc. If the negotiation
is successful both the parties will be happy.
It leads to win win situation which is good for
the flourishment of an industry.
O Apart from this, it uses many tools like
slope, differentiation, functions,
econometric modules, etc.
Responsibility of Managerial Economists
O First and the foremost important responsibility of a
O
O
O
O
O
Managerial Economist is to make profit on the
invested capital.
Set the objectives and goal according to the
situations prevailing inside the firm and type of the
firm.
Make proper decision making policies, programs
and plans for the proper working of the firm.
Make correct forecast about the future and plan
for the forward planning
Minimize the risk because business means risk
and uncertainty
Be vigilant
Role of Managerial Economist:
O Making decision and processing information
are two primary tasks of managers
O In order to make intelligent decisions,
managers must be able to obtain, process
and use information
O The purpose of learning economic theory is
to help managers know what information
should be obtained and how to process and
use the information
QUESTION BANK FOR UNIT I
ESSAY QUESTIONS
1) Bring out the nature of managerial economics.
2) Bring out the SCOPE of managerial economics.
3) Explain the major economic tools applicable in managerial economics.
4) What are the characteristic features of managerial economics?
SHORT QUESTIONS
1)
2)
3)
4)
5)
Define managerial economics
Discounting principle
TIME ELEMENT
OPPORTUNITY COST
Forward planning and goal setting
Managerial Economics
UNIT – 2 : Demand & Supply Analysis
O. S. Suguna Sheela
Syllabus
O Meaning of Demand, Demand Function,
Curves, Individual and Market Demand,
determinants of demand-Types of Demand.
Elasticity of Demand - Types of Elasticity, its
measurement and business uses.
O Meaning of supply-supply function-supply
curve-determinants of supply –law of supply
Demand - Definition
O According to Prof. Hibson, “Demand means the
various quantities of goods that would be purchased
per time period at different prices in a given market. “
thus three things are necessary for the demand to
exist;
O (1) Desire for the commodity,
O 2) ability to purchase the commodity and
O 3) willingness to pay the price of the commodity.
O Benham - “The demand for a commodity refers to the
amount of it which will be brought per unit of a time
at a particular price”.
Demand - Function
O The functional relationship between the demand for a
commodity and its various determinants may be
expressed mathematically in terms of a Demand
Function.
Dx = f(Px,Py,M,T,A,U)
O
Dx = Quantity demanded for commodity X
O
Px = Price of commodity X
O
Py = Price of substitutes and complementary goods
O
M = Money income of the consumer
O
T = Taste of the consumer
O
A = Advertisement effects
O
U = Unknown variables or influence.
Determinants of Demand
O Individual Demand
O Market Demand
Determinants of individual Demand
O Price
O Income
O Price of related goods
O Taste and habit
O Price expectation
O Income expectation
O Climatic condition
Determinants of market Demand
O Price
O Distribution of Income & wealth
O Price of other related goods in market
O Scale of preference
O Future Price expectation
O General standard of living & spending
habit
O No. of buyers in the market &
population growth
Determinants of market Demand
O Age structure & sex ratio of population
O Tax
O Fashion & custom
O Climatic & weather condition
O Advertisement & sales propoganda
O Inventions & innovations
Individual Demand Schedule
O Demand schedule expresses the relationship between
price and demand of an individual
PRICE
DEMAND
26
1
18
2
12
3
10
4
Demand Curve
O A demand curve is a graphical
representation of a demand schedule when
price quantity information is plotted on a
graph. Thus, demand curve depicts a picture
of a data contained in the demand
schedule.
Individual Demand Curve
Market Demand Schedule
PRICE per
Quintal (Rs)
Amount
Amount
Total Market
Demanded by Demanded by DEMAND
Buyer A
Buyer B
50
5
10
15
40
15
20
35
30
25
30
55
Market Demand Curve
Law of Demand
Other things remaining constant, people will
buy more at less price and buy less at high
price – Samuelson
In Fergusons’s words, “According to the law of
demand, the quantity demanded varies
inversely with price”.
Statement of Law
O Marshall states the law of demand as:
“The amount demanded rises with a
fall in price and diminishes with a rise
in price.”
O The law can also be stated as “other
things being equal, higher the price of a
commodity, the smaller is the quantity
demanded and lower the price, larger is
the quantity demanded.”
Assumptions of the law
O Consumers income should remain same.
O There should not be any change in tastes
and preferences of consumers.
O The price of related goods should remain
unchanged.
O There should not be any change in fashions,
weather conditions, populations, etc.
O The consumer should also not expect the
prices to change in the future.
Explanation of the law
O The law of demand can be illustrated through a
demand schedule and through a demand curve.
O Following is a demand schedule that shows an
inverse relationship between price and quantity of a
product.
Price
Quantity Demanded
12
10
10
20
8
30
6
40
4
50
2
60
O Write & explain individual demand schedule
O Draw and explain individual demand curve
O Write & explain market demand schedule
O Draw and explain market demand curve
Why does the demand curve
slope downwards
O Law of diminishing M.U.
O SUBSTITUTION EFFECT
O INCOME EFFECT
O PSYCHOLOGICAL EFFECT
O NEW BUYER
O MULTIPLE USE
Exceptions to the law of
demand
O Giffen paradox-inferior good
O Veblen effect-snob appeal good
O Expectation about future price
O Speculation
O Expectation of future income
O Demonstration effect
O Market ignorance
O Price illusion- high priced product –quality
Exceptions to the law of
demand
O Price ignorance
O Off season & fashion
O Lottery,acquiring property,,,,
Importance of demand
O Sales forecasting
O Product decisions
O Pricing policy
O Market decisions
O Financial decisions
O Government policy
Types of demand
O Price demand
O Income demand
O Cross demand
O Individual demand
O Market demand
O Autonomous demand& derived demand
O Company demand & industry demand
O Short run &long run demand
Types of demand
O Joint demand and composite demand
O Demand for perishable good & durable
goods
O Demand for consumer good &producer good
Income demand
O According to Prof. Hibdon, “ income Demand
means the various quantities of goods that
would be purchased per time period at
different income in a given market. “
O D=f(Y)
Income Demand Schedule
O Demand schedule expresses the
relationship between income and demand of an
individual
income
demand
10,000
10
20,000
20
30,000
30
40,000
40
Cross demand
O Demand is of two types of goods……related
O
O
O
O
and unrelated.
Cross demand deals only with related goods
Related goods is of two types--1)substitutes
2)complementary
Cross demand
O In price demand, price & demand of the
same product is considered
O But in cross demand , price of one product
and demand of another related product is
studied
Cross demand for substitute goods
O Eg of substitute goods
O Tea or coffee
O Htc or apple phone
Cross demand for substitute
goods
O When the price of coffee goes up, coffee will
O
O
O
O
become dearer & so the consumer will
substitute a cheaper product tea. With that
demand for tea will go up
substitutes have a positive cross demand.
i.e.when p of C RISE, D for T rise
Table
graph
Cross demand for
complementary goods
O When the price of ink goes up, demand for
pen goes down
O Complementary goods have a negative cross
demand.
O i.e.when p of INK RISE, D for fall
O Table
O graph
increase
decrease
ELASTICITY OF DEMAND
O According to Marshall, “Elasticity or
responsiveness of demand in a market is
great or small according, as the amount
demanded increases much or little for a
given fall in the price and diminishes much
or little for a given rise in price.”
O . Stonier and Hague deifned Elasticity of demand
as a technical term used by the eocnomist to
describe the degree of responsiveness of the
demand for a commodity to a change in its price.
https://www.economicsdiscussion.net/elasti
city-of-demand/5-types-of-price-elasticity-ofdemand-explained/3509
ELASTIC DEMAND CURVE
P
S
Q
T
INELASTIC DEMND CURVE
P
S
Q
T
DETERMINANTS OF ELASTICITY OF
DEMAND
O 1)Nature of the commodity
O Necessary-inelastic
O Luxury –ela
O 2) availability of substitutes
O Yes- ela
O No –inela
O 3)uses
O Multiple-ela
O Single -inela
DETERMINANTS OF ELASTICITY OF
DEMAND
O 4)Postponment of consumption
O no -inelastic
O Yes –ela
O 5) price of product
O Low & medium - ela
O High –inela
O 6) time
O long run -ela
O Short run -inela
DETERMINANTS OF ELASTICITY OF
DEMAND
O 7)Percentage of expenditure
O low -inelastic
O High –ela
O 8) knowledge of the market
O Yes - ela
O No –inela
Types of price elasticity of
demand
O Running note I sem poe
O table
Uses of elasticity of demand
O Useful to businessmen –elastic-decrese in
O
O
O
O
O
O
O
price will benefit, inelastic-increase in price
Monopoly
Discriminating momopoly
Poverty in the midst of plenty
Devaluation
Trade union
Finance minister
Joint product
METHODS TO MEASURE THE
ELASTICITY OF DEMAND
O https://www.youtube.com/watch?v=ZWwOE
kb0iOM
O https://www.youtube.com/watch?v=pVeJVIJ
uaUI
O https://www.yourarticlelibrary.com/economi
cs/elasticity-as-demand/4-most-importantmethods-of-measuring-price-elasticity-ofdemand/10672
METHODS TO MEASURE THE
ELASTICITY OF DEMAND
O PERCENTAGE METHOD
O POINT METHOD
O TOTAL EXPENDITURE METHOD
O ARC METHOD
O SLOPE METHOD
O REVENUE METHOD
PERCENTAGE METHOD
O Known as proportionate method or
Arithmetic method or ratio method
O Same as in eg--- formula
Income elasticity of demand
O In economics, the income elasticity of demand is
the responsiveness of the quantity demanded
for a good to a change in consumer income. It is
measured as the ratio of the percentage change
in quantity demanded to the percentage change
in income.
O Income Elasticity of Demand (YED) =
%
change in quantity demanded / % change in
income
O As income rises, qty dd rise-----positive slope
Income elasticity of demand
Ey
O Similar table to price elasticity
O E=0, per.inela---- SALT , MEDICINE
O E<1, rel inela---necessary
O E =1, unitary ela.---- comfort
O E>1 , rel ela-------- luxury
O E=infinite X BUT E WILL BE NEGATIVE for
inferior goods
Cross elasticity of demand
Exy
O cross elasticity of demand, is measurement
of percentage change in the
quantity demanded by the percentage
change in the price of the related good
O Related good can be substitutes or
complementary goods
O Sub---when of coke rise, dd for pepsi rise---+slope upwards
Cross elasticity of demand
Exy
O complementary goods--- -ve- slope
downwards--O Table
O Substitutes----e=0unrelated
e>1  better sub
E=infin----per sub
SUPPLY
MEANING
The term supply refers to the amount of a
good or service that the producers are
willing and able to offer to the market at
various prices during a period of time.
DETERMINANTS OF SUPPLY / FACTORS AFFECTING
SUPPLY
1. Price of the Product
2. Price of Related Goods
3. Prices of Factors of Production
4. Availability & quality of raw M.
5. Technology
6. Government Policy
7. Future Expectation about Price
8. Other Factors
SUPPLY FUNCTION
S = f (P, Pr, Pf, T, G, E, O)
1. P - Price of the Product
2. Pr - Price of Related Goods
3. Pf - Prices of Factors of Production
4. T - Technology
5. G - Government Policy
6. E - Future Expectation about Price
7. O - Other Factors
DETERMINANTS OF SUPPLY /
FACTORS AFFECTING SUPPLY
Price of the Product (P): When price increases then supply
increases and when price decreases then supply also
decreases. There is a positive relation between price and
supply.
Price of Related Goods (Pr): The supply of a commodity
depends upon the prices of all other commodities. If prices of
related commodities (substitutes or complements) rise, they
will become relatively more attractive to produce and the
supply of that commodity rises. But supply of another
commodity will fall. So there is an inverse relation.
DETERMINANTS OF SUPPLY /
FACTORS AFFECTING SUPPLY
Prices of Factors of Production (Pf) – Cost of Production: A
rise in prices of factors of production of a commodity will
make the production of that commodity less profitable, so
supply will decrease. If costs of production decreases then
supply will increase. There is an inverse relation between
supply and cost of production.
Technology (T): Technology advances based on new
discoveries and innovations reduce the cost of production
and results in more and more supply of the commodity. With
the traditional technology, supply cannot be increased.
DETERMINANTS OF SUPPLY /
FACTORS AFFECTING SUPPLY
Government Policy (G): The government policy may affect
the supply by imposing taxes and providing subsidy. If
government policies are favourable (decrease in taxes and
increase in subsidy) then supply will increase and if
government policies are unfavourable (increase in taxes and
decrease in subsidy) then supply will fall.
Future Expectations about Prices (E): If there is future
expectation about rise in price then supplier will not increase
the supply at present and if there is future expectation about
fall in price then supplier will increase his supply.
DETERMINANTS OF SUPPLY /
FACTORS AFFECTING SUPPLY
Other Factors: The supply of product also depends
upon natural factors, government’s industrial and
foreign policies, infrastructure facilities, time,objectives
of the firm, applicability of law of returns to scale,
market structure and production capacity.
LAW OF SUPPLY
“Ceteris Paribus, the quantity supplied of a
commodity tends to rise with the rise in its
price, conversely, the quantity supplied of a
commodity tends to fall with a fall in its
price.”
Assumptions:






No change in the prices of factors of production.
No change in Technology.
No change in Government Policy.
No change in the future expectation about prices.
No change in Price of related goods.
No change in the business environment.
SUPPLY SCHEDULE & CURVE
INDIVIDUAL
SUPPLY SCHEDULE
& CURVE
MARKET SUPPLY
SCHEDULE &
CURVE
INDIVIDUAL SUPPLY SCHEDULE &
CURVE
Price (Rs.)
Quantity
Supplied (Units)
1
10
2
20
3
30
4
40
5
50
MARKET SUPPLY SCHEDULE &
CURVE
Price
QS by QS by QS by Total
Seller Seller Seller (Mar
1
2
3
ket)
1
1
2
3
1+2+3
=6
2
2
3
4
9
3
3
4
5
12
4
4
5
6
15
5
5
6
7
18
MOVEMENT IN SUPPLY CURVE
(CHANGE IN QUANTITY SUPPLIED)
 When supplied quantity due to change in only PRICE,
it is called MOVEMENT.
 MOVEMENT are two types:
 Expansion in Supply – Rise in supply due to rise in its
price is called “Expansion in Supply”.
 Contraction in Supply – Fall in supply due to fall in its
price is called “Contraction in Supply”.
MOVEMENT IN SUPPLY CURVE
(CHANGE IN QUANTITY SUPPLIED)
SHIFT IN SUPPLY CURVE
(CHANGE IN SUPPLY)
 When supply of a commodity changes due to change
in factors OTHER THAN PRICE i.e., Pr, Pf, T, G, E, O.
 Following are the factors that can shift a supply curve:






Changes in the price of related goods.
Change in factor price (cost of production)
Change in Technology
Change in Govt. Policy.
Future Expectations about prices
Other
INCREASE IN SUPPLY
 Reasons for Increase in Supply:
 Decrease in price of related
goods.
 Decrease in cost of production.
 Advanced Technology.
 Favourable Govt. Policy
 Future Expectation about
decrease in price.
 Others
DECREASE IN SUPPLY
 Reasons for Decrease in Supply:
 Increase in price of related
goods.
 Increase in cost of production.
 Traditional Technology.
 Unfavourable Govt. Policy
 Future Expectation about
increase in price.
 Others
Exceptions to the Law of Supply








Backward sloping supply of Labour
Auction
Rare Collections
Agricultural Output in the Short Run
Need for hard cash of the entrepreneur
Share Market
Leaving the industries or closing the industry.
Expectation of the future prices.
QUESTION BANK FOR UNIT II
Essay
1) LAW OF DEMAND
2) DETERMINANTS OF DEMAND
3) WHAT ARE THE DIFFERENT TYPES OF ELASTICITY OF
DEMAND?
4) WHAT ARE THE DIFFERENT TYPES OF PRICE ELASTICITY OF
DEMAND ?
5) WHAT ARE THE DIFFERENT TYPES OF MEASURES TO
MEASURE THE ELASTICITY OF PRICE DEMAND ?
6) WHAT ARE THE DIFFERENT TYPES OF DEMAND ?
7) LAW OF SUPPLY
SHORT QUESTIONS
1) DEMAND FUNCTION
2) DETERMINANTS
3) INCOME OR CROSS DEMAND
4) ELASTICITY OF DEMAND
5) METHOD
6) DETERMINANTS OF SUPPLY
7) EXCEPTIONS OF DEMAND
8) EXCEPTIONS OF SUPPLY
9) USES OF ELASTICITY
10) DEMAND CURVE
SYLLABUS –III UNIT
Unit III: Production Function
• Meaning of Production Function, Production
function with one variable input, Law of
Variable Proportions, Single output Isoquants,
Optimal Combination of Factor inputs, and
returns to scale. Cobb Douglas Production
Function.
PRODUCTION
• Production is an activity carried out under the
control and responsibility of an institutional unit
that uses inputs of land, labour, capital, and
organisation to produce outputs of goods or
services.
• Changing the input into output with the use of
some technology
• Not only goods-even services –agricultural
harvesting--> production
PRODUCTION FUNCTION
• The production function is expressed in a
functional form as Q = f( L,k, P,O,T,G,I,R,…)
• The simplest production function is:
• Q = f(L, K)
Types of production function
long run production function Q=f(L,K)
Short run production function Q=f(K), L or
Q=f(L), K
LINEAR & NON LINEAR
PRODUCTION FUNCTION
• The production function is expressed in a
functional form as Q = f( L,k, P,O,T,G,I,R,…)
• The simplest production function is:
• Q = f(L, K)
PRODUCTION FUNCTION
•
•
•
•
•
Short run production function can be
Q= a+bl
----linear
Q=a+bL-c𝐿2
----quadratic
Q=a+bL-c𝐿2 +d𝐿3 -----cubic
Q=a+b𝐿𝛼
----- power function
Types of production function
•
•
•
•
•
•
Cobb-Douglas production function
Q = ALαKβ Aconstant, 𝛼, 𝛽 are parameters
Leontief production function
Constant elasticity of substitution p.f.
Variable elasticity of substitution p.f.
Linear programming p.f.
BASIC CONCEPTS
DEFINITION OF
law of variable proportion
• According to Sammuel son “An increase in
some input related to other comparitively
fixed inputs will cause output to increase. But
after a point the extra output resulting from
the same additions of inputs will become les
and less. This falling off of extra returns is a
consequence of the fact that the new doeses
of the varying resources will have less and less
of the constant resources to work with.
DEFINITION OF
law of variable proportion
• This law is applicable in the short run.
• the studies about the output or returns when
the variable inputs are changed, keeping the
fixed input as consant.
• This law proves that output changes in 3
stages.
DEFINITION OF
law of variable proportion
• In the first stage when the variable input
increases, the marginal output increases.
• In the 2nd stage, when the variable input
increases in the same proportion, the
marginal output decreases.
• In the 3rd stage even though variable input is
increased in the same proportion the output
becomes negative.
Assumptions OF
law of variable proportion
• This technique of production remains
constant.
• This law is applicable in the short run.
• All the variable inputs are homogenous.
• The ratio of variable inputs to the fixed
input remains constant
• The price of the inptus are given and remains
constant
TOTAL NO.OF
WORKERS
TOTAL
PRODUCT
1
2
3
4
5
6
7
8
8
20
36
48
55
60
60
56
M.P
A.P
LIMITATIONS
• Technology changes often in this modern world
• The prices of input changes
• The proportion of variable input to fixed input may not be
suitable with the change in technology.
• The law will not be applicable if it is newly cultivated land.
• The labour and capital are in less than the optimal
proportion to land i.e. the output may be increased with
the increase in the proportion of labour and capital
.
Importance
•
•
•
•
•
•
Malthus population theory
Ricardian rent theory
Optimal production point can be known
Helpuful to industrialist
Disguised unemployment
Secular stagnation in developed cty.---rate of
growth decrease—new K dimin. R OF k, --inventions to absorb new K
Law of Returns of Scale
• When all the inputs are increased in the same
proportion in the long run,The marginal
output will increase initially. Then, it will
become constant and finally the marginal
output will diminish, even though the input is
increased in the same proportion.
• The responsiveness of output to a given
proportionate change in the quantities of all
inputs is called returns to scale.
Assumptions
• The law is applicable in long run.
• The price of inputs are given and remains
constant.
• The inputs are homogenous.
• We will be able to calculate the marginal output
continuously
• All the inputs are increased in the same
proportion i.e. the proportion of various inputs
increased are kept constant.
Explanation
Input
2K+5L
4K+10L
6K+15L
Marginal output
8
9
10
stage
8K+20L
10K+25L
11
11
CONSTANT
12K+30L
14K+35L
16K+40L
10
9
8
DIMINISHING
INCREASING
Reasons for increasing returns to scale
•
•
•
•
•
Specialisation
Use of special machinery
Economies of large scale production
Full capacity utilisation of indivisible factors
Dimensional economies
Reasons for diminishing returns to
scale
•
•
•
•
•
Diseconomies of large scale production
overutilization of indivisible factors
Management & coordinaton becomes difficult
Higher factor price
Exhaustible natural resources
ISOQUANT
• Production function using 2 variable inputs
• Greek word iso means equal and Latin
word qunatus meaning ‘quantity’.Isoquant is
therefore called as the “Equal Product Curve”
• As isoquant curve can be defined as the locus of
points representing various combinations of two
inputs yielding the same output.
• An isoproduct curve is a curve along which the
maximum achievable rate of production is
constant
Definition of ISOQUANT
• According to Ferguson, "An isoquant is a curve
showing all possible combinations of inputs
physically capable of producing a given level of
output“
• In the words of Peterson, "An isoquant curve may
be defined as a curve showing the possible
combinations of two variable factors that can be
used to produce the same total product"
Example
ISOQUANT SCHEDULE
COMBINATION
UNITS OF
CAPITAL
UNITS OF
LABOUR
TOTAL
OUTPUT
A
9
5
100
B
6
10
100
C
4
15
100
D
3
20
100
• GRAPH IN JAM BOARD
PROPERTIES OF ISOQUANT
• 1) isoquants are negatively iNCLINED--if any
other shape input increases but output will
not increase
• Jam board
• 2)an isoquant lying above & to the right of
another represents a higher output level
• graph
PROPERTIES OF ISOQUANT
• 3) no two isoquants can intersect each other
• 4) isoquants need not be parallel to each
other-----rate of subtitution need not be same
in all Iso. Sch.
• 5) in between two isoquants there can be any
number of isoquants representing different
levels of outputs
PROPERTIES OF ISOQUANT
• 6) units of output shown on isoquant are
arbitrary
• 7) no isoquant can touch either axis
• Graph
• 8)each isoquant curve is convex to the origin------MRTS diminishes
• 9) Each isoquant is oval shaped
• graph
MRTS
COMBINATION
UNITS OF
CAPITAL
UNITS
OF
LABOUR
MRTSOF
TOTAL
OUTPUT L FOR C
A
9
5
100
…
B
6
10
100
3:5
C
4
15
100
2:5
D
3
20
100
1:5
https://www.youtube.c
om/watch?v=8W4Qab
BsW0A
ISOCOST CURVE
• Isocost line shows various combinations of
inputs that a firm can purchase or hire at a
given cost
• IT IS ALSO CALLED AS PRODUCER’S OUTLAY
LINE
The firm’s cost equation:
TC = rK + wL
K
Example: Isocost Lines
TC2/r
Direction of increase
in total cost
TC1/r
Slope = -w/r
TC0/r
TC0/w TC1/w TC2/w
L
43
• WHEN COST OF THE LABOUR FALLS---ISO
COST CURVE WILL BECOME
• …………….JAM BOARD
• WHEN COST OF KAPITAL FALLS……
OPTIMAL COMBINATION
• Producer can maximise profit
when he is in equilibrium
where optimal factor
combination is done or least
cost combination of factors is
done.
OPTIMAL COMBINATION
• The two conditions of optimal combination
are
• 1) the slope of the isocost line must be equal
to the slope of the isoquant curves
• The slope of isocost line is w/r
• the slope of the isoquant curve is MRTS
Expansion path
• Expansion path is the combination of
equilibrium points
• jam board
• It shows how the firm can expand or when it
expands what is the path it has to take
Expansion path & returns to scale
• When the distance between the equilibrium
point decreases----increasing r.t.s.---graph
• When the distance between the equilibrium
point increases----diminishing r.t.s.---graph
• When the distance between the equilibrium
points is equal in the expansion path ---constant r.t.s.---graph
COBB-DOUGLAS PRODUCTION
FUNCTION
• Cobb–Douglas production function is one
more type of linear production function. It
represents the technological relationship
between the amounts of two inputs
(i.e.physical capital and labor) and the amount
of output that can be produced by those
inputs. During 1927–1947, Charles
Cobb and Paul Douglas introduced Cobb–
Douglas production function.
https://www.youtube.com/watch?v=CZ3dQdjD
yHQ
Cobb–Douglas production function
• Cobb–Douglas production function is
• Q=ALα Kβ
• where Q is output and L is labour and С is
capital respectively. A, α and β are positive
parameters where α> O, β > O.
Properties of Cobb–Douglas
production function
• first Cobb–Douglas production function was
introduced for constant returns to scale
• i.e.α+β=1
• Later on it was extended to increasing
returns to scale & diminishing returns to
scale
• When α+β>1 –increasing r.t.s
• When α+β<1 –decreasing r.t.s
Properties of Cobb–Douglas
production function
• the marginal rate of technical substitution
MRSLC=α/β XC/L
• it represents the factor intensity i.e. if α is
more it will be labour intensive……….
• Represents the efficiency of production---A
• Multiplicative function---- i.e. if L or K IS zero,
then output is zero
• α,β --output elasticity w r t L & C
QUESTION BANK FOR UNIT III
Essay questions
1. Law of variable proportion
2. Properties of isoquant curves
3. Reasons for increasing returns to scale & diminishing returns to
scale
Short question
1. Law of returns to scale
2. Cobb- douglas production function
3. Types of production function
4. Producers equilibrium or optimal combination of factor inputs
5. Explain isoquant & iso cost curve
6. Expansion path
7. How expansion path related to returns to scale
COST
ANALYSIS
UNIT IV
COST FUNCTION
Cost function refers to the mathematical relation
between cost of production of a product and the
various determinants of costs.
In cost function, the dependent variable is unit
cost or total cost and the independent variables
are the price of a factor, size of the output or any
other relevant phenomenon which have a bearing
on cost.
C = f(O,S,T,P, G, I, EX,Q,T,…)
C is Cost
O is the level of output
S is the size of the plant
T is the time under consideration
P is the prices of the factors of production
MONEY COST
MONEY COST –money cost is the amount of
money spent by the firm in producing a particular
product. It includes the money spent on pruchase
of raw mateials,rent, wages, interest, normal
profit,etc
Real cost – the effort and the pain taken by the
entrepreneur & labourers to produce a commodity
is called as real cost
OPPORTUNITY COST
According to Leftwitch, “Opportunity cost of a
particular product is the value of the forgone
alternative product that resources used in its
production could have produced”.
Opportunity cost is concerned with the cost of
foregone opportunity.
It involves comparison between the policy that was
chosen and the policy that was rejected.
Example- The cost of lending capital and using the
capital for its own purpose
Opportunity cost are not recorded in the books of
account.
Next best alternative foregone
e.g. adamsmith----hunter
OUTLAY COSTS
Outlay Costs involve actual outlay (spending) of
funds on, say, wages, materials, rent, interest etc.
Similar to money cost
It involves financial expenditure at sometime and
are thus recorded in the books of account.
INCREMENTAL COSTS
Incremental costs are the added costs resulting
from a change in the level of business activity i.e
adding a new machinery, adding a new product
etc.
In other words Incremental cost is variation in cost
caused by change in business activity.
INSTEAD OF ONE MORE P. IN M.C. -----FEW
Sunk Costs- The cost which is incurred once and
will not be altered by the change in business
activity is described as sunk cost. It is irrelevant
with regard to the business decisions of the future.
Eg- – It is the Cost of producing an additional
output
EXPLICIT COST
Explicit or Out of Pocket Cost
Explicit cost are direct contractual monetary
payment incurred through market transactions.
It refers to actual money outlay or out of pocket
expenditure of the firm to hire productive
resources required in the process of production.
They are actual monetary expenditure of the firm
Examples-
1. Cost of raw materials
2. Wages and salaries
3. Interest on capital invested
4. Insurance premium
5. Rent
6. Taxes like property tax, license fee
IMPLICIT COST
Implicit cost is called as Book cost or Computed
cost.
Implicit costs are payments which are not directly
or actually paid out by the firm.
Such cost arises when the owner or entrepreneur
uses the products which are owned by him.
Example-
The implicit money cost are
1. The wages of labor rendered by entrepreneur
himself.
2.
Interest on capital supplied him.
3. Rent of land or premises belonging to the
entrepreneur himself and used in his production.
4. Normal returns (profits) of entrepreneurs,
compensation needed for his management and
organizational activities.
SOCIAL COST
the amount of money spent by the society to overcome the
pollution & other hazardous factors caused by firm is callled
as social cost
CSR
HISTORICAL COST
It is the original price of plant and material incurred
by the firm.
In accounting books the value of the asset of the
firm is recorded at their historical past.
They are of the past
REPLACEMENT COST
It is the price for the same plant and material
currently prevalent in the market.
The historical cost needs to be readjusted with
replacement cost for sound business decision
making and for measurement of true profits.
SHORT RUN COST
Short run or operating cost are associated with the
change in output along with the fixed plant size.
In short run, we have the fixed factor inputs and
variable factor inputs.
In Short run, cost varies in relation to only the
variable inputs.
LONG RUN
They are the operating cost due to the change in
the scale of output and the alterations in the size of
plant.
In long run factor inputs are variable.
FIXED COST
Fixed cost are those cost that are incurred as a
result of the use of fixed factor inputs.
They remain fixed at any level of output in the
short run.
They remain fixed because the firm does not
change its size and amount of fixed factors
employed.
Fixed cost are also called as supplementary cost
or overhead cost
1. Payment of rent for the building
2. Interest paid on capital.
3. Insurance premium.
4. Depreciation & maintenance allowance.
5. Administrative expenses like salaries of
managerial and office staff
6. Property & business taxes, license fees etc.
Fixed cost are of two types:
(a) Recurrent cost : recurrent costs are those
which give rise to cash output like rent, interest
on capital, general insurance premiums,
salaries of permanent irreducible staff etc.
(b) allocable cost : implicit money cost like
depreciation which do not have any direct cash
outlay but have to recognize with the passage
of time rather than usage.
VARIABLE COST
Variable costs are those costs which are incurred
by the firm as a result of the use of variable factors
inputs.
They are dependent upon the level of output.
They are also called as direct costs or primary
cost. They are regarded as avoidable contractual
cost, when the output is nil.
SHORT RUN
VARIABLE COST
Short run variable cost include :
(i) Prices of raw material
(ii) Wages of labour.
(iii) Fuel & power charges.
(iv) Excise duties, sales tax
(v) Transport expenditure etc.
Variable costs are of two types;
1. Fully variable cost: they change more or less
with the change in output. Ex. Cost of raw
material, power etc.
2. Semi variable cost: these do not change with
output, but eliminated with nil output.
FIXED COST
SUPPLEMENTARY
COST,GEN.,INDIRECT ,
OVERHEAD C
e/g/ land , machinery
It will not vary with
output
Expenditure will not
increase with increase
O
A.F.C. decrease
continously
VARIABLE C
Prime c, special c, direct
c
Rawmaterial ,wages
Vary with output
Increase with increase in
output
A.V.C. INACREASES
first, then becomes
constant, then decrease
AVC—U SHAPE
AFC—rectangular
hyberbola
Fixed cost remain only IN THE L.R. all costs are
in S.R.
variable costs
BEHAVIORAL COSTS AND
THEIR MEASUREMENT
1. Total cost: total cost is the total of expenditure
incurred by the firm in producing a given level of
output. Total cost is measured in relationship to the
production function by multiplying the factor prices
with their quantities.
If the production function is: Q = f(a,b,c…..n), then the
total cost is;
TC = F(Q)
which means total cost varies with output.
For measuring the total cost of a given level of output
we have to aggregate the product of factor quantities
multiplied by their respective prices.
TC=TFC+TVC
TOTAL FIXED COST
2. Total Fixed Cost corresponds to fixed inputs in
the short run production function.
It is obtained by summing the product of quantities
of the fixed factors multiplied by their respective
unit prices.
TFC remains same at all levels of output in the
short run.
TFC WILL NOT VARY WITH THE OUTPUT
PRODUCED
TOTAL VARIABLE COST
3. Total Variable Cost corresponds to variable
inputs in the short run production.
It is obtained by summing up the product of
quantities of input multiplied by their prices.
All costs are variable costs in the long run
4. Average Fixed CostAverage fixed cost is total fixed cost divided by
total units of output.
Thus AFC = TFC/Q
Where Q stands for Number of units of the product
5. Average Variable Cost – AVC is the total variable cost
divided by the total units of output.
Thus AVC = TVC/Q
Thus AVC is variable cost per unit of output.
6. Average Total Cost – cost of production per unit of
outpupt produced
ATC or Average cost is total cost divided by total units
of output.
Thus ATC = TC/Q in the short run
Since TC = TFC +TVC
Therefore ATC = TC/Q which is equal to (TFC+TVC)/Q
Hence ATC can be computed by adding AFC and AVC at
each level of output
AC= AFC+AVC
7. Marginal Cost- Marginal cost is the addition
made to the total cost by producing one more unit
of output.
MCn = TCn – TCn-1
This means marginal cost of the nth unit of output
is the total cost of producing n units minus the
total cost of producing n-1 units of output.
M.C. is the additional cost incurred by the firm to
produce one more unit of the output
SHORT-RUN TOTAL COST
SCHEDULE OF A FIRM
A cost schedule is a statement of variations in cost
resulting from variations in the level of output. It
shows the response of costs of changes in output.
Cost schedules depend upon the length of the time
interval. So they vary from short period to long
period.
Short-run total cost: to examine the cost behavior
in the short run, we may begin our analysis with
the consideration of the following three total cost
concepts:
1. Total fixed cost
2. Total variable cost
3. Total cost
ASSUMPTION
1. Labour and capital are the 2 factor inputs.
2. Labour is the variable factor.
3. Capital is the fixed factor.
TP
TVC
TC
0
100
0
100
1
100
25
125
2
100
40
140
3
100
50
150
4
100
60
160
5
100
80
180
6
100
110
210
7
100
150
250
8
100
300
400
9
100
500
600
10
100
900
1000
Behavior of Total Cost-
1. TFC remains constant at all levels of output. It
remains same when there is nil output.
2. TVC varies with output nil when no output, VC is
direct costs of output.
3. TVC does not change in the same proportion. Initially
decreases at a decreasing rate. This is due to Law of
Variable proportions, which suggests that initially to
obtain a given amount of output relatively, variations in
factors are needed in less proportion, after a point
when the diminishing phase operates, variable factors
are to be employed in a greater proportion to increase
in the same level of output.
4. TC varies in the same proportion as the TVC
EXPLANATION OF THE GRAPH:
1. TFC is the curve of total fixed cost.
It is a horizontal
straight line parallel to X-axis.
2. TVC represents total variable cost; it rises
initially; eventually becomes steeper denoting a
sharp rise in TVC. The upward rising TVC are
related to the size of output.
3. The curve TC represents total cost. It is derived
by vertically adding up TVC & TFC curves. It is
easy to see that the shape of TC is largely
influenced by the shape of TVC. When two
curves become steeper, TC also becomes
steeper., distance between TVC & TC is amount
of fixed factors.
(Schedule given in class)
From the schedule the following points have been observed
regarding per unit cost of a firm
•
AFC declines as output increases, Since TFC remains
same AFC declines continuously. This is because of
spreading overhead cost over more units
•
AVC first declines and then increases as output increases
•
ATC decreases initially, it remains constant for a while
then goes on increasing as output increases
•
Marginal cost decreases initially, then increases as output
is increased
•
Marginal cost is determined by the rate of increase in total
variable cost
•
When AC is minimum MC = AC
OUTPU
T
(Q)
0
1
2
3
4
5
6
7
TFC TVC TC
MC AFC
AVC AC
300
300
300
300
300
300
300
300
300
100
50
50
100
120
170
8
300 1100 1400 210 37.5
9
300 1350 1650 250 33.3
0
300
200
150
125
120
120
127.
2
137.
5
150
10
300 2000 2300 750 30
0
300
400
450
500
600
720
890
300
600
700
750
800
900
1020
1190
300
300
150
100
75
60
50
42.8
300
600
350
250
200
180
170
170
175
183.
3
200 230
BEHAVIOR OF SHORT RUN
AVERAGE COST CURVES
The graph depicts a generalized form of behavior of cost in
short run
1. AFC Curve (Average Fixed Cost Curve)
As the output increases, the TFC gets spread over a larger
output and therefore the AFC goes on progressively
declining. As a result the AFC curve slopes downwards from
left to right throughout it entire stretch. The AFC curve
approaches both the axes but never touches either axes
2. AVC Curve (Average Variable Cost Curve)
The AVC generally declines in the initial stages as the firm
expand and approaches the optimum level of output. After
the plant output capacity is reached, the AVC curve begins to
rise sharply.
Thus AVC curve is decreasing initially reaches minimum and
Then goes on rising
The AVC curve is slightly U shaped indicating that as the output
increases, initially the AVC is declining then remains constant
for a while and again starts increasing
3.
Average Total Cost Curve (ATC)
ATC curve is a summation of AFC and AVC curves. ATC is
derived by superimposition of AVC curve over the AFC curve. As
such the ATC curve is a U shaped Curve
Explanation of U shaped ATC curve
The economic reason underlying the U shaped of The average
cost curve is that, there is a greater importance of FC in any
firm, till the normal capacity is exhausted and the point of least
combination of various factors is reached.
The average cost therefore declines in the beginning. Once the
normal output of the plant is reached, more and more variable
factors are to be employed due to diminishing returns so the
variable cost rises sharply to the increase in the output
This outweighs the effect of AFC so the ATC starts moving
with AVC cost
4. Marginal Cost Curve
The MC curve assumes U shape indicating that in the
beginning MC declines as output expands. Thereafter it
remains constant for a while and then starts rising upwards.
MC is the rate of change in total cost, When output is
increased by one unit the MCC reflects the law of diminishing
returns.
In short run MC is independent to the FC and is directly
related to VC. MC can be derived from TVC
RELATIONSHIP BETWEEN AVERAGE
COST AND MARGINAL COST
• When AC is minimum, MC=AC, Thus MC curve
must intersect at the minimum point of ATC
curve.
• When AC is falling MC is also falling initially,
after a point MC starts rising, AC continues to
fall but MC is less than AC, MC reaches
minimum and then starts rising, MC < AC
• When MC=AC, then with an increase in output,
AC starts rising and MC continues to rise, but
MC is greater than AC, MC is above AC (MC>AC)
• Both M.C & A.C ARE U SHAPED
• BOTH A.C & M.C CAN BE CALCULATED FROM
T.C.
LONG RUN COSTS
The long run period is long enough to enable a
firm to vary all its factor its inputs.
In the long run, a firm is not tied to a particular
plant capacity.
The firm can expand its plant in order to meet the
long term increase in demand or reduce plant
capacity if there is a drop in demand.
In long run, there are only variable cost or direct
cost.
FEATURES OF LAC CURVE
1. TANGENT CURVE : by joining the LAC of
various plant curves of the different short run
phase, we get a LAC curve drawn tangent. LAC
curve is the locus of all the short run average
cost curves which have taken place in the firm
by small changes in the capacity of the firm.
2. ENVELOPE CURVE: since it is an envelope of
group of short run average cost curves of
different levels of output, it is called an
envelope curve.
3. PLANNING CURVE: LAC is a planning device,
as it denotes the least unit cost of producing
each possible level of output. The entrepreneur
determines his course of expansion of output
and the size of plant in relation to the LAC
curve. The optimum size is that plant size at
which SAC is tangent to LAC.
4. MINIMUM COST COMBINATION: since LAC is
derived as tangent to various SAC curves, the
cost levels represented by LAC curve at different
costs of output reflect, minimum cost
combination of resource inputs adopted by the
firm at each long run level of output.
5. FLATTER U-SHAPED: in the beginning it
gradually slopes downwards, then after a certain
point gradually slopes upwards. In long run, the
long run average cost declines, then remains
constant and then rises.
RELATIONSHIP BETWEEN LAC
AND LMC
• When LAC curve decreases, LMC also
decreases (LAC>LMC)
• At a certain stage LMC rises, but LAC continues
to fall but LMC<LAC
• When LAC is minimum LMC=LAC, Thus LMC
intersects at the minimum point of LAC.
• LMC and LAC slope upwards (LMC>LAC
Economies Of
Scale
• When a firm expands its scale of production, the
economies (advantages), which accrue to this firm, are
known as internal economies.
• According to Cairncross, “Internal economies are those
which are open to a single factory or a single firm
independently of the action of other firms.
• They result from an increase in the scale of output of the
firm, and cannot be achieved unless output increases.
They are not the result of inventions of any kind, but are
due to the use of known methods of production which a
small firm does not find worthwhile.”
Internal Economies
• Technical economies are those, which accrue to a firm
from the use of better machines and techniques of
production. As a result, production increases and cost per
unit of production decreases.
• Following Prof. Cairncross, we may classify the various
kinds of technical economies as follows:
Technical Economies
• Certain technical economies may arise because of
increased dimensions. For example, a double decker bus
is more economical than a single decker. One driver and
one conductor may be needed, whether it is a double
decker or a single decker bus.
Economies of Increased
Dimensions
• As a firm increases its scale of operations, it can properly be
linked to various production processes more efficiently.
• After the work is finished in one section it can be sent
automatically to next section by conveyor belt
• backward link in getting the raw material & foward link in
marketing the product can be done in largescale production
• In the words of Prof. Cairncross, “There is generally a saving
in time and a saving in transport costs, when the two
departments of the same factory are brought closer together
than two separate factories.”
Economies of Linked
Processes
• A large firm is in a better position to utilize the byproducts efficiently and attempt to produce another new
product. For example, in a large sugar factory, the
molasses left over after the manufacturing of sugar can be
used for producing alcohol, cardboard etc by installing a
small plant
• Eg..processing of crude oil
Economies of the Use of
By-products
• Large sized machines without continuous running are
often more economical than small sized machines
running continuously in respect of power consumption.
For example, a big boiler consumes more or less the same
power as that of a small boiler but gives more heat.
Economies in Power
• A large firm can divide the work into various subprocesses. Therefore, division of labor and specialization
become possible. At one stroke, all the advantages of
division of labor can be achieved.
• Eg corporate hospitals have specialised doctors….cornea
..lazy eyes
Economies of Increased
Specialization
• A large firm can afford to research
• When research is done , they can go for innovation, new
technology, finding new raw material etc
Economies of research
• We generally observe that when the scale of the firm
increases it tries to go for diversification of production
• By this same excess capacity can be utilised
• Fixed factors can be utilized
• The loss in one product can be compensated in other
products
Economies of
diversification
• Technical economy is also realized due to al long-run
continuation of the production process. For example,
composing and printing of 1000 copies may cost $200;
but if we increase the number of copies to 2000 it may
cost only $250, because the same sheet plate which has
been composed previously can be utilized for the
increased number of copies also.
• Jaquard design
2. Economies of
Continuation
• A large firm employs a large number of laborers.
Therefore, each person can be employed in the job to
which he is most suited. Moreover, a large firm is in a
better position to attract specialized experts into the
industry. Likewise, specialization saves time and
encourages new inventions. All these advantages result in
lower costs of production
3. Labour Economies
• Economies are achieved by a large firm both in buying raw
materials as also in selling its finished products. Since the large
firm purchases its requirements in bulk, it can bargain on its
purchases on favorable terms. It can ensure continuous supply
of raw materials. It is eligible for preferential treatment. The
special treatment may be in the form of freight concessions
from transport companies, adequate credit from banks and
other financial treatments etc.
• In terms of advertisements also, it is better placed than the
smaller firms. Better-trained and efficient sales persons can be
appointed for promoting sales.
4. Marketing Economies
• The credit requirements of the big firms can be met from
banks and other financial institutions easily. A large firm
is able to mobilize much credit at cheaper rates. Firstly,
investors have more confidence in investing money in the
well-established large firms. Secondly, the shares and
debentures of a large firm can be disbursed or sold easily
and quickly in the share market.
5. Financial Economies
• On the managerial side also, economies can be achieved;
when output increases, specialists can be more fully
employed. A large firm can divide its big departments
into various sub-departments and each department may
be placed under the control of an expert. A brilliant
organizer can devote himself wholly to the work of
organizing while the routine jobs can be left to relatively
low paid workers
6. Managerial Economies
• The larger the size of a firm, the more likely are its losses to be
spread among its various activities according to the law of
averages.
• A big firm produces a large number of items and of different
varieties so that the loss in one can be counter balanced by the
gain in another. For example, a branch bank can spread its risk
by diversification of its investment portfolio rather than a unit
bank. Suppose a bank in a particular locality is facing a run on
the bank, it can recall its resources from other branches, and
can easily overcome the critical situation. Thus, diversification
avoids “putting all its eggs in one basket.”
7. Risk Bearing
Economies
• A large sized firm can spend more money on its research
activities. It can spend huge sums of money in order to
innovate varieties of products or improve the quality of
the existing products. In cases of innovation, it will
become an asset of the firm. Innovations or new methods
of producing a product may help to reduce its average
cost.
8. Economies of Research
• External economies refer to gains accruing to all the firms
in an industry due to the growth of that industry. All the
firms in the industry irrespective of their size can enjoy
external economies. The emergence of external
economies is due to localization.
• Geographical specialication
External Economies
• When a number of firms are located in one place, all the
member firms reap some common economies. Firstly, skilled
and trained labor becomes available to all the firms.
• Secondly, banks and other financial institutions may set up
their branches, so that all the firms in the area can obtain
liberal credit facilities easily. Thirdly, the transport and
communication facilities may get improved considerably.
Further, the power requirements can be easily met by the
electricity boards. Lastly, supplementary industries may
emerge to assist the main industry
• Social economic overheads
1. Economies of
Concentration
• Many firms when located together can provide welfare
facilities to its employees such as quaters, hospitals,,
subsidized canteens, crèches for the infants of women
worker, recreation facilities etc.; all these measures have
an indirect effect on increasing production and at
reducing the costs.
2. Economies of Welfare
• The economies of information may arise because of the
collective efforts of the various firms. Firstly, an
individual firm may not be in a position to spend
enormous amounts on research. However, by pooling all
their resources new inventions may become possible. The
fruits of the invention can be shared by all the member
firms. Secondly, publication of statistical, technical and
marketing information will be of vital importance to
increase output at lower costs.
3. Economies of
Information
• When the industry grows, it becomes possible to split up
production into several processes and leave some of the
processes to be carried out more efficiently by specialized
firms. This makes specialization possible and profitable.
For example, in the cotton textile industry, some firms
may specialize in manufacturing thread,, some in knitting
briefs, some in weaving t-shirts etc. The disintegration
may be horizontal or vertical. Both will help the industry
in avoiding duplication, and in saving time materials.
4. Economies of
Disintegration
• When many industries of same type are located nearby
they share the physical .factors
• Eg. Dying facilities by textile industry
• Pumping out water by mining
5. Economies of
physical factor
•
•
•
•
•
•
•
•
•
•
Difficulties of management
Difficulties of coordination
Difficulties of decision making
Difficulties of increased risk
Labour diseconomies
Scarcity of factor supply & increase in the cost of poroduction
Marketing diseconomies
Financial diseconomies
Technical limits
Exhausting natural resources
Diseconomies of scale
• An economy of scope means that the production of one good reduces
the cost of producing another related good. Economies of scope
occur when producing a wider variety of goods or services in tandem
is more cost effective for a firm than producing less of a variety, or
producing each good independently. In such a case, the long-run
average and marginal cost of a company, organization, or economy
decreases due to the production of complementary goods and
services.
• While economies of scope are characterized by efficiencies formed
by variety, economies of scale are instead characterized by volume.
The latter refers to a reduction in marginal cost by producing
additional units. Economies of scale, for instance, helped drive
corporate growth in the 20th century through assembly line
production.
Economies of scope
• Economies of scope exist when the cost of producing two
or more goods together is less than the cost of producing
each good separately. Economies of scope can result if
two or more products share the same production facilities.
For example, General Motors produces different car
models that use the same engines and transmissions.
• For eg in distribution unilever is having economies of
scope
Economies of scope
https://www.youtube.com/watch?v=zWgIW5n5
sMA
• Economies of scope are determined with the following formula
• In the formula, C(qa) is the cost of producing the quantity qa of
good a separately, and C(qb) is the cost of producing the
quantity qb of good b separately. The term C(qa + qb) is the cost
of producing the same quantities of good a and
good b together.
• Example
Formula for findingEconomies of
scope
Question bank for IV UNIT
ESSAY
1)
2)
3)
4)
5)
RELATION BETWEEN COST & OUTPUT
BEHOVIOURIAL COST OR RELATION OF VRIOUS COST----S.R.
INTERNAL ECONOMIES
EXTERNAL ECONOMIES
TYPES COST
SHORT QUESTIONS
1.
2.
3.
4.
5.
6.
7.
8.
COST FUNCTION
DISECONOMIES OF SCALE
ECONOMIES OF SCOPE
ANY FEW TYPES OF COST
RELATION BETWEEN S.R. & L.R. A.C .CURVES
RELATION BETWEEN M.C. & A.C.
FEATURES OF L.A.C.
WHY A.C. CURVE IS ‘U’ SHAPED
Unit V
Definition of market
The word market was derived from the Latin word ''mercatus" meaning “to trade". Many economists have defined
market in their own words.
According to Benham market is “any area over which buyers and sellers are in close touch with one another, either
directly or through dealers, ,that the price obtainable is one part of the market affects the price paid in other parts” In
economic sense, a market is a system in which the buyer and the seller bargain for the price of a product, they come
to an agreement about the price and quantity of goods and services to be sold and purchased, i.e., the act of buying
and selling is decided by this system .it can be a physical market place like olden days, where people come together
to exchange goods and services in person or through telephone or computer or a virtual market like( online shopping
) where they contact by some medium of communication which helps them in buying and selling the goods , what we
have to notice here is ,by the wide and easy communication facility, the price decided in one part of a region, affect
the price decided in other parts of the region .Market is a system where a common market price is fixed according to
aggregate demand and aggregate supply . Market can be a common commodity market or specialised market like
cotton market, money market etc.
Classification of Market can be studied based on various factor like area , time , competition function etc.
Classification of market
1. Based on area
Based on area, market can be classified as local, regional, national and international market. If the buying and selling
is confined to a particular village, town or city, we call it as local market. If it is confined to regional, national and
international market then it is called as regional, national and international market. The confinement depends on
nature of the product, transportation, durability, storage facility etc.
2. Based on competition
Based on competition market structure can be divided as Perfect competition and imperfect competition. Imperfect
competition is divided into monopoly, duopoly, oligopoly, and monopolistic competition. The major factors which
influence the type of competition are number of sellers, number of buyers, nature of product and entry conditions.
Type of
competition
Nature of the
Product
Number of
sellers
Number of
Buyers
Entry
Perfect competition
Homogenous
Large
Large
Monopoly
Unique products
Different from all
other products
Can be homogenous
Or differentiated
Can be homogenous
Or differentiated
One
Many
Free entry and free
exit
Ban on entry of other
firms
Two
Many
Barrier on entry
Few
Many
Barrier on entry
Duopoly
Oligopoly
Monopolistic
competition
Or differentiated
3. Based on time
Many
Large
Free entry and free
exit
When economists had divided opinion about the influence of demand and supply on the market price,
Alfred Marshall came out with time element to explain that. According to Marshall, market structure can be divided
according to the time element into very short period, short period, long period and very long period. In the very short
run period, even the variable input can't be changed. So supply will be perfectly inelastic and market price will be
determined according to changes in demand. In the short period variable input can be changed. supply cannot be
adjusted to demand and here also demand will be influence market price but not strong as in the case of very short
period .In the long run , all input can be varied and supply will influence the price . In very long period, technology
taste and preferences will change and prediction is very difficult.
4. Based on volume of business
The market can be grouped as whole sale market and retail market.
5. Based on nature of transaction
Market can be classified as spot market and future market. In the spot market, goods and services will be sold and
purchased on the spot. In the future market, agreement is made to make future transaction.
6. Based on regulation
Market can be classified as regulated or unregulated market. When government regulates the price and quantity sold
in the market , it is called as regulated market if not unregulated. market.
7. Based on status of seller
Market can be divided as primary, secondary and territory primary market consists of manufacturer secondary market
consist of wholesale sellers and territory market consist of retailers.
8. According to function
Market can be classified as mixed, specialized , sample, and grading. Mixed market means variety of goods will be
sold.In specialized market a particular type of goods are bought and sold like share market and vegetable market
etc. In the sample market,,firms sell their product to the agent and wholesalers through the sample they send.
Market by grade means the dealing done by means of grades. For e.g.: cement, iron rod etc.
9. According to the commodity- it can be divided as product, stock, bullion.
10. on the basis of legality-the market can be classified as legal and illegal.
FIRM
Firm refers to an business enterprise engaged in the production of commodity , firm is a productive unit . it changes
the input into output a firm maybe owned .operated and controlled by a single person or contolling body such as the
board of director in the case of joint stock companies.A firm maybe a small one a large one,
An industry refers to the group of firms producing similar products for eg: Tata motors is a firm. automoblies industry
including all the firm producing cars like Honda, tata , maruti etc,.
EQUILIBRIUM
equlibrium is a state of rest. It is a state of no change. at equilibrium, a firm has no tendency either to expand or
contract its output.
according to a Hanson, " a firm will be in equilibrium when iot is of no advantage to increase or decrease its
advantage ". so at equilibrium , a firm will try to stick to the same position at equilibrium firms wont like to change the
market price , it will maintain the same price. Similarly the amount of goods produced and supplied to the market
also . it will maintain the same amount of output. the price determined at equilbrium price and output produced and
sold as equilibrium output.A rational firm would always like to maximise the profit always but in the short t run a firm
can have super normal profit, normal profit or loss. Incase of a loss the firm will try to minimise the loss but in the
long run the firm will have normal profit if it has chronical loss in long run then the firm has to close in long run . Even
in the short run the firm has to close down because of loss if the market price is less than short run variable cost.
Equilibrium of the firm can be studied by two method
1.Marginal cost , marginal revenue approach
2.Total cost , total revenue approach
1. MR MC APPROACH
EQUILIBRIUM CONDITION OF THE FIRM
A firm will be in equilibrium when it satisfies two conditions
1. MC=MR
2. MC curve cuts MR curve from below
For monopoly or duopoly firms MC curve can cut MR curve from below , from side or from above but for
easiness for the student to understand same conditions is accepted for all the types of competition MC cuts MR
curve from below.MR is a marginal revenue which is additional revenue received by the firm by selling one more unit
of the product.MC means marginal cost which is the additional cost incurred by the firm to produce one more unit of
the product. The first condition says that the additional revenue they receive should be equal to the additional cost
they incur. Fulfilling the second condition is also essential for equilibrium we will understand this through a group. In
the y axis we represent MR, MC and in x axis we represent the amount of output produced
.(a)
perfect competition
Under perfect competition MR curve is a straight line parallel to x axis because a firm under perfect competition
is a price taker and whatever amount of output he sells in the market will not make any difference, The additional
revenue of the firm received will be the same, which makes the MR curve a straight line (.Unlike imperfect
competition , where they have to decrease the price to sell more ), MC curve is of U-Shape. Because in the initial
stage due to the law of increasing returns to scale , it slopes down, then becomes constant and then increases due to
diminishing returns to scale.
C
D
Q
In the graph at point a MC curve cuts the MR curve from
above and the output produced by firm is OM if the firm consider that as equilibrium point and stops production then
the firm will lose the cup of profit between ADB , suppose the firm produces OQ amount of output, then the firm’s
MR is QC & MC is QD. When firm is producing OQ output, it will have an profit of CD per unit.
Profit =MR-MC
so the firm will continue producing after OM output also and when it stop at M1 , where MC=MR that will be
considered as equilibrium point..if it is forcing to produce more than this, then MC>MR which will lead to loss. So B
is the equilibrium when MR=MC or MC cuts MR curve from below here the profit will be maximum.
(b) Imperfect competition
Under imperfect competition, the MR curveslope downward because the firm will be able to sell more when the
firm reduces price. MC curve is of U shape but for easiness tick mark shape is considered.
MC
P
O
E
MR
Q
Here 'E' is the equilibrium point when MC cuts the MR curve from below. Equilibrium price is OP and OQ is
equilibrium quantity of output.
EQUILIBRIUM CONDITION OF AN INDUSTRY
An industry will be in equilibrium state when all the firms are in equilibrium in the long run. i.e. industry doesn’t
want any change in the output or price or usage of input or technology or employment etc. There should not be any
entry or exit of firms. if it has to happen then all the firm must have normal profit in the long run (except monopoly) if
the firms in the industry have super normal profit , then new firms will enter the industry , attracted by the profit . If
some firms have loss, it will close and exit the industry by which the supply will decrease and the price will rise and
the firms in the industry will have normal profit. The industry will be in equilibrium when aggregate demand will be
equal to aggregate supply.
So the equilibrium condition of an industry is:1. All the firms must be in equilibrium (a) MC=MR (b)MC cuts MR from below.
2. All the firm must earn normal profit in the long run (super normal profit in the case of monopoly and duopoly when
both the firm syndicate)
AC=AR= MC=MR=price. Will exists in equilibrium.
TR -TC approach
(a)Equilibrium of a firm under perfect competition
TR (total revenue ) of a firm rises continuously as the firm sells goods at the same price in the market.
TC (total cost) curve fall at first and then rise taking the 'U' shape due to the law of variable proportion.
According to the TR-TC approach the firm will be in equilibrium when it makes maximum profit The profit will be
maximum when the difference between total revenue and total cost is maximum so for equilibrium the firm should
satisfy two condition i.e
1. The difference between TR and TC is positively maximised
PERFECT COMPETITION
According to Joan Robinson “perfect competition prevails when the demand for the output
of each producer is perfectly elastic. This entails that the number of seller is large so that the output of any one seller
is negligible small proportion of the total output of the commodity and 2nd that the buyer are alike in respect of their
choice of rival sellers , so that the market is perfect” for e.g.- agriculture product , mud diya, plane glass bangle etc
huge amount of commodity is sold in the market nobody can recognise in the market that this is produced by a
particular farmer etc( no brands, all can sell at the price decided by the industry )
Assumption or condition or characteristic feature of firm
1There is large no. of small unorganized sellers. The firm under perfect competition will be very small. the output
produced and sold by a single firm form a small part of the total amount of goods supplied by the industry for e.g.
even if a farmer produces 10000 bags of food grains, he sells very small amount because the Indian agriculture
industry produces and sells 300 million tons of food grains. The sellers are not only small but unorganised because if
they are organised then they can manipulate the price.
2. There will be large number of small unorganised buyers. It is not like monopsony (single buyer ) or oligopsony,
there will be large number of buyers, the number of buyers are so many in the market that an individual buyer can't
influence the price. The buyers don’t have any cooperation or organisation among themselves so that they can
influence the market price.
3There will be freedom of entry and exit there won’t be any natural or artificial restriction on the firm to enter or leave
the industry, if the firms have super normal profit i.e. when AR>AC, new firms will enter the industry if certain firms
have loss then the firm making loss will leave the industry
4. The product produced by all the firm should be homogenous .All the products available in the market should be
very similar the buyer should not be in a position to discriminate between the product produced by different
producers. Brand names are not used in perfect competition for eg - plane glass bangles sold in the market cannot
be discriminated from each other
When all this four conditions are satisfied it is called as pure competition by economists
5. There will be perfect knowledge about the market among buyers and the sellers. The buyer is aware of prevailing
market price so that if the seller charges higher price than others, nobody will buy from him. so he will be forced to
charge the same price as charged by other sellers.the buyer are aware of the quality available in the market if any
seller sells a product which is of less quality buyer will not buy from him. so seller has to maintain similar quality
maintained by competitors
6. There will be perfect mobility of factors of production and goods. When the factors of production move freely
production can be done wherever it is needed. If the factors of production and goods doesn’t move freely then there
will be price difference in different area. When they move freely there will be same price in the entire market.
7. Absence of transportation cost. This will bring same price in all market. If the transport price is prevalent then price
difference occurs. Transport cost will be added to price. if the same price has to prevail the transport cost should be
absent
8. There will be absence of selling cost because all the goods available in the market are similar. Even if a particular
firm gives an advertisement it will benefit the entire industry ,not the particular firm which gives advertisement. So it
is a waste on the part of firm to give advertisement or some other selling cost practices.
9. All the firms under perfect competition are price takers & they charge the same price. Since the products
produced by all the firms are homogeneous, consumer doesn’t have preference of one firm’s product over the other.
So no firm can have a price policy of its own. The market price is determined by the industry based on the
aggregate demand and supply in the market.. since each firm forms a small part of the market industry & supply a
small part of the market demand, they take up the price decided by the industry.
10. AR curve and MR curve coincide with each other & they are parallel to X axis. AR, average revenue is nothing
but market price or aggregate demand curve. It is the revenue per unit of output sold. The firm can sell as many units
as it wants in the market at a given price. So the AR curve becomes perfectly elastic i.e. it becomes parallel to X axis.
Unlike imperfect competition, the firm can sell its additional product in the market without reducing the price that is at
the same price & so the MR curve is also parallel to X axis.
Equilibrium of
a firm under perfect competition in the short run
The firm will be in equilibrium when SMC=SMR and SMC cuts SMR curve from below in the short
run , a firm can have super normal profit, normal profit or loss
[Key point
In order to the graph easily & find out the
equilibrium point )
Equilibrium output, Equilibrium price, loss, profit etc., Some easy steps which can be followed
is given.
1. Draw the A.R curve
2. Then draw M.R curve
3. Then draw the tick mark shaped M.C curve
4. Now mark the equilibrium point E, where MC is cutting MR.
5. After marking point E, draw a line through E called equilibrium line, parallel to Y-axis.
6. Let it touch the X-axis & mark that point as M& from the origin to that point M
represents equilibrium output produced.
7. Find out where this equilibrium line cuts AR curve & from that point, draw a line
(parallel to x-axis) to y-axis. Mark the point as P & OP in the Y-axis represents the
equilibrium price.
8. Now along the equilibrium line, we have to look where the AC curve is going to cut.
So the drawing of the AC curve is very important. If the firm having normal profit,
then AC curve must touch ( or tangents to ) AR curve. If the firm is having super
normal profit, then AC curve must cut the equilibrium line below AR curve. If the
firm is having loss, then the AC curve must touch the equilibrium line above AR
curve.
9. In order to find out total loss or profit, draw a line from AC to Y-axis (parallel to xaxis) the difference between AR & AC box will give profit or loss.
10. For Normal profit, since AR=AC, no box will come.]
(a) Super normal profit: The firm which are efficient advanced in technology and which moves towards
least cost combination can gain supernormal profit in the short run . The industry determines the price according to
the aggregate market and market supply. The firms under perfect competition are price takers is the firm can sell any
amount of output at the given market price.so the short run average revenue curve is a straight line parallel to X-Axis
showing whatever maybe the output sold, the market price will be the same. Since the firm can sell the additional
goods to whatever is its capacity, at the same price, short run marginal revenue curve coincides with AR curve and is
parallel to X-Axis .the average cost curve is an U shaped curve. Due to law of returns to scale MC curve is also U
shaped but for easiness tick mark is considered. Let us explain the super normal profit of a firm with the help of a
graph
Let quantity of output produced and sold be represented in the X-Axis and price, SMR SAR ,SMC ,SAC be
represented in the Y-Axis. SAR=SMR=Price line or market demand curve for the firm. Equilibrium condition is
represented at that situation where MC=MR and MC cuts MR curve from below. In the graph E1 is the equilibrium
point, where profit can be maximized. If a line is dropped from the equilibrium point to the X-Axis, it cuts the X-Axis at
Q1 and OQ1 represents the equilibrium output and when a line is drawn from equilibrium point to Y-Axis, which
represents price, PP is the equilibrium price. When Q1th output is produced, SAR is E1Q1 ,whereas SQ1 is AC . here
AR>AC which gives abnormal or super normal profit. For OQ amount of output produced total revenue will be
OQ1E1P and total cost will be OQ1ST ( = OQ1 X OP ) so the total profit will be TR-TC i.e OQ1E1P- OQ1ST which is
equal to TSE1P.
(b) Normal profit: under perfect competition, some firms can have normal profits. Normal profit is a
situation where AR=AC and TR=TC. Normal profit is the minimum amount of profit which an entrepreneur
receives. It is equal to opportunity cost of the entrepreneur .if the entrepreneur cannot get minimum amount
for the work he does,then he will close the firm and start other work for survival. So economist suggested
that minimum amount of remuneration for the entrepreneur (factor payment) must be included in the cost of
production itself. Here the firm will work at the minimum point of AC curve.
In this graph,MC cuts the MR curve at E point. When extended to X-axis, it gives the equilibrium output OQ1
and on Y-axis gives the equilibrium price OP. In this situation, SAC(short run average cost curve) coincides
with equilibrium point, which is equal to SAR. here SAC=SMC=SMR=SAR= market price
Normal profit = TR-TC=OQ1EP1-OQ1EP1.
Here TR=TC
(C) Loss : In the short run , a firm under perfect competition can even undergo loss. The firm can be in
equilibrium even in this situation. It will try to minimize the loss. This is the Best it can do. Here, AC>AR and
TC>TR
In the graph, let Short run AR=Short run MR, which is parallel to X-Axis and let E be the equilibrium point
where MC=MR and MC cuts MR curve from below. Here the SAC curve is lying above the SAR curve,
showing its inefficiency in bringing down the cost of production when the firm is producing OQ1 output.
When the firm is producing Q1th output, AR is Q1E and AC is Q1G. Here AC is greater than AR and GE is
the loss per unit. Since OQ1 output is produced at equilibrium OQ1 X Q1E = OQ1EP =
AR X Q = PR.
OQ1 X Q2G = OQ1GF which is equal to AC X Q = TC.
Loss = TR-TC = PEGF
NORMAL PROFIT---TR=TC
SUPER NORMAL PROFIT----TR GREATER TC
LOSS----TR LESS TC
Equilibrium of a firm under prefect competition in long run
In the short run, the firm even with loss managed to produce. The firms adjusted production with the existing
plant capacity is fixed input remain constant and variable inputs only will be changed. but in the long run, the
plant capacity can be changed. All the inputs are variable inputs in the long run.
If the firms are having super normal profits then many new firms will be attracted to the industry and with the
new firms the price will come down, market supply will increase which will bring normal profit in the long run.
In the long run, the firms which are having loss will exit the industry. the firms in the industry will observe the
firms which are having losses they will also improve their techniques of production and try to decrease their
cost of production
All the firms in long run will improve their efficiency, try to produce the optimum output to the minimum point
of LAC curve, where the cost of production is minimum .so all the firms will have scope in long run .this can
be shown with the help of graph
Here, market price=AR=AC=MC=MR
Here we see that AR=AC,where the firm is having normal profit.the firm is working at the optimum level, that
is there is no idle capacity of the firm. It works at the minimum point of AC curve. Because of prefect
competition the firms with a higher cost of production cannot survive in the industry they have to quit the
industry because they will have lose .that is why economists say that perfect competition benefits both the
economy and the consumer.
Influence of Equilibrium of an industry on firms in short run
The industry will be in equilibrium when all the firms are in equilibrium, where it doesn’t want any change.
The industries equilibrium price and output is determined where aggregate market demand is equal to
aggregate market supply .aggregate market supply is attained by the summation of goods supplied by all
the firms in the short run ,even though the firms are in equilibrium they can have normal profits, super
normal profits or loss. This depends upon the cost of production of the firms. Here the firms under perfect
competition have to take the price decided by the industry, so the firms whose cost of production is very
high will have loss whose cost of production is less will have super normal profits. We can understand this
through a graph
In the graph we have depicted the equilibrium of the industry where AD=AS. The meeting point of demand
and supply forms equilibrium price and output and equilibrium price OP is taken by the firms. According to
the cost condition of the firm, we see that the firm is having super normal profit or loss or normal profit. We
observe from figure 1, equilibrium price of industry OP is decided. In figure 2 the cost of production of the
firm is less so it is earning super normal profits. In figure 3 we observe that the cost of production of this firm
is very high and so it’s earning loss in the short run.
Assuming that different firms have different cost of production, in this short run the firms can have super
normal profit, normal profit or loss. But all the firms have to take price decided by the industry by aggregate
demand curve and aggregate supply.
Influence of equilibrium of the Industry on firms in the Long Run:
In Long run the industry will be in equilibrium, where all the firms will be in equilibrium and all
the firms will be making Normal profits. Let us explain this with the help of the graph assuming
all the firms will be having similar cost conditions.
Suppose D is the original aggregate demand for the industry & S is the original aggregate supply
for the industry. Then E is the equilibrium and OP is the equilibrium price by the industry. The
firms under perfect competition take this price & E is the equilibrium conditions for all the firms
existing in the industry. All the firms are earning Normal profits. This is the long run equilibrium
of the firm.
Now let us explain the situation with another graph where if the demand in the market
increases by some reason, the market price will increase and due to this increase in price, firms
will start earning super normal profit. Attracted by his super normal profit many firms will enter
the industry and by this the market supply will increase and so once again the price will come
down and firms will start earning only normal profits.
Suppose due to some reasons like depression, fall in the purchasing power the market demand
falls, then the market price will fall. With the fall in the price, firms will start earning loss. The
most efficient firms or small firms cannot withstand loss for long & start exiting the industry,
which will decrease the supply & so the price will increase & so the firms will start earning
normal profit.
E
a) Suppose D is the original demand curve of the industry & S is the original supply curve of the industry.
E will be the equilibrium point, where demand =supply. Here OP is determined as the equilibrium
price..This equilibrium price op is taken by all the firms, where they are in equilibrium at E, where
Market price=AR=MR=MC=AC. Here all the firms will have normal profit.
b) In the market, due to some reason when the demand rises, the demand curve move upwards from D to
D1,because of this the price also will move from OP to OP1 .When the firm accepts this price, AR curve
becomes AR1 and the equilibrium E becomes E1 . Now the firms will start earning super normal profits
P1E1ST. Attracted by this abnormal profit, new firms will enter the industry & the supply of the industry
increases to S1 . With the increased aggregate supply in the market, the price once again falls to OP.by
this in the long run they will once again start earning normal profit.
c) Due to some reason now let the market demand fall from D to D2 . Now the market price will fall to OP2 .
When the firm takes up this price , the AR curve will become AR2. The equilibrium will become E2 . and
the firms will start having loss of P2 E2 LT. unable to withstand the loss some of the firms exit the
industry & so the aggregate supply of the industry falls to S2 from S1 .because of this the price will rise
from OP2 to OP1 and the firms will start earning normal profit.
Thus in the L.R. both the industry and the firm will have normal profit.
Time element and price determined under prefect competition
Marshall introduced the time element in order to explain that whether demand is more important in
determining the price or supply is important in determining the price. In order to explain the influence of time
element of price, Marshall has divided the time period into 4 they are:
(1)Very short time period (2) Short time period (3)Long period (4) Very long time period
1. Very short time period: It is also called as market period. In this time period, even the variable input
cannot be changed. The supply cannot be increased so whatever stock is available can only be brought to the
market .In this time period , the supply remains perfectly inelastic. So in this time period, demand is very important in
determining the price .As the demand increases the price also increases. The influence of price can be studied with
the help of a graph for the perishable commodity
In this case of perishable goods,if the market price is less than the cost of production, then also
the firm will supply to the market because the goods will be spoiled. Due to this, we will observe that supply curve is
straight line parallel to Y-Axis. When the demand curve is D, the equilibrium price will be OP. Suppose the demand
increases to D1, price also increases to OP1 and when the demand decreases to D2, price also decreases to OP2.
When the good is non-perishable, and if the market price is less than cost of production then producer will
keep a stock of the commodity instead of selling it into the market. They will start supplying it to the market when the
price = cost of production which is called as the reserve price . when the market price increases above , the supply in
the market will going on increasing and entire stock will be brought to the market. If the demand is increasing further
after all the stocks are brought to the market , the price will be increasing with increase in demand. So, we conclude
that in the very short run period the price is influenced by the demand
2. Short Run Period : In this period also the demand is important in determining the price but not as
influential as in the case of very short run period. In the short run, the production of output can be increased to some
extent by increasing the variable input .if the increase in demand can be taken care by the increase in supply, then
there wont be any increase in the price. In the short run, if increase in the demand is greater than increase in supply,
there will be increase in price. This is clearly explained with the help of a graph
In the X-Axis we represent quantity demanded and supplied. In the Y-Axis we represent the price. Let S be
the short run relatively inelastic supply curve and D be the initial demand curve. E is the equilibrium condition which
determines OP as the market price and OQ as the market equilibrium output demanded and sold. In case the
demand increases to D2 then the price increases to OP2. If the demand decreases to D1 then the price also
decreases to OP1
3. Long Run Period : the price determined under long run period is called as normal price. In the long run
supply of the firm is more important in determining the price because the supply to the market can be increased
according to the increase in the demand in the long run. In this period the output can be increased by increasing all
the inputs. The market price is purely decided by the cost of production of the firm.



If the firm is having constant returns to scale then the market price remains constant whatever may be
increase in the demand.
If the firm is undergoing increasing returns to scale, Then the firm will have diminishing cost of production
with increase in output. Under this circumstance with the increase in supply to the market, The market price
will decrease,
If the firm will have diminishing returns to scale, Then with the increase in supply to the market the market
price will increase.
Let us represent the long run equilibrium of the firm having constant returns to scale, Let us represent
through a graph
Let us suppose the long run supply curve is LRS which is perfectly elastic because of constant
returns to scale. Initially let D1 be the original demand curve. Here the equilibrium will be E1, where Demand=Supply.
Here the equilibrium price is OP and equilibrium quantity demanded and supplied be OQ1. Suppose the demand
increases to D2 then the equilibrium will shift to E2. The quantity demanded and supplied will increase to OQ2 but
the price will remain constant as OP. Similarly if the demand falls to OD, the equilibrium will shift to E. The quantity
supplied and demanded will become OQ now where as the price will remain constant as OP.
4. Very Long Run Period: it is also called as secular period. In this period, demand , technology, taste and
preferences etc changes. So, economists say that predicting about price or output will be very difficult in this
situation, so case study about this time period is not possible.
MONOPOLY:
Monopoly is originated from a Latin word. ‘Mono’ means single and ‘poly’ means seller.
According to professor Braff A.J “Under pure monopoly there is a single seller in the market.
The monopolist’s demand is the market demand. The monopolist is the price maker. Pure
monopoly suggests no substitute situation“
As on today monopoly is a situation which is very difficult to find in practice. Indian railways can
be considered as an example for monopoly. Monopoly and the perfect competition are the two
extreme situation of market based on competition. Economists like Schumpeter says that when
a new product is introduced in a market it will be monopoly, because it has no close substitutes
in the beginning . after sometime some sellers will start entering the market and it will become
duopoly, oligopoly, monopolistic and it will go to perfect competition due to competition. For
e.g. Euroclean was a monopoly in selling vacumn cleaner for a long time. Because the sales was
very less , once the sales picked up many competitors joined the industry.
FEATURES:
1) No. of sellers:
There is single seller who controls the whole supply of the commodity, Since there is
single seller in the market, the market demand is the firm’s demand. Here there won’t
be any difference between firm and an industry. Firm is equal to industry
under Monopoly.
2) Buyers:
Like perfect competition here also there will be large number of buyers, small in size in
market demand, they will also be unorganized.
3) The product produced by the monopolist will not have any close substitute in the
market. The product will be unique in its own way and will be different from all the
other products available in the market.this gives the decision making power to
monopoly independently & makes him king in the market.in the case of pure monopoly,
cross elasticity of demand will be zero.
4) In a Monopoly market there is a strict barrier on the entry of new firms. No new firms
will be allowed to enter the industry. Monopolists face no competition. If there is
monopoly, then nobody should be allowed to produce similar products.
5) Goods and factors of production will not move freely from one region to another region
like perfect competition particularly in the case of discriminating monopoly. Movement
of factors of production and goods should be restricted.
6) Producer will have perfect knowledge of the market where as the consumer will not
have proper knowledge of the market particularly in the case of discriminating
monopoly.
7) If the price charged by monopoly becomes very high & when the product is a necessary
product Government may intervene to stop the exploitation. In order to save the
citizens government may take over the industry or bring a price ceiling.
8) There is no selling cost under monopoly. Because there are no competitors, no
counteraction by them, he has the liberty to charge any price, selling cost is a waste.
But initially when the product is introduced in the market, informative selling cost must
be incurred by the firm. the consumer should come to know about the availability of the
product & its use. So information about the product should be advertised in various
media, so that consumers will come to know about the product. After some time it can
be withdrawn because by ‘demonstration effect’ & ‘word of mouth’ consumers will start
knowing about the product.
9) The firm and the industry is the same. Monopoly is the ‘price maker’. Firm can decide
the price, but the quantity demanded is decided by the consumer. When the price
charged is very high then quantity demanded will be less. Price can be decided by the
monopoly according to the elasticity of demand for the product. Since the price charged
by monopoly is highest, sales will be less .so the monopoly may not use full capacity of
the plant installed.
10) AR & MR curve slopes downwards. AR slopes downwards to the right in monopoly
indicating that the monopoly is required to reduce the price in order to sell more.
Geometrically MR curve also slopes downwards but below AR. In pure monopoly,AR
will be a rectangular hyberbola and MR will merge with X axis.
Determination of equilibrium price and output of a firm under monopoly
Monopoly is a form of imperfect competition. It is the market system where a single
producer controls the whole supply of commodity which has no substitutes.
Assumptions
1. there is a single seller who controls the whole supply of commodity
2. the products produced by the firm doesn’t have any substitutes in the market
3. there will be so many consumers who will be unorganized
4. There will be strong barriers on the entry of the other firms.
5. Consumers will not have proper knowledge of the market whereas sellers will
have perfect knowledge of the market
6. The factors of production and the goods will not be allowed to freely move from
one place to another
7. Except introductory cost there won’t be any selling cost
8. Monopoly can determine only price or output. Generally monopoly chooses the
price.
9. Under monopoly firm=industry
10. AR & MR curve will slope downwards
11. Firm under monopoly will be a price maker
Short run equilibrium:
AR and MR curve are different since, monopoly can sell more by decreasing price. The
AR slopes downwards which lies above the MR. So, AR and MR slopes downwards from
left to right. The rate at which MR falls is greater than that of AR. AC and MC curves are
also “U” shaped. The equilibrium of the monopoly is determined at the point whereI. MC=MR and
II. MC cuts the MR curve from below (or) Above (or) from side but, for easiness we
are considering MC cuts MR from below.
The equilibrium price is determined at that point from where vertical line of equilibrium
point cuts AR curve.
The firm will have super normal profits if AR>AC and the normal profit is
attained when AC = AR and the loss when AC> AR.
In the short run the monopoly firm can have loss or super normal profit or normal
profit. But in long run equilibrium it can have super normal profit. The main goal of
monopoly will be profit maximization. He can attain very easily because there are no
competitors under monopoly. We can explain the equilibrium price and output under
monopoly.
Super normal profits
The super normal profit is earned when the price charged by the monopolists is very
high. E is the equilibrium point, where MC cuts MR curve from below. From the
equilibrium point E, we draw a straight line parallel to Y axis. From the point where the
equilibrium line touches AR, we draw a line parallel to X axis from AR to Y axis, which is
a representating price, we get OP (AQ) as equilibrium price.
E
From the point where equilibrium line touches the AC curve ,we draw a line from AC to
Y axis we get OC (OQ) as average cost. Here AR >AC
Since the equilibrium price is OP & equilibrium output is OQ, TR=OPAQ, TC =OCBQ.
super normal profit =OPAQ-OCBQ =ABCP. OR it can be calculated like this also.
Difference between AR and AC is AB , AB XOQ =ABCP .
Normal Profit
E is the equilibrium, OM is the output produced and OP is the equilibrium price. So
AC=AR and TC=TR .Here the firm earns normal profit.
E
E is the equilibrium point. OQ is the equilibrium output and OP is the equilibrium price.
When equilibrium output OQ is produced, AC=AR, where the firm makes normal profit.
Loss:
In the Short Run even in monopoly there can be loss. The firm can survive in the market
expecting that in the future it will be able to overcome the hurdles and make profit in
the long run. When the cost of production of the firm is greater than the revenue, (i.e.
AC > AR) the firm will have loss. In the graph AR is the average revenue curve and MR is
the marginal revenue curve lying below AR curve. AC is the average cost curve .
LONG RUN EQUILIBRIUM:
Since there is no competition in the market, even if the cost of production is high that
can be shifted on the buyers and high price can be charged from them. More than
utilizing the plant capacity to maximum extent and working towards attaining the
minimum point of LAC and producing at least cost combination, the monopolist will be
interested in making supernormal profit. Monopolist may also try to adjust the inputs,
technology and other factors so that he can reduce cost. In long run he will have
sufficient time to adjust this but his ultimate aim will be to maximize profit than
concentrating on sales max, etc.
Figure 3 represents a situation of supernormal profit. Here AR>AC & the firm reaps a
super normal profit of ABCP. Of course the firm will be in equilibrium when MR=MC.
With a very high price, if the firm is able to sell only very less quantity of output. Due to
expansion of production when monopoly firm can reap economies of scale it can
reduce the price in the market, increase production and sales .But here also monopoly
should be able to maximize total revenue and profits.
DIFFERENCES BETWEEN MONOPOLY EQUILIBRIUM AND COMPETETIVE
EQUILIBRIUM
Perfect Competition
Monopoly
1.Under perfect competition there will be
large number of small unorganized sellers
1.The monopoly will be a single organized
seller
2.In pure competition, there are large
number of sellers, selling homogeneous
product.
2.Monopoly is the sole producer, the
commodity produced by the monopoly will
have no close substitutes and it will be
unique in market
3.There will be free entry & exit of firms.
4.The firm under perfect competition is a
price taker
3.Entry of new firms will be cpmpletly
banned
4. the firm will be a price maker because it is
a single firm.
5. A single seller can’t affect the market
price by changing its supply. The demand
curve is perfectly elastic, i.e a horizontal
straight line. Hence AR=MR=Price.
5. The demand curve is relatively inelastic it
slopes downwards showing that only when
price is reduced monopoly can sell more.MR
curve lies below AR curve.
6.The demand curve is perfectly
elastic, and hence the seller can only
determine the output as the price is
fixed, he can sell as many output as he
wants at a given price.
6.The monopolist can determine his
output or price but not both, If one is
decided the other is simultaneously
determined by the consumer.
7. Firm under perfect competition
attains equilibrium when MC=MR and
MC cuts the MR curve from below,
hence MC curve should be rising.
Since price is given, AR=MR.So, the at
equilibrium position P=MC=AR=MR
7. Under monopoly the essential
equilibrium conditions are MC=MR
and MC cuts MR curve from below or
from side or from above , according to
the applicability of the law of returns
to scale
8.In long run only normal profits are
earned by the firms
8.In the long run ,firm will earn super
normal profit.
9.Price is low and output that can be
sold is infinite. Price will be the same
in the entire market. Price =AR=MR
10.Firm forms small part of industry
9.price will be very high when
comparing to perfect competition.
Monopoly charges different price in
different markets under discriminating
monopoly.price >MR
10.FIrm=Industry
Monopolistic Competition:
Introduction:
Monopolistic competition is an important part of imperfect competition. It is the combination
of monopoly and perfect competition. Professor Chamberlin in his book “Theory of
monopolistic competition” & Professor Joan Robinson in his book “Economics of imperfect
competition” brought out a synthesis of monopoly and perfect competition as monopolistic
competition. As on today, both monopoly and perfect competition have become myth.
Monopolistic competition is the most practical type of competition one can see in the market.
For e.g. Monopolistic competition can be in retail sector, banking, cosmetics, automobile
industry, soaps, textile companies, etc. In those days when an entrepreneur found some
formula or a new product, it was difficult for others to find out the secret of that product, so
they remained as monopoly for long time in market. But nowadays due to advancement of
technology, communication, availability of information, literacy, research facility. Within no
time a similar product is found and competitors appear in market and rivals take monopoly to
monopolistic competition.
Perfect competition is also very difficult to find. They try (now brand names and
advertisements are helping these firms) to distinguish their products from other company’s
product & try to have their own price policy unaffected by other products available in the
market. We find different brands of rice bags available in the shelves of super markets. Even if
you take the case of Mud Diya’s, they put some design on it and call it as designer wear diyas
and price is changed for them in many folds higher than the ordinary mud diyas.
According to Joe S. bain, “Monopolistic competition is found in the industry where there is a
large number of small sellers, selling differentiated but close substitute products”.
H.H.Liebhofsky definition says, “Monopolistic Competition has today come to mean a state of
affairs in which there is a large number of sellers selling non-homogenous or slightly
differentiated products and in which freedom of entry exists”.
Features of Monopolistic Competition:
1. There will be many sellers in the market. The number of sellers are many but not as
many as in case of perfect competition. Each seller forms only a small part of the
market. But the interdependency on other firms will not be there. As there are large
numbers of firms, the impact of one firm’s action upon the other will tend to be too
insignificant to cause any reaction among rivals.
2. There will be large number of buyers. Each buyer has a preference for a specific brand of
product unlike perfect competition, here buying is by choice and not by chance.
3. There will be free entry and exist of the firms. This makes competition stiff because of
close substitutes produced by the new entrants with their own brand names.
4. Products produced are heterogeneous. It can be real or artificial. Each firm’s product is
differentiated from other firm’s product by brand names and other factors, which we
will discuss in detail later.
5. The buyers will not have proper information about the market as in the case of perfect
competition. But he will have some knowledge unlike monopoly. The special feature is
the buyer will be covered by a veil created by the firm’s, through advertisement.
6. There will be movement of product from one place to another but the firms can have
control over it at anytime.
7. Selling cost is very important. There are different types of selling cost. (We will discuss in
detail.) But what we have to know here is every firm has to spend lot of money on
selling cost. It becomes important for the survival of the firms to spend on selling cost.
8. Along with price competition, non-price competition also plays a very important role.
9. Even though there are large number of firms, each firm will have its own price policy i.e
they will be price makers than price takers. Each firm will have it’s own bunch of
consumers, where there will be brand loyalty.(As we are seeing for patanjali products
now)
10. Chamberlin has said that instead of industry we have to use the word ‘group' because
the firms do not produce identical products. Group includes the firms which produce
similar products but not identical products.
11. The demand curve i.e. the average revenue curve slopes downwards. However that is
much more elastic than that of the firm under monopoly. Because there are large
number of competitors selling similar products as close substitutes. MR curve is below
AR curve and it can be calculated from AR curve. The downward sloping AR & MR curve
indicates that the firm can sell more of its commodity by reducing the price.
Price determination under Monopolistic Competition:
Monopolistic competition is a situation where there will be many sellers but not many as in
the case of perfect competition. But not less as in case of oligopoly also. The price
determination under monopoly & monopolistic competition will become similar if product
differentiation, selling cost &freedom of entry is kept away.
Monopolistic Competition is based on following assumptions:
1)
2)
3)
4)
5)
6)
7)
There will be many sellers in the market.
There will be large number of buyers.
The products produced by the firms are differentiated from each other.
There will be free entry and exit of the firms.
There will be imperfect knowledge among the buyers.
Selling cost is very important.
There is an existence of non-price competition or importance is given to non-price
also.
In most of the monopolistic competition firms there will be excess capacity and
price charged by them will be greater than the price charged by firms under perfect
competition. This is because of the selling cost spent by the firms.
In the short run, the monopolistic firms can have super normal profit or
normal profit or loss. But in the long run, all the firms will have normal profit. But,
some economist has opined that in the long run also the monopolistic firms can
have “Super normal profit”.
Price determination in the short run
In the short run, the firm will try to maximize the profit or minimize the loss in
equilibrium. In the short run, the firm can have super normal profit or normal profit
or even loss. In the case of loss, it will try to make it into profit or expect to make it
in the long run and try to run the firm even with the loss in the short run. The
chronic loss making firms will close in the long run. The firm will be in equilibrium
where MC=MR & MC cuts the MR curve from below. The AR & MR curve slopes
downward. i.e. the firms can sell more when they reduce the price.
I. Super Normal Profit:
Let us show a situation of super normal profit through a graph.
FIGURE 1
In the graph, equilibrium point is where MC=MR & MC cuts MR from below which helps us to
derive equilibrium output sold i.e. OQ is the equilibrium output and OP is the equilibrium price.
Since, the AC curve is below the AR curve at the equilibrium point, BC is profit per unit & the
firm reaps the super normal profit PBCD.
II.
NORMAL PROFIT:
In the short run, the firm can have Normal profit, which is shown through the
graph
FIGURE. 2
Here, where MC curve cuts MR curve, that point is known as E1which is known as Equilibrium
point. When we draw a line from E1, it touches the AR curve. At that point only, AC=AR. i.e.
average revenue will be equal to average cost, which leads to normal profit. Here OQ is the
equilibrium output & OP is the equilibrium price.
III.
LOSS:
When the cost of he production of the firm is greater than the revenue, (i.e.
AC > AR) the firm will have loss. In the graph AR is the average revenue curve
and MR is the marginal revenue curve lying below AR curve.
FIGURE. 3
In the graph, E is the equilibrium point. Since, AC is greater than AR, when the firm is producing
ON equilibrium output. For the Nth output, loss per unit is AH. Since the firm is producing ON
output, the total loss is ON X AH i.e. GTAH, which is the total loss of the firm. Or it can be
explained like this. When the firm produces ON amount of output, total cost is ONHG = ON X
NH (A.C.) & T.R. = ONAT =ON X NA (A.R.) loss = T.C.-T.R.=ONHG – ONAT = GTAHNA=OT=Market
price, NH=OG=Cost of production
LONG RUN EQUILIBRIUM:
In the long run the monopolistic firm will have normal profit. in the short run, the firms can
have loss or supernormal profit. The firms which are having loss in the long run will quit the
industry. So the supply will decrease and the price will increase in long run and normal profit
will be attained. If the firms have super normal profit in the short run, they will attract more
firms into the group & so the supply for the market will increase and the price will fall, which
will bring normal profit in the long run. The long run normal profit situation is explained in
Figure.2. AR will be equal to AC. Equilibrium price is OP & equilibrium output is OQ.
Equilibrium of the industry ( group) :
Eminent economist Chamberlin suggested that instead of industry, group of firms will be a
better explanation under monopolistic competition. Even though Chamberlin used only AC
curve to explain the equilibrium, here the MR, MC approach is utilized to make it easier. In the
long run when some firms have super normal profits, then it will attract more and more
number of firms into group or market and the inelastic AR curve will become elastic and
number of firms entering will stop till the price is reduced and comes to normal profit, because
with the increase in supply in the market, price will decrease and it will reduce the super
normal profit to normal profit. When some firm have loss, then certain firms will exit from the
group, which decreases supply in the market and price will increase, which will eradicate loss
and lead to normal profit. This can be expressed by solution which is shown in figure.2. The
graph will be in equilibrium when OP1is the equilibrium price &OQ1 is the equilibrium output.
Special problems in analyzing the equilibrium of the firm and the group:
1. The foremost difficulty in the monopolistic competition is identifying the industry. In
case of perfect competition, all the firms produce similar products. So we easily say the
supply curve of the industry, can be derived by the summation of the supply curves of
all the firms. But in case of monopolistic competition, it is difficult to identify the
industry and also to get supply curve of industry. Firms produce different products
which are not complete substitutes for each other. For example, for body wash,
different kinds of soaps, like winter soaps with or without moisturizer, baby soaps,
beauty soaps, hand wash, face wash. In addition to that, you have liquid soap which is
very different. It is very difficult to define or group them into industry. To avoid this,
Chamberlin introduced the concept called group in place of industry. A group is a cluster
of firms producing goods having a high cross elasticity of demand.
2. Chamberlin brought out the importance of non-price competition (product
differentiation & selling cost) in monopolistic competition, which plays a very important
key role. Chamberlin explained the equilibrium, with help of price and AC curves. He did
not use the usual MR MC approach which made his explanations very difficult to digest
for many economists.
3. Chamberlin theory gave basically S.R theory of the firms. L.R theory was given in an
informal way.
4. According to Professor Chamberlin, in order to maximize profit, a monopolistic firm has
to adjust its price policy or product policy or selling cost policy or the adjustments in all
policies together.
We can discuss these three situations a little bit elaborately.
I.
Product variation or product differentiation Equilibrium:
When a market price is in trend and when the all firms try to stick to it, then
the firms find it beneficial to differentiate their products from other products
available in the market and try to charge higher price. They try to show that
their product is very different from all the other products in the market and
superior to all & try to attract customers towards them. This is non-price
competition and called as product quality variation.
The retailer may try to change presentation, place of sale, method of sale
(instead of permanent sales, he may go for exhibitions, online sales) or even
change location, etc. A manufacturer may bring “product differentiation “by
changing the quality of product, color, design, workmanship, packing,
maintenance, service, brand names, etc. It may be real or artificial. When
product variation is done, there will be variation in cost of production. In
order to make maximum profit, the firm has to analyze about the changes
made in the cost of production & changes made in total revenue the firm will
acquire after this changes in product variation. It has to consider the changes
in the market due to the product variation. The firm has to choose that
product which bring largest difference between total revenue and total cost
that gives maximum profit. For example, if a car making firms introduce cars
with auto lock system, it has to see what is the change in the cost of
production and if it gets more profit, then it should go for it.
Various theories of oligopoly:
Various economists like Paul Sweezy, Cournot, Bertrand, stakleberg, Shapiro has given their
own theories. Because of its special feature, it is difficult to find a standardized price-output
equilibrium theory. Under oligopoly we find various types of price-output equilibrium theories
which are shown in a tree diagram below.
Oligopoly theories
t
Paulsweezy
model
Collusive
perfect models
Differentiated
product model
CARTELS
Collusive
imperfect M
imperfect
mmodemodels
PRICE LEADERSHIP
Joint profit
maximizing centralized
cartel
Low cost price leadership
Market sharing cartel
Barometric wise Mgt. P. L.
Paul sweezy model of Oligopoly
Nash
equilibrium
game theory
Market share dominant P. L.
Aggressive price leadership
There are so many models in oligopoly. But paul sweezy model is the most familiar model. The
kinked demand curve and sticky price makes the model very familiar.
Paul sweezy model is based on certain assumptions.
Assumption
There are few sellers in the market.
There will be many buyers in the market.
In Sweezy model, we assume the product are homogeneous & the products produced by one
firm can be substituted by other firm’s product.
The firm in the industry are inter-dependent on each other i.e., the changes made in the
prices, cost, etc of one firm will affect the other firms.
The product produced by oligopolies will have high cross elasticity of demand. i.e. one firm’s
product can be easily substituted by other firms product.
There will be free entry & exit of firms.
Generally, advertisements are important in oligopoly but in sweezy model there is no
advertisement expenditure.
There will be constant struggle among the firms.
There may be lack of uniformity in size.
The decrease in the price by one firm is followed by
other firms, whereas, the increase in the price is not
followed.
The average revenue curve in the Sweezy Model is a
kinked demand curve.
The M.R curve is a dis-continuous curve.
The M.C curve passes though the gap in M.R curve.
The price will be rigid for long time.
Explanation :The AR curve i.e., the market demand curve is having (bend) in it, here the current price & the
output is determined. For ex:- Let dED be the AR curve & there is a Kink at point E where a price
rigidity is maintained under Oligopoly. For example , when the firm decrease the price from OP
to P, it Expects that the sales will increase from OQ to OM but it increase only to OL, Because all
the firms also decreases the price. The firm under Oligopoly thinks that the demand curve is
dEd where the firm can benefit by decreasing the price .When the firm decreases the price, it
cannot increase the sales to a greater extent as it expected .But the firm will be able to
increase the sales a little bit because the decrease in the price is followed by all the firms in the
market which is making the elastic demand curve into inelastic demand curve So, instead of
dEd, the demand curve becomes dED. Now, if the firms assumes its curve as inelastic demand
curve & increases the price, then no, firms follows it& the curve becomes elastic
L
M
.Because of this, there is a kink at E , where the price OP is kept constant for long time, To
avoid unnecessary loss by increase or decrease in price , price rigidity is maintained in
Oligopoly.
Because of kinded demand curve, MR curve under Oligopoly will have a discontinuity.
The MR curve is represented as MR, where there is a gap AB which is shown in a graph . The
discontinuity of MR curve must be drawn below the kink.
The MC curve cuts the MR curve in the gap, where the equilibrium price and output is
determined. If the cost of production increases, MC curve will move up in the gap & when the
cost of production decreases MC curve will move down in the gap.Paul swezy has opines that
the MC curve will cut the MR curve in the gap only. He has not favored increase in the price.&
has not explained how rigid price has been arrived at, where all the firms are satisfied
2. Pricing under Perfect collusion model;
a) In the model of centralized cartel or perfect cartel the firms in an industry reach with an
agreement which maximises joint profits .So the cartel can act as an monopolist since the firms
in the cartel are assumed to produce homogenous product. The market demand for the
product is cartel’s demand .It is also assumed that the cartel management knows the demand
at each possible price. The output of the cartel is shared between the firms on the basis of
efficiency of the firms.
b) In the case of market sharing cartel the firm agree to share the market & fix the quotas. All
the firms will sell at the same price but sells within the given region. Here price is fixed in such a
way that all the firms get super normal profit. Here the cost of production of all the firms is
assumed to be similar & products produced by them are assumed to be homogenous.
3. Pricing under imperfect collusion in price leadership;
a) In the low cost price leadership model, an oligopolistic firm having lower costs than the
other firms sets a lower price which the other firms have to follow. This will maximize the
profit of low cost firm but not the other firms. The other firms will not dare to increase the
price because it will lose its buyers to low coat firm & it will start incurring loss. If the low cost
firm charges very less price so that all the firms will quit, then it will become monopoly.
b)Dominant price leadership occurs when there is one large dominant firm and the others are
small firms in the industry .The large dominant firm can derive out its rival by price war. To
avoid such possibility, tactic collusion may be arrived at between the dominant firm & the small
firms. By this collusion ,small firms become price token & can sell any amount of output they
want. They behave similar to perfect competition firms. the dominant firm supplies to the
remaining market which is not satisfied by the small firms. Even though the dominant firm in
the price leader, it is quantity follower..It sells at a high price.
C) The barometric leadership is very different from the other types of price leadership. Here
following the leadership doesn’t come due to low cost, high market share or aggression. The
group accepts that firms as a leader who can take wisest management decision. This firm’s
management acts like a barometer in forecasting changes in cost, changes in demand, changes
in the technology, changes in economic conditions etc. The firms in industry (or group) accept
this firms as leader, on the basis of formal or informal agreement & follow it in making price
changes for the product. This leader could have been chosen based on the expertise it has
shown in the overcoming the difficult times like depression, global competition, bad business
weather etc. They may be following this business leader due to cut throat competition, bitter
price war, inexperience in forecasting perfectly like this barometric leader.
d) In the aggressive price leadership, one organization establishes its supremacy by threatening
the other firms to follow its leadership. It establishes aggressive price policies and forces other
firms to follow the price set by it.
iii) In the differentiated product model each firm (e.g. cell phone) produces & makes it’s
product to look different from other products in the market. When the firm produce
differentiated product, if all the firm go for collusion it can act like a monopoly, If they don’t go
for collusion they may act like monopolistic competition.
IV) Game theory is concerned with predicting the outcome of a game with different strategy in
which the participants have incomplete information about the others’ intention. The classic
example of game theory is the prisoner’s dilemma, a situation where two prisoners are being
questioned over guilt or innocence of a crime separately. Nash equilibrium is an important idea
in game theory which describe an situation where all the participants in a game are pursuing
their best possible strategy, guessing others’ strategies but don’t know how they will react in
reality. when the firms have no collusion they will not have control over the rivals. But they
closely watch their rivals. They decide the price-output policy keeping in view the reaction of
the rival’s firm in the industry. Each firm will be having price control due to product
differentiation and the firm’s price will be near to monopoly price. If price war breaks out
between the rivals then they may charge a price at the competitive level.
5th unit M.E. QUESTION BANK
ESSAY
1) EQUILIBRIUM price & output determination of a firm under perfect
2)
3)
4)
5)
competition-----L.R. & S.R.
EQUILIBRIUM price & output determination of a firm under MONOPOLY
competition-----L.R. & S.R.
EQUILIBRIUM price & output determination of a firm under
MONOPOLISTIC competition-----L.R. & S.R.
EXPLAIN paul sweezy model of oligopoly.
Explain various types pricing policy
Short
1) 1 . characteristic features of perfect competition
2) characteristic features of monopoly
3) characteristic features of monopolistic competition
4) product differentiation
5) sales promotion
6) kinked demand curve
7) price rigidity
8) all 5 types ---of pricing
St.Josephs Degree & PG College
B.Com (IF&A)(CBCS)
Semester-III
Managerial Economics (w.e.f 2019 -20)
Scheme of Instruction
Scheme of Examination
Total duration
:60Hrs
Max Marks :100
Hours / Week
:5
Internal Examination :30
Credits
:5
Skill Based Test
:10
Instruction Mode : Lecture
External SemesterExam:60
Course Code
: BC.05.101.18T
Exam Duration
:3Hrs
Course Objective: To make students aware of economic concept and to make them understand
the importance and practicability of the subject.
Course Outcomes –
CO 1: Apply the tools of economics to practice and facilitate the decision making prcoess of the
firm.
CO 2: Apply the theories of law of demand and supply in practice .
CO 3: Examine the various types of production function and its applicability to optimize the
output .
CO 4: evaluate the various types of competitions and frame strategies to reduce cost and
maximize revenues and profits.
CO 5: Analyze the economies and diseconomies of large scale production.
KL
Unit I: Introduction to Managerial Economics:
12 Hrs
Meaning of managerial economics-nature and Scope, Basic tools in Managerial Economics –
Opportunity cost principle, Incremental principle, Principle of time perspective, discounting
principle. .
UnitII:Demand&supplyAnalysis:
12 Hrs
Meaning of Demand, Demand Function, Curves, Individual and Market Demand, determinants
of demand-Types of Demand. Elasticity of Demand - Types of Elasticity, its measurement and
business uses.
Meaning of supply-supply function-supply curve-determinants of supply –law of supply
Unit III: Production Function:
12 Hrs
Meaning of Production Function, Production function with one variable input, Law of Variable
Proportions, Single output Isoquants, Optimal Combination of Factor inputs, and returns to
scale. Cobb Douglas Production Function.
Unit IV: Cost Function:
12 Hrs
Cost concepts, Relevant Costs in decision making, Cost-Output relationship in the short and the
long run, Economies and Diseconomies of scale. Economies of scope.
Unit V: Market Structure:
12 Hrs
Kinds of competitive situations-Perfect competition, Monopoly, Monopolistic Competition and
Oligopoly-features. Equilibrium output determination of a firm under perfect competition in the
short run and long run. Equilibrium Price and out put determination of a firm under a)
monopoly b) Monopolistic Competition in the short run and long run. Paul Sweezy’s kinked
demand curve model of oligopoly. -incremental and full cost pricing, loss leader pricing,
skimming and penetration pricing policy.
Reference Books:
1 Business Economics: Mithani & Murthy- Himalaya Publishing House, Revised 2009
2 Business Economics: P.N. Chopra,- Kalyani Publishers, Edition 1998, Reprint 2011
3 Business Economics : A.V. Ranganadhachary, V. Surender, J. Girija Sastry-Kalyani
Publishers, Revised 2003
4 Business Economics :I.C.Dhingra
5 Business Economics: KPM Sundharam & E.N Sundharam, Sultan Chand & Sons