Business Economics Notes (UGC NET Unit 3)

An analysis of 248 previous year questions of Unit 3 across 24 exam cycles (prepared for this site) shows where the marks come from. The unit mixes theory, graphs and short numericals, so revise in the order below.

How to use this unit

• Graph questions are rarely drawn, but graphs decide the answer. Know the shape and the point of equilibrium for each market form so that statements about MR, MC, AC and price can be checked quickly.
• Matching questions dominate. Learn who proposed which theory, which market form has which feature, and which pricing strategy fits which situation.
• Short numericals repeat. Elasticity, cross elasticity, equilibrium price from demand and supply equations, point elasticity of supply and returns to scale appear again and again. The formula section lists them.
• Related macro and Indian economy questions appear under this unit. Inflation measures, Okun’s law and passage-based questions on the Indian economy were asked, so the section on macroeconomic basics covers the concepts you need.

Business economics (also called managerial economics) is the use of economic theory, logic and quantitative tools to analyse business problems and take decisions. It sits between pure economics and the practice of management: economics supplies the principles and management supplies the problems.

Definitions of economics (who said what)

What economics and an economy are

In simple words, economics is the study of scarcity and its implications for the use of resources, the production of goods and services, the growth of production and welfare over time, and many related issues that matter to society. An economy is a system of inter-related production and consumption activities that determines how resources are allocated within a group; the production and consumption of goods and services together meet the needs of the people living in it.

Why study economics: it helps people understand the world around them, including people, businesses, markets and governments, and respond better to threats and opportunities when conditions change. Root of every economic problem: human wants are unlimited while resources are limited.

Scarcity, choice and the aim of economics

• The word economics comes from two Greek words, oikos (household) and nemein (management): management of a household. Wants are unlimited, but the means to satisfy them (wealth) are limited.
• Scarcity means demand for resources exceeds their supply. Choice is the selection among limited alternatives, and it arises because resources are scarce and also have alternative uses (land can grow wheat or carry a factory). So scarcity causes choice, and choice means decision-making.
• Economics is therefore a science of human behaviour concerned with allocating scarce means to alternative uses so that the consumer maximises satisfaction, the producer maximises profit and society maximises welfare.
• Scarcity continues even for a good available at zero price, as long as it involves an opportunity cost (free medicine in a hospital is still scarce). A good is not scarce only when it is free and has no opportunity cost. If there were no scarcity there would be no choice and no economic problem; and not all resources are equally scarce at a time (in India labour is less scarce than capital).

Causes of the economic problem and the central problems in more detail

• Three causes: wants are unlimited and keep growing with time (laptops, phones and cars were once not in demand); means are limited, so the goods are scarce whatever the price; and the limited means have alternative uses (milk can become cheese, ice cream or sweets), so society must decide which wants to meet first.
• What to produce has two parts: which goods (consumer goods or capital goods; war-time goods such as guns or peace-time goods such as bread) and how much of each. More of one good means less of another.
• How to produce is the choice of technique: the efficient technique gives the same output with the least scarce resources, i.e. at minimum cost. In a country like India, labour-intensive technology gives more employment while capital-intensive technology gives more efficiency and a higher growth rate, so employment and efficiency pull in opposite directions.
• For whom to produce concerns the sections of society, the rich and the poor. Producing more for the poor promotes social justice but lowers producers’ profit, so investment and GDP growth stay low; favouring the rich gives more savings and growth but deprives the poor. The choice is between social equality and GDP growth.
• Add-on problems of underdeveloped economies: fuller utilisation of resources (actual output below potential output, as in mass unemployment) and growth of resources (untapped natural gas, oil and minerals because technology is lacking).

How different economies solve the central problems

• Market economy: producers decide by supply and demand. They make the goods whose prices are high, use the inputs whose prices are low, and sell to buyers who offer the highest price, all to maximise profit.
• Centrally planned economy: a central authority decides with social welfare in mind. It picks the goods and technique that are most useful to society (for example labour-intensive technology when unemployment is high) and may supply goods to the hungry even at a loss.
• Mixed economy: market forces decide in some areas (private firms making cloth or steel for profit) and social considerations decide in others (railways run by the government at nominal rates so that the poor can use them).

Central problems read on the PPC

• What to produce: every point on the curve is full and efficient use of resources, and moving along it gives more of one good and less of the other, which is the problem of allocation.
• How to produce: a point well inside the curve shows an inefficient technique; with an efficient technique the economy can move to the curve, producing more of one good without losing the other, or more of both.
• For whom to produce: income skewed to the rich raises savings and investment and shifts the PPC to the right, but the poor suffer deprivation; growth without equality widens the economic divide and can lead to unrest.
• Fuller utilisation: a point inside the curve means actual output is below potential output because resources are idle or inefficiently used (mass unemployment in India). Growth of resources: a rightward shift, for example more skilled IT labour in India or oil discoveries in Gulf countries; better labour quality (skill and sanitation missions) also shifts it right.
• Cautions: unemployment does not shift the PPC to the left, because the curve already assumes full and efficient use; it only moves the economy to a point inside the curve. Full employment does not mean the economy is on the PPC, since resources may still be used inefficiently. A rise in labour productivity from better technology shifts the PPC right. A leftward shift needs a fall in the stock of resources (floods, war). Resources are not equally efficient in all uses, which is why the PPC is concave.

Opportunity cost and marginal opportunity cost: extra points

• When a factor has more than two uses, opportunity cost is the value in its next best use only. Example: one hectare gives wheat ₹10,000, rice ₹8,000, maize ₹7,000 or sugarcane ₹12,000; the land goes to sugarcane and the opportunity cost is ₹10,000 (wheat), not the sum of all the other uses.
• Opportunity cost is the total output lost when resources move from Use-1 to Use-2; marginal opportunity cost is the ratio of loss of output to gain of output, the cost of one more unit. Both rise as specialised resources are moved, because productivity falls when they leave the use they suit best. MOC is the slope of the PPC and is also called the marginal rate of transformation.

Central problems of an economy

Nature of business economics

• Micro in character. It deals with the individual firm, the consumer and the industry, though macro conditions (inflation, interest rate, policy) form the environment.
• Pragmatic. It picks the theory that helps a decision, not theory for its own sake.
• Normative as well as positive. Positive economics says what is (price rises when supply falls); normative economics says what ought to be (the firm should maximise profit, the government should cut tax).
• Prescriptive and decision oriented. It uses concepts such as opportunity cost, the incremental principle, the equi-marginal principle, the time perspective and the discounting principle.
• Interdisciplinary. It borrows from statistics, mathematics, accounting, operations research and psychology.

Economics as a science and as an art

• Normative science deals with what ought to be and does not avoid moral judgements; positive science deals with what is, explains cause and effect and stays neutral about ends (Robbins is the economist linked with this neutrality).
• As an art, economics helps solve practical problems and shows the best method of reaching an economic objective. It is both a science and an art, and business economics sharpens the executive ability to solve decision problems scientifically.

Positive and normative statements: extra points

• A positive statement is verifiable but need not be true: saying that the population of India is 100 crore or 121 crore are both positive statements, though only one is right. Positive economics answers what was, what is and what would be, and carries no value judgement.
• A normative statement gives an opinion on what ought to be, causes debate and cannot be tested against facts (“a subsidy programme should be stopped”). An opinion need not be the best solution: giving priority to the public sector after independence was later replaced by greater reliance on the private sector in the 1991 New Economic Policy.

Positive and normative economics

Micro and macro: extra points

• Micro studies price determination of an individual firm or industry and assumes macro variables (aggregate output, price level) are constant; macro studies aggregate output and the general price level and assumes micro variables (such as the distribution of income) are constant.
• Market forces of demand and supply play the leading role in micro problems (product or factor pricing); government monetary and fiscal policy plays the leading role in macro problems (unemployment, poverty, inflation).
• Micro also uses aggregates: market demand is the sum of all buyers’ demand for a commodity and market supply is the sum of all sellers’ supply.
• What is logical at the micro level need not hold at the macro level: one person saving more raises his future prosperity, but if everyone saves more, demand, investment, output and employment may fall.

Microeconomics and macroeconomics

The paradox of thrift and the fallacy of composition show why the two levels differ: what is good for one person (saving more) can be bad for the whole economy (lower demand and income).

Scope of business economics

1. Demand analysis and forecasting: accurate demand estimates are needed for two reasons, forecasting demand and manipulating demand. The main topics are demand determinants, demand distinctions and demand forecasting (also elasticity).
2. Production and cost analysis: production function, returns, cost curves, break-even analysis.
3. Pricing decisions: price under each market form, price discrimination, pricing strategies.
4. Profit management: theories of profit, profit planning and control.
5. Capital budgeting and investment decisions: the firm’s choice between projects.
6. Macro environment: business cycles, inflation, policy changes, and their effect on the firm.

Role of a business economist

The business economist forecasts demand, studies the market and competitors, advises on pricing, helps in cost control, appraises investment and interprets government policy for the firm. He or she links the firm with the economy.

Fundamental concepts used in decision-making

Economists and their books (frequent matching question)

Classical economists (Smith, Ricardo, Malthus, Mill) emphasised wealth creation, free markets and self-correcting economy. Neoclassical economists (Marshall and others) brought in marginal analysis and demand-supply equilibrium. Keynes showed that markets can stay in under-employment equilibrium, so government spending is needed.

The exam places a few macroeconomic and Indian economy questions in Unit 3. They test concepts, not data, so learn the definitions and the logic.

National income aggregates

Inflation and its measures

Inflation is a sustained rise in the general price level. Types by cause: demand-pull (too much demand), cost-push (higher input cost), structural (supply bottlenecks), imported (higher import prices). By speed: creeping, walking, running, hyperinflation.

RBI follows flexible inflation targeting: a CPI inflation target of 4 per cent with a tolerance band of plus or minus 2 per cent (2 to 6 per cent). The Government reviews the framework every five years, and in March 2026 it renewed the same target and band for 1 April 2026 to 31 March 2031. The CPI series was rebased from 2012 to 2024=100 and released from 12 February 2026, using the 2023-24 Household Consumption Expenditure Survey.

Unemployment and Okun’s law

• Frictional: between jobs. Structural: mismatch of skills. Cyclical: fall in demand. Seasonal: agriculture. Disguised: more workers than needed, marginal product near zero (typical in Indian agriculture). Open: willing but without work.
• Okun’s law: an empirical link between output and unemployment. Roughly, a 2 per cent fall in output below its potential is associated with 1 per cent rise in unemployment (the exact coefficient differs by country and period).
• Phillips curve: short-run inverse relation between inflation and unemployment.

Fiscal and monetary basics

• Fiscal deficit = total expenditure minus total receipts excluding borrowing. Revenue deficit = revenue expenditure minus revenue receipts. Primary deficit = fiscal deficit minus interest payments.
• Under the FRBM framework the Government has moved from a fixed fiscal deficit target to a debt-to-GDP anchor, with fiscal deficit declining year by year; check the latest Budget for the current figure.
• Monetary policy tools: repo rate, reverse repo (standing deposit facility), CRR, SLR, open market operations, marginal standing facility.

How to attack passage-based questions on the Indian economy

• Read the questions first, then the passage once, and mark numbers and cause-effect words.
• A statement that goes beyond the passage (absolute words such as “always”, “only”, “all”) is usually the wrong one.
• For “which factor does NOT support the growth story” find the factor that the passage links with a fall, a risk or a constraint.
• The questions on India Stack, Aadhaar and welfare targeting are answered from the text; do not bring outside figures.

Scarcity forces every society to answer the central questions: what to produce, how much to produce, how to produce and for whom to produce. Growth of the economy, efficiency of utilisation and who owns and controls production are added as further problems (see the table in section 2).

Production possibility frontier (PPF)

The PPF (also production possibility curve or transformation curve) shows the maximum combinations of two goods that can be produced with given resources and technology when resources are fully and efficiently used. It captures scarcity, choice and trade-offs. Other names: production possibility curve, production possibility boundary, transformation curve, transformation frontier and transformation boundary.

Assumptions of the PPF

1. Resources are fixed in amount but can be moved from one use to another.
2. Only two goods can be produced with them.
3. Resources are fully and efficiently used.
4. Resources are not equally efficient in all uses, so productivity falls when they are moved from one good to another.
5. Technology is constant.

Worked schedule: guns and butter

All resources in guns give 21 guns and no butter (A); all in butter give 6 butter and no guns (G). MOC rises because a worker best suited to guns is less efficient in butter. Marginal opportunity cost is the sacrifice of one good to gain one more unit of the other; MRT = change in guns divided by change in butter, the slope of the PPF. Note: MRT is measured in physical units, while MOC is the same sacrifice read in money terms.

• Points on the curve are efficient. Points inside show unemployment or waste of resources. Points outside are not attainable now.
• The curve is concave to the origin because the marginal rate of transformation (MRT) rises: as more of one good is made, resources less suited to it are drawn in, so the opportunity cost grows (law of increasing opportunity cost).
• A straight-line PPF means constant opportunity cost; a curve convex to the origin would mean falling opportunity cost (unusual).
• MRT = slope of the PPF = ratio of marginal costs of the two goods.

Shift and rotation

• Outward shift: more resources, better technology, growth.
• Biased shift (rotation): technology improves for one good only. Rotation for the good on the X-axis (butter): improvement turns AB to AC (right), degradation turns it to AD (left). Rotation for the good on the Y-axis (guns): improvement turns AB to CB, degradation turns it to DB. A shift needs a change in capacity for both goods (rightward for growth, leftward for decline); a straight line needs equally efficient resources in all uses.
• Inward shift: war, disaster, loss of resources.

Nature and types of economy

• An economy is a system by which the people of an area earn their living. Its nature depends on what most people do (agricultural economy, industrial economy); its type depends on how far the government controls economic activity (production, consumption, investment and exchange).
• Controlled (centrally planned) economy: very high government control, decisions driven by social welfare, the central authority decides what is produced and at what price, consumer is not sovereign, public sector dominates (China, Russia and North Korea are cited).
• Free (market) economy: control is only nominal, market forces govern, decisions follow profit, the consumer is sovereign, resources are privately owned, prices are set by the market and the private sector dominates (USA, UK).
• Mixed economy: moderate control, market forces regulated by the government, both profit and social welfare drive decisions, the public distribution system secures essential goods for consumers, prices are market-set but essentials are regulated, and both sectors dominate (India).

Economic systems

Characteristics of capitalism that are commonly asked: private property, freedom of enterprise, profit motive, price mechanism, competition, consumer sovereignty and limited government role. A feature such as “major means of production owned or controlled by the Government” belongs to socialism, not to capitalism.

Indian economic policy in brief (as asked in this unit)

• Industrial Policy Resolution 1956: public sector given the commanding heights; industries divided into three schedules (exclusive State, mixed, private); based on the Mahalanobis growth model.
• New Economic Policy 1991: liberalisation (licensing abolished for most industries), privatisation (disinvestment, reduced list of reserved industries) and globalisation (opening to trade and foreign investment).
• Privatisation routes: disinvestment (sale of shares), strategic sale with transfer of control, and opening areas to private entry. Second generation reforms target labour, land, tax (GST), banking, bankruptcy (IBC) and public sector efficiency.
• Infrastructure services such as power, telecom, roads and airports have been opened to private participation through public-private partnership models.

The traditional objective is profit maximisation, reached where MR = MC (first-order condition) with MC cutting MR from below, so that the slope of the MC curve is greater than the slope of the MR curve (second-order condition). Because modern firms have separated ownership and control, economists propose other objectives.

Why profit maximisation is questioned

• Owners and managers are different people (principal-agent problem).
• Information is imperfect, and uncertainty is high.
• Firms also care for market share, survival, prestige and social image.
• Large oligopolies fear new entry and regulation.

Alternative objectives

Wealth maximisation (maximising the present value of expected future profits, or shareholders’ value) is the objective preferred in modern financial management.

Other views of the firm objective (economists and their goals)

The traditional view stresses profit maximisation, while modern views add stakeholder welfare, innovation and sustainability.

Baumol’s sales revenue maximisation

The firm produces where total revenue is maximum (MR = 0), which is a larger output and lower price than at profit maximisation, unless the minimum-profit constraint binds first. Advertising is raised as long as it adds to revenue.

• Reason given by Baumol: managers’ pay and status depend more on sales than on profit; sales support credit, dealers and growth.
• If the minimum-profit constraint is binding, output lies between the profit-maximising and the revenue-maximising level.

Marris growth hypothesis

The firm maximises the balanced growth rate where the growth rate of demand for its product equals the growth rate of its capital supply. Faster growth needs diversification and finance, but it lowers profit and raises the risk of takeover, so the valuation ratio acts as a constraint.

Constraint optimisation and satisficing

Constrained optimisation means maximising one goal (sales, growth) subject to a minimum on another (profit). It is therefore closest to satisficing behaviour: the firm tries to reach acceptable levels instead of the single best level. This is how the exam ties the two ideas together.

Consumer rationality (also asked here)

A consumer is rational if he or she has clarity of preferences (can rank bundles), non-satiation (prefers more to less), possession of information, and a selfish economic motive to maximise satisfaction within the income. Homogeneous expectations is not a core part of this list.

Accounting profit and economic profit

Normal profit is the minimum return needed to keep the entrepreneur in the business; it is treated as part of the economic cost. Supernormal (abnormal) profit is the surplus above normal profit. Under perfect competition, free entry removes supernormal profit in the long run.

Theories of profit and their propounders (asked in most cycles)

Order in time (as most textbooks list them): Walker (rent of ability), Hawley (1893, risk), Clark (1900, dynamic), Knight (1921, uncertainty), Schumpeter (innovation). Schumpeter’s book first appeared in German in 1911 and in English in 1934, so if a question gives dates, go by the dates it gives.

• Hawley: risk. Knight: uncertainty. Both are “bearing” theories, but Knight distinguishes insurable risk from uninsurable uncertainty.
• Clark: dynamic changes (population, capital, technique, wants, organisation). Schumpeter: innovation is the cause of change.

Profit planning and control

• Break-even analysis finds the output at which total revenue equals total cost (see the cost section).
• Cost-volume-profit analysis studies the effect of volume, price and cost on profit.
• Target return pricing and mark-up pricing set price so as to earn a planned profit.

Demand is the quantity of a good that a consumer is willing and able to buy at each price in a given period, other things remaining the same. Desire alone is not demand; it must be backed by purchasing power. Market demand is the sum of all individual demands.

Demand function and schedule

A demand schedule is a table of price and quantity; the demand curve is its graph. The linear form is Qd = a − bP, where b is the slope parameter (change in quantity for a one-unit change in price).

Elements, schedules and types of demand

• Elements of demand: desire for the good, sufficient means to buy, willingness to pay, a given price and a given time.
• Individual demand schedule: quantities one buyer will take at different prices. Market demand schedule: quantities all buyers together will take. The demand curve is the graph of the schedule, the locus of price-quantity points under ceteris paribus, showing the inverse price-quantity relation.
• Example: at price 1, buyer P takes 4 and buyer Q takes 5, so market demand is 9; at 2 it is 3+4=7; at 3 it is 2+3=5; at 4 it is 1+2=3.
• Market demand function: Dx = f(Px, Pr, Y, T, E, P, Yd), where P is the size and composition of population and Yd the distribution of income (the individual function omits these two).
• Joint demand: two or more goods wanted together (bat and ball, scooter and petrol). Derived demand: demand for one good arising from demand for another. Composite demand: one good wanted for several uses (electricity for light, power, heat).

Determinants of demand

Demand as a flow concept

• Demand has three parts: the desire for the good, the ability to pay and the willingness to pay. A statement of demand is complete only with a quantity, a price and a time period, so demand is a flow concept (so much per day, week or year), not a stock.
• Further exceptions to the law of demand: fear of shortage (in an emergency people buy more even at higher prices) and speculative goods (a rise in price makes people expect a still higher price, so they buy more now).

Demand versus quantity demanded, slope and the market curve

• Demand means the whole set of quantities a buyer is ready to take at the different possible prices. Quantity demanded is one single quantity at one single price. Example: 10, 8 and 6 units at Rs 5, 6 and 7 is demand; 8 units at Rs 6 is quantity demanded.
• The market demand curve is the horizontal sum of the individual curves: at each price add the quantities of all buyers (A takes 4 and B takes 5 at Rs 1, so market demand is 9). Both the individual and the market schedule show the inverse price-quantity relation.
• Slope of the demand curve = −ΔP/ΔQ, the change in price per unit change in quantity; the minus sign shows the inverse relation. For a straight-line demand curve the slope is the same at every point.
• In everyday use the difference between demand and quantity demanded is often ignored, and the law is stated as a price-demand relation.

Worked algebraic example

• Take Qd = 1000 − 20P. At P = 10, 20, 30, 40, 50 the quantity is 800, 600, 400, 200, 0. The constant 1000 is the quantity at zero price.
• Each Rs 10 rise in price cuts quantity by 200, so b = ΔQ/ΔP = 20, and the slope of the curve (ΔP/ΔQ) = 10/200 = 1/20.

Market demand aggregation (practice)

• If buyer 1 wants 9, 8, 7, 6, 5, 4 and buyer 2 wants 24, 20, 18, 16, 14, 12 at prices 1 to 6, market demand is 33, 28, 25, 22, 19, 16.

Related goods and the cross-price effect

• Cross-price effect: the change in demand for one good when the price of a related good changes. Related goods are either substitutes (tea and coffee, pen and ink-pen) or complements (pen and ink, car and petrol); unrelated goods do not affect each other.
• Substitutes: if the price of Y rises, the demand curve of X shifts right (buyers move to X); if the price of Y falls, it shifts left.
• Complements: if the price of Y rises, the demand curve of X shifts left (less X is wanted along with dearer Y); if the price of Y falls, it shifts right.
• Test for substitutes: price and demand of the other good move in the same direction; for complements they move in opposite directions.

Income and the type of good

• Normal good: income effect positive. Income up gives a forward (rightward) shift; income down gives a backward shift. It may or may not be a necessity.
• Inferior good: income effect negative (coarse grain, coarse cloth). Income up gives a backward shift as buyers move to better substitutes; income down gives a forward shift as buyers fall back on the cheap good.
• For a normal good the law of demand always holds; for an inferior good it may or may not hold. A good can be normal for a rich buyer and inferior for a poor one, depending on the income level.

Tastes and preferences

• Three sources: personal likes and dislikes, trends and fashions, and the climate (tea and coffee in winter, cold drinks and ice cream in summer).
• A favourable change raises demand at the same price (forward shift); an unfavourable change lowers it (backward shift).

Law of demand

Other things being equal, quantity demanded rises when price falls and falls when price rises, so the demand curve slopes downward. The assumptions (ceteris paribus) are constant income, tastes, prices of related goods, population size, quality of the good, distribution of income and wealth, and government policy, and the good must not be a prestige good.

• Why the curve slopes down: (1) the substitution effect, (2) the income effect, (3) the law of diminishing marginal utility (consumers pay less for additional units), (4) new buyers enter at lower prices, and (5) different uses: when the price of a multi-use good such as milk rises, it is kept for the most important use, and when the price falls it is put to all uses.

Causes of increase and decrease in demand

• Increase in demand (forward shift): income rises (normal good), price of a substitute rises, price of a complement falls, tastes turn in favour of the good (fashion, climate), or the good is expected to become scarce soon.
• Decrease in demand (backward shift): income falls (normal good), price of a substitute falls, price of a complement rises, tastes turn against the good, or the good is expected to become plentiful or cheaper soon.
• Extension and contraction come only from a fall or rise in own price, with every other factor constant, and show as a move down or up the same curve (point A to B).

Differences to remember

• Extension versus increase: extension is a rise in quantity because own price fell; increase is a rise in quantity at an unchanged price because other factors changed. Contraction versus decrease follows the same logic with a fall in quantity.
• Extension and contraction are a downward and upward movement along one curve; increase and decrease are rightward and leftward shifts.

Price, substitution and income effects (definitions)

• Price effect: change in quantity demanded caused by a change in own price, other things constant.
• Substitution effect: change in quantity when the relative price Px/Py changes; if Px falls with Py constant, X is cheaper than Y and more X replaces Y.
• Income effect: change in quantity when real income changes because of a price change.
• Normal good: income effect positive and price effect negative. Inferior good: income effect negative, price effect usually positive in the Giffen case. Giffen good: an inferior good whose price effect is positive because the negative income effect outweighs the substitution effect.

Points on reasoning and application

• Assumption behind a demand curve: every determinant other than own price stays constant.
• Demand can rise even when price rises if buyers fear a coming shortage of a necessity (salt and cereals in a curfew; rice in a flood-hit region).
• Water has high value in use but low market price because it is plentiful; diamonds are scarce, so their price is high. A buyer stranded in a desert would pay much more for water.
• Goods demanded at a zero price (free medicines in a government hospital) are still scarce, since they carry an opportunity cost. Only scarce goods are demanded.
• A fall in price does not always mean extension of demand; the exceptions are Giffen goods, goods of social distinction and goods judged by price alone.
• If petrol and diesel become cheaper, demand for cars (a complement) shifts right even though the price of cars is unchanged.

Dos and donts

• Do not define an inferior good as one for which the law of demand fails. It is a good whose demand falls when income rises. All Giffen goods are inferior, but not all inferior goods are Giffen goods.
• Do not list population size or distribution of income in an individual demand function; they apply only to market demand.

Movement along versus shift of the demand curve

• Movement (extension or contraction): caused only by a change in the good’s own price.
• Shift (increase or decrease in demand): caused by any other determinant. Rightward shift is an increase; leftward shift is a decrease.
• Fall in price of a normal good: extension of demand. Rise in income for a normal good: increase in demand.

In a few cases the demand curve slopes upward, so a higher price is followed by higher demand.

All Giffen goods are inferior goods but not all inferior goods are Giffen goods. A Giffen good also has a negative income elasticity and a positive price elasticity.

Key link: In the Hicks-Slutsky decomposition, for a normal good the income and substitution effects work in the same direction; for an inferior good the income effect opposes the substitution effect; for a Giffen good it opposes and exceeds it. The detailed graph is in the section on price, income and substitution effects.

Price elasticity of demand (Ep) measures how strongly quantity demanded responds to a change in price.

The value is negative for a normal downward-sloping demand curve, but it is quoted in absolute value (the minus sign is dropped). For exceptions to the law of demand (Giffen and Veblen goods) the value is positive. The concept was developed by Alfred Marshall in his Principles of Economics. The law of demand is a qualitative statement, while elasticity is a quantitative one and a pure number with no unit. The kinds are price, income, cross and advertising (promotional) elasticity; Hicks (1939) added the elasticity of price expectation, the expected change in future price caused by a change in the current price.

Five degrees of elasticity

Elasticity and total revenue (total outlay method)

Rule: TR and price move in the opposite direction when demand is elastic and in the same direction when demand is inelastic. Thus when price falls and TR falls, demand is inelastic. The most inelastic demand is for goods with no substitutes and low share in the budget.

Methods of measuring elasticity

1. Total outlay (expenditure) method by Marshall: compare total expenditure before and after the price change, as in the table above.
2. Percentage (proportional) method (credited to Prof. Flux): the formula above; a % change in Q greater than, equal to or less than the % change in P gives Ep above, equal to or below 1.
3. Point method: elasticity at a point on the demand curve, Ep = (dQ ÷ dP) × (P ÷ Q). On a straight-line demand curve, Ep = lower segment ÷ upper segment of the curve at that point.
4. Arc method: elasticity over a range, using the average of the two prices and quantities; it is more useful when the price change is large. If the demand curve is not a straight line, draw a tangent at the point and apply the segment rule to the tangent.

Point elasticity on a straight-line demand curve

• Midpoint of the line: Ep = 1. Above the midpoint: elastic. Below the midpoint: inelastic.
• At the price axis intercept Ep = ∞, at the quantity axis intercept Ep = 0.
• For Q = a − bP, Ep = bP ÷ Q. The slope is constant but elasticity changes along the curve. Slope and elasticity are not the same thing.
• A rectangular hyperbola has unit elasticity at every point, although its slope changes at every point.
• Two parallel straight demand curves: at the same price, the curve further to the right has a lower elasticity.

Worked examples

Example 1 (percentage method). Price falls from ₹100 to ₹60 and the original quantity is 30 units. If Ep = 1.5, the price change is −40 per cent, so quantity rises by 1.5 × 40 = 60 per cent, to 30 × 1.6 = 48 units.

Example 1b (percentage method, reverse). Ep = 2, original price 500, quantity rises from 1500 to 1800. Quantity change = 20 per cent, so price must change by 20 ÷ 2 = 10 per cent, a fall to 450.

Example 2 (point method on a demand function). For Q = 200 − 4P at P = 20, Q = 120, so Ep = 4 × 20 ÷ 120 = 0.67 (inelastic).

Elasticity in general and why the formula is built this way

• Elasticity of demand measures how far quantity demanded responds to a change in a determinant. It comes in three kinds: price elasticity (response to own price), income elasticity (response to buyers income) and cross elasticity (response to the price of another good).
• Price elasticity of demand is the degree of responsiveness of demand to a change in own price. Written out: Ed = (−) [change in Q ÷ initial Q × 100] ÷ [change in P ÷ initial P × 100] = (−) (ΔQ/ΔP) × (P/Q), with Q1 and P1 the new values.
• Why percentage change and not absolute change: absolute changes cannot be compared across goods. If the chair price doubles (10 to 20) and demand halves (50 to 25), while the table price halves (20 to 10) and demand doubles (25 to 50), absolute figures say little. In percentage terms a 1 per cent price change moves chair demand by 0.5 per cent (Ed = 0.5) and table demand by 2 per cent (Ed = 2), so tables are far more elastic.
• Why the minus sign: price and quantity move in opposite directions, so the raw ratio is negative (price 10 to 5, quantity 50 to 100 gives −2). By convention the sign is dropped and elasticity is quoted as 2, because a larger negative number such as −3 would otherwise look smaller than −2 even though it means more elastic demand. If a question itself gives Ed as a negative number, do not add the minus sign again in the formula.

Slope versus elasticity (derivation)

• Slope of the demand curve shows the absolute change in price per unit change in quantity (ΔP/ΔQ); elasticity shows the percentage response. Linking them: Ed = (−) (1/slope) × (P/Q).
• Example: slope = −5/10 = −1/2 at a point where P = 30 and Q = 20. Then Ed = 2 × 30/20 = 3, meaning a 1 per cent price change causes a 3 per cent change in quantity, whereas the slope only says a unit price change moves quantity by 2 units.
• A straight line has a constant slope, but its elasticity differs from point to point.
• Horizontal line: slope = 0, so Ed = (1/0) × P/Q = infinity (perfectly elastic: at the going price, any quantity is bought, and a slight rise sends demand to zero). Vertical line: slope is infinite, so Ed = (1/infinity) × P/Q = 0 (perfectly inelastic: price changes leave quantity unchanged).
• Rectangular hyperbola: every rectangle under it (P × Q) is the same, so total expenditure is constant whatever the price. Marshall treated this as unitary elasticity, Ed = 1 at every point.
• If two demand curves start from the same point, the flatter curve is the more elastic one, because the same price fall brings a larger rise in quantity.

More numerical examples

• Price of ice cream falls from Rs 4 to Rs 2 and demand rises from 1 cup to 4 cups: Ed = (4/1) × (3/2) = 6, which is above 1 (elastic).
• Price rises from Rs 5 to Rs 7 and demand falls from 20 to 12 units: Ed = (5/20) × (8/2) = 1 (unitary).
• Price rises from Rs 4 to Rs 5 and demand falls from 25 to 20: Ed = (4/25) × (5/1) = 0.8 (inelastic).
• For D = 10 − 3p at p = 5/3: D = 5 and ΔD/Δp = −3, so Ed = (5/3 ÷ 5) × 3 = 1.
• If Ed = 0.2 and price rises 5 per cent, quantity demanded falls by 0.2 × 5 = 1 per cent.
• If a 5 per cent price rise raises expenditure by 5 per cent, quantity bought is unchanged, so elasticity is zero. Water has inelastic demand because it is an essential of life.

Do not judge elasticity from absolute changes

• On a steep line it can look as if the quantity change is smaller than the price change, which tempts one to say Ed < 1. That is wrong. With Q = 10, ΔQ = 5, P = 50, ΔP = 10, Ed = (5/10) × (50/10) = 2.5, even though the absolute price change is larger than the absolute quantity change.

Determinants of price elasticity

• Availability of substitutes: more substitutes, more elastic.
• Nature of the good: necessities inelastic, luxuries elastic.
• Share in the budget: small items (salt, matches) are inelastic.
• Time period: demand is more elastic in the long run.
• Number of uses: multi-use goods (electricity, steel) are more elastic.
• Habit and addiction: inelastic. Durability and postponability: elastic.
• Order of increasing elasticity (frequent question): necessities, then differentiated products, then durable goods, then homogeneous products (which have the closest substitutes).
• Level of price: very high and very low prices are relatively more inelastic.

More determinants and applications from the textbook

• Income level of buyers: if buyers are very rich (luxury cars for multi-millionaires), price hardly matters and demand is inelastic; if buyers are middle class (small cars), demand is elastic.
• Jointly demanded goods (bread and butter, pen and ink, camera and film) show moderate elasticity: a rise in the price of butter will not cut its demand much if the demand for bread has not fallen.
• Postponable use: housing demand falls when loan interest rates are high, so it is elastic.
• Goods with several uses, a high price tag and many close substitutes are the most elastic; low-priced essentials with no close substitutes are the least elastic.
• Cigarettes: taxes keep raising the price, yet demand falls little because there are no close substitutes and the habit is hard to break (inelastic).
• Electricity: lower off-peak tariffs can shift appliance use (washing machine, dishwasher) away from peak hours and ease load-shedding, since electricity has many uses. Demand can also be cut by energy-efficient appliances (star ratings) and subsidies on solar equipment.
• Diesel cars: demand was low in elasticity while diesel was much cheaper than petrol; as the price gap narrows, buyers may switch to petrol cars and elasticity of demand for diesel cars rises.
• Short and long run: after a big rise in the price of wine, consumers may not cut consumption at once but reduce it gradually, which is why long-run demand is more elastic.

Practical uses of elasticity

• Pricing: raise the price where demand is inelastic, cut it where demand is elastic.
• Taxation: heavy tax on inelastic goods (tobacco, petrol) yields more revenue.
• Farmers’ dilemma: a bumper crop of an inelastic product cuts farm income.
• Product decisions: for low income-elastic products in a rising-income period, the sensible response is product improvement (quality, features), not simply promotion.

Income elasticity of demand (Ey)

Order of income elasticity for typical goods: inferior goods (negative) < necessities (between 0 and 1) < luxuries (above 1). All normal goods have a positive income elasticity (greater than zero). Engel curve shows quantity demanded of a good at different levels of income; Engel’s law says the share of food in the budget falls as income rises.

Cross elasticity of demand (Exy)

Uses: defining an industry (goods with high cross elasticity belong to the same industry), measuring market power and deciding the effect of competitors’ price changes. A firm with a low cross elasticity with all others is close to a monopolist.

Example 3 (substitutes). Price of coffee rises from ₹25 to ₹35 (+40 per cent) and tea demand rises from 5 kg to 8 kg (+60 per cent). Exy = 60 ÷ 40 = +1.5, so tea and coffee are substitutes.

Example 4. If the cross elasticity of A with respect to B is −0.8 and B’s price rises by 20 per cent, demand for A changes by −0.8 × 20 = −16 per cent. If the price of good X rises, demand for a substitute Y rises.

Advertising (promotional) elasticity

It is high at the start of a product’s life and falls as the market matures; it guides the advertising budget. It lies between zero and infinity and is never negative.

Elasticity of supply (Es)

• A straight-line supply curve through the origin has Es = 1 at every point. If it cuts the quantity axis (positive intercept on the X axis), Es < 1. If it cuts the price axis, Es > 1.
• Es is higher in the long run, for goods that can be stored, and when spare capacity exists. Agricultural goods have low short-run supply elasticity.

Example 5 (point method). For q = −100 + 10p at p = 15, q = 50 and dq/dp = 10, so Es = 10 × 15 ÷ 50 = 3.

Total revenue (TR) = price × quantity. Average revenue (AR) = TR ÷ Q, which is the price, so the AR curve is the demand curve. Marginal revenue (MR) = change in TR for one more unit = ΔTR ÷ ΔQ.

When price is constant (perfect competition)

Because the firm sells each extra unit at the same price, AR = MR = Price and all are the same horizontal line. TR is a straight line through the origin.

When price falls as output rises (imperfect competition)

• AR slopes downward and MR lies below AR, because to sell one more unit the firm cuts the price on all units.
• For a straight-line AR, the MR curve has the same intercept but twice the slope, so MR cuts the horizontal axis at half the distance of AR; it bisects any horizontal line between the AR curve and the vertical axis.
• TR rises while MR is positive, is maximum when MR = 0, and falls when MR is negative. At MR = 0 elasticity is 1.

Revenue, profit and the three measures

• Revenue is the money a firm receives from selling its output (1,000 ice creams sold for Rs 10,000 give revenue of Rs 10,000). Revenue differs from profit: Profit = Revenue − Costs, so Revenue = Costs + Profit.
• TR = P × Q (100 slabs at Rs 100 = Rs 10,000). AR = TR/Q, the revenue per unit; with TR = 1,000 and Q = 100, AR = 10, which is the price. Proof: AR = (P × Q)/Q = P.
• MR is the change in TR when one more unit is sold. If TR is 10,000 at 10 units and 11,000 at 11 units, MR = 1,000. It is not the price of the last unit; it can be zero or even negative.
• When output rises by several units at a time, MR = ΔTR/ΔQ: TR of 10 units = 1,000 and of 15 units = 1,500 gives MR = 500/5 = 100.
• Since MR is the addition to TR with each unit, MR1 + MR2 + … + MRn = TR (TR = ΣMR). Geometrically, the area under the MR curve up to an output is TR.

Constant price: perfect competition in detail

• A price-taking firm cannot raise its price above the market level, because buyers would go to the many other firms selling the same product, and it need not cut it, because it can sell any quantity at the going price. So AR (= price) is constant and MR = AR.
• Schedule at price 5: output 1 to 4, TR 5, 10, 15, 20, MR 5 each. At constant price TR rises at a constant rate; TR is a straight rising line from the origin (TR = 0 at zero output).
• The firm demand curve, price line and AR curve are the same thing; they are perfectly elastic (elasticity infinite), a horizontal line. It does not mean the firm can supply the whole market: it is one of many small firms, and the market price itself can move if market demand or supply changes.
• If TR is a rising straight line through the origin, MR is a horizontal line; if TR is a horizontal line, MR is zero.

Falling price: tables and cases

• Price 10, 9.5, 9, 8.5 for 1 to 4 units: TR 10, 19, 27, 34; MR 10 (first unit), 9, 8, 7. AR falls by 0.5 each step but MR falls by 1, so MR falls twice as fast as AR and AR > MR. TR rises at a decreasing rate.
• Zero and negative MR: price 100, 80, 40, 30 at output 1, 2, 4, 5 gives TR 100, 160, 160, 150, so MR = 100, 60, 0 (at 4 units) and −10 (at 5 units). TR is maximum when MR = 0 and falls when MR is negative.
• Another example: price 4 at output 10 gives TR 40; price 3 at output 11 gives TR 33; MR = −7. Negative MR is possible only where AR is falling, never under perfect competition.
• AR can never be zero or negative in practice; TR touches zero only if AR touches zero, and these cases are only theoretical.
• Rate of TR: constant MR means TR rises at a constant rate; falling MR means TR rises at a diminishing rate; MR zero means TR is maximum; negative MR means TR falls.

Geometry of TR, AR and MR

• The slope of the ray from the origin to any point on the TR curve equals AR (TR 30 at 5 units gives 30/5 = 6).
• The slope of the tangent to the TR curve at any output equals MR at that output; at the top of the TR curve the tangent is horizontal, so MR = 0.
• Area under the MR curve up to OT equals TR (area OTPA), because TR is the sum of MR of each unit.
• For straight-line AR and MR, MR passes through the mid-point of any horizontal line drawn from the vertical axis to AR, so the slope of MR is twice that of AR (AR falls by 1 per unit while MR falls by 2).

Meaning of revenue and schedules

• Revenue is the money a producer receives from selling a given quantity of a commodity in the market (e.g. 16,000 from selling 100 chairs). It rises with the level of sales.
• MR(n) = TR(n) − TR(n−1). Schedule with price 10, 9, 8, 7, 6, 5, 4 for 1 to 7 units: TR = 10, 18, 24, 28, 30, 30, 28; AR = price; MR = 10, 8, 6, 4, 2, 0, −2.
• Price constant: at price 5, TR = 5, 10, 15, 20, 25 and MR = 5 each time, so Price = AR = MR (horizontal line) and TR is a straight line from the origin because TR is zero at zero output. Since TR = ΣMR, the area under the price line up to OQ equals TR = OP × OQ.
• Price falls: AR = 5, 4, 3, 2.25, 1; TR = 5, 8, 9, 9, 5; MR = 5, 3, 1, 0, −4. MR can fall to zero and turn negative, but AR can be neither zero nor negative because TR is always positive.
• General rule: when MR > AR, AR rises; when MR = AR, AR is at its maximum (constant); when MR < AR, AR falls.
• Under monopoly and monopolistic competition both AR and MR slope downward (more units sell only at a lower price), but under monopolistic competition they are more elastic (flatter) because close substitutes exist; a price rise cuts demand proportionately less under monopoly.

Monopoly and monopolistic competition: textbook tables and comparisons

• Monopoly: the seller is a price maker but can sell more only by cutting price. Price 10, 9, 8, 7 for 1 to 4 units: TR 10, 18, 24, 28; MR 10, 8, 6, 4. A rise of price from 7 to 8 cuts sales from 4 to 3 units.
• Monopolistic competition has the same pattern (price 10, 9.5, 9, 8.5; TR 10, 19, 27, 34; MR 10, 9, 8, 7), but its AR curve is more elastic because close substitutes are available, while a monopoly product has none.
• On one diagram: the perfect-competition demand curve is horizontal (infinite elasticity, perfect substitutes available), the monopolistic competition curve is flatter and downward sloping (high elasticity), and the monopoly curve is the steepest (low elasticity).

Reasoning points and applications

• Greater output does not always mean greater TR, since price may fall so much that TR falls. Greater TR does not always mean greater profit, since profit = TR − TC and TC may rise more.
• The TR curve starts from the origin (TR = 0 at zero output); the AR curve does not, because price is not zero. AR is not zero when TR is maximum; it is MR that is zero then.
• Under monopoly TR rises only at a diminishing rate, and a monopolist can sell more only by lowering price, so MR keeps falling. A firm facing falling AR still raises output as long as TR − TC is rising, and stops when that gap is greatest.
• If a farmer produce is destroyed, a price-taking firm AR is unaffected: it remains a horizontal line, since one producer cannot influence market price.
• More hotel rooms increase supply, so room rents may fall and hotel revenue may fall.

The elasticity link

A monopolist never produces on the inelastic part of the demand curve, because MR is negative there while MC is positive.

Example 6. If AR = ₹20 and e = 2, MR = 20 × (2 − 1) ÷ 2 = ₹10. If MR = 5 and e = 2, AR = 5 × 2 ÷ 1 = ₹10.

Example 7 (linear demand). AR = 100 − 2Q gives TR = 100Q − 2Q² and MR = 100 − 4Q: the slope of MR is twice that of AR, and MR = 0 at Q = 25, which is half of the Q = 50 where AR meets the axis.

Supply and its determinants

Supply is the quantity a seller is willing and able to sell at each price. The law of supply says quantity supplied rises with price (upward-sloping curve), because a higher price covers rising marginal cost and attracts producers. Determinants: cost of inputs, technology, prices of other goods, taxes and subsidies, number of sellers and expectations.

Supply versus stock, and supply versus quantity supplied

• Stock is the total quantity with the producer, available for present or future sale; supply is only the part the producer is ready to sell at a given price. Example: with 100 tonnes of wheat in stock, a producer offering 10 tonnes at Rs 500 supplies 10 tonnes; at Rs 600 offering 50 tonnes, the supply is 50 tonnes.
• Supply is a flow measured per unit of time and always linked to price; stock is measured at a point of time and is linked to expected demand (it is the firm inventory).
• Supply means the whole schedule or curve (various quantities at various prices); quantity supplied means one specific quantity at one specific price, that is, one point on the curve.

Supply schedule and supply curve

• An individual supply schedule lists quantities one firm will sell at different prices; a market supply schedule is the total for all firms (the industry). Example: price Rs 10, firm A 10 units, firm B 5 units, market 15; price Rs 15, 20 + 10 = 30; price Rs 20, 30 + 15 = 45.
• Both schedules show a positive link between price and quantity supplied.
• The individual supply curve slopes upward. The market supply curve is the horizontal summation of the individual curves of all firms producing the commodity.
• Minimum supply price (also called reserve price): the price below which the producer will not supply any quantity; supply starts only when the market price is at least this price.
• Slope of the supply curve = ΔP ÷ ΔQ; it is constant along a straight-line supply curve.

Supply function

• Sx = f(Px, Pr, NF, G, PF, T, Ex, Gp): own price, price of related goods, number of firms, goal of the firm, price of factors of production, state of technology, expected future price and government policy.
• Own price: higher price, higher quantity supplied.
• Related goods: if the price of coffee rises, a tea seller supplies less tea at the existing price.
• Number of firms: more firms raise market supply.
• Goal of the firm: profit maximising firms supply more only at a higher price; sales or output maximising firms supply more even at the same price.
• Factor prices: a fall lowers cost and raises supply at the existing price; a rise does the opposite.
• Technology: improvement lowers cost per unit and raises supply.
• Expected future price: a rise expected soon reduces current supply; a fall expected raises it.
• Government policy: higher tax tends to reduce supply, subsidy raises it.
• Simple linear form: Qs = c + dPx, where d = ΔQs ÷ ΔPx. Example: Px 10, 15, 20, 25, 30 gives Qs 0, 10, 20, 30, 40, so d = 2 and c = −20, giving Qs = −20 + 2Px.

Law of supply: assumptions and exceptions

• Assumptions: no change in factor prices, technique, goal of the firm, prices of related goods, expected future price or government policy.
• Example: price Rs 10, 11, 12 gives quantity 100, 200, 300.
• Exceptions: agricultural output governed by natural factors; goods of social distinction; perishable goods, which sellers may sell even at a lower price because shelf life is short.
• Common usage says supply for quantity supplied when relating to own price.

Movement along versus shift of the supply curve

• Example of extension: price Rs 1 to Rs 5, quantity 1 to 5 units. Contraction is the reverse.
• Example of increase: at Rs 10, quantity 20 rises to 30 (forward shift from S1 to S2). Decrease: 30 falls to 20 (backward shift).
• Causes of increase: better technology, lower factor prices, fall in price of a competing product, more firms, expected fall in price, shift from profit to sales maximisation, lower tax or higher subsidy.
• Causes of decrease: outdated technology, higher factor prices, rise in price of a competing product, fewer firms, expected rise in price, shift from sales to profit maximisation, higher tax or withdrawal of subsidy.
• Increase in supply is basically a fall in cost of production; decrease is a rise in cost.
• Two reasons more is supplied at a higher price: higher price means higher profit, and diminishing returns raise MC so price must rise to induce more output.

Shifts caused by policy and input changes

• Technology improvement lowers cost, forward shift. Input price rise gives backward shift, fall gives forward shift.
• GST is a tax on value addition, it raises cost, backward shift. Import duty on inputs also shifts supply backward.
• Subsidy compensates the producer for loss at the existing price, forward shift.
• Price of a related product: a rise in the price of tea shifts coffee supply backward (producers shift to tea); a fall shifts it forward.

Elasticity of supply: shape and factors

• Es = (ΔQ ÷ ΔP) × (P ÷ Q). Example: price Rs 10 to Rs 5 and quantity 400 to 200 give Es = (200 ÷ 5) × (10 ÷ 400) = 1.
• A straight upward-sloping supply line from the origin has Es = 1 whatever its angle (it need not be 45 degrees); from the Y-axis Es > 1; from the X-axis Es < 1.
• Vertical supply curve: Es = 0 (perfectly inelastic). Horizontal supply curve: Es = infinity (perfectly elastic).
• Es > 1 elastic, Es < 1 inelastic, Es = 1 unitary elastic.
• Relation with slope: Es = (1 ÷ slope) × (P ÷ Q), so the slope and elasticity are different things.
• Factors: nature of inputs (common inputs make supply elastic), natural constraints (teak takes years), risk taking, nature of the commodity (perishables less elastic), cost of production, time factor (longer period, more elastic), technique of production (complex technology, less elastic).
• Numericals: price Rs 10 to Rs 15 with revenue Rs 50 to Rs 150 means quantity 5 to 10 so Es = (10 ÷ 5) × (5 ÷ 5) = 2. Price Rs 5 to Rs 20, quantity rises 15, Es 0.5 gives initial output 10 and final 25. Price Rs 10 to Rs 30, quantity 4, Es 1.25 gives new quantity 14.
• Firm supply curve: the rising part of MC above minimum AVC in the short run, above minimum AC (break-even) in the long run.
• Market supply with identical firms: multiply one firm quantity by the number of firms (for example 3 firms, 4 units each, market 12).

Equilibrium price

• Equilibrium is where quantity demanded equals quantity supplied. Above it there is a surplus that pushes the price down; below it a shortage that pushes the price up.
• Demand rises (shift right): price and quantity rise. Supply rises: price falls, quantity rises. Both can shift together; the effect on one variable is then uncertain.
• Equilibrium is stable when the demand curve cuts the supply curve from above (Walrasian stability) and an equilibrium once reached tends to persist.

Example 8. Demand: D = 10,000 − P; supply: S = 1,000 + 4P. At equilibrium 10,000 − P = 1,000 + 4P, so 5P = 9,000 and P = ₹1,800, Q = 8,200.

Market equilibrium: schedule reading and adjustment

• Market equilibrium is the state where market demand equals market supply (Dx = Sx): the market clears itself, with neither excess demand nor excess supply. The price is the equilibrium price and the matching quantity is the equilibrium quantity.
• Schedule example (dozens): price Rs 5 supply 50 demand 10 (excess supply); Rs 4 supply 40 demand 20; Rs 3 supply 30 demand 30 (equilibrium); Rs 2 supply 20 demand 40 and Rs 1 supply 10 demand 50 (excess demand). So equilibrium price is Rs 3 and quantity 30 dozen.
• Excess supply arises above the equilibrium price; the price falls, demand extends and supply contracts until equality returns. Excess demand arises below it; the price rises, demand contracts and supply extends.
• Three basic assumptions: supply curve slopes upward, demand curve slopes downward, and demand and supply act freely without government intervention.
• Price mechanism: the interaction of market demand and market supply co-ordinates the decisions of consumers and producers.
• Equilibrium is reached only when demand equals supply because otherwise excess demand or excess supply keeps moving the price. A cleared market does not mean everyone is satisfied: some buyers may still be unable to afford the product, and a high equilibrium price of a necessity (rice, wheat) may call for government intervention.
• When a market clears, producers hold no undesired (unplanned) stock; desired stock is planned inventory for future demand.

Shifts in demand and supply: effects

• Adjustment path: after demand rises there is excess demand at the old price, price rises, demand contracts and supply extends until the new equilibrium (the reverse for a fall). After supply rises there is excess supply, price falls, demand extends and supply contracts.
• Causes: a rise in consumer income (normal good) or in the number of consumers shifts demand right; more firms or a fall in input price shifts supply right; a rise in the price of a substitute raises demand for the other good; shoes and socks are complements, so dearer shoes shift demand for socks left and lower both its price and quantity.
• For an inferior good, a rise in income lowers demand, so price and quantity fall.

Perfectly elastic or inelastic supply and demand

• Perfectly elastic supply (horizontal): a shift in demand leaves price unchanged and only quantity changes, because supply is infinite at the given price (a fall in price would mean zero supply).
• Perfectly inelastic supply (vertical): a shift in demand changes only price; quantity stays fixed.
• Perfectly elastic demand: a shift in supply leaves price unchanged and only quantity changes.
• Perfectly inelastic demand: a shift in supply changes only price; quantity stays constant.

Simultaneous shifts in demand and supply

• So an increase in demand does not always raise price: it does only when other things stay constant; if supply rises more or is perfectly elastic, price may fall or stay constant.

Price ceiling, price floor and support price: detail

• Price ceiling is a legal maximum price set below the equilibrium price so the poor can afford essentials. It causes excess demand (a gap between quantity demanded and supplied), which is handled by rationing; this leads to long queues, low quality and black marketing, which defeats the purpose. Government must improve the distribution system, for example through direct benefit transfer to bank accounts linked to a unique identity number.
• Price floor is a legal minimum price above equilibrium, used for farm products because seasonal output causes a glut and a price crash, which brings low farmer income. Traders may not buy at the floor, so the government offers a support price and buys the surplus. A floor price invariably implies a support price.
• Effect: demand contracts and supply extends, creating excess supply which the government buys and stores as a buffer stock for public distribution. The cost of storage is the main demerit.
• Support price is the assured minimum price offered by the government to farmers for their output, often higher than equilibrium price.

Worked numerical: salt market

• Qd = 1,000 − p and Qs = 700 + 2p: equating, 3p = 300, so p = Rs 100 and Q = 900.
• If an input price rises and supply becomes Qs = 400 + 2p: 3p = 600, p = Rs 200, Q = 800 (price up, quantity down, as expected for a backward supply shift).
• If GST adds Rs 3 per unit, supply becomes Qs = 700 + 2(p − 3): 1,000 − p = 700 + 2p − 6, so 3p = 306, p = Rs 102 and Q = 898.

Viable and non-viable industry

• An industry is economically viable if there is some price at which demand and supply meet, so the curves intersect. It is non-viable if the supply curve lies entirely above the demand curve, so there is no price at which any buyer will purchase.

Price ceiling and price floor

A ceiling that is above the equilibrium price has no effect, and likewise a floor below it. Both policies lower efficiency and cause a deadweight loss.

Demand forecasting predicts future demand for a product so that the firm can plan production, inventory, finance and marketing.

Steps in systematic forecasting

1. Define the objective of the forecast (new product, expansion, short or long run).
2. Decide the time period and level (firm, industry, whole economy).
3. Select the method that fits the data and the purpose.
4. Collect data (primary and secondary).
5. Estimate the demand using the chosen method.
6. Test the accuracy of the result against actual figures.
7. Interpret and adjust the forecast.

Methods

• Delphi technique: a panel of experts gives forecasts anonymously over several rounds until opinions converge.
• A new product has no sales history, so the survey, test-marketing and substitute-product approaches are the main tools.

Utility is the want-satisfying power of a good. The cardinal approach of Alfred Marshall (with Gossen, Jevons, Menger, Walras) assumes that utility can be measured in numbers called utils.

Consumer behaviour and the meaning of utility

• Consumer behaviour is the study of how consumers buy or use goods and services to satisfy their needs and wants, that is, how a consumer deals with the market to get the greatest satisfaction from limited means.
• Utility is the want-satisfying power of a good. In Marshall's words, the utility of a thing to a person at a time is measured by the extent to which it satisfies his wants. The cardinal approach (traditional) is by Marshall and Pigou and measures utility in utils; the ordinal approach (modern) is by Hicks and Allen and only ranks satisfaction.
• Points to remember: utility differs from person to person and from time to time; utility and pleasure do not always go together (a vaccine has utility but gives no pleasure); utility is not the same as usefulness (a cigarette has utility for a smoker though it is harmful).

Total, marginal and average utility

• TU rises at a decreasing rate while MU is positive, is maximum when MU = 0 (point of satiety) and falls when MU is negative.
• MU is the slope of the TU curve. MU is the vertical difference between successive TU values.

Assumptions of the cardinal approach

1. The consumer is rational and aims to maximise total satisfaction.
2. Utility is cardinally measurable (in utils) and independent: the utility of one good does not depend on another (additive utilities).
3. Diminishing marginal utility of each good.
4. The marginal utility of money is constant.
5. The consumer has limited money income.
6. Tastes, income and prices are constant; goods are homogeneous and consumed in standard units.

Consistency and transitivity of choice belong to the ordinal approach as well; what is special to the cardinal approach is measurability of utility, additivity and constant marginal utility of money.

Law of diminishing marginal utility (LDMU)

As a consumer takes more units of a good, the marginal utility from each additional unit falls, other things remaining the same. Assumptions: units are identical and of standard size, consumption is continuous (no gap), tastes do not change, and the consumer is rational. Exceptions (apparent): hobbies and collection, misers’ money, drunkards’ liquor, music or reading in some cases, and very small units.

Marginal utility of money and the one-good equilibrium in detail

• Marginal utility of money (MUm) is the worth of a rupee to the consumer: the utility he expects from spending ₹1 on a standard basket of goods. It is taken as constant because money acts as the measuring rod of utility.
• The purchase of a good depends on three things: its price, its marginal (and total) utility, and the marginal utility of money.
• Worked case: MUm = 2 utils per rupee and Px = ₹4. MUx of 20, 18, 16, 8, 0, −5 utils for units 1 to 6 is worth ₹10, 9, 8, 4, 0, −2.5 (utils divided by 2). The consumer buys while the rupee worth of MUx exceeds the price and stops at the 4th unit, where the rupee worth of MUx = Px = ₹4; equivalently MUx ÷ Px = MUm gives MUx = 8 utils.
• Each point on the MUx curve (in rupees) is the price the consumer is willing to pay for that unit; equilibrium is where the price he is willing to pay equals the price he actually pays. If Px falls, MUx ÷ Px rises above MUm and he buys more until MUx falls enough (law of diminishing marginal utility). If MUm rises with Px constant, MUx ÷ Px falls below MUm and he cuts consumption until MUx rises back. A poor man stops buying onions when a rupee spent on them gives less satisfaction than a rupee elsewhere, so MUx ÷ Px < MUm.

More points on equilibrium and utility

• Conditions of equilibrium: for one good, MUx ÷ Px = MUm; for two goods, MUx ÷ Px = MUy ÷ Py = MUm. The last two conditions are common to both cases: MUm stays constant and diminishing marginal utility holds (if MU rose, consumption would never stop). If Px = Py = ₹1 the condition becomes MUx = MUy = MUm.
• The MUx ÷ Px = MUm equation is the same for every consumer, but the quantity bought is not: each consumer has his own scale of marginal utility and his own MUm, so equal prices do not mean equal purchases. Rising total utility does not mean he should keep buying; he must stop where MUx ÷ Px = MUm.
• Several points can show MUx = MUy (for example, with Px = Py = ₹8, equal at 6X and 1Y, 8X and 3Y, 9X and 5Y). The equilibrium point is the one whose total spending equals the income: with ₹88 income, only 8X + 3Y costs ₹88 (the others cost ₹56 and ₹112).
• TU is the sum of MUs and, geometrically, the area under the MU curve up to the quantity consumed. The point of satiety (MU = 0, TU maximum) is different from the point of equilibrium (price = money worth of MU, maximum satisfaction for the income).
• Main limitation of utility analysis: it assumes utility can be expressed in numbers (1, 2, 3 utils), but a consumer can at best rank satisfaction as higher or lower. This led Hicks to propose indifference curve analysis.

Equi-marginal principle (law of substitution)

The law of diminishing marginal utility is also called Gossen's first law (H. H. Gossen, German economist) and the equi-marginal principle is Gossen's second law of consumption. Further assumptions of the diminishing-utility law: the prices of substitutes and the mental state of the consumer do not change.

Meaning of equilibrium: a state of rest with no tendency to change; the consumer is in equilibrium when he does not wish to alter his consumption because satisfaction is the highest his income and the prices allow.

The consumer reaches equilibrium when the marginal utility of the last rupee spent is the same on every good.

• If MUx ÷ Px > MUy ÷ Py, buy more X and less Y until the ratios are equal.
• For one good, equilibrium is where MU = Price (MU of money taken as one).

Numerical illustrations of cardinal equilibrium

• One good: with Px = 4 and MUx falling 10, 8, 6, 4, 2 for units 1 to 5, the consumer stops at the 4th unit where MUx = Px (MU of money taken as 1).
• Two goods: income 60, Px = 10, Py = 5. MUx for units 1 to 6 is 100, 90, 80, 70, 60, 50 and MUy is 35, 30, 25, 20, 15, 10. At 5 units of X, MUx/Px = 60/10 = 6, and at 2 units of Y, MUy/Py = 30/5 = 6. The ratios are equal and the spending 5 x 10 + 2 x 5 = 60 uses the whole income, so equilibrium is 5X and 2Y.

Consumer’s surplus (Marshall)

Consumer’s surplus = what the consumer is willing to pay − what he actually pays. It is the triangle between the demand (MU) curve and the price line. The idea rests on diminishing marginal utility and the constant MU of money. Criticisms: utility cannot be measured precisely, there are no substitutes assumed, and it is hard to apply for necessities and prestige goods.

The ordinal approach (Pareto, Slutsky, Hicks and Allen) says utility cannot be measured but can be ranked: a consumer can say he prefers bundle A to B, not by how much.

Assumptions

• Rationality and a consistent preference ordering (completeness, transitivity).
• Non-satiation: more of a good is preferred to less (the monotonic preference).
• Diminishing marginal rate of substitution.
• Given tastes, income and prices; two goods only (for the diagram); goods are homogeneous and divisible.

Indifference curve and indifference map

An indifference curve (IC) shows all combinations of two goods that give the same level of satisfaction; because satisfaction is equal at every point it is also called the equal satisfaction curve. Hicks presented the idea in Value and Capital (1939). An indifference map is a set of IC; higher curves mean higher satisfaction.

Marginal rate of substitution (MRS)

The slope of an indifference curve at a point is the MRS. Along a normal IC the MRS diminishes, because as the consumer holds more X and less Y, he values each extra X less and each remaining Y more. This gives the convex shape. The MRS is a ratio of marginal utilities, but it is ordinal because only the ratio matters.

Properties of indifference curves

1. Slope downward to the right (more of one good must be offset by less of the other).
2. Convex to the origin (diminishing MRS; goods are imperfect substitutes).
3. Cannot intersect or be tangent to each other (that would violate transitivity and non-satiation).
4. Higher curve = higher satisfaction.
5. Do not touch the axes in the standard case (both goods are consumed).
6. They are not necessarily parallel, and they are thin (one combination per point).

Special shapes

Curves that violate the rules

If two IC cross, the point of intersection would give equal utility to two different levels, which breaks transitivity. A concave IC would mean an increasing MRS, which conflicts with the usual assumption.

Budget set, budget line and how the line moves

• The budget set is all combinations the consumer can afford: P1·X1 + P2·X2 ≤ Y (income). The budget line contains only the combinations that use up the whole income (P1·X1 + P2·X2 = Y); the set also includes points below the line where spending is less than income. It changes if P1, P2 or income Y changes.
• Points beyond the line form the non-feasible region. The line slopes downward because, at given income and prices, more of one good can be bought only by buying less of the other. Its slope Px ÷ Py is constant (a straight line) because prices are given in the market, and it tells how many units of Y must be given up for one more unit of X.
• Income rises: the line shifts right, parallel to the old one; income falls: it shifts left, parallel. Example: ₹60 with prices ₹2 and ₹1 gives intercepts 30 and 60; income ₹120 gives 60 and 120; income ₹30 gives 15 and 30.
• Rotation: if Px or Py falls, the line rotates outward (to the right), pivoting on the intercept of the good whose price is unchanged; if Px or Py rises it rotates inward (to the left). If both prices and income double (or change in the same proportion), the budget set is unchanged. A parallel shift to the right also happens when both prices fall in the same proportion with income unchanged.

Equilibrium: why MRS must equal the price ratio

• The slope of the budget line is the rate at which the market allows X to be substituted for Y, and the MRS is the rate at which the consumer is willing to do so. At equilibrium the two are equal (tangency, with the IC convex there), and the whole income is spent. Example: MRS = 2 : 1 and Px ÷ Py = 2 : 1 means he is willing to give up 2 Y for 1 X and the market asks exactly that.
• If MRSxy > Px ÷ Py, he is willing to give up more Y than the market requires, so he buys more X in place of Y and moves down along the IC; the convexity makes MRS fall until it equals Px ÷ Py. If MRSxy < Px ÷ Py he buys more Y in place of X until the two are equal. If the IC were concave (MRS rising), no stable equilibrium would exist.
• A fall in the price of a good moves the budget line (it does not change the IC); it lets the consumer move to a higher IC because his real income (the quantity of goods his money income can buy) rises, while a rise in price pushes him to a lower IC.

Budget line (price line)

The budget line is also called the price line, income line or iso-cost line. It shows all combinations of two goods the consumer can buy with his money income at the given prices. Points on it or inside it are attainable; points outside it are unattainable.

• Income rise: parallel outward shift. Price of X falls: line rotates outward on the X axis, with the Y intercept unchanged.
• Cardinal versus ordinal: the ordinal approach needs less restrictive assumptions and shows the substitution and income effects separately, which the cardinal approach could not do.

Consumer equilibrium: ordinal approach

The consumer reaches equilibrium at the point where the budget line is tangent to the highest attainable indifference curve.

Because MRSxy = MUx ÷ MUy, the condition is the same as the cardinal condition MUx ÷ Px = MUy ÷ Py. In a corner solution the consumer buys only one good and the tangency condition does not hold.

Income consumption curve (ICC) and Engel curve

• ICC joins equilibrium points as income rises with prices constant. For two normal goods it slopes upward. For an inferior good the ICC bends back (quantity of that good falls as income rises).
• The Engel curve plots quantity of one good against income and is derived from the ICC.

Price consumption curve (PCC) and the demand curve

• PCC joins equilibria as the price of X changes with income and Py constant. Reading the price and quantity pairs from the PCC gives the demand curve of the consumer.
• If the PCC is horizontal, spending on X is constant: unit elastic demand. If it slopes down, demand is elastic; if it slopes up, demand is inelastic.

Price effect = substitution effect + income effect

When the price of X falls, the price effect has two parts.

• Substitution effect (SE): the consumer substitutes the cheaper good for the dearer one. It is always negative (price and quantity move in opposite directions) for every good.
• Income effect (IE): the fall in price raises real income. For a normal good it adds to the SE; for an inferior good it works against the SE; for a Giffen good it is so strong that it outweighs the SE.

• Hicks method: keep real income constant by keeping the consumer on the original indifference curve. Slutsky method: keep purchasing power constant so that the original bundle is just affordable.
• Normal goods: price effect is negative. For Giffen goods the price effect is positive.

Revealed preference theory (Samuelson, 1938)

• The consumer’s choices reveal his preferences. If the bundle A is chosen when B was also affordable, A is revealed preferred to B.
• Weak axiom (WARP): if A is revealed preferred to B, B cannot be revealed preferred to A. A strong axiom (SARP) adds transitivity for chains of choices.
• It derives the law of demand without the idea of utility, using observed behaviour, and so is called behaviourist. Hicks later added a theory of consistency with the ordinal approach.

Revealed preference: assumptions, limits and the Hicks-Samuelson contrast

• Idea (Samuelson, 1938): all combinations on a budget line cost the same, so if the consumer buys one particular combination his preference for it is revealed by the choice. It is described as the third root of the logical theory of demand (after the cardinal and ordinal approaches).
• Assumptions: two commodities; no change in taste and preference; a rational consumer; strong ordering (choices are consistent, with no contradiction); consistency (if A is preferred to B, B will not be preferred to A in similar conditions); transitivity (A over B and B over C means A over C); income elasticity of demand is positive.
• Limitations: it considers only a single act of choice; it does not explain the Giffen paradox; it does not use the indifference curve.
• Contrast: Hicks uses real income to show the level of satisfaction, while Samuelson uses real income to represent purchasing power.

Cardinal versus ordinal: summary

A production function shows the maximum output obtainable from each combination of inputs with a given technology. It is written Q = f (L, K, N, T, …) where L is labour, K capital, N land and T technology.

• Short run: at least one factor (usually capital) is fixed; only the variable factor changes. The law of variable proportions applies.
• Long run: all factors can be changed. Returns to scale apply.
• Very long run: technology also changes.

Production, factors and the production function

• Production is the process of combining material inputs and immaterial inputs (plans, thoughts, knowledge) to make something for consumption; it creates an output, a good or service, that has value and adds to utility.
• Factors of production are the inputs that help production: land, labour, capital and entrepreneurship (enterprise). They are the starting point of production and decide the size of output.
• Example: for chairs, Q = f(L, K); if 250 = f(7L, 2K), 7 units of labour and 2 units of capital can produce at most 250 chairs.
• Assumptions of the production function: it relates to a particular period of time; technical knowledge is constant in that period; the producer uses the best technique available; there is no difference in cost between firms; the quantity of factors cannot all be changed in the short run; all inputs can be changed in the long run.

Production function: nature, fixed and variable factors

• The production function is a technical relation, not an economic one: it is engineers, not economists, who say that 10 workers on 2 machines make about 100 units. It links physical inputs to physical output and ignores the money value of either.
• It is always tied to a given state of technology. If know-how improves, the same inputs may give 110 units instead of 100, which is a shift of the production function.
• Fixed factors do not change with output; they are installed before production starts and exist even at zero output (a machine). Variable factors change with output and are zero when output is zero (labour, raw material).

Short-run and long-run production functions compared in detail

• Short run, with capital fixed: Qx = f(L, K-bar). For example 40 = f(5L, 4K) and 45 = f(6L, 4K). Only labour changes, so the labour-capital ratio changes from 5:4 to 6:4; hence this is the variable proportions production function.
• Long run, all factors variable: Qx = f(L, K). For example 40 = f(5L, 4K) and 80 = f(10L, 8K). The ratio stays 5:4 at both outputs, so this is the constant proportions production function. What is fixed in the short run becomes variable in the long run, because a bigger plant or more plants can be installed.
• Difference 1: factor ratio changes with output in the short run and stays constant in the long run.
• Difference 2: the scale of output (size of plant) is constant in the short run and changes in the long run.
• Difference 3: the short run shows returns to a factor; the long run shows returns to scale. Returns to a factor is a short-run idea; returns to scale is a long-run idea. The syllabus here deals with returns to a factor.

Short run versus long run

TP, MP and AP: definitions and worked tables

• TP is the sum of the output of all units of the variable factor used with the fixed factor, also called total return. Example: outputs 10, 12, 15, 12, 10, 6 for labour 1 to 6 give TP = 65.
• MP is the change in TP when one more unit of the variable factor is used: MPn = TPn − TP(n−1). Example: TP rises from 40 (5 workers) to 45 (6 workers), so MP of the 6th worker = 5. Adding the MPs of all units gives TP.
• AP is output per unit of the variable factor: 40 units from 5 workers gives AP = 8. All three are physical (units of output), not rupee values.
• Illustration: labour 1 to 7 with TP 50, 90, 120, 140, 150, 150, 147 gives AP 50, 45, 40, 35, 30, 25, 21 and MP 50, 40, 30, 20, 10, 0, −3. TP at 6 workers = AP × L = 25 × 6 = 150, also the sum of MPs (50+40+30+20+10+0).
• Negative MP is possible when there is excessive employment or disguised unemployment (as in some public undertakings): extra workers lower efficiency, so TP rises when some workers are withdrawn.
• Practice 1: TP 20, 36, 48, 56, 60, 60, 56 gives AP 20, 18, 16, 14, 12, 10, 8 and MP 20, 16, 12, 8, 4, 0, −4. Practice 2: MP 18, 16, 14, 12, −5 gives TP 18, 34, 48, 60, 55 and AP 18, 17, 16, 15, 11.
• Practice 3: TP 15, 35, 50, 40, 48 gives AP 15, 17.5, 16.67, 10, 9.6 and MP 15, 20, 15, −10, 8. If AP is 2, 3, 4, 4.25, 4, 3.5 then TP is 2, 6, 12, 17, 20, 21 and MP 2, 4, 6, 5, 3, 1. If MP is 3, 5, 7, 5, 3, 1 then TP is 3, 8, 15, 20, 23, 24 and AP 3, 4, 5, 5, 4.6, 4.

Total, average and marginal product

Law of variable proportions (law of diminishing returns)

When more and more units of a variable factor are combined with a given quantity of fixed factors, the marginal product of the variable factor first rises, then falls, and may become negative.

• MP cuts AP at AP’s maximum (MP above AP, AP rises; MP below AP, AP falls). TP is maximum when MP = 0. TP has a point of inflexion where MP is maximum.
• Why stage I: better use of the fixed factor, specialisation. Why diminishing returns: the fixed factor becomes scarce relative to the variable one, so the factors are imperfect substitutes.
• Assumptions: state of technology is given; only one factor varies while the others are fixed; units of the variable factor are homogeneous; input prices are given; the proportions can be varied.
• A production function such as Q = −L³ + 5L² + 10L shows increasing and then diminishing returns to the variable factor, so the law of diminishing returns operates.

Law of diminishing returns versus returns to scale. Variable proportions: one factor changes, others fixed, short run. Returns to scale: all factors change in the same proportion, long run. When all factors change in the same proportion the process is called the law of returns to scale (also the long-run production function).

Law of variable proportions: land and labour illustration, causes and assumptions

• Take 1 hectare of land with labour added one at a time: TP is 2, 5, 9, 12, 14, 15, 15, 14 and MP is 2, 3, 4, 3, 2, 1, 0, −1 for 1 to 8 workers. TP rises at an increasing rate while MP rises (up to 3 workers, MP peaking at 4), at a decreasing rate while MP falls, is highest when MP = 0, and falls when MP is negative. MP stops rising and starts falling at the same point, so the two overlap where MP is at its peak.
• Causes of increasing returns: fuller use of an under-used fixed factor; division of labour and specialisation, which raise efficiency; better coordination between fixed and variable factors.
• Causes of diminishing returns: fixity of the factor (the fixed factor is over-used, wears and loses efficiency); imperfect substitutability of factors (labour cannot go on replacing capital); poor coordination, because more of the variable factor disturbs the ideal factor ratio.
• Assumptions: factor proportions can be changed; units of the variable factor are equally efficient and added one by one (diminishing returns come from the changed ratio, not from weaker later units); technology is unchanged.
• Point of inflexion: the point on TP where its slope changes from rising to falling; here MP stops rising and TP begins to rise only at a diminishing rate.

Constant returns, stages and postponement of the law

• Between increasing and diminishing returns a firm may meet a spell of constant returns: MP stays equal (say 10), so TP rises at a constant rate.
• A producer will not stop in stage I, because each extra unit adds more and more. He will not enter stage III, because TP falls while costs rise. Therefore equilibrium lies only in stage II, where MP is falling but positive. In cost terms, stage I matches falling MC, stage II rising MC and stage III negative MP.
• Postponement: the law can be delayed by better technology (high-yielding seeds raised Indian grain output) or by finding a substitute for the fixed factor. This does not repeal the law; it sets in again once the new technology is used up. Output once seemed to fail the law only because it was deferred.

AP, MP and the point of inflection

• AP and MP are both derived from TP. When MP is above AP, AP rises; when MP equals AP, AP is at its maximum; when MP is below AP, AP falls.
• Both MP and AP curves are inverted-U shaped. The output level at which MP is at its maximum is called the point of inflection of the TP curve.

Worked schedule and statement of the law

P. A. Samuelson states the law this way: increasing some inputs relative to others raises output, but beyond a point the extra output falls. Schedule (labour: TP, AP, MP): 1: 8, 8, 8; 2: 18, 9, 10; 3: 30, 10, 12; 4: 48, 12, 18; 5: 65, 13, 17; 6: 78, 13, 13; 7: 84, 12, 6; 8: 88, 11, 4; 9: 90, 10, 2; 10: 90, 9, 0; 11: 88, 8, -2; 12: 84, 7, -4. Stage I runs to labour 5 or 6 where AP peaks (MP above AP), stage II runs to labour 10 where MP = 0 and TP is highest at 90, and stage III is after that where MP is negative.

Relation between TP, MP and AP: observations

• Rising MP means TP rises at an increasing rate; falling but positive MP means TP rises at a decreasing rate; constant MP means TP rises at a constant rate (a straight rising line); MP = 0 means TP is maximum; negative MP means TP falls. MP is the rate of change of TP.
• Example: MP of 6, 14, 28 (TP rises faster and faster), then 24, 8, 4 (TP rises by smaller steps), then 0 at the 7th worker (TP 84, the maximum), then −4 (TP drops from 84 to 80).
• AP rises while MP is above AP, falls while MP is below AP, and is maximum when MP = AP, so the MP curve cuts the AP curve from its top. MP may be zero or negative but AP stays positive, because AP is TP over a positive number of workers.

Reasoning points

• TP can rise even when MP falls, because MP is only the addition to TP. TP falls only when MP is negative.
• Diminishing returns does not mean a falling TP: falling MP means TP rises at a decreasing rate, and TP falls only in the negative stage.
• AP can rise even when MP is falling, as long as MP is still above AP. If AP is falling, MP must be below AP and falling too.
• At MP = AP = 10 the law will not keep them equal as output grows: MP and AP both decline, MP faster, so AP stays above MP.
• Rising TP does not always point to increasing returns; with diminishing returns TP also rises, but at a diminishing rate.

Dos and donts, and applications

• There is no law of increasing returns or law of constant returns; they are only possible situations on the way. Only diminishing returns is a law, because it must eventually occur.
• A good economist cannot avoid the law by planning. It is the technocrats who say that using more of the variable factor beyond a limit lowers MP, and they who show that better technology raises potential output and postpones the law.
• Average product is far higher in developed economies than in India for two reasons: more advanced technology, and more capital per worker, so that labour productivity is higher.
• Mechanisation in farming raises productivity by replacing labour with capital, but it creates surplus labour and unemployment.
• New technology, as FDI in the car industry can bring, shifts the short-run production function up (more output from the same inputs) and the average cost curve down.

Production function sums

• Q = 5 L^(1/2) K^(1/2) with L = 100 and K = 100 gives 5 × 10 × 10 = 500.
• Q = 2 L^2 K^2 with L = 5 and K = 2 gives 2 × 25 × 4 = 200.
• Q = 5L + 2K with L = 10 and K = 10 gives 50 + 20 = 70.

Optimal use of a variable factor (marginal productivity theory)

• MRP (marginal revenue product) = MP of the factor × MR of the product; it is the extra revenue from hiring one more unit. MRC of the factor is the extra cost of that unit (equal to the wage in a competitive labour market).
• The firm hires up to the point where MRP = MRC. In perfect competition in the product market, MRP equals VMP (value of marginal product = MP × price).
• The demand curve for labour of a competitive firm is its MRP curve in stage II.

Special production functions

Cobb-Douglas: the original finding

• The function is multiplicative: both factors are needed together to produce output. From their study of manufacturing, Cobb and Douglas found that about 75% of the increase in output came from labour input and the remaining 25% from capital input.
• They also found that the sum of the exponents was equal to one (α + β = 1), which means constant returns to scale and a linearly homogeneous production function; a sum above 1 means increasing returns and a sum below 1 means decreasing returns.

Cobb-Douglas: meaning and reading the exponents

• Developed by Paul Douglas and Charles Cobb in the 1920s; it is a mathematical tool for analysing and optimising production in industries.
• In Q = A L^a K^b: Q is total output, A is a constant for the level of technology and efficiency, L is labour (number of workers), K is capital (tools, machines), and a and b are the output elasticities of labour and capital.
• If a is greater than b, labour has the larger impact on output, and the reverse otherwise. Example: a = 0.6 and b = 0.4 means labour matters more than capital.
• If a + b = 1, doubling both labour and capital exactly doubles output (constant returns); a + b > 1 gives increasing and a + b < 1 decreasing returns to scale.

CES function in more detail

• Introduced by Arrow, Chenery, Minhas and Solow in their 1961 paper. Its special feature is that it allows different degrees of substitution between labour and capital: if labour becomes costly, capital can replace it to some extent.
• Another common form: Q = A [aK^p + (1 − a)L^p]^(1/p), where a is the distribution parameter and p (rho) the substitution parameter. If p = 0 it becomes Cobb-Douglas; if p tends to minus infinity, inputs are perfect complements (fixed proportions); if p tends to plus infinity, they are perfect substitutes.

Leontief function: illustration

• Named after Wassily Leontief. In Q = min (K/a, L/b), a and b are the fixed proportions of inputs required.
• If a factory needs 1 machine and 2 workers for one unit of output, adding more machines without more workers (or the reverse) does not raise output; a shortage of one input cuts output.
• Another case: one stove and one chef make one dish; a second stove with one chef adds nothing, and a second chef with one stove adds nothing.

The two forms of the CES function in the exam (with K or L first) are the same function: it is called the constant elasticity of substitution (CES) function.

• In Cobb-Douglas, MPL = b × Q ÷ L; the exponents are shares of factors in output when factors are paid their marginal products (Euler’s theorem works fully when a + b = 1).

An isoquant (iso-product curve) joins all combinations of two inputs that give the same output. An isoquant map shows several isoquants; a higher isoquant means more output.

The word isoquant comes from Latin roots: iso means equal and quant means quantity, so the curve stands for a constant amount of output. It is also called an equal product curve, a production indifference curve or an iso-product curve.

Properties of isoquants

1. Slope downward (to keep output unchanged, more of one factor must replace less of another).
2. Convex to the origin because of diminishing MRTS.
3. Do not intersect each other.
4. A higher isoquant gives a higher output.
5. They do not touch the axes (both factors are needed) except in special cases.
6. They need not be parallel; they are thin.

The ridge lines mark the economic region of production: outside them, the MP of a factor is negative. Marginal rate of technical substitution (MRTS) diminishes because factors are imperfect substitutes.

Isocost line

The isocost line shows all input combinations the firm can buy for a given outlay. A higher outlay shifts it outward; a change in factor price rotates it.

Producer equilibrium (least-cost combination)

• Least-cost combination for a given output, or maximum output for a given cost, occurs at the tangency of the isocost line and the isoquant, where the isoquant is convex.
• The expansion path joins equilibrium points as outlay rises (prices constant). It is the long-run output path; a straight-line path means homothetic production.
• Isoquant analysis is the producer-side counterpart of indifference-curve analysis.
• Difference: an isoquant gives a cardinal measure of output (100, 200 units) while an indifference curve gives only an ordinal ranking.

Returns to scale describe the effect on output when all inputs are increased in the same proportion in the long run.

Example. One unit of labour and one of capital produce 200. Doubling both gives 400 (constant returns). Doubling both gives 300 (decreasing returns). Quadrupling both (4L and 4K) gives 1,000, which is five times 200, so output rises more than in proportion: increasing returns.

Meaning and numerical illustration

• Returns to scale is a long-run concept: no factor is fixed, all factors are variable, and output is studied when every input is changed in the same proportion.
• Note: unlike the law of variable proportions, there is no negative stage in returns to scale.
• Schedule (labour = capital, TP, AP): 1: 100, 100; 2: 250, 125; 3: 450, 150; 4: 760, 190 (increasing returns, AP rises); 5: 950, 190; 6: 1140, 190 (constant returns, AP same); 7: 1260, 180; 8: 1280, 160 (decreasing returns, AP falls).

Causes of increasing returns

• Division of labour and specialisation; use of large machines (indivisibilities); better organisation; economies of massed reserves; learning by doing.

Why decreasing returns appear

• Limits to management and coordination, loss of control, and diseconomies of scale.

Economies and diseconomies of scale

Persisting economies of scale in large firms is the reason many industries are dominated by few firms. The minimum efficient scale is the smallest output at which LAC reaches its lowest level.

• Economies of scope are cost savings from producing several related products together.
• A U-shaped long-run average cost curve is explained by economies of scale at small outputs and diseconomies at large outputs; the middle portion is constant returns.

Cost concepts

Classification of costs

• Costs fall into three broad groups: monetary costs, real or social costs, and opportunity costs.
• Monetary cost is the money cost of production, as opposed to costs not directly billed. Example: a house may cost 45,000 to build in money terms, but that leaves out the time spent organising it and later alterations or furnishing. Monetary cost = explicit cost + implicit cost + normal profit.
• Explicit costs are payments made to others for factors used (raw materials, interest on loans, rent on buildings). They are also called paid-out, out-of-pocket, expenditure, overhead or accounting costs.
• Implicit costs are the price of factors owned by the producer himself (own land, building, capital, own services, or working as manager without a salary). He pays nothing directly for them, so they are also called non-expenditure costs.
• Real or social cost means all the pains, efforts and sacrifices borne in producing a commodity.

Cost as opportunity cost: worked example and related ideas

• A firm buys two kinds of inputs: factor inputs (land, labour, capital, entrepreneurship) and non-factor inputs (raw material). Cost is the expenditure, explicit or implicit, on both for a given output. Explicit cost is the opportunity cost of inputs bought from the market (payments to others); implicit cost is the opportunity cost of self-owned inputs, valued at their best alternative use (market value of the next best use).
• Total cost = explicit cost + implicit cost, so economic cost is always opportunity cost: the full sacrifice made to produce a given output.
• Worked example: an entrepreneur gives up a job paying Rs 40,000 a month, evicts a tenant paying Rs 50,000 a month for the factory premises, and pays Rs 10,00,000 for inputs. Explicit cost = 10,00,000; implicit cost = 40,000 (own services) + 50,000 (imputed rent) = 90,000; total cost = 10,90,000.
• Another case: withdrawing Rs 10,000 from a bank deposit to buy equipment costs the Rs 10,000 spent (explicit) plus the interest the deposit would have earned (implicit).
• Selling cost (advertising and other spending to promote sales) differs from production cost (spending on inputs to produce a given output). The syllabus concerns production cost.
• Cost function: C = f(Q), the relation between cost and output when technology is given.

Differential cost

• Differential (incremental) cost is the change in total cost caused by a change in the level or nature of activity, such as adding a product line or accepting an extra order; it is used in decisions between alternatives.

Short-run total costs

Fixed and variable costs: further details

• Fixed costs are also called supplementary, overhead or indirect costs. They arise even at zero output because the fixed factor is bought before production starts. Example: a carpet firm hires a machine at Rs 500 a day; that Rs 500 is paid whether 0 or 6 carpets are made. Main items: machine and plant, land and building, licence fees, salaries of permanent staff.
• Variable costs are also called prime or direct costs. They are zero at zero output and rise as output rises. Main items: raw material, wages of casual workers, electricity, wear and tear.
• Example schedule: TFC 10 at every level; TVC 0, 10, 18, 24, 28, 32, 38 for 0 to 6 units; TC = 10, 20, 28, 34, 38, 42, 48. TC starts at 10 on the vertical axis because TFC is 10 when TVC is zero, and TC and TVC are parallel because their gap is the constant TFC.
• Differences: fixed costs relate to fixed factors, do not change with output, stay constant even at zero output and are incurred before production; variable costs relate to variable factors, rise and fall with output, are zero at zero output and are incurred only once production starts.
• The fixed-variable split holds only in the short run. In the long run every factor is variable, so all costs are variable and the long-run total cost curve starts from the origin.
• Behaviour of TVC: at first it rises at a decreasing rate, because increasing returns (rising MP) mean falling marginal cost (for example, the extra cost is 8 for the 2nd unit, then 6). Later diminishing returns set in, MC rises and TVC rises at an increasing rate (extra cost 4, then 4 and more).

Notes on TFC, TVC and TC

• TFC is cost on fixed factors and does not change with output (e.g. TFC = 100 at every level); its curve is a horizontal line parallel to the output axis. TFC never starts from zero; salary is a fixed cost; electricity is semi-fixed or semi-variable (a fixed charge even with no use, then varying with consumption).
• TVC changes with output (raw materials, wages, transport). Schedule: output 0 to 8 gives TVC 0, 20, 36, 47, 56, 65, 80, 105, 136. TVC is inverted S-shaped because the law of variable proportions works in reverse: first it rises at a decreasing rate (flat), then at an increasing rate (steep); the in-between case is when both rise in the same proportion.
• TC = TFC + TVC (with TFC 100: 100, 120, 136, 147, 156, 165, 180, 205, 236). TC can never be zero because TFC cannot be zero; the TC curve is also inverted S-shaped; TVC = TC − TFC; TC and TVC never intersect because TFC is constant.
• AFC (e.g. TFC 60: 60, 30, 20, 15, 12, 10 for output 1 to 6) is continuously downward sloping, can never be zero and never touches the output axis because TFC cannot be zero; its shape is a rectangular hyperbola.
• The firm uses AVC to decide when to stop production in the short run. AVC schedule from TVC above: 20, 18, 15.6, 14, 13, 13.3, 15, 17, so it is U-shaped with its minimum at 5 units.
• AC is always above AVC because AC = AFC + AVC; the AC–AVC gap is AFC and keeps falling as output rises; AC and AVC never become zero and never intersect.

Marginal cost: textbook points

• Marginal cost is the addition to total cost from one more unit of output. Example: TC of 5 units = 135 and of 6 units = 180 gives MC of the 6th unit = 45. If TC of 5 units is 20 and of 4 units is 15, MC = 5.
• Schedule: TC 10, 20, 28, 34, 38, 42, 48, 56, 72 gives MC 10, 8, 6, 4, 4, 6, 8, 16: first falling, then rising, so MC is U-shaped. Falling MC matches rising MP (increasing returns); rising MC matches falling MP (diminishing returns). MC is the reciprocal of MP.
• MC is always a variable cost. Additional cost cannot be a fixed cost, so the sum of MC over 1 to n units is TVC: 10+8+6+4+4+6+8+16 = 62 = TVC at 8 units. Geometrically, TVC at an output is the area under the MC curve up to that output.
• Because MC is variable cost only: MC(n) = TC(n) − TC(n−1) = TVC(n) − TVC(n−1), since TFC cancels. In the short run TC = TFC + ΣMC, not ΣMC alone.

Marginal cost: calculation and links

• MC is the addition to total cost when one more unit is produced: MC(n) = TC(n) − TC(n−1) = TVC(n) − TVC(n−1). Example: TC of 2 units 200 and of 3 units 240 gives MC = 40.
• For a change of more than one unit, MC = ΔTC ÷ ΔQ. Example: TC of 2 units 200 and of 5 units 350 gives (350 − 200) ÷ (5 − 2) = 50.
• MC is U-shaped in the short run because of the law of variable proportions: it first falls to a minimum and then rises.
• TVC is the sum of all MC; if output is perfectly divisible, the area under the MC curve up to an output equals TVC.
• Other identities: TFC = AFC × output = TC at zero output = AC − AVC; TVC = AVC × output; TC = AC × output = ΣMC + TFC; AVC = AC − AFC.

Average cost: textbook points and relations

• AC = TC/Q is the cost per unit, also called unit cost. Example: TC of 6 units = 48 gives AC = 8. At zero output AC is undefined (TFC over zero).
• AFC schedule for TFC = 10: 10, 5, 3.3, 2.5, 2, 1.67, 1.43, 1.25 for 1 to 8 units. AFC × output equals TFC at every point (4 × 2.5 = 10, 8 × 1.25 = 10), which is why the curve is a rectangular hyperbola.
• AVC schedule from TVC 10, 18, 24, 28, 32, 38, 46, 62: 10, 9, 8, 7, 6.4, 6.3, 6.6, 7.7. It falls up to the 6th unit (increasing returns) and then rises (diminishing returns), giving a U shape.
• AC is the vertical sum of the AFC and AVC curves: at any output the AC height equals AVC height plus AFC height. Hence AC lies above AVC, and the two can never be equal.
• AC is U-shaped: it falls with increasing returns to a factor, tends to stay constant with constant returns, and rises with diminishing returns.
• Why AC and AVC come closer as output grows: AFC keeps falling, so the AFC part of AC shrinks. In later stages AC can rise even though AFC falls, because AVC rises. The gap between AVC and AFC curves narrows only until they cross, after which it widens again.

AC, AVC and MC relations

• AC falls: MC is below AC. AC rises: MC is above AC. AC is minimum and constant: MC = AC, so MC cuts AC at its lowest point. Same rule for AVC and MC.
• Example: AC falls to 8 at 6 or 7 units while MC stays below it; AC rises from 8 to 9 when MC jumps from 8 to 16.
• MC falls faster than AC and reaches its low point earlier, so MC starts rising while AC is still falling. For that range, AC can fall even though MC is rising (as long as MC < AC). MC cuts both AVC and AC at their lowest points.
• Relation with TC: while MC falls, TC rises at a diminishing rate; while MC rises, TC rises at an increasing rate; at the lowest MC the rise of TC stops slowing and begins to speed up. MC is the rate of change of TC (and the same holds between TVC and MC).

Time element and cost

• Very short (market) period: output cannot be raised, so cost is irrelevant to the price accepted.
• Short period: only variable factors can be changed; the producer controls only variable cost, so he must at least cover variable cost.
• Long period: all factors can be changed, so all costs are variable and must be covered.

Reasoning points and applications

• AFC always falls with output, whereas AVC first falls and then rises; the combination decides the shape of AC.
• Falling overhead cost per unit does not mean ever-rising profit; profit depends on the gap between total revenue and total cost, which includes variable cost.
• Land acquisition rules that raise compensation lift the fixed cost of a new industry; it will not attract the firm, because fixed cost is paid before output starts. A higher commercial electricity tariff raises variable cost, not fixed cost.
• Schedule check: TC 10, 30, 45, 55, 70, 90, 120 for output 0 to 6 gives TFC 10, TVC 0, 20, 35, 45, 60, 80, 110, AVC 20, 17.5, 15, 15, 16, 18.33, and SMC 20, 15, 10, 15, 20, 30.

Short-run average and marginal costs

• AFC is a rectangular hyperbola: falls all the way and cannot be U-shaped. AVC, AC and MC are U-shaped (law of variable proportions).
• MC cuts AVC and AC at their minimum points. When MC < AC, AC falls; when MC > AC, AC rises; when MC = AC, AC is minimum.
• MC rises faster than AC, so MC cuts AC from below. AC reaches its minimum after AVC because AFC is still falling when AVC starts to rise.
• The gap between AC and AVC is AFC and shrinks as output rises.
• AFC versus AVC changes: if the fall in AFC is less than the rise in AVC, AC rises; if the fall in AFC equals the rise in AVC, AC is constant; if the fall in AFC is greater, AC falls.
• The rising MC above AVC is the firm’s short-run supply curve under perfect competition.
• MC is related to the TP curve: when MP is highest, MC is lowest.

Long run: meaning and the three long-run costs

• The long run is the conceptual period with no fixed factors of production; the firm can adjust every input to the level it wants, so all costs are variable. It can change its size and shape, build new factories and hire new workers, and its main aim is to minimise average total cost. The short run, by contrast, has at least one fixed factor.
• Long-run total cost (LRTC or LTC) is the total cost of production when all inputs are variable. It helps firms find the most efficient way to produce, shows how input changes affect cost, lets them exploit economies of scale, and also counts the opportunity cost of an input (for land, the value of its next best use). The LRTC curve shows how cost rises with output.
• Long-run average cost (LAC) is the cost per unit over the long period = total cost (fixed and variable parts) ÷ output. It is a key input in pricing decisions and in judging competitiveness.
• Long-run marginal cost (LMC or LRMC) is the change in total cost from one more unit when all inputs, including labour, can be varied. It is used to decide how much to produce and to study how a firm’s cost and an industry’s structure change as firms enter and leave.
• Relation of LMC and LAC: when LMC < LAC, LAC falls; when LMC = LAC, LAC is at its minimum (constant at that point); when LMC > LAC, LAC rises.

Long-run average cost (LAC)

In the long run all factors are variable, so there are no fixed costs. The firm can pick any plant size, so the LAC curve is an envelope that touches (is tangent to) each short-run average cost (SAC) curve; it is called the planning curve.

• To the left of the minimum point of LAC, tangency occurs on the falling portion of the SAC; to the right, on the rising portion. Only at the minimum of LAC does the tangency coincide with the minimum of the SAC.
• The LAC is flatter than SAC, because a firm has more flexibility in the long run. LMC cuts LAC at its minimum.
• Shape: the classical shape is U-shaped: falling LAC reflects economies of scale (increasing returns to scale), the flat bottom constant returns, and the rising part diseconomies of scale (decreasing returns).
• Empirical studies (Bain, Johnston and others) find the long-run average cost curve to be L-shaped: costs fall at first and then remain constant over a wide range of output, with little sign of rising costs. This suggests that large firms suffer no strong diseconomies.
• Learning curve: cost falls with cumulative output as workers learn.

Modern-shaped cost curves

• Saucer-shaped (flat-bottomed) short-run AVC: SAVC and SMC stay equal and flat over a wide range of output, and the stretch between normal and full capacity output is the reserve capacity that firms keep to meet a rise in demand.
• L-shaped long-run average cost curve: LAC falls steeply and then flattens without rising, because economies of scale persist and diseconomies are weak or absent.

More on the LAC curve

• LAC is the envelope of all the short-run average cost curves, hence the names envelope curve, boat curve, planning curve and plant curve (it guides plant-size decisions).
• LAC is never above SAC, so every SAC curve lies on or above it. It indicates the minimum cost of production and the optimum size of the firm. It only touches the SAC curves and does not cut them.
• Example: for output OQ1 the firm picks the plant on SAC2, not SAC1; if demand rises to OQ3, average cost starts rising along SAC2, so it sets up the larger plant on SAC3.
• The downward-sloping part of LAC comprises only the increasing-returns, falling-cost portions of the SAC curves; LAC is therefore not the locus of the lowest points of the SACs.

Economies and diseconomies of scale: definitions and scope

• Economies of scale are cost advantages a firm gains by expanding production in the long run: lower average cost per unit as sales grow, and savings that can be used to buy raw materials in bulk at a discount (other sources: efficient production, cheaper capital, lower logistics and promotion costs, spreading risk).
• Diseconomies of scale occur when average cost rises as the scale rises, typically from bureaucracy and organisational complexity, inefficient communication and coordination, lack of specialisation and worker motivation, and diminishing marginal returns once the firm is too large to manage well.

Break-even analysis

The break-even point is where TR = TC (profit is zero). In the figure on the left TR cuts TC from below at the break-even output; below it there is a loss, above it a profit. In the unit price diagram, the break-even price is the minimum of AC.

Break-even point: TR = TC, so the firm meets all its costs (loss to the left, profit to the right in the TR-TC diagram). Dividing by Q, TR ÷ Q = TC ÷ Q, so break-even also occurs where AR = AC.

Shut-down point: the firm just covers its variable cost, TR = TVC or AR (price) = AVC. Here it loses its fixed cost but need not stop at once because fixed cost is incurred anyway; it closes only if AR falls further and cannot meet even AVC.

Shut-down and break-even: clarifications

• Profit maximisation is a goal, not a guarantee. Some firms suffer losses and still produce in the short run so long as AR ≥ AVC (TR ≥ TVC), since they then bear only the fixed cost that they would lose anyway.
• Shut-down point does not mean closing the firm: it is a short-run idea at which the firm just covers variable cost (AR = AVC); the firm may still carry on or suspend output for a time. It cannot quit the industry in the short run, only in the long run, when all costs must be covered.
• At the shut-down point the loss is the fixed cost: AFC per unit times output, equal to TFC. At break-even (TR = TC or P = AC) the firm earns just normal profit.
• A firm in an economically viable situation covers its variable cost; one that cannot cover even that is in an economically unviable situation and will not produce.

Shut-down point

• In the short run a firm shuts down when the price falls below the minimum of AVC, because it then cannot cover even variable cost (it loses less by stopping, as fixed cost is lost either way). It can operate at a loss while price is between minimum AVC and minimum AC, since it still covers variable cost and part of the fixed cost.
• In the long run it exits when the price is below the minimum of AC.
• A multi-product firm judges shut-down by comparing total revenue with total variable cost (or average revenue with average variable cost) across its products.
• First-order condition for profit maximisation: MR = MC. Second-order condition: MC cuts MR from below, that is, the slope of MC exceeds that of MR.

A market is the arrangement through which buyers and sellers come into contact for a good. The market structure (form) depends on the number of sellers, the nature of the product, entry conditions and information.

Meaning and features of a market

• A market is any place or arrangement, physical (a retail shop) or virtual (an online broker with no physical contact), where buyers and sellers exchange goods and services.
• Features: a commodity that is demanded and sold; buyers and sellers; communication between them; a place or area, online or offline, where they meet; and competition among them.
• Market structure means the different types of firms operating in an industry. It is determined by the nature of the commodity, the number of buyers and sellers, restrictions on and movement of firms, availability of information about market conditions, and mobility of factors of production.

Classification and features

Order of number of sellers (high to low): perfect competition, monopolistic competition, oligopoly, duopoly, monopoly. Order of pricing power (low to high): perfect competition, monopolistic competition, oligopoly, duopoly, monopoly. Manufacturing in India and in most countries is dominated by oligopoly.

Product differentiation exists in monopolistic competition and in oligopoly (differentiated), but not in perfect competition or monopoly. Oligopoly may bring more technological change and product improvement than the other forms, because firms with profits and rivals to beat spend on research.

Perfect competition: vital conclusions

• A firm is a price taker, not a price maker. Reasons: the number of firms is so large that no single firm can change market supply or price; and the product is homogeneous, so a firm charging more loses all buyers to rivals, while a firm cutting price suffers an unnecessary loss because it can already sell any amount at the market price.
• The firm demand curve is perfectly elastic (Ed = infinity), a horizontal line parallel to the X-axis at the market price; slope is zero (not infinity). A small rise in price takes demand to zero. AR = MR = price.
• In the long run the firm earns only normal profit: extra-normal profit attracts entry, supply rises and price falls; losses cause exit, supply falls and price rises.
• Why a firm cannot capture the whole market by cutting price: each firm is tiny, with limited capacity, so it cannot supply all buyers who rush to it.
• Further features: no selling cost (homogeneous product rules out advertising), perfect knowledge, free entry and exit, independent decisions with no agreement among sellers, perfect mobility of factors, and no extra transport cost (so one price prevails).
• Consumer demand curve shows price against quantity demanded by buyers of the commodity; the firm demand curve shows price against the quantity sold by that one firm, which is its output or sales.

Monopoly: features, price making and origin

• Features: one seller with a large number of buyers (no buyer can influence price); restrictions on entry (patents, exclusive control of a technique or raw material); no close substitutes (railways as a bulk carrier); full control over price; and possible price discrimination (different prices for the same good from different buyers).
• Monopoly firm is also the industry, so the distinction between firm and industry disappears. A monopolist cannot sell any amount at any price: the demand curve slopes downward, so more is sold only at a lower price.
• Price maker because: no competition, no close substitutes and barriers to entry. A monopolist restricts output and fixes a high price, so the greater the monopoly power, the lower the output and the higher the price.
• Monopoly arises from: government licensing (for example Railways), patent rights (official recognition of an innovation, with patent life the years it lasts; granted to encourage research and new discoveries), cartels (collective decisions to avoid competition) and natural occurrence (the only spring in an island).
• Zero-cost monopoly (a single spring): with zero cost, profit is highest where total revenue is highest, that is, where MR = 0.

Monopolistic competition: further points

• Partial control over price arises through product differentiation (design, colour, packaging); full control is ruled out because there are many competitors and many close substitutes (toothpaste brands).
• Selling costs are the expenses on advertisement and publicity. The demand curve slopes downward and is flatter (more elastic) than under monopoly because close substitutes exist.
• Non-price competition: promoting the product without cutting price, for example celebrity promotion, sponsoring programmes in schools, better after-sale service on durables.
• Entry is free but not absolute, since some products are legally patented (for example a patented brand of shoes). Factor mobility and market knowledge are imperfect, so different prices can prevail for the same factor, and buyers can be exploited by higher prices for low quality.
• Price discrimination (one producer charges different buyers different prices for the same product, typical of monopoly) differs from product differentiation (producers make their products different in shape, size, packaging or brand, typical of monopolistic competition).

Oligopoly: further points

• Few big firms each hold a significant share and have partial control over price through brand loyalty built by heavy advertising. Competition is often cut-throat because the price and output of one firm strongly affect rivals (for example car makers).
• Fear of rival reaction: a firm may not raise price (buyers shift to rivals) nor cut price (rivals cut more). So the firm demand curve is indeterminate, no precise price-quantity link can be drawn, and price becomes rigid, which pushes firms to non-price competition and high selling costs.
• Cartel: a formal collusive agreement fixing output quotas and price, sometimes with a price leader whose price all members accept; it earns monopoly profit. Example: OPEC, set up in 1960 by five major oil producers (Iran, Iraq, Kuwait, Saudi Arabia and Venezuela). Coke and Pepsi sell at the same price and compete through sponsorship and schemes.
• Why few firms: government licensing (coal mining rights offered to a few companies), patent rights, and large scale of investment with heavy selling costs (software, autos).
• Collusive (cooperative) oligopoly: firms agree to avoid competition. Non-collusive (non-cooperative): each firm sets its own price and output and competes for share. Perfect oligopoly has a homogeneous product; imperfect oligopoly has differentiated products. Only two firms is a duopoly.
• Applications: FDI in retail may first bring price-cutting, then higher prices once big firms gain a foothold (high market concentration); Indian cell phone prices fell over time, showing price competition typical of non-collusive oligopoly; a Buy Indian appeal tends to reduce competition and push the market toward oligopoly.

Basis of classification and comparison notes

• Markets are classified by: number of buyers and sellers, nature of the commodity, degree of price control, knowledge of the market, and mobility of factors (perfect mobility is unique to perfect competition).
• Comparison table notes: in oligopoly the firm demand curve and slope cannot be specified; under monopoly and monopolistic competition AR is greater than MR; long-run profit is normal (AR = AC) under perfect and monopolistic competition and extra-normal (AR > AC) under monopoly and oligopoly. Product under monopoly is sometimes described as homogeneous or differentiated, because price discrimination makes prices non-uniform.
• A monopolist fixes price on the basis of elasticity of demand: price is high when elasticity is low and low when elasticity is high.
• When AR is constant, AR = MR and both are one horizontal line; when AR falls, MR falls faster. Rising AR is not studied because it would mean more is sold at a higher price.
• Only under perfect competition does the firm settle in the long run at the lowest point of AC, where MR = MC (rising), AR = AC (normal profit) and resources are most efficiently used. A demand curve that makes total revenue a rising straight line through the origin must be horizontal.
• Competitive behaviour (rivals compete for market share, like Coke and Pepsi) differs from competitive market structure (many sellers, as in perfect competition, where there is no competitive behaviour).

Market period, short run and long run (Marshall)

• Market (very short) period: supply is fixed; demand determines price.
• Short run: supply can be changed only by using the existing plant more or less intensively; both demand and supply act.
• Long run: all factors can change; cost of production governs price. Marshall’s synthesis: price is determined like a piece of paper cut by two blades, demand and supply, with demand dominating in the short period and supply in the long period.

Measures of concentration and market power

Contestable markets (Baumol, Panzar and Willig)

A market is contestable when entry and exit are completely free and costless (no sunk costs), so even a single firm cannot charge above competitive price for fear of hit-and-run entry. The threat of potential entry disciplines price, so a monopolist or oligopolist in a contestable market earns zero supernormal profit. The theory shifts attention from the number of firms to barriers to entry and sunk costs.

Efficiency by market form

• Productive efficiency: production at minimum AC. Allocative efficiency: P = MC.
• Only perfect competition in the long run achieves both. Monopoly and monopolistic competition set P > MC. Monopolistic competition produces with excess capacity (output below the minimum-AC output).

Conditions

• Large number of buyers and sellers, each too small to influence price.
• Homogeneous product; perfect knowledge; free entry and exit; perfect mobility of factors; no transport cost; no government intervention.

Under perfect competition price is determined by the industry, through market demand and supply, and the firm is a price taker. The firm’s demand curve is horizontal at the market price, so AR = MR = Price.

Why each condition matters

• Perfect competition is a theoretical model with many buyers and sellers, identical products and no entry barriers; price is set by demand and supply and no single buyer or seller can affect it.
• Many sellers: no individual seller can change the market price; many buyers: each buys a very small share, so none can affect price.
• Homogeneous product: one unit is a perfect substitute for another (same taste, colour, size, shape), so buyers pay the same price.
• Free entry and exit: the firm earns only normal profit in the long run, while in the short run it may earn abnormal profit or loss.
• No selling cost: products are homogeneous and buyers know the market, so no promotion is needed. Perfect knowledge: buyers already know the price, so the seller cannot play with it and a uniform price prevails.
• Price taker: a change in one firm’s output does not alter industry output, and no single buyer can alter the price, which is given to him. The firm faces a perfectly elastic demand curve (Ed = infinity).
• Revenue schedule at price 10: quantity 1 to 5 gives TR = 10, 20, 30, 40, 50 with AR = MR = 10.

Producer and profit maximisation: definitions

• A producer is an economic agent who produces goods and services to sell for profit. His goal is to make the gap between revenue and cost as large as possible. Producer equilibrium means profit maximisation: the output at which profit is highest, any other output giving less.
• Profit = TR − TC. Economic profit = TR − (explicit + implicit cost); accounting profit = TR − explicit cost only. Gross profit = TR − TVC; net profit = TR − TC (= TR − TVC − TFC).
• Abnormal (extra-normal) profit: TR > TC, or AR > AC. Normal profit: TR = TC, or AR = AC; it is the minimum return the entrepreneur expects on his capital, below which he would move the capital elsewhere, and it is counted as part of cost. Sub-normal profit (loss): TR < TC, or AR < AC.

Conditions of producer equilibrium and their reasons

• Three conditions: (i) MR = MC; (ii) MC is rising at that output; (iii) AR (price) is at least AVC.
• Why MR = MC: if MR > MC, one more unit adds more revenue than cost, so profit rises with output; if MR < MC, the last unit adds more cost than revenue, so cutting output raises profit. Only at MR = MC is there no scope for improvement.
• Why MC must be rising: with price given, falling MC means the gap TR − TVC (and sum of MR minus sum of MC) is still widening, so stopping would waste profit; equilibrium cannot be in the falling-MC stage (increasing returns). It comes in the stage of diminishing returns, when MP is falling.
• Why AR is at least AVC: a firm that cannot cover variable cost would lose more by producing than by shutting down.
• Under perfect competition AR = MR, so the conditions become: price = MC and MC rising. MR = MC is a necessary condition; the sufficient condition is that MC is rising.

Numerical illustration of the MR-MC approach

• Take MR = 12 at every output and MC of 15, 12, 10, 9, 8, 7, 8, 9, 10, 12, 15 for units 1 to 11. MR = MC at 2 units (MC falling) and at 10 units (MC rising).
• At 2 units: TR = 12 + 12 = 24; TVC = 15 + 12 = 27; gross profit = −3 (a loss). At 10 units: TR = 120; TVC = 100; gross profit = 20, the maximum. At 11 units: TR = 132, TVC = 115, profit = 17, which is lower than 20.
• Diagram reading: TR is the area under the MR line and TVC the area under the MC curve up to the output. At the first crossing (falling MC) the area under MC exceeds that under MR, so there is a loss; at the second crossing (rising MC), TR exceeds TVC, so profit exists and is greatest.
• Beyond the equilibrium output, the added TVC is more than the added TR, so profit shrinks; below it, the loss of TR is more than the saving in TVC, so profit also shrinks. Any departure from equilibrium reduces profit.

Reasoning points and applications

• Equilibrium can be reached even with losses (TR < TC) as long as MR = MC, MC is rising and AR ≥ AVC; the loss is then limited to total fixed cost.
• Equilibrium is not revenue maximisation or a TR = TC position: it is where the TR-TC gap is greatest. Profit is not maximised when MR > MC.
• Diminishing MP means rising MC, so equilibrium is struck where MP is diminishing.
• If input costs rise, MC shifts up and the equilibrium output falls; if demand changes, MR shifts and a new equilibrium is found. A producer must therefore re-find equilibrium when conditions change.
• Cheaper petrol and diesel (from a gas discovery that lowers international prices) reduce the cost of transport firms, which use fuel as a key input.
• Practice: with TR 0, 5, 10, 15, 20, 25, 30, 35 and TC 5, 7, 10, 12, 15, 23, 33, 40 for 0 to 7 units, profit is −5, −2, 0, 3, 5, 2, −3, −5; the price is 5 and profit peaks at 5 at 4 units. At price 10 with TC 5, 15, 22, 27, 31, 38, 49, 63, 81, 101, 123 (0 to 10 units), profit is −5, −5, −2, 3, 9, 12, 11, 7, −1, −11, −23, so the maximum of 12 is at 5 units.

Equilibrium of the firm

Short-run equilibrium

The firm’s short-run supply curve is the part of its MC curve above minimum AVC. The industry’s supply curve is the horizontal sum of these.

Long-run equilibrium of firm and industry

• Supernormal profit attracts entry, supply rises and price falls; losses cause exit. In the long run price = minimum LAC = LMC = MR = AR: each firm earns only normal profit and operates at the optimum scale.
• The industry is in equilibrium when long-run demand equals long-run supply and no firm wishes to enter or leave.
• Long-run industry supply depends on how input prices change with industry output: horizontal for a constant cost industry, upward for an increasing cost industry, downward for a decreasing cost industry.
• Perfect competition gives allocative and productive efficiency in the long run. Its criticism: unrealistic assumptions, no innovation incentive, and homogeneous products are rare.

Monopoly is a market with a single seller of a product with no close substitutes and with barriers to entry (legal patents, control of raw materials, economies of scale, government licence). Natural monopoly arises when one firm can supply the whole market at lower cost than two or more (railways, water supply).

Equilibrium

• The monopolist is a price maker. AR (demand) slopes down and MR lies below AR.
• It chooses output where MR = MC (with MC cutting MR from below) and then reads the price from the demand curve, so P > MC.
• It never operates on the inelastic part of demand, where MR is negative.
• A monopolist may earn supernormal profit in the long run because entry is blocked. A simple monopoly firm does not always earn supernormal profit; in the short run, when AC is above price, it may make a loss.
• Monopoly has no supply curve: the same price can go with different outputs depending on the demand elasticity.
• The monopolist can decide either price or quantity, not both independently.
• It can produce even when AC is rising; it needs MC to be rising above MR, not AC.

Features of monopoly and its revenue

• Mono means single and poly means seller: a single seller (e.g. Indian Railways) of a product with no close substitute; the firm is a price maker because firm and industry are the same.
• Selling cost (advertising and promotion) is minimal because there is no rival.
• Revenue schedule (price falls to sell more): quantity 1 to 5, price 10, 9.5, 9, 8.5, 8, TR = 10, 19, 27, 34, 40. Depending on AR and AC: AR > AC gives supernormal profit, AR = AC normal profit, AR < AC loss.

Monopoly power and the social cost of monopoly

Compared with perfect competition, a monopoly produces less and charges more. The loss of consumer and producer surplus that no one gains is the deadweight loss (also called the allocation loss or welfare loss). Further social costs: rent-seeking expenditure, X-inefficiency, and lower incentive to innovate (though monopoly profit can also fund research, as Schumpeter argued).

• Degree of monopoly (Lerner) = (P − MC) ÷ P, equal to 1 ÷ elasticity at the profit-maximising point.
• Regulation: price ceilings, marginal cost pricing (efficient, but a natural monopoly loses money so subsidy is needed), average cost pricing (normal profit), anti-trust law, and public ownership.
• The relation between P, MC and elasticity: P = MC ÷ (1 − 1 ÷ e). Since MC is positive, the monopoly price is above MC and the firm operates where e > 1.

Price discrimination means charging different prices for the same product to different buyers, not based on differences in cost.

Conditions

1. The firm must have some market power (it need not be a pure monopolist).
2. The market must be separable (segmentation by place, age, time, use) and resale between markets must be impossible.
3. Price elasticity must differ in the markets.

Free entry and exit of other firms would remove the market power, so it is not a condition of price discrimination.

Kinds and degrees: further detail

• By basis: place discrimination (e.g. Amul milk at different prices in different states), personal discrimination (e.g. railway fares for different segments) and use discrimination (e.g. electricity rates for rural and urban use).
• First degree (Pigou) is also called personalised or perfect price discrimination and extracts the whole consumer surplus; examples are a doctor’s or lawyer’s fee.
• Second degree: the seller lacks information on each buyer, so it prices by group preferences or quantity; it does not remove consumer surplus entirely but raises profit on a part (bulk or quantity discounts, warehouse retailers, loyalty and reward cards).
• Third degree: prices differ by the demographics of subsets (students, military personnel, seniors), using their different price elasticities; seen in cinema tickets, amusement park entry and restaurant offers.

Degrees

Third-degree equilibrium

The firm adds the MR curves horizontally, picks total output where combined MR = MC, then splits the output so that the MR of the last unit is the same in each market. Price discrimination in international trade is called dumping (a lower price abroad).

• Price discrimination can raise profit and output, and cross-subsidise poor users; it is not always harmful.

Developed by E. H. Chamberlin and Joan Robinson (1933). Many firms sell differentiated products that are close substitutes. Each firm has some monopoly over its own brand, but competes with others.

Features

• Large number of sellers, product differentiation (quality, brand, packaging, location, service), free entry and exit in the long run, and selling costs.
• The firm’s demand curve slopes downward and is highly elastic. Firms are small relative to the market and each has limited market power.
• Chamberlin used a large group of firms, no collusion and independent decisions; the product group of rival brands is the “industry”.

Equilibrium

• Short run: the firm equates MR and MC and earns supernormal profit, normal profit or a loss.
• Long run: entry shifts each firm’s demand curve down until it touches the AC curve at one point. The firm then earns only normal profit (price = AC) at an output where MR = MC, but AC is still falling at that point.
• Because the tangency is on the falling part of AC, the firm produces below the minimum-AC output: this is the excess capacity theorem (Chamberlin). Output is also less than under perfect competition, and price is higher than MC.
• Selling costs (advertising, sales promotion) shift the demand curve to the right and make it less elastic, but they raise cost; they inform or persuade buyers. In monopolistic competition they influence buying behaviour; in oligopoly they are a key rivalry tool; in perfect competition they are not needed, because the product is homogeneous.

Non-price competition and revenue curves

• Monopolistic competition = monopoly (own differentiated brand) + competition (many close rivals). Examples: soap, toothpaste, air conditioners.
• Besides price competition (cutting price), firms use non-price competition: free gifts, easy credit terms and similar offers without changing the product’s price. Selling costs are a substantial part of total cost.
• Product differentiation means buyers see the same product from different firms as different and will pay different prices, which gives each firm a little monopoly power.
• Under monopoly the AR and MR curves are steeper (less elastic): a small rise in sales needs a larger price cut. Under monopolistic competition they are flatter (more elastic): a small price fall brings a big rise in demand.

Key differences from perfect competition

Oligopoly has a few sellers, each of whom knows that its action will provoke a reaction from rivals. The firms are therefore interdependent. A special case with two sellers is duopoly. Oligopoly is the dominant structure in manufacturing.

Features

• Few sellers and many buyers; products may be homogeneous (pure oligopoly) or differentiated.
• Interdependence of price and output decisions; barriers to entry.
• Price rigidity and non-price competition (advertising, service, product variety).
• Indeterminateness: no single theory because the reaction of rivals is uncertain.
• Assumptions often quoted in the exam: a few sellers with many buyers, restricted entry and interdependence. “One seller and many buyers” describes monopoly, and “many sellers and many buyers” describes competition.

Features of oligopoly explained

• Oligopoly is an industry dominated by a few firms, each producing a significant part of total market output (examples in India: automobiles, cement, steel, aluminium). It may be pure (homogeneous) or differentiated.
• Mutual interdependence: one firm’s price and output decision affects the profits of the others, which gives each firm an incentive to look for alternatives to price competition.
• Barriers to entry limit the threat of competition and let firms earn economic profit in the long run.
• To avoid a price war, firms use non-price competition (advertising, better customer service) and stick to a rigidity policy: prices stay constant despite changes in demand and supply.
• Demand curve is indeterminate because of the high interdependence; Sweezy (American, 1939) explained it with the kinked curve, with different elasticities above and below the current price.

Models

Sweezy’s kinked demand curve (1939)

• Rivals are assumed to match a price cut but ignore a price rise. So the demand curve above the current price is elastic, and below it is inelastic, giving a kink.
• The MR curve has a vertical gap at the kink output. Within the gap, MC may change without altering the profit-maximising price and output, which explains price rigidity.
• Criticism: it explains rigidity but not how the price was fixed in the first place, and empirical support is weak; the price can still change when the cost shift is large.

Cournot reaction curves

Firm 1’s best output depends on firm 2’s output and vice versa. The two reaction curves meet at the Cournot equilibrium, where neither firm wants to change its output. In the figure both firms produce 4 units.

Cartel

• A cartel is a formal agreement among firms to fix price and output, acting like a monopoly (OPEC is the standard example). It maximises the joint profit and shares output by quotas.
• Factors that hinder formation or sustainability: many firms, differences in cost and demand, product differentiation, incentive to cheat, entry of new firms, recession, government and competition-law restrictions, and mistrust.

Game theory and Nash equilibrium

Game theory (von Neumann and Morgenstern, 1944) studies strategic decisions. A Nash equilibrium (John Nash) is a set of strategies in which no player can gain by changing his strategy alone, given what the others do. A dominant strategy is the best choice whatever the rival does.

In this prisoner’s dilemma, low price is the dominant strategy for both firms, so the Nash equilibrium is (low, low) with payoffs 5 and 5, even though both would do better at (high, high). This is why cartels are unstable without enforcement.

In price leadership one firm (the leader) announces a price change and others follow, without a formal agreement. It is a form of tacit collusion.

Dominant-firm model

• The leader’s demand curve is market demand minus the supply of the fringe firms (D_d = D − S_f). The leader equates its MR with its MC and sets the price; the fringe firms act as price takers and supply along their supply curve, and the leader supplies the rest.
• In the figure the leader’s output is 8.4 and the fringe output is 6.4 at the price of 5.2, which together meet the market demand of 14.8.
• Barometric price leadership: a firm announcing price changes which are followed by others, because it is trusted to read conditions correctly (not necessarily the dominant firm).

Pricing strategy is the plan by which a firm sets and changes prices to reach its objectives (profit, share, survival, image). Strategy depends on demand elasticity, cost, competition and the stage of the product life cycle.

Price skimming

The firm sets a high initial price and lowers it gradually in stages, skimming the “cream” from the least price-sensitive buyers first.

• Suitable when: the product is new and has no close substitutes; demand is initially inelastic; a sufficient number of buyers signal high demand; a high price does not attract competitors (patent, high entry barrier); a high price signals quality; production in small batches is costly.
• Not suitable when the market is highly price sensitive.
• Examples: new smartphones, new medicines under patent, new technology gadgets.

The statement that skimming requires a lower initial price is false: it requires a higher initial price.

Penetration pricing

• A low initial price to win share and volume quickly, then raise price later.
• Suitable when: demand is elastic, the market is price sensitive, there are economies of scale, competition is intense, and price-quality association is weak. It discourages new entrants.
• Risks: low profit at start, a price war and difficulty in raising price later.

Product life cycle and pricing

• Introduction: skimming or penetration. Growth: price is held or lowered slightly as competitors enter. Maturity: competitive pricing and discounts. Decline: harvest at low price or withdraw.

More pricing strategies in detail

• Skimming (extra points): the price is lowered as the first buyers’ demand is satisfied and competitors enter, to reach a more price-sensitive segment. It fails when the product can be copied easily, because the high price then earns revenue only briefly; it needs buyers who value uniqueness and will pay for it.
• Penetration (extra points): elastic goods suit it best, since a small price cut brings a large rise in demand. The firm must be able to expand output as demand grows. Risk: new buyers may try the brand at the low price and switch to a rival once the price rises.
• Peak-load example: if electricity costs more at peak hours, users shift washing, dishwashers and bathing to the night off-peak hours, which saves the consumer money and saves resources for society.
• Cost-plus pricing: a straightforward method that ensures all costs are covered before profit. Full cost = average variable cost + average fixed (overhead) cost + normal margin, so P = AVC + AFC + mark-up. The two parts, cost and mark-up, are analysed separately.
• Marginal (incremental) cost pricing: price is set equal to the extra cost of one more unit, i.e. variable cost plus a profit margin. Used when demand is slack and the market is highly competitive, or to enter a new market and beat rivals. Because it ignores fixed cost, it cannot be a long-term strategy.
• Target-return pricing: as cost-plus, but the margin comes from a target rate of return decided on the firm’s experience, buyers’ paying capacity, the risk involved and similar factors.
• Penetration as competition-based pricing: a firm entering a market ruled by existing players charges even less than the going price; marginal costing can fix it. It is short-term, and its success depends on the price elasticity of demand, because in the long run other factors matter more than price.
• Entry-deterring (limit) pricing: price is kept low so the market looks unattractive to newcomers. It succeeds only if the firm earns economies of scale and can afford the low price.
• Going-rate (imitative) pricing: also called follow-the-leader pricing; the firm matches rivals’ prices to avoid losing share. Common where products are homogeneous and price is a key factor in buying, and popular in monopolistic competition and oligopoly. It is about staying competitive, not about cost.

Product life cycle pricing by stage

• Introduction (high price): awareness and acceptance are minimal and promotion costs are high, so profit may be low; the firm uses skimming or penetration pricing.
• Growth (fairly high, then beginning to decline): the product gains acceptance and sales rise fast through promotion and word of mouth. Pricing differs little between growth and maturity.
• Maturity (lower price; gifts may be offered to prolong the stage): competition is keen, sales grow at a falling rate, rivals cut prices and modification costs squeeze the margin. The stage warns the firm to be careful in pricing.
• Saturation: sales are at their peak and demand is stable and only replacement demand remains, so price is full cost plus a normal mark-up.
• Decline: sales fall as buyers tire of the product and substitutes and imitations arrive; price becomes the competitive weapon and a price cut is more or less needed to clear stock. The product may be reformulated to suit preferences, which is possible for few goods.

Cyclical pricing

• Pricing decisions are taken to suit fluctuations in business conditions: prices are cut in recession and pegged up in demand-pull or cost-push (demand-push) inflation.
• A cyclical policy should weigh demand, competition, cost-push, price rigidity, price changes caused by substitutes, purchasing power, market share and demand fluctuation.
• Rigid pricing: a stable price policy whatever the phase of the cycle (inflation or recession). Flexible pricing: prices are kept flexible to meet changes in demand.

Multi-product, retail and other pricing

• Loss-leader pricing: a multi-product firm sells one product at a low price and makes up the loss on its other products.
• Transfer pricing: the charge when a company supplies goods, services or finance to its subsidiary or sister concern; used in large organisations for dealings between divisions, i.e. internal rather than external-market pricing.
• Every Day Low Pricing (EDLP): a low price all year with few or no special discounts; works only for a very large retailer with economies of scale and very low overheads.
• High-low pricing: high regular prices plus temporary promotional discounts; on normal days price is above EDLP, on discount days below it. Used by firms with high overheads that cannot afford everyday low prices.
• Value pricing: the seller builds high perceived value and charges a low price; suited to maturity and saturation, when demand is kept up by high quality and low cost.
• Intuitive pricing: the price is a guess at what customers will pay; if the item does not sell, the price is changed until it sells in worthwhile quantities. It rests on hunches and trial and error, not calculation.
• Refusal pricing: the price or discount offered to a customer who first refused to buy the firm’s product.
• Ramsey pricing (example): a public water utility charges households, whose demand is inelastic because water is essential, a higher price, and industries, whose demand is more elastic because alternatives exist, a lower price. Costs are covered with the least distortion in resource allocation.

Other pricing methods and strategies

Peak-load pricing is charging a higher price in the peak period and a lower price in the off-peak period for services that cannot be stored, such as electricity, telephone, transport, hotel rooms and cinema seats.

• Why the price differs: capacity must be built for the peak, so peak users cause the capacity cost; off-peak users use idle capacity and cause only the operating cost.
• Rule: peak price = operating cost (b) + capacity cost (c); off-peak price = operating cost (b). The capacity is fixed where the peak demand curve meets b + c.
• Applies where products are non-storable and demand varies by time; the firm can separate peak and off-peak users.
• Effects: it shifts demand from peak to off-peak, improves capacity use and reduces the need for new capacity. In the figure capacity is 7 units: peak price b + c is 5, off-peak price is the operating cost 2.

Elasticity and total revenue rules

Market form at a glance

Full forms

Who said what: a one-page list

1. Q1. Economics as the study of human behaviour in relation to unlimited ends and scarce means having alternative uses was defined by
   (a) Lionel Robbins (b) J. M. Keynes (c) Adam Smith (d) Alfred Marshall

   Answer: (a). This is the scarcity definition of Robbins (1932).

2. Q2. Which of the following is a normative statement?
   (a) Inflation was 5 per cent last year (b) The government should reduce tax on petrol (c) A fall in supply raises price (d) Demand falls when price rises

   Answer: (b). A normative statement says what ought to be; the others state what is or was.

3. Q3. Which of the following belongs to macroeconomics?
   (a) Consumer behaviour (b) Factor pricing (c) Level of savings and investment (d) Pricing of a product

   Answer: (c). Aggregate savings and investment concern the whole economy.

4. Q4. Maximisation of the balanced growth rate subject to managerial and financial constraints was proposed by
   (a) Herbert Simon (b) William Baumol (c) Oliver Williamson (d) Robin Marris

   Answer: (d). This is the Marris hypothesis.

5. Q5. The firm maximises sales revenue subject to a minimum acceptable profit according to
   (a) Cyert and March (b) Baumol (c) Marris (d) Knight

   Answer: (b). Baumol’s sales revenue maximisation model.

6. Q6. Satisficing behaviour and bounded rationality are associated with
   (a) Paul Sweezy (b) Joan Robinson (c) Herbert Simon (d) E. H. Chamberlin

   Answer: (c). Simon argued that firms aim at satisfactory, not maximum, results.

7. Q7. Which theory regards profit as the reward for bearing non-insurable risk?
   (a) Hawley’s risk theory (b) Clark’s dynamic theory (c) Schumpeter’s innovation theory (d) Walker’s rent theory

   Answer: (a). Hawley’s theory (risk), whereas Knight stressed uninsurable uncertainty.

8. Q8. Profit as the reward for the entrepreneur who introduces new products and methods is the view of
   (a) Walker (b) Taussig (c) Hawley (d) Schumpeter

   Answer: (d). This is the innovation theory of profit.

9. Q9. Economic profit equals
   (a) Accounting profit minus implicit cost (b) Normal profit minus accounting profit (c) Total revenue minus explicit cost (d) Accounting profit plus implicit cost

   Answer: (a). Economic profit deducts implicit costs as well.

10. Q10. Which of the following is NOT a characteristic of capitalism?
    (a) Profit motive (b) Major means of production owned by the Government (c) Price mechanism (d) Private property

    Answer: (b). Government ownership of the major means of production is a feature of socialism.

1. Q1. The downward slope of the demand curve is explained by
   (a) Law of increasing returns (b) Price ceiling (c) Substitution and income effects (d) Constant marginal cost

   Answer: (c). Substitution and income effects, together with diminishing marginal utility, explain the law of demand.

2. Q2. A fall in the price of a good leads to
   (a) A shift of the demand curve to the right (b) A fall in supply (c) A fall in income (d) An extension of demand (movement along the curve)

   Answer: (d). A price change causes movement along the same demand curve.

3. Q3. A rise in consumer income reduces the demand for
   (a) Luxury goods (b) Inferior goods (c) Complements (d) Normal goods

   Answer: (b). For inferior goods income and demand move in opposite directions.

4. Q4. If the price of tea rises, the demand for coffee (a substitute) will
   (a) Remain unchanged (b) Fall and then rise (c) Rise (d) Fall

   Answer: (c). Consumers switch to the substitute.

5. Q5. A good for which the price effect is positive is called
   (a) Giffen good (b) Normal good (c) Public good (d) Substitute

   Answer: (a). For a Giffen good the income effect outweighs the substitution effect, so demand rises with price.

6. Q6. Demand that falls as more people consume the good, because buyers want to be exclusive, is the
   (a) Veblen effect (b) Substitution effect (c) Bandwagon effect (d) Snob effect

   Answer: (d). This is the snob effect.

7. Q7. The fashion-driven rise in demand because many others buy a good is called the
   (a) Bandwagon effect (b) Snob effect (c) Giffen paradox (d) Price effect

   Answer: (a). It is the bandwagon (demonstration) effect.

8. Q8. Conspicuous consumption of luxury goods whose demand rises with price is the
   (a) Giffen effect (b) Veblen effect (c) Engel effect (d) Income effect

   Answer: (b). Thorstein Veblen explained status goods.

9. Q9. Expectation of a future rise in the price of a good will, in the present period,
   (a) Not affect demand (b) Reduce supply only (c) Increase its demand (d) Reduce its demand

   Answer: (c). Buyers purchase more now to avoid the higher price.

10. Q10. A price ceiling set below the equilibrium price often leads to
    (a) Surplus (b) Commodity glut (c) Fall in demand (d) Shortage and black marketing

    Answer: (d). Quantity demanded exceeds quantity supplied, creating queues and black markets.

1. Q1. For a decline in price, total revenue declines if demand is
   (a) Unitary elastic (b) Inelastic (c) Elastic (d) Perfectly elastic

   Answer: (b). For inelastic demand, TR moves in the same direction as price.

2. Q2. For Q = 100 − 2P, the price elasticity of demand at P = 20 is
   (a) 0.33 (b) 0.67 (c) 1.00 (d) 2.00

   Answer: (b). Q = 60 and Ep = 2 × 20 ÷ 60 = 0.67.

3. Q3. Income rises by 10 per cent and the demand for a good rises by 15 per cent. The good is
   (a) Necessity (b) Inferior (c) Luxury (d) Giffen

   Answer: (c). Income elasticity is 1.5, which is greater than 1, so the good is a luxury.

4. Q4. A negative cross elasticity of demand shows that the goods are
   (a) Complements (b) Unrelated (c) Substitutes (d) Inferior

   Answer: (a). A rise in the price of one reduces the demand for the other.

5. Q5. If AR is ₹30 and price elasticity is 3, the marginal revenue is
   (a) ₹10 (b) ₹15 (c) ₹20 (d) ₹25

   Answer: (c). MR = AR × (e − 1) ÷ e = 30 × 2 ÷ 3 = ₹20.

6. Q6. When MR is zero, the price elasticity of demand is
   (a) Zero (b) Infinite (c) Greater than one (d) One

   Answer: (d). At MR = 0, TR is maximum and elasticity is unity.

7. Q7. On a straight-line demand curve, the elasticity at the midpoint is
   (a) Equal to 1 (b) Zero (c) Infinite (d) Greater than 1

   Answer: (a). Elasticity is 1 at the midpoint, more than 1 above it and less than 1 below it.

8. Q8. A rectangular hyperbola demand curve has
   (a) Elasticity that rises downward (b) Elasticity equal to 1 at every point (c) Zero elasticity (d) Infinite elasticity

   Answer: (b). Total outlay stays constant, so e = 1 throughout.

9. Q9. For supply function q = −20 + 5p, the elasticity of supply at p = 10 is
   (a) 1 (b) 1.67 (c) 2 (d) 3

   Answer: (b). q = 30, dq/dp = 5, so Es = 5 × 10 ÷ 30 = 1.67.

10. Q10. When price falls from ₹10 to ₹8 and quantity demanded rises from 100 to 120, the arc elasticity (absolute value) is about
    (a) 0.50 (b) 0.82 (c) 1.00 (d) 1.50

    Answer: (b). (20 ÷ 220) ÷ (2 ÷ 18) = 0.818.