Study material of Bcom(H) I MICRO ECONOMICS

B.Com (H) I - 101
MICRO ECONOMICS

Unit I
S. No Questions
1. Define economics. Explain briefly its nature and scope?
2. Explain the meaning, importance and limitations of micro economics?
3. Explain the basic economic problems of an economy. Why do they arise?
4. Distinguish between Cardinal and Ordinal aspects of utility? And explain the relationship between marginal utility and total utility?
5. Explain the Law of Diminishing Marginal Utility and mention its exceptions?
6. Explain with diagram the Law of Equi-marginal utility?
7. Explain the concept of consumer’s surplus. What are the difficulties in its measurement?
8. What are indifference curves? Explain their properties.

Unit II
S. No Questions
9. Explain the meaning, essential elements and types of demand?
10. Explain the law of demand with the help of a demand schedule and demand curve. Also point out the exception of the law?
11. Explain the concept of elasticity of Demand. What are the various concepts and types of elasticity of demand?
12. Explain the factors affecting elasticity of demand and also the practical importance of it?
13. Explain the factors affecting demand of a commodity?
14. What do you mean by supply? Explain the factors affecting supply?
15. Explain the Law of Supply with the help of a suitable example?
16. Explain the different concepts of elasticity of supply?







Unit III
S.No Questions
17. Explain the different concepts of cost?
18. Explain the different concepts of revenue?
19. What are the internal and external economies of large scale production?

Unit IV
S.No Questions
20. What do you mean by perfect competition? Discuss its characteristics. Explain how price and output is determined under perfect competition?
21. What do you mean by monopoly? Discuss its characteristics. Explain how price and output is determined under monopoly?
22. What do you mean by monopolistic competition? Discuss its characteristics. Explain how price and output is determined under monopolistic competition?
23. What do you mean by oligopoly? Discuss its characteristics. Explain how price and output is determined under oligopoly?




















Unit I
Question1. Define economics. Explain briefly its nature and scope?
Ans. Economics is the study of those activities of human beings, which are concerned, with the satisfaction of unlimited wants by using the limited resources. Adam Smith is regarded as the father of economics. He defined economics as the science of wealth, that is, he regarded economics as the science that studies the production and consumption of wealth.

Robbins’s definition of economics (economics is the science of scarcity): Robbins has defined economics as, “The science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” This definition seems to emphasize on three basic issues— ends, scarce means, and alternative applications. Here in this definition ‘ends’ refer to human wants. It is known that wants are unlimited as some of the wants are satisfied, others become important. This is unending process. Therefore, people prioritize their wants to satisfy the most important want first.

Scope of Economics
‘Scope’ means the sphere of study. We have to consider what Economics studies and what lies beyond it.
The scope of Economics will be brought out by discussing the following:
(a) The subject-matter of Economics.
(b) Whether Economics is a Science or an Art?
(c) If Economics is a science, whether it is a positive science or a normative science?
(d) Relation of economics with other sciences

(A) Subject matter of economics
The subject matter of economics is presently divided into two major branches. Micro Economics and Macro Economics. These two terms have now become of general use in economics.
Micro Economics
Micro economics studies the economics behaviour of individual economic units and individual economic variable. The unit of study in micro economics is the part of the economy, such as individual households, firms and industries. Thus, the study of economic behaviour of the households, firms and industries form the subject-matter of micro economics. In other words, micro economics is a microscopic study of the economy. Thus, micro-economics is concerned with the theories of product pricing, factor pricing and economic welfare.
Macro Economics
Macro Economics is the study of the economy as a whole. The unit of study in macroeconomics is the entire economy rather than a part of it and it deals with the problems faced by the entire economy. Thus, macroeconomics deals with the functioning of the economy as a whole. In other words, macroeconomics is the theory of national income, employment, aggregate consumption, savings and investment, general price level and economic growth.

(B) Nature of economics: In the nature of economics we may consider whether it is a science or an art. Science not only means the collection of facts but it also means that the facts are arranged in such a manner that they speak for themselves. It means that some laws are discovered through these facts. Thus science is a systematic body of knowledge concerning the relationship between causes and effects of a particular phenomenon.
Characteristics of a science
1 First of all the facts are observed. E.g. when price raise the demand contracts.
2 After the compilation of facts and having knowledge about the magnitude of a problem a law is framed keeping onto consideration the cause and effect of a fact. E.g. Law of demand
3 The final feature of science is by applying the scientific laws to real life. It is verified whether they are valid or not.
Thus from the above discussion it could be concluded that economics is a science. But some economists believe that it is not an exact science.
Arguments in favour of social science
1. Economics is a systematic study. It is the study of the interrelated activities like production consumption and exchange of wealth.
2. Laws of economics show a cause and effect relationship between them
3. Laws of economics are based on real experiences of life.
Thus economics is not a natural science. It is a social science.
Economics As A Positive Or A Normative Science
Positive science is that science which studies an accurate and true description of events as they happen. Thus it deals with what, how and why. Normative science is suggestive in nature. Normative science tells us what ought to be.
Economics as a positive science
1 Positive science is logical whereas normative science is emotional. Therefore it is more exacts it is based on the logic.
2 If economics studies only the realities of the real world then the chances of the disagreement are less, as the case would be if it studies both.
3 The economists cannot make the rational judgments if they try to analyze both what is and what ought to be.
Economics as a normative science
1. Economics would offer more meaningful conclusions if it gives suggestions too long with the facts.
2. Economics will be more useful if it is fruit bearing too along with the light bearing. Most of the people study economics for the fruits and not for the light merely.
3. If the economist synchronizes the analysis of economic problems with concrete economic policies he would save time. Else it would be difficult if one person finds the solutions and the other tries to justify those solutions.
Thus the argument can be put to an end only by saying that it is both the positive as well as normative science.
Arguments in favour of economics as an art
1. Economics offer a solution to the problems of human beings. It tells us how we can make the judicious use of our resources.
2. It is through the art that we can verify the economic laws. For example the law of demand
3. The doubts can be removed by dividing the economics into science as well as an art.
Thus we can say that economics is a science as well as an art.

(C) Relation of Economics with Other Sciences
Economics has relation with almost all other sciences. All sciences have been developed by man for the benefit of mankind. As a science, which is primarily concerned with man’s welfare, Economics freely makes use of the other sciences in its study. It uses, in its own reasoning, the conclusions at which the other sciences may have reached. But its relation with social sciences like Politics, History and Ethics is the closest. Let us consider this relationship.
Economics and Politics: Economics and Politics are very closely mixed up these days. All political events have their roots in economic causes. All political problems are economic in nature. If you follow discussions in the legislature, you will find that most of the time of the legislature is taken up by economic matters.
Political institutions also affect economic conditions, and vice versa. Dictatorship moulds economic conditions in a different manner from a democracy. Foreign rule in India was largely responsible for Indian poverty. Thus, there is a very close connection between Economics and Politics.
Economics and History: Economics makes use of History in understanding the background of the present-day economic problems. History is also useful in establishing or verifying economic theories and laws. But History is incomplete unless it discusses the economic condition of man. History must devote its attention to the discussion of the economic condition of the people. It does not merely tell a tale of kings. Thus, Economics without History has no root; History without Economics has no fruit.

Economics and Ethics: Ethics is a science of what ought to be. It tells us whether a thing is right or wrong. Now ethical or moral considerations govern all economic activity. The economist cannot justify immoral activities. Some modern, economists (e.g., Robbins), however, think that Economics is a pure science arid as such it is not concerned with right or wrong. It is said to concern itself merely with means, and ends lie outside its scope. It is regarded as neutral as regards ends. The ends may be good or the ends may be bad, Economics is not concerned.

Question2. Explain the meaning, importance and limitations of micro economics?
Ans. The word micro has been derived from the Greek word mikros which means small. Microeconomics is the study of economic actions of individuals and small groups of individuals. It includes particular households, particular firms, particular industries, particular commodities and individual prices.
Assumptions
1. All individuals behave in a rational manner.
2. There is free flow of valid information about demand and supply, prices and other market conditions.
3. Goods and labour efforts are divisible.
4. It is based on the assumption of full employment and laissez faire.
5. It is based on the assumption ‘ceteris paribus’ which means other things being equal or constant.

Uses / Importance / Advantages of Microeconomics
1. Individual Behaviour Analysis: Micro economics studies behaviour of individual consumer or producer in a particular situation.
2. Resource Allocation: Resources are already scare i.e less in quantity. Micro economics helps in proper allocation and utilization of resources to produce various types of goods and services.
3. Price Mechanization: Micro economics decides prices of various goods and services on the basis of 'Demand-Supply Analysis'.
4. Economic Policy: Micro economics helps in formulating various economic policies and economic plans to promote all round economic development.
5. Free Enterprise Economy: Micro economics explain operating of a free enterprise economy where individual has freedom to take his own economic decisions.
6. Public Finance: It helps the government in fixing the tax rate and the type of tax as well as the amount of tax to be charged to the buyer and the seller.
7. Foreign Trade: It helps in explaining and fixing international trade and tariff rules, causes of disequilibrium in BOP, effects of factors deciding exchange rate, etc.
8. Social Welfare: It not only analyse economic conditions but also studies the social needs under different market conditions like monopoly, oligopoly, etc.

Disadvantages / Limitations of Microeconomics
1. Unrealistic Assumptions: Micro economics is based on unrealistic assumptions, especially in case of full employment assumption which does not exist practically. Even behaviour of one individual cannot be generalized as the behaviour of all.
2. Inadequate Data: Micro economics is based on the information dealing with individual behaviour, individual customers. Hence, it is difficult to get correct information. So because of incorrect data Micro Economics may provide inaccurate results.
3. Ceteris Paribus: It assumes that all other things being equal (same) but actually it is not so.

Question3. Explain the basic economic problems of an economy. Why do they arise?
Ans. An economic problem is basically the problem of choice which arises because of scarcity of resources. Human wants are unlimited but means to satisfy them are limited. Therefore, all human wants cannot be satisfied with limited means. Wants differ in intensity and limited resources have alternative uses. In such a background, every consumer tries to satisfy his maximum wants. Therefore, one has to choose as to what goods one should consume and in what quantity. Economic problem arises the mo-ment problem of choice arises. Actually speaking, economic problem is basically the problem of choice.
Due to scarcity of resources, the problem which arises before an individual consumer also arises collectively before an economy. On account of scarcity of resources, an economy has to choose between the following:
(i) Which goods should be produced and in what quantity?
(ii) What technique should be adopted for production?
(iii) For whom goods should be produced?
These three problems are known as the central problems or the basic problems of an economy. This is so because all other economic problems cluster around these problems. These problems arise in all economies, whether it is socialist economy like that of China or a capitalist economy like that of America.
From the above analysis, it is clear that an economic problem arises because of the following causes:
(i) Human wants are unlimited: Human wants are unlimited. After the satisfaction of one want, another want arises. There is a difference in the intensity of wants also. Thus, there is an unending circle of wants, when they arise, are satisfied and arise again.
(ii) Limited resources: Means are limited for the satisfaction of wants. Scarcity of resources is a relative term, for satisfying a particular human want, resources can be in abundance, but for the satisfac¬tion of all the wants, resources are scarce. This is called relative scarcity of resources where resources are scarce in relation to the wants they are expected to satisfy.
(iii) Alternative uses of resources: Limited resources can be put to many alternative uses. For example, electricity can be used for domestic light as well as for industrial power.
(iv) Problem of choice: Human wants are unlimited but resources to satisfy them are limited and this gives rise to the problem of choice, such as what should be produced and how and for whom production should be done. The problem of choice is the economic problem. Had resources also been unlimited like human wants, there would have been no problem of choice and hence no economic problem. In other words, scarcity of resources is the mother of all economic problems. In short, "Multi¬plicity of wants and scarcity of means are the two foundation stones on which the whole edifice of economic problems stands."
These 3 problems are studied under the problem of ‘Allocation of Resources’.
Allocation of Resources:
Allocation of resources refers to the problem of assigning the scarce resources in such a manner so that maximum wants of the society are fulfilled. As resources are limited in relation to the unlimited wants, it is important to economize their use and utilize them in the most efficient manner.
The problem of allocation of resources is studied under 3 heads:
(1) What to produce;
(2) How to produce;
(3) For whom to produce.
In nutshell, an economy has to allocate its resources and choose from different potential bundles of goods (What to produce), select from different techniques of production (How to produce), and decide in the end, who will consume the goods (For whom to produce).
1. What to Produce:
This problem involves selection of goods and services to be produced and the quantity to be produced of each selected commodity. Every economy has limited resources and thus, cannot produce all the goods. More of one good or service usually means less of others.
For example, production of more sugar is possible only by reducing the production of other goods. Production of more war goods is possible only by reducing the production of civil goods. So, on the basis of the importance of various goods, an economy has to decide which goods should be produced and in what quantities. This is a problem of allocation of resources among different goods.
The problem of ‘What to produce’ has two aspects:
(i) What possible commodities to produce: An economy has to decide, which consumer goods (rice, wheat, clothes, etc.) and which of the capital goods (machinery, equipment’s, etc.) are to be produced. In the same way, economy has to make a choice between civil goods (bread, butter, etc.) and war goods (guns, tanks, etc.).
(ii) How much to produce: After deciding the goods to be produced, economy has to decide the quantity of each commodity that is selected. It means, if involves a decision regarding the quantity to be produced, of consumer and capital goods, civil and war goods and so on.
2. How to Produce:
This problem refers to selection of technique to be used for production of goods and services. A good can be produced using different techniques of production. By ‘technique’, we mean which particular combination of inputs to be used. Generally, techniques are classified as: Labour intensive techniques (LIT) and Capital intensive techniques (CIT).
i. In Labour intensive technique, more labour and less capital (in the form of machines, etc.) is used.
ii. In Capital intensive technique, there is more capital and less labour utilization.
For example, textiles can be produced either with a lot of labour and a little capital or with less labour and more capital. Availability of factors and their relative prices helps in determining the technique to be used. The selection of technique is made with a view to achieve the objective of raising the standard of living of people and to provide employment to everyone. For example, in India, LIT is preferred due to abundance of labour, whereas, countries like U.S.A., England, etc. prefer CIT due to shortage of labour and abundance of capital.
3. For Whom to Produce:
This problem refers to selection of the category of people who will ultimately consume the goods, i.e. whether to produce goods for more poor and less rich or more rich and less poor. Since resources are scarce in every economy, no society can satisfy all the wants of its people. Thus, a problem of choice arises.
Goods are produced for those people who have the paying capacity. The capacity of people to pay for goods depends upon their level of income. It means, this problem is concerned with distribution of income among the factors of production (land, labour, capital and enterprise), who contribute in the production process.
The problem can be categorised under two main heads:
(i) Personal Distribution:
It means how national income of an economy is distributed among different groups of people.
(ii) Functional Distribution:
It involves deciding the share of different factors of production in the total national product of the country. Guiding Principle of ‘For whom to Produce’: Ensure that urgent wants of each productive factor are fulfilled to the maximum possible extent.
It must be noted that in addition to ‘Allocation of Resources’, there are two more Central Problems:
(i) Problem of fuller and efficient utilisation of resources: Resources are scarce and it is important to use them as efficiently as possible. Thus, it is essential to know if the production and distribution of national product made by an economy is maximally efficient. The production becomes efficient only if the productive resources are utilized in such a way that any reallocation does not produce more of one good without reducing the output of any other good.
(ii) Problem of Growth of resources: If productive capacity grows, an economy can produce progressively more goods, which raises the standard of living. The increase in productive capacity of an economy is called economic growth.
Question4. Distinguish between Cardinal and Ordinal aspects of utility? And explain the relationship between marginal utility and total utility?
Ans. The simple meaning of ‘utility’ is ‘usefulness’. In economics utility is the capacity of a commodity to satisfy human wants.
Utility is the quality in goods to satisfy human wants. Thus, it is said that “Wants satisfying capacity of goods or services is called Utility.” In this way utility is measured in terms of money and it is relative. A consumer buys or demands a particular commodity he derives some benefit from its use. He feels that his given want is satisfied by the use or consumption of the commodity purchased. Utility is the basis of consumer demand. A consumer thinks about his demand for a commodity on the basis of utility derived from the commodity. Utility depends upon the intensity of want. When a want is unsatisfied or more intense, there is a greater urge to demand a particular commodity which satisfies a given want. In modern time utility has been called as ‘expected satisfaction.’ Expected satisfaction may be less or equal to or more than the real satisfaction.
Characteristics of Utility:
The following are the important characteristic features of utility:
1. Utility has no Ethical or Moral Significance:
A commodity which satisfies any type of want, whether moral or immoral, socially desirable or undesirable, has utility, i.e., a knife has utility as a household appliance to a housewife, but it has also a utility to a killer for stabbing some body.
2. Utility is Psychological:
Utility of a commodity depends on a consumer’s mental attitude and assessment regarding its power to satisfy his particular want. Thus, utility of a commodity may differ from person to person. Psychologically, every consumer has his likes and dislikes and everyone determines his own level of satisfaction. For instance:  A consumer who is fond of apples may find a high utility in apples in comparison to the consumer who has no liking for apples. Similarly a strictly vegetarian person has no utility for mutton or chicken.
3. Utility is always Individual and Relative:
Utility of a commodity varies in different situations in relation to time and place. Even the same consumer may derive a higher or lower utility for the same commodity at different times and different places. For example—a person may find more utility in woolen clothes during the winter than in summer or at Kashmir than at Mumbai.
4. Utility is not Necessarily Equated with Usefulness:
Utility simply means the ability to satisfy a want. A commodity may have utility but it may not be useful to the consumer. For instance—A cigarette has utility to the smoker but it is injurious to his health. However, demand for a commodity depends on its utility rather than its usefulness. Thus many commodities like opium liquor, cigarettes etc. have demand because of utility, even though, they are harmful to human beings.
5. Utility cannot be Measured Objectively:
Utility being a subjective phenomenon or feeling of a consumer cannot be expressed in numerical terms. So utility cannot be measured cardinally or numerically. It cannot be measured directly in a precise manner. Professor Marshall has however, unrealistically assumed cardinal measurement of utility in his analysis of demand.
6. Utility Depends on the Intensity of Want:
Utility is the function of intensity of want. A want which is unsatisfied and greatly intense will imply a high utility for the commodity concerned to a person. But when a wan is satisfied in the process of consumption it tends to experience a lesser utility of the commodity than before. Such an experience is very common and it is described as a tendency of diminishing utility experienced with an increase in consumption of a commodity. In other words, the more of a thing we have, the less we want it.
7. Utility is Different from Pleasure:
A commodity may have utility but its consump¬tion may not give any pleasure to the consumer, e.g., medicine or an injection. An injection or medicinal tablet gives no pleasure, but it is necessary for the patient.
8. Utility is also Distinct from Satisfaction:
Utility and satisfaction, both are though inter-related but they have not been considered as the same in a strict sense.
Different Types of Utility:
In economics, production refers to the creation of utilities in several ways.
Thus, there are following types of utility:
1. Form Utility:
This utility is created by changing the form or shape of the materials. For example—A cabinet turned out from steel furniture made of wood and so on. Basically, from utility is created by the manufacturing of goods.
2. Place Utility:
This utility is created by transporting goods from one place to another. Thus, in marketing goods from the factory to the market place, place utility is created. Similarly, when food-grains are shifted from farms to the city market by the grain merchants, place utility is created.
Transport services are basically involved in the creation of place utility. In retail trade or distribution services too, place utility is created. Similarly, fisheries and mining also imply the creation of place utility. Place utility of a commodity is always more in an area of scarcity than in an area of scarcity than in an area of abundance e.g., Kashmir apples are more popular and fetch higher prices in Pune than in Srinagar on account of such place utility
3. Time Utility:
Storing, hoarding and preserving certain goods over a period of time may lead to the creation of time utility for such goods e.g., by hoarding or storing food-grains at the time of a bumper harvest and releasing their stocks for sale at the time of scarcity, traders derive the advantage of time utility and thereby fetch higher prices for food-grains. Utility of a commodity is always more at the time of scarcity. Trading essentially involves the creation of time utility.
4. Service Utility:
This utility is created in rendering personal services to the customers by various professionals, such as lawyers, doctors, teachers, bankers, actors etc.
Can Utility be Measured?
Utility is a psychological concept. This is different for different people. Therefore, it cannot be measured directly. Professor Marshall has said that “Utility can be measured and its measuring rod is ‘money. The price which we are ready to pay for an article is practically its price. Nobody will be prepared to pay more than the utility which we derive from the article.


For example:
If I am ready to pay Rs. 1500 for a watch and Rs. 2,000 for a Radio, then I can say that I derive utility from that watch up to the value of Rs. 1500; and from Radio up to the value of Rs. 2,000. “The inference which we can draw from the above example is that the price which we pay for any article is the utility which we derive from that article.” But Prof. Hicks, Allen and Pareto have not supported Marshall’s view of measuring utility.
They are of this opinion that measuring of utility is not possible because of the following reasons:
(i) Utility is personal, psychological and abstract view which cannot be measured like goods.
(ii) Utility is different for different people. Utility is always changeable and it changes according to time and place. Therefore, it is difficult to measure such thing that is of changeable nature.
(iii) Further, measuring material ‘money is not static. Value of money always changes; therefore, correct measurement is not possible.
Kinds of Utility:
Utility are of three kinds:
(i) Marginal Utility,
(ii) Total Utility,
(iii) Average Utility
(i) Marginal Utility:
Definition:
Marginal utility is the utility derived from the last or marginal unit of consumption. It refers to the additional utility derived from an extra unit of the given commodity purchased, acquired or consumed by the consumer. It is the net addition to total utility made by the utility of the additional or extra units of the commodity in its total stock. It has been said—as the last unit in the given total stock of a commodity.
According to Prof. Boulding—”The marginal utility of any quantity of a commodity is the increase in total utility which results from a unit increase in its consumption.”
For example:
Suppose Mr. Shanker is consuming bread and he takes five breads. By taking first unit he derives utility up to 20; second unit 16; third unit 12; fourth unit 8 and from fifth 2. In this example the marginal unit is fifth bread and the marginal utility derived is 2. If we will consume only four bread then the marginal unit will be fourth bread and utility will be 8.
Kinds of Marginal Utility—Marginal utility is of three kinds:
(i) Positive Marginal Utility,
(ii) Zero Marginal Utility,
(iii) Negative Marginal Utility.
It is a matter of general experience that if a man is consuming particular goods, then receiving of next unit of goods reduces the utilities of the goods and ultimately a situation comes when the utility given by the goods become zero and if the use of the goods still continues, then the next unit will give dis-utility. In other words it can be said that we will derive “negative utility”.
This can be studied better by the following table:

From the table given above it is clear that up to the consumption of the fifth bread we receive positive utility; 6th unit is the unit of full satisfaction i.e., Utility derive from that unit is zero. From 7th unit the utility received will be negative utility. The table can be represented in shape of diagram as follows: In diagram No. 1 OX axis (line) shows unit of bread and OY line shows the Marginal Utility received. From the figure it is clear that from the first unit of bread utility received are 20 which have been shown on the top of the line.

Similarly 2, 3, 4, 5 Unit of bread’s utility is 16, 12, 8, 4 respectively All these have been shown on OX line which shows positive marginal utility. Utility of the sixth bread is zero and that of the seventh bread is negative and negative rectangle has been shown below OX line.
Zero Utility: When the consumption of a unit of a commodity makes no addition to the total utility, then it is the point of Zero Utility. It is thus seen that the total utility is maximum when the Marginal Utility is zero.
Negative Utility: Negative Utility is that utility where if the consumption of a commodity is carried to excess, then instead of giving any satisfaction, it may cause dis-satisfaction. The utility is such case is negative.
(ii) Total Utility:
Total Utility is the utility from all units of consumption. According to Mayers—”Total Utility is the sum of the marginal utilities associated with the consumption of the successive units.” For example: Suppose, a man consumes five breads at a time. He derives from first bread 20 units of satisfaction from 16, from third 12, from fourth 8 and from fifth 4 i.e., total 60 units.
This can be shown by the following table:

(iii) Average Utility:
Average Utility is that utility in which the total unit of consumption of goods is divided by number of Total Units. The Quotient is known as Average Utility. For example—If the Total Utility of 4 bread is 40, then the average utility of 3 bread will be 12 if the Total Utility of 3 bread is 36 i.e., (36 ÷ 3 = 12).
The following table will explain the point clearly:

It is clear from the above table that by the increasing use of any article Marginal and Average Utility reduces gradually and Total Utility increases only up to that point where the Marginal Utility comes to zero.
Relation between Total Utility and Marginal Utility:
There is a close relationship between Total Utility and Marginal Utility. As there is increase in the unit of a particular commodity, the Marginal Utility goes on diminishing and Total Utility goes on increasing. Total Utility goes on increasing up to that extent till the Marginal Utility becomes Zero. When Marginal Utility is zero Total Utility is maximum. After zero, Marginal Utility comes to negative and the result is that Total Utility starts reducing.
 (i) When Marginal Utility is reducing, the Total Utility will increase so long Marginal Utility does not become zero.
(ii) When Marginal Utility becomes zero; Total Utility will be maximum.
(iii) After zero when Marginal Utility is negative then there is reduction in Total Utility.
Relationship between Marginal Utility and Total Utility can be studied from the following:

From the above table it is clear that up to fourth bread Marginal Utility is positive and there is no regular increase in the Total Utility. And on fifth bread the Marginal Utility is zero and on this point the increase in Total Utility stops. This is point of safety. If after fifth bread, extra bread is consumed then there will be dis-utility and Marginal Utility will be negative. Sixth and seventh bread shows dis-utility.

In both the diagrams OX line shows bread. In diagram No. 1 OY line shows Marginal Utility and is diagram No. 2 OY line shows Total Utility. As the number of bread increases Marginal Utility goes on diminishing and Total Utility goes on increasing:
(1) Marginal Utility goes on diminishing with the consumption of every additional unit of bread.
(2) Total Utility goes on increasing with the consumption of every additional unit but at a diminishing rate.
(3) Marginal Utility is equal to the increase in the Total Utility. Total Utility is the sum total of the Marginal Utilities derived from all the units consumed.
(4) When Marginal Utility becomes 0, total utility does not increase.
(5) When Marginal Utility becomes negative, Total Utility decreases.
(6) Increase in Total Utility depends on Marginal Utility.
(7) Since Marginal Utility diminishes, Total Utility increases at a diminishing rate.
(8) When Marginal Utility is Zero, Total Utility is maximum.
(9) When Marginal Utility is negative, Total Utility declines.

Question5. Explain the Law of Diminishing Marginal Utility and mention its exceptions?
Ans. In the words of Marshall “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with the every increase in the stock that he already has.” It means that more one has of anything; less important to him is any one unit of it.
The Law of Diminishing Marginal Utility, as defined above, is derived from one of the characteristics of human wants. It is observed that although a person cannot satisfy all of his wants, he can satisfy one of these provided he has the means to do it. As he gets more and more of a thing (say, an apple or tea), his intensity of desire for that thing gradually diminishes, indicating that additional utility decreases as its total stock increases. As the consumption of a commodity increases the consumer’s TU also increases. He gets greater satisfaction as he eats more and more chocolates.
But as the consumption of chocolates increases his desire or inclination for every extra unit will gradually fall. In other words, his psychological capacity to appreciate every extra unit will gradually diminish. So every extra unit will add less and less to his total satisfaction. In other words, the rate of increase in TU will fall. In our example the second chocolate gives less satisfaction than the first one.
And a sixth one begins to make the consumer feel ill—total satisfaction from the assumption consumption of chocolate falls. From this emerges one famous law of economics, known as the Law of Diminishing Marginal Utility.
This law can be stated thus:
“The more one consumes of one commodity during any period of time the less satisfaction one gets from consuming an additional unit of it”.
As one adds to his (her) weekly consumption of chocolate, each additional unit adds to his TU or total satisfaction, but each unit adds less utility than the one before it.
Utility schedule presented in Table can be represented diagrammatically. In Fig.  Mr. X is seen to add to his total satisfaction as he increases weekly purchase of chocolate until he is buying 5 units (bars) per day. A 6th bar per week gives him disutility or dissatis¬faction.
Fig. 4.2 (which is derived from Fig. 4.1) illustrates the Law of Diminishing MU. This indicates that the additions to TU of chocolate became less as more bars per day are purchased. It is clear that the MU of the six bars per day is negative, i.e., the sixth bar causes a decrease in TU.


Assumptions of the Law:
The Law of Diminishing Marginal Utility is based on the assumptions:
1. The utility that a consumer gets can be measured and expressed in numbers (utils). Moreover, the units of the commodity must be properly defined.
2. The maximum price a consumer is ready to pay for the commodity depends on its marginal utility to him.
3. The taste and preference of the consumer remain unchanged during the period of purchases.
4. The initial amount of consumption is sufficient to give the consumer full satis¬faction.
Causes of Diminishing Marginal Utility:
Three important causes of the diminishing marginal utility are:
1. Satisfaction of a Particular Want: Although human wants are unlimited, a particular want is limited. So it can be satisfied. As a person consumes more and more of a commodity, his indication becomes less and less. So his marginal utility from the successive units becomes gradually smaller. It means that too many units of a commodity bring complete satisfaction.
2. Introspection: The validity of the law can be established through introspection (i.e., an examination of one’s own thought or mental reaction). The classical economists used to look into their minds for their own psychological reaction to the extra consumption of a particular thing (say, an apple, an ice-cream, a chocolate, etc.) and tested the truth of the law.
3. Less Important Uses of Additional Quantities: Furthermore, marginal utility diminishes because a person, having several units of a commodity capable of alternative uses, puts one unit to its most important use and the additional units to the successively less important uses.

Limitations of the Law:
The Law may not operate in certain circumstances and in those exceptional cases the marginal utility of a thing may increase for some time.



Six important exceptional cases to the law are:
1. Change of Taste and Preferences:
If a consumer’s taste changes so that he likes a commodity more, the marginal utility of any quantity of that commodity rises. A person may not have initially any interest in eating egg roll. But after taking one egg roll, he may form a good taste for it and may get a great satisfaction from the 2nd or the 3rd one.
2. Inadequate Initial Consumption:
If a person consumes a very small quantity of a particular thing at the initial stage, he may not get full satisfaction from it. In such a case his satisfaction will be greater from the second unit. Thus, coke in a small glass may not quench one’s thirst at all, as such, the satisfaction from the second one is likely to be greater.
3. Emotional or Fancy Buying:
The marginal utility of a thing does not diminish when a buyer purchases it in a larger quantity out of sheer emotion or fancy. An example is the art work of a known painter or a rare book of a dead author.
4. Miser’s Collections or Hobby Collections:
A miser gets a greater satisfaction from the additional collection of money. Similarly, a person gets more and more satisfaction as his hobby-collections (e.g., stamps, coins, works of art, etc.) increase gradually.
5. Consumption at Different Time Periods:
If a person consumes different units of a particular thing at different times, the marginal utility from the successive units is not likely to be smaller. Thus, if he consumes the 1st ice-cream in the morning, the 2nd in the afternoon and the 3rd at night, the marginal utility may not diminish.
6. Stock with Other Persons:
Sometimes the utility of a thing depends on its stock with the others. If in a locality all but one have two cars, the second car to that man will not yield diminishing utility.
Question6. Explain with diagram the Law of Equi-marginal utility?
Ans. All human activities are directly connected towards satisfaction of human wants. The consumer wants to get maximum satisfaction of his wants. The wants are unlimited and the means to satisfy them are limited. Thus, the limited means are used in such a manner that the consumer gets maximum satisfaction.
To explain this point, the law of Equi-marginal Utility has been given by Marshall. This law is one of the basic principles of Economics. It is also known as the Law of Substitution and the Law of Maximum Satisfaction. This concept is also known as “The Second Law of Gossen”.
Assumptions of the Law of Equi-Marginal Utility:
 (1) Consumer is a rational being, it means he wants to get maximum satisfaction with the limited means which he has got, and therefore, he spends his money very cautiously and after examining all Pros and Cons of his expenditure.
(2) It has been considered essential to measure the utility in terms of money.
(3) There must be perfect competition in the market.
(4) Goods must be divided as per need and requirement.
(5) Marginal utility of money must be stable.
(6) There need not be any change in the income, taste, fashion etc. in the make this law applicable.
(7) Consumer should spend his income gradually and in small quantity.
(8) Price of the goods should be stable and the consumer should know available.
Explanation of the Law of Equi-Marginal Utility:
In order to get the maximum satisfaction out of the funds which the man has, he carefully weigh the satisfaction which he derives from each rupee which he has spent. If he finds that a rupee spend on any one item has greater utility than the other he prefers to spend on the former item till the utilities derived from the last rupee spent in the two cases are equal.
In other-words, he substitutes some units of a commodity of greater utility for some units of less utility. The result of this satisfaction will be that the marginal utility of the former will fall and that of the latter will rise till the two marginal utilities are equalised. Thus, the law is called the Law of Substitution or the Law of Equi arginal Utility.
This can be explained by the following table:

Let us suppose that there are two commodities apples and mangoes which are to be purchased and have fourteen rupees to spend on this purchase. We have spend six rupees on mangoes and eight rupees on apples. What is the result? The utility of the 3rd unit of mangoes is 12 and that of 4th unit of apples is 4.
In this table, the marginal utility of mangoes is higher we would purchase more of mangoes and less of apples. Further, let us substitute one mango for one apple, so that we purchase eight mangoes and six apples. Now, the marginal utility of both i.e., mangoes and apples is the same i.e., 8. This arrangement will yield maximum satisfaction.
The total utility of 8 mangoes would be 20 + 16 + 12 + 8 = 56 and six apples 16 + 12 + 8 = 36 which gives us a total utility of 56 + 36 = 92. The satisfaction given by 8 mangoes and 6 applies at one rupee each is greater than could be obtained by any other combination of apples and mangoes. In no other case does this utility will be 92.
From this example the conclusion can be drawn will be that we can obtain maximum satisfaction when we equalize marginal utilities by substituting the more useful for the less useful commodity, this can be shown with the help of a diagram as follows:
Diagrammatic Representation of the Law of Equi-Marginal Utility:
In the two figures given below, OX and OY are the two axis. On X-axis OX measures money and on Y-axis marginal utilities. Suppose, a person has 14 rupees to spend an apples and mangoes whose diminishing marginal utilities are shown by the two curves AQ and OS respectively.
The consumer will gain maximum satisfaction if he spends OM money (i.e., rupees six) on apples and OM’ money (8 rupees) on mangoes because here the marginal utilities of the two are equal i.e., (PM = P’M’). Any other way of measurement may give less total satisfaction.

In this example the purchase spends MN money (one rupee) more on apples and the same amount of money; N ‘M’ (= MN) less on oranges. The diagram shows a loss of utility represented by the shaded are LN’M’F and a gain of PMNE utility.
As MN = N’M’ and PM = P ‘M’, it is proved that the figure LN ‘M’ P’ (loss of utility from reduced consumption or mangoes) is bigger than PMNE (gain of utility from increased consumption of apples). So, the total utility of this new-combination is less.
In the end it can be said that no other combinations of apples and mangoes gives as great, a satisfaction to the consumer as when PM = P ‘M’, i.e., where the marginal utilities of apples and mangoes purchased are equal, with given resources which can be obtained at our command.
Practical Importance of the Law of Equi-Marginal Utility or Application of This Law in Different Fields:
In Economics the law of Equi-Marginal Utility has got wide-importance. It will not be improper to say that it is “Backbone of Economics”. This law is applicable in all the fields of Economics therefore it has been called as “Universal Law”. Regarding this Law Prof. Marshall has said—“The application of the principle of substitution extends over almost every field of economic enquiry.”
This law is used in different fields of economics as follows:
1. Importance in the Field of Consumption:
It has been seen that a wise consumer always try to follow this law while he is arranging to incur expenditure. His expenditure is so distributed that the same price measures equal utilities at the margin of different purchases and different expenses.
It is human nature that every man tries to spend his income in such a way which yields him the greatest satisfaction. This he will be able to do, if he spends his money in such a manner as to obtain equal satisfaction from the marginal units of money spent on the various commodities he purchases.
2. Importance in the Field of Production:
The name of this law in the field of production is “Law of Equimarginal Return”. This law is of great importance in the field of production. In production producer wants maximum of ‘Net Profit’. Therefore he should substitute one factor for another, so as to have the most economical expense. For this purpose, he will substitute labour for machinery and machinery for labour, so that the marginal utility or marginal productivity of the two is equalised in this way and he will get the most economical combination of production.
3. Importance in the Field of Exchange:
By exchange we mean substitute of one thing for another. This law is also applicable in exchange when we sell a commodity say, rice, we get money. With the help of this money we can buy another commodity say, wheat. In this way we can substitute rice for wheat.
4. Importance in the Field of Distribution:
In the field of distribution the principle of marginal productivity applies. And as per the principle of marginal productivity the share of each factor of production i.e., land, labour, capital and organisation is determined and applied in the completion of the activities.
Here, the use of each factor is pushed up to a point where its marginal product is equal to the marginal product of every other factor. This is the activity of substituting one factor for the other and in distribution the various factors of activities are taken together.
5. Importance in the Field of Public Finance:
This law is helpful in guiding the government when the activities of public expenditure were taken up. As per the law the Government must cut down all wasteful expenditure where the return is not proportionate and proper.
He should therefore, concentrate its resources on more productive, suitable and more beneficial expenditure. Further, the public revenue is spent on such heads, so that the government may secure maximum welfare for the community.
6. Helpful in Influencing Prices:
This law of substitution influences prices in the market. When the price of a commodity goes up it becomes scarce in the market then in that case we substitute for the thing, some other things which are less scarce. The price of the commodity automatically comes down.
Modern Interpretation of the Law, Law of Proportionality:
Modern economists have discussed the Law of Equi-marginal Utility in a different and new way. The new methods and systems have been given the name—”Law of Proportionality”. Their view is that we can get maximum satisfaction from a commodity only when there is perfect co-relation and co-ordination between the price of each commodity and its Marginal Utility.
This can be shown in the following manner:

If there is rise in the price of the commodity A people will start the use of commodity B and if there is rise in the price of B people will start the use of commodity C and in the end such a situation will come where the demand and supply will be in proportion of all the three goods and will be equal and here the situation of maximum satisfaction will come up. Because of this approach and opinion of the modern economists there will be no need to measure the utility of each unit of the commodity.
Our interest will be to keep the price of the commodity and its marginal utility in the same proportion. But regarding this law one important thing to note is that we cannot measure the profit and loss derive from the Law of Substitution. So the above equation will hold good, if the consumer’s tastes and other circumstances remain unchanged and the commodities are perfectly divisible.
Criticisms
1. Ignorance of consumers: His satisfaction may not be the maximum because the marginal utilities from his expenditure cannot be equalised due to ignorance. Therefore, on account of his ignorance the consumer may not know where the utility is greater and where it is less.
2. Indivisibility of Commodities: Prof. Boulding has said that for the operation of this law the goods must be of divisible nature but people in their normal life consume such commodities which are of indivisible nature, therefore, this rule may not apply. For example—Use of Radio, Watch, Motor Car etc.
3. Durability of the Goods: Consumption of some goods is for long period where it becomes difficult to find. Out its marginal utility. For example— Use of Refrigerator, Motor Cycle etc.
4. Effect of Customs and Fashions: Sometimes a consumer may be in the strong clutches of custom or is a slave of modern fashion. In that case, he will not be able to derive maximum satisfaction out of his expenditure, because he cannot give up the consumption of such commodities.
5. Fixed Proportion of Consumption: Again, there are certain goods whose consump¬tion is fixed portion is possible. It cannot be either increased or decreased. For example—Consumption of milk, tea, bread or butter etc. Consumer can use these commodities only up to proper quantity. Hence, this law cannot be active or can operate actively.
6. Control or Rationing of Consumption Goods: Sometimes, government puts rationing or control over the consumption of certain commodities, then in that case the desire of the consumer is to use more goods but he cannot use it due to control or rationing.
7. Frequent Changes in the Price of the Commodity: Frequent changes in the prices of different goods render the enforcement of the law very difficult. The consumer may not be able to make the necessary adjustments in his expenditure in a constantly changing price situation.
8. Consumer’s Indefinite Budget Period: Majority of the consumer do not prepare their family budget they on meeting expense as per their requirements. In such cases it becomes difficult to know the activeness or the use of Equimarginal Utility.
9. When the Resources are Unlimited: The law has obviously no place where the resources are unlimited. For example—In the case of the free gift of nature. In such cases, there is no need of diverting expenditure from one direction to another.
10. Incompetent Organizer of Business: It has been seen that an incompetent organizer of business will fail to achieve the best results from the units of land, labour and capital that he employs. This is because he may not be able to divert expenditure to more profitable channels from the less profitable ones.
11. Economists are of this Opinion that Consumers are not so rational as this Law Considers: Economists have said that man is a rational being but he is not as rational as under this law it has been presumed. He cannot analyse or can make difference the amount of utility which he is going to derive.
In this connection, Prof. Chapman has said—”We are of course, not compelled to distribute our income according to the Law of Substitution or Equimarginal expenditure as a stone thrown in the air is compelled, in a sense to fall back to the earth but as a matter of fact, we do so in a certain rough fashion because we are rational.”

Question7. Explain the concept of consumer’s surplus. What are the difficulties in its measurement?
Ans. Consumer’s Surplus is one of the most important concepts in Economics. It was expounded by Alfred Marshall. In our daily expenditure, we often find that the price we pay for a commodity is usually less than the satisfaction we derive from its consumption. In our own mind, sometimes we are prepared to pay much more for a commodity than we actually have to pay.
Consumer’s surplus is the excess of what we are prepared to pay over what we actually pay for a commodity. It is the difference between what we are prepared to pay and what we actually pay. Thus, Consumer’s surplus = what one is prepared to pay minus what one actually pays.

We can put it in the form of an equation thus:
Consumer’s Surplus = Total Utility – Total Amount Spent.
Explanation:

It is assumed in the above table that the price of oranges in the market is 50 P per orange. The consumer will purchase as many oranges as make his marginal utility equal to the price. Thus he will purchase 5 oranges and pay for each 50 P. In this way he will spend in all Rs. 2.50P. But the total utility of the 5 organs is equal to 690 P He thus gets a consumer’s surplus equal to (690 – 250) =440P.
The consumer’s surplus can also be found from the fourth column of the table. The utility of the first unit of oranges to the consumer is equal to 200 P.; therefore he would be prepared to pay 200 P. for it rather than go without it. But he pays for the first orange only 50 p. because the price of an orange in the market is 50 p.
Therefore, from the first unit, the consumer gets consumer’s surplus equal to (200 —50) = 150P, which is written m the fourth column. Similarly, the utility of the second orange is equal to ISO, while the consumer pays 50P. For it and therefore obtains (180 — 50) = 130P as consumer’s surplus. From the fifth unit the consumer derives satisfaction equal to 50 and he also pays 50P for it. Thus there is no consumer’s surplus from the fifth unit. Now if we add the figures in the 4th column, we shall get the total consumer’s surplus equal to 440P.
Diagrammatic Representation:
We can represent consumer surplus with the help of the following diagram. Along OX are measured the units of the Commodity and along OY is measured Marginal utility in terms of money, which means the price that the consumers willing to pay, rather than go with¬out a particular unit of the commodity.
If the market price is PM, the consumer will extend his purchase up to the Mth unit: That is, he will purchase OM quantity. This is so because for this amount his marginal utility is equal to the price. But his marginal utility for the earlier units is more than PM. For M th unit, for instance, his marginal utility is P’M’, but he only pays the market price PM (= P”M’) for this unit as for others. He thus obtains an excess of utility for the Mth unit equal to P’P”. This is consumer’s surplus from this unit.
Similar surplus arises from the purchase of other units. The total consumer’s surplus thus derived by him when OM units are purchased at PM Price is shown by the shaded area UAP. If the market price rises to ‘M’ he will purchase only OM’ quantity and the consumer’s surplus will fall to the smaller triangle UA ‘ P’.


Criticism of Consumer’s Surplus:
The concept of consumer’s surplus has been criticized on several grounds:
Imaginary: It is said that this is a purely imaginary idea. You just imagine what you are prepared to pay and you proceed to deduct from that what you actually pay. It is all hypothetical. One may say that one is prepared to pay anything. Hence it is unreal.
Difficult to Measure: It is difficult to measure consumer’s surplus exactly. Few can say what they would be prepared to pay for a thing. Besides, different people are prepared to pay different amounts. It would be a hopeless task to put down how much each individual would be willing to pay. Hence the total consumer’s surplus in the market cannot be measured.
Surplus Exhausted: It is pointed out that if the consumer knew that any such thing existed, he would go on buying more and more till the surplus utility he enjoyed disappeared. This is wrong. A consumer does not run after a surplus yielded by one commodity. He has to weigh the utilities of other commodities too.
Not Applicable to Necessaries: The idea of consumer’s surplus does not apply to the necessaries of life. In such cases the surplus is immeasurable.

Question8. What are indifference curves? Explain their properties.
Ans. Modern economists disregarded the concept of ‘cardinal measure of utility’. They were of the opinion that utility is a psychological phenomenon and it is next to impossible to measure the utility in absolute terms. According to them, a consumer can rank various combinations of goods and services in order of his preference. For example, if a consumer consumes two goods, Apples and Bananas, then he can indicate:
1. Whether he prefers apple over banana; or
2. Whether he prefers banana over apple; or
3. Whether he is indifferent between apples and bananas, i.e. both are equally preferable and both of them give him same level of satisfaction.
This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use of ordinal numbers like 1st, 2nd, 3rd, 4th, etc. which can be used only for ranking. It means, if the consumer likes apple more than banana, then he will give 1st rank to apple and 2nd rank to banana. Such a method of ranking the preferences is known as ‘ordinal utility approach’.
Meaning of Indifference Curve:
When a consumer consumes various goods and services, then there are some combinations, which give him exactly the same total satisfaction. Indifference curve refers to the graphical representation of various alternative combinations of bundles of two goods among which the consumer is indifferent. Alternately, indifference curve is a locus of points that show such combinations of two commodities which give the consumer same satisfaction. Let us understand this with the help of following indifference schedule, which shows all the combinations giving equal satisfaction to the consumer.
Table 2.5: Indifference Schedule
Combination of Apples and Bananas   Apples
(A) Bananas
(B)
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1




As seen in the schedule, consumer is indifferent between five combinations of apple and banana. Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on. When these combinations are represented graphically and joined together, we get an indifference curve ‘IC1’ as shown in Fig..
In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points (P, Q, R, S and T) on the curve show different combinations of apples and bananas. These points are joined with the help of a smooth curve, known as indifference curve (IC1).

Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the consumer is said to be indifferent between the combinations located on Indifference Curve ‘IC1’. The combinations P, Q, R, S and T give equal satisfaction to the consumer and therefore he is indifferent among them. These combinations are together known as ‘Indifference Set’.
Indifference Map:
Indifference Map refers to the family of indifference curves that represent consumer preferences over all the bundles of the two goods. An indifference curve represents all the combinations, which provide same level of satisfaction. However, every higher or lower level of satisfaction can be shown on different indifference curves. It means, infinite number of indifference curves can be drawn.

In Fig., IC1 represents the lowest satisfaction, IC2 shows satisfaction more than that of IC1 and the highest level of satisfaction is depicted by indifference curve IC3. However, each indifference curve shows the same level of satisfaction individually.
It must be noted that ‘Higher Indifference curves represent higher levels of satisfaction’ as higher indifference curve represents larger bundle of goods, which means more utility because of monotonic preference.
Assumptions of Indifference Curve
The various assumptions of indifference curve are:
1. Two commodities: It is assumed that the consumer has a fixed amount of money, whole of which is to be spent on the two goods, given constant prices of both the goods.
2. Non Satiety: It is assumed that the consumer has not reached the point of saturation. Consumer always prefer more of both commodities, i.e. he always tries to move to a higher indifference curve to get higher and higher satisfaction.
3. Ordinal Utility: Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods.
4. Diminishing marginal rate of substitution: Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this assumption, an indifference curve is convex to the origin.
5. Rational Consumer: The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total satisfaction.
Properties of Indifference Curve:
1. Indifference curves are always convex to the origin:
An indifference curve is convex to the origin because of diminishing MRS. MRS declines continuously because of the law of diminishing marginal utility. As seen in Table 2.6, when the consumer consumes more and more of apples, his marginal utility from apples keeps on declining and he is willing to give up less and less of bananas for each apple. Therefore, indifference curves are convex to the origin. It must be noted that MRS indicates the slope of indifference curve.
2. Indifference curve slope downwards:
It implies that as a consumer consumes more of one good, he must consume less of the other good. It happens because if the consumer decides to have more units of one good (say apples), he will have to reduce the number of units of another good (say bananas), so that total utility remains the same.
3. Higher Indifference curves represent higher levels of satisfaction:
Higher indifference curve represents large bundle of goods, which means more utility because of monotonic preference. Combination Q on the higher indifference curve IC2 will give a consumer more satisfaction than combination S on the lower indifference curves IC1 because the combination Q contains more of both goods X and Y than the combination S. Hence the consumer must prefer Q to S. And by transitivity assumption, he will prefer any other combination such as combination R on IC2 (all of which are indifferent with Q) to any combination on IC1 (all of which are indifferent with S) We, therefore, conclude that a higher indifference curve represents a higher level of satisfaction and combinations on it will be referred to the combinations on a lower indifference curve.


4. Indifference curves can never intersect each other:
As two indifference curves cannot represent the same level of satisfaction, they cannot intersect each other. It means, only one indifference curve will pass through a given point on an indifference map. In Fig. 2.7, satisfaction from point A and from B on IC1 will be the same.
Similarly, points A and C on IC2 also give the same level of satisfaction. It means, points B and C should also give the same level of satisfaction. However, this is not possible, as B and C lie on two different indifference curves, IC1 and IC2 respectively and represent different levels of satisfaction. Therefore, two indif¬ference curves cannot intersect each other.



Unit II
Question9. Explain the meaning, essential elements and types of demand?
Ans. In common usage, demand means a desire or a want but in economics desire, want and demand are three different concepts. In economics, every desire is not a want and every want is not a demand. Desire is the wish to have something or to enjoy a service.
Want= Desire + Resources + Willingness
But demand implies more than mere desire. It means that the person is willing and able to pay for the object he desire. Demand thus means desire backed by willingness and ability to pay. Besides, demand also signifies a price and a period of time in which demand is to be fulfilled. It is obvious that a person’s demand for anything varies with the price at which it is offered. He buys more of it at a lower price, and less of it at a higher price. Similarly, his demand varies with the period of time.
Demand= Want + Relationship of Want with certain price, time and quantity
“By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices, or at various incomes, or at various prices of related goods.”— (Bober).
We can represent demand symbolically as a functional relationship as under:
DA=F (Pa, Pc, Pd………………….: I: T)
In this equation DA stands for the households demand for goods A: Pa, Pc, Pd denote the prices of other goods: I stands for (he income of the household, and the households’ tastes are represented by T.
Kinds of Demand:
Three kinds of demand may be distinguished:
(a) Price demand,
(b) Income demand, and
(c) Cross demand.
Price Demand: This demand refers to the various quantities of a commodi¬ty or service that a consumer would purchase at a given time in a market at various hypothetical prices. It is assumed that other things such as consumers’ income, his tastes and prices of related goods remain unchanged.
The demand of the individual consumer is called Individual Demand and the aggregate demand of all the consumers combined for the commodity or service is called Industry Demand. The total demand for the product of an individual firm at various prices is known as firm’s demand or Individual Seller’s Demand.
Income Demand: The income demand refers to the various quantities of goods and services which would be purchased by the consumer at various levels of income. Here we assume that the prices of the commodity or service as well as the prices of related goods and the tastes and desires of consumers do not change.
The price demand expresses relationship between prices and quantities and the income demand brings out the relationship between income and quantities demanded. For preparing demand schedule of income demand, we write incomes in one column and quantities purchased at these incomes in the second column. Superior goods or high-priced articles command brisk sales when income increases. On the other hand, inferior goods command large sales when incomes are at a lower level.
Cross Demand: Cross demand means the quantities of a good or service which will be purchased with reference to changes in the price not of this good but of other related goods. These goods are either substitutes or complementary good. A change in price of tea will affect demand for coffee. Similarly, if horses become sheep, demand for carriages may increase.
Some other kinds of demand
i.Individual and Market Demand: It refers to the classification of demand of a product based on the number of consumers in the market. Individual demand can be defined as a quantity demanded by an individual for a product at a particular price and within the specific period of time. For example, Mr. X demands 200 units of a product at Rs. 50 per unit in a week. The individual demand of a product is influenced by the price of a product, income of customers, and their tastes and preferences.
On the other hand, the total quantity demanded for a product by all individuals at a given price and time is regarded as market demand. In simple terms, market demand is the aggregate of individual demands of all the consumers of a product over a period of time at a specific price, while other factors are constant. For example, there are four consumers of oil (having a certain price). These four consumers consume 30 liters, 40 liters, 50 liters, and 60 liters of oil respectively in a month. Thus, the market demand for oil is 180 liters in a month.

ii. Organization and Industry Demand: It refers to the classification of demand on the basis of market. The demand for the products of an organization at given price over a point of time is known as organization demand. For example, the demand for Toyota cars is organization demand. The sum total of demand for products of all organizations in a particular industry is known as industry demand. For example, the demand for cars of various brands, such as Toyota, Maruti Suzuki, Tata, and Hyundai, in India constitutes the industry’ demand. The distinction between organization demand and industry demand is not so useful in a highly competitive market.
This is due to the fact that in a highly competitive market, organizations have insignificant market share. Therefore, the demand for an organization’s product is of no importance. However, an organization can forecast the demand for its products only by analyzing the industry demand.
iii. Autonomous and Derived Demand:
It refers to the classification of demand on the basis of dependency on other products. The demand for a product that is not associated with the demand of other products is known as autonomous or direct demand. The autonomous demand arises due to the natural desire of an individual to consume the product. For example, the demand for food, shelter, clothes, and vehicles is autonomous as it arises due to biological, physical, and other personal needs of consumers.
On the other hand, derived demand refers to the demand for a product that arises due to the demand for other products. For example, the demand for petrol, diesel, and other lubricants depends on the demand of vehicles. Apart from this, the demand for raw materials is also derived demand as it is dependent on the production of other products. Moreover, the demand for substitutes and complementary goods is also derived demand.
iv. Demand for Perishable and Durable Goods:
It refers to the classification of demand on the basis of usage of goods. The goods are divided into two categories, perishable goods and durable goods. Perishable or non-durable goods refer to the goods that have a single use. For example, cement, coal, fuel, and eatables.
On the other hand, durable goods refer to goods that can be used repeatedly. For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present demand of individuals. However, durable goods satisfy both present as well as future demand of individuals. Therefore, consumers purchase durable items by considering its durability.
In addition, durable goods need replacement because of their continuous use. The demand for perishable goods depends on the current price of goods and customers’ income, tastes, and preferences and changes frequently, while the demand for durable goods changes over a longer period of time.
v. Short-term and Long-term Demand:
It refers to the classification of demand on the basis of time period. Short-term demand refers to the demand for products that are used for a shorter duration of time or for current period. This demand depends on the current tastes and preferences of consumers. For example, demand for umbrellas, raincoats, sweaters, long boots is short term and seasonal in nature.
On the other hand, long-term demand refers to the demand for products over a longer period of time. Generally, durable goods have long-term demand. The long-term demand of a product depends on a number of factors, such as change in technology, type of competition, promotional activities, and availability of substitutes. The short-term and long-term concepts of demand are essential for an organization to design a new product.
Question10. Explain the law of demand with the help of a demand schedule and demand curve. Also point out the exception of the law?
Ans. Demand Schedule:
If we write down the different quantities that an individual or a group of individuals would buy at different prices, we get that individual’s or that group’s demand schedule. Thus, a demand schedule is a table or a chart which shows the quantities of a commodity demanded at different prices in a given period of time.
The following is the demand schedule of an imaginary consumer of milk:





Market Schedule:
The above is the demand schedule of a particular individual. But we can also construct a market schedule showing the total quantity of milk demanded at different prices in a market by the whole body of consumers. We can divide them into three classes: ‘A’—with u monthly income up to Rs. 500, ‘B’—Rs. 501 to Rs. 1000 and “C”—above Rs. 1000. We can see how much will each class buy at each price, and then total them up


The demand schedule is useful as follows:
(i) After all, businessmen do make an intelligent forecast of the quantity they could dispose of at higher or lower prices. Monopolists sometimes deliberately lower prices to stimulate demand. Businessmen would like to know the various quantities that are likely to be demanded at different prices. This would help them to forecast profits and to arrange production.
(ii) In order to find out the effect of different rates of taxes on the sale of a commodity, a Finance Minister has to get the help of demand schedules. The calculations may be rough, but they are all the same useful. Imposition of tax is bound to raise prices which would in turn reduce demand. The Government revenue will depend on how much is actually sold. Demand schedule is helpful in making these calculations.
Demand Curve:
With the help of the demand schedule of an individual given above, we can draw the curve as shown on the previous page. The quantities are measured along OX and prices (in rupees) along OY.

When the price is Rs. 7.00 a liter, the consumer purchases only half a liter. We travel half a point on OX-axis and plot a point against the price of Rs. 7.00; we plot the other points in the same manner, and by joining these points we get the curve. Like the individual demand curve, we can also have a market demand curve by plotting the market demand schedule given above.
Why Demand Curves Slope Downwards:
Generally the demand curve slopes downwards. This is in accordance with the law of diminishing utility. The purchases of most of us are governed by this law. When the price falls, new purchasers enter the market and old purchasers will probably purchase more. Since this commodity has become cheaper, it will be purchased by some people in preference to other commodities.
These are the three obvious reasons why people buy more when the price falls:
(i) A unit of money goes farther and one can afford to buy more.
(ii) When a thing becomes cheaper one naturally likes to buy more.
(iii) A commodity tends to be put to more uses when it becomes cheaper. Thus, the old buyers buy more and some new buyers enter the market.
Substitution Effect, Income Effect and Price Effect:
If the price of a commodity rises relatively to other goods, the consumer will buy less of that commodity and buy more of the other goods in place of this particular good. This is called Substitution Effect in Economics. Another reason for buying less of goods whose prices have risen is that raise in prices means a loss of purchasing power. It is as it were that the consumer’s income has come down. This is called the Income Effect. This is, the consumer has become relatively poor since his real income (i.e., income in terms of goods) has fallen. When the price of a commodity falls, more of it is demanded and substituted for of the commodities and there is income effect too, for the purchaser feels better o when the price falls and is able to buy more.
The combination of the substitution effect and income effect is known as the price effect. This is the case with normal or ordinary goods. But if the goods are considered inferior, the effect will be opposite, i.e. less will be purchased even if the price falls. But if the substitution effect is greater than the negating income effect, the law of demand will apply even to inferior goods, i.e. demand will extend when price falls.
Exceptional Demand Curves:
Sometimes the demand curve, instead of sloping downwards, will rise onwards. In other words, sometimes people will buy more when the price rises.
We can think of the following four cases:
(a) In case a serious shortage is feared, people may be in a panic and buy more even though the price is rising. They are anxious to avoid the necessity of having to pay a still higher price in future.
(b) When the use of a commodity confers distinction, then the wealthy will buy more when the price rises, to be included among the few distinguished personages. Conversely, people tend to cut their purchases, if they believe the commodity to be inferior.
(c) Sometimes people buy more at a higher price in sheer ignorance.
(d) If the price of a necessary of life goes up, the consumer has to readjust his whole expenditure. He may cut down his expenses on other food articles and, in order to make up, more may have to be spent on this particular food, more of which will, therefore, be purchased in spite of its high price.
Question11. Explain the concept of elasticity of Demand. What are the various concepts and types of elasticity of demand?
Ans. The degree of responsiveness of quantity demanded of a commodity to the change in price is called elasticity of demand. Price elasticity of demand is popularly called elasticity of demand. It is the rate of which quantity demanded changes in response to the change in price. Elasticity of demand expresses the magnitude of change in quantity of a commodity.
Precisely stated, price elasticity demand is defined as the ratio of percentage change in quantity demanded to a percentage change in price.
Types of Elasticity:
Distinction may be made between Price Elasticity, Income Elasticity and Cross Elasticity. Price Elasticity is the responsiveness of demand to change in price; income elasticity means a change in demand in response to a change in the consumer’s income; and cross elasticity means a change in the demand for a commodity owing to change in the price of another commodity.

Five cases of Elasticity of Demand:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unitary elastic demand
1. Perfectly Elastic Demand:
When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or ep = 00.
In perfectly elastic demand, the demand curve is represented as a horizontal straight line, which is shown in Fig:

From above figure it can be interpreted that at price OP, demand is infinite; however, a slight rise in price would result in fall in demand to zero. It can also be interpreted from fig. that at price P consumers are ready to buy as much quantity of the product as they want. However, a small rise in price would resist consumers to buy the product. Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real situation. However, it can be applied in cases, such as perfectly competitive market and homogeneity products. In such cases, the demand for a product of an organization is assumed to be perfectly elastic.
2. Perfectly Inelastic Demand:
A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. The numerical value for perfectly inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is represented as a straight vertical line, which is shown in fig:

It can be interpreted from above fig. that the movement in price from OP1 to OP2 and OP2 to OP3 does not show any change in the demand of a product (OQ). The demand remains constant for any value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation. However, in case of essential goods, such as salt, the demand does not change with change in price. Therefore, the demand for essential goods is perfectly inelastic.
3. Relatively Elastic Demand:
Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity. Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For example, if the price of a product increases by 20% and the demand of the product decreases by 25%, then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually sloping, as shown in Fig.

It can be interpreted from above fig. that the proportionate change in demand from OQ1 to OQ2 is relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices.
For example, the price of a particular brand of cold drink increases from Rs. 15 to Rs. 20. In such a case, consumers may switch to another brand of cold drink. However, some of the consumers still consume the same brand. Therefore, a small change in price produces a larger change in demand of the product.
4. Relatively Inelastic Demand:
Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep<1 as="" being="" demand="" elasticity="" has="" inelastic="" less="" marshall="" p="" relatively="" termed="" than="" unity.="">The demand curve of relatively inelastic demand is rapidly sloping, as shown in Fig:

It can be interpreted from above fig. that the proportionate change in demand from OQ1 to OQ2 is relatively smaller than the proportionate change in price from OP1 to OP2. Relatively inelastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices.
5. Unitary Elastic Demand:
When the proportionate change in demand produces the same change in the price of the product, the demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal to one (ep=1).
The demand curve for unitary elastic demand is represented as a rectangular hyperbola, as shown in Fig:

From fig., it can be interpreted that change in price OP1 to OP2 produces the same change in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.
The different types of price elasticity of demand are summarized in Table-4:

Question12. Explain the factors affecting elasticity of demand and also the practical importance of it?
Ans. Various factors which affect the elasticity of demand of a commodity are:
1. Nature of commodity:
Elasticity of demand of a commodity is influenced by its nature. A commodity for a person may be a necessity, a comfort or a luxury.
i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is generally inelastic as it is required for human survival and its demand does not fluctuate much with change in price.
ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as consumer can postpone its consumption.
iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more elastic as compared to demand for comforts.
iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor person but a necessity for a rich person.
2. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa. Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of demand.
3. Income Level:
Elasticity of demand for any commodity is generally less for higher income level groups in comparison to people with low incomes. It happens because rich people are not influenced much by changes in the price of goods. But, poor people are highly affected by increase or decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price:
Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma TV, etc. have highly elastic demand as their demand is very sensitive to changes in their prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption:
Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand as their consumption can be postponed in case of an increase in their prices. However, commodities with urgent demand like life saving drugs, have inelastic demand because of their immediate requirement.
6. Number of Uses:
If the commodity under consideration has several uses, then its demand will be elastic. When price of such a commodity increases, then it is generally put to only more urgent uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand rises.
For example, electricity is a multiple-use commodity. Fall in its price will result in substantial increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not employed formerly due to its high price. On the other hand, a commodity with no or few alternative uses has less elastic demand.
7. Share in Total Expenditure:
Proportion of consumer’s income that is spent on a particular commodity also influences the elasticity of demand for it. Greater the proportion of income spent on the commodity, more is the elasticity of demand for it and vice-versa.
Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a small proportion of their income on such goods. When prices of such goods change, consumers continue to purchase almost the same quantity of these goods. However, if the proportion of income spent on a commodity is large, then demand for such a commodity will be elastic.
8. Time Period:
Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a year or a period of several years. Elasticity of demand varies directly with the time period. Demand is generally inelastic in the short period.
It happens because consumers find it difficult to change their habits, in the short period, in order to respond to a change in the price of the given commodity. However, demand is more elastic in long rim as it is comparatively easier to shift to other substitutes, if the price of the given commodity rises.
9. Habits:
Commodities, which have become habitual necessities for the consumers, have less elastic demand. It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming commodities.
Finally it can be concluded that elasticity of demand for a commodity is affected by number of factors. However, it is difficult to say, which particular factor or combination of factors determines the elasticity. It all depends upon circumstances of each case.
Price Elasticity of Demand is useful in the following ways:
1. Useful for Business: It enables the business in general and the monopolists in particular to fix the price. Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximize his profit.
2. Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand.
3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing inconvenience to the people. Moreover, it is also useful for the planning.
4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.
5. In the Sphere of International Trade: It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.
6. Paradox of Poverty: It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are perishable and not storable.
7. Effect on Employment: The effect of machines on employment opportunities depends on elasticity of demand for the goods produced by such machines. In the initial stage, use of such machines cause unemployment and prices will also fall. But when demand for such commodities is more elastic, then fall in prices will generate more increase in its demand.
As a result, demand will stimulate greater production and hence more employment. If demand for commodities produced by these machines is inelastic, then even fall in price will not increase demand as well as employment.
8. Significant for Government Economic Policies: The knowledge of elasticity of demand is very important for the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of demand is most useful.
9. Incidence of Taxation: Incidence of tax lies on the person who ultimately pays the tax. The incidence is on the buyer, if demand is perfectly inelastic. He will go on buying as much as before despite the price rise. Thus, the government has to keep the watch on the ultimate burden of the tax, which depends on the elasticity of demand of the commodity taxed. If necessaries, which have less elastic demand are taxed the burden will fall more on the poor sections of society. Therefore, principle of justice in taxation is based on elasticity of demand.
10. Changes in Rate of Exchange: Rate of exchange between two currencies can be changed through devaluation or overvaluation of one currency in relation to other currencies. A country while deciding for such a course of action will take into consideration the elasticity of demand for its exports and imports. If the government devalues the currency without considering the elasticity of demand for its exports and imports it may not be able to correct unfavorable balance of payments. Under these circumstances the demand both for its exports and imports turns out to be inelastic.
11. Joint Products: The concept of elasticity of demand plays an important role in determining the price of joint products. In case of joint products like skin and meat of goat, separate costs are not known. The producer will be guided mostly by demand and its nature while fixing his price. For instance, when goat is bought, it is not kept in mind the separate costs of skin and meat.
When the seller sells the skin and meat, the seller keeps in mind the elasticity of demand of skin and meat. If elasticity of demand for meat is less elastic, in that case the price of meat will be higher. On the other hand if elasticity of demand for skin is more elastic, in that case the price of the skin will be low and vice versa.
12. International Trade: The concept of elasticity of demand also plays a significant role in the international trade or the terms of trade. It is the nature of demand which is helpful in determining the amount of gain being enjoyed by different countries. The terms of trade would be favourable in case of those countries, whose exports are of the nature of more elastic demand. On the other hand, the terms of trade would be un-favourable if the exports of a country are of the nature of less elastic demand.
13. Market forms: The concept of elasticity of demand is also useful is knowing the different market forms. If cross elasticity of demand is infinite, in that case there is perfect competition in the market. If cross elasticity is zero (or Ec = 0) it is a case of absolute or pure monopoly. If cross elasticity of demand is less than one (or Ec < 1), in that case there is relative monopoly. And if cross elasticity of demand is greater than one (or Ec >1), in that case, there is monopolistic competition or imperfect competition.
14. Determination of Price of Public Utilities: This concept is significant in the determination of the prices of public utility services. Economic welfare of the society largely depends upon the cheap availability of the essential products like water, electricity, cooking gas, transportation etc. For such commodities, demand is inelastic and these should be controlled by the government.
The government will distribute these products at fair price. Therefore, Government helps to fix the prices of necessities of life. Thus, elasticity of demand is a very important tool of analysis and it plays an important role in economic analysis.
Question13. Explain the factors affecting demand of a commodity?
Ans. Factors Influencing Demand for a Commodity:
They are many factors on which the demand for a commodity depends. They are called determinants of demand. They are discussed as under:
1. Income of the consumer:
A consumer’s demand is influenced by the size of his income. With increase in the level of income, there is increase in the demand for goods and services. A rise in income causes a rise in consumption. As a result, a consumer buys more. For most of the goods, the income effect is positive. But for the inferior goods, the income effect is negative. That means with a rise in income, demand for inferior goods may fall.

2. Price of the commodity:
Price is a very important factor, which influences demand for the commodity. Generally, demand for the commodity expands when its price falls, in the same way if the price increases, demand for the commodity contracts. It should be noted that it might not happen, if other things do not remain constant.

3. Changes in the prices of related goods:
Sometimes, the demand for a good might be influenced by prices changes of other goods. There are two types of related goods. They are substitutes and complements. Tea and Coffee are good substitutes. A rise in the price of coffee will increase the demand for tea and vice versa. Bread and butter are complements. A fall in the price of bread will increase the demand for butter and vice versa.

4. Tastes and preferences of the consumers:
Demand depends on people’s tastes, preferences, habits and social customs. A change in any of these must bring about a change in demand. For example, if people develop a taste for tea in place of coffee, the demand for tea will increase and that for coffee will decrease.

5. Change in the distribution of income:
If the distribution of income is unequal, there will be many poor people and few rich people in society. The level of demand in such a society will be low. On the other hand, if there is equitable distribution of income, the demand for necessaries commonly consumed by the poor will increase and the demand for luxuries consumed by the rich will decrease. However, the net effect of an equitable distribution of income is an increase in the level of demand.

6. Price expectations:
Expectations of people regarding the future prices of goods also influence their demand. If people anticipate a rise in the prices of goods in future due to some reasons, the demand for goods will rise to avoid more prices in future. Contrarily, if the people expect a fall in price, the demand for the commodity will fall.



7. State of economic activity:
The state of economic activity is major determinant influencing the demand for a commodity. During the period of boom, prosperity prevails in the economy. Investment, employment and income increase. The demand for both capital goods and consumer goods increase. But in period of depression demand declines due to low investment and low income.

8 . Population:
An increase in population of region will result in an increased demand of various goods. Also, the composition of population determines the demand of certain goods proportionately. For example, an increased number of females in the region will generate more demand for sarees, ornaments, cosmetics etc.
9. Government Policy:
Economic policy adopted by the government also influences the demand for commodities. If the government imposes taxes on various commodities in the form of sales tax, excise duties, octroi etc., the price of these commodities will increase. As a result, the demand of such commodities is very likely to fall.
10. Advertisement:
In this age of advertisement demand for many fashionable items are created by advertising agents through T.V., newspapers, radios etc.
11. Weather Conditions:
The demand for various household goods depends upon the changes in weather conditions. For example, the demand for woolen clothes, coal and electric heaters increases during winter and the demand for cold drinks, ice creams, room coolers, etc. goes up during hot weather.
The level of demand for a commodity is also influenced by other factors like pattern of saving, inventions and discoveries and outbreak of war, emergencies, technical progress etc.
Question14. What do you mean by supply? Explain the factors affecting supply?
Ans. In economics, supply during a given period of time means, the quantities of goods which are offered for sale at particular prices. The supply of a commodity is the amount of the commodity which the sellers or producers are able and willing to offer for sale at a particular price, during a certain period of time.
Definition of Supply:
According to J. L. Hanson – “By supply is meant that amount that will come into the market over a range of prices.”
In short supply always means supply at a given price. At different prices, the supply may be different. Normally the higher the price, the greater the supply and vice-versa.
Factors Affecting Supply:
There are a number of factors influencing the supply of a commodity. They are known as the determinants of supply.
Important factors are as follows:
1. Price of the Commodity:
Price is the most important factor influencing the supply of a commodity. More is supplied at a lower price and less is supplied at a higher price.
2. Seller’s Expectations about the Future Price:
Seller’s expectations about the future price affect the supply. If a seller expects the price to rise in the future, he will with¬hold his stock at present and so there will be less supply now. Besides change in price, change in the supply may be in the form of increase or decrease in supply.
3. Nature of Goods:
The supply of every perishable goods is perfectly inelastic in a market period because the entire stock of such goods must be disposed of within a very short period, whatsoever may be the price. If not, they might get rotten. Further, if the stock of goods can be easily stored its supply would be relatively elastic and vice-versa.
4. Natural Conditions:
The supply of some commodities, such as agricultural products depends on the natural environment or climatic conditions like—rainfall, temperature etc. A change in the natural conditions will cause a change in the supply.
5. Transport Conditions:
Difficulties in transport may cause a temporary decrease in supply as goods cannot be brought in time to the market place. So even at the rising prices, quantity supplied cannot be increased.
6. Cost of Production:
If there is a rise in the cost of production of a commodity, its supply will tend to decrease. Similarly, with the rise in cost of production the supply curve tends to shift downward. Conversely, a fall in the cost of production tends to decrease the supply.
7. The State of Technology:
The supply of a commodity depends upon the methods of production. Advance in technology and science are the most powerful forces influencing productivity of the factors of production. Most of the inventions and innovations in chemistry, electronics, atomic energy etc. have greatly contributed to increased supplies of commodities at lower costs.
8. Government’s Policy:
Government’s economic policies like—industrial policy, fiscal policy etc. influence the supply. If the industrial licensing policy of the government is liberal, more firms are encouraged to enter the field of production, so that the supply may increase.
Import restrictions and high customs duties may decrease the supply of imposed goods but it would encourage the domestic industrial activity, so that the supply of domestic products may increase. A tax on a commodity or a factor of production raises its cost of production, consequently production is reduced. A subsidy on the other-hand provides an incentive to production and augments supply.

Question15. Explain the Law of Supply with the help of a suitable example?
Ans. The law of supply states that, other things remaining the same, the quantity supplied of a commodity is directly or positively related to its price. In other words, when there is a rise in the price of a commodity the quantity supplied of it in the market increases and when there is a fall in the price of a commodity, its quantity supplied decreases, other things remaining the same. Thus, the supply curve of a commodity slopes upward from left to right.
Assumptions
The term “other things remaining the same” refers to the following assumptions in the law of supply:
1. No change in the state of technology.
2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve as explained below.
Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity supplied by the seller or producer during a period of time. We can show the supply schedule through the following imaginary table.


The given schedule shows positive relationship between price and quantity supplied of a commodity. In the beginning, when the price is Rs.10 per kg, quantity supplied by the seller is 1kg. As the price increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30 per kg, the quantity supplied by the seller also increases from 1 kg to 2 kg and then to 3 kg respectively. Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity supplied by the seller to 4kg and then to 5kg. Thus, the above schedule shows that there is positive relationship in between price and quantity supplied of a commodity.
Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various combinations of price and quantity supplied of the table, we can derive an upward sloping demand curve as shown in the figure below:

In the given figure, price and quantity supplied are measured along the Y-axis and the X-axis respectively. By plotting various combinations of price and quantity supplied we derived points A,B, C, D, E curve and joining these points we find an upward sloping i.e. SS1. The positive slope of the supply curve SS1 establishes the law of supply and shows the positive relationship in between price and quantity supplied.
Exceptions and Limitations of the Law of Supply
The law of supply states that quantity supplied increases with increase in price and vice-versa. But this law doesn’t hold true in case of auction sale. An auction sale takes place at that time when the seller is in financial crisis and needs money at any cost.
Price expectation of seller
If the seller expects that the price of commodity is going to fall in near future, he will try to sell more even if the price level is very low. On the other hand, if the seller expects further rise in price of the commodity he will not sell more even if the price level is high. It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large quantity of goods at heavily discounted price. It is also against the law of supply.
Fear of being out of fashion
As we know that quantity supplied of a commodity is affected by fashion, taste and preferences of the consumer, technology and time. If the seller thinks that the goods are going to be outdated in the near future, he sells more at a lower price which is also against the law of supply.
Perishable goods
Those goods which have very short life-time and they become useless after that are all perishable goods. Those goods must be made available in the market at its right time whatever be its price. So the seller becomes ready to sell his goods at any offered price. It is also against the law of supply.

Question16. Explain the different concepts of elasticity of supply?
Ans. Elasticity of supply: Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate PES.

While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly elastic.
• High elasticity indicates the supply is sensitive to changes in prices, low elasticity indicates little sensitivity to price changes, and no elasticity means no relationship with price. It is also called price elasticity of supply.

If supply is elastic (i.e. PES > 1), then producers can increase output without a rise in cost or a time delay
• If supply is inelastic (i.e. PES <1 a="" change="" find="" firms="" given="" hard="" in="" it="" p="" period.="" production="" then="" time="" to="">• When Pes = 0, supply is perfectly inelastic
• When Pes = infinity, supply is perfectly elastic following a change in demand




Unit III
Question17. Explain the different concepts of cost?
Ans. The analysis of cost is important in the study of business operations and decisions because it provides a basis for two important decisions made by managers:
(a) whether to produce or not and
(b) how much to produce when a decision is taken to produce.
1. Opportunity Cost and Actual Cost: Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of resources. If resources were unlimited, there would be no need to forego any income-yielding opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have alternative uses with different returns. Incomes maximizing resource owners put their scarce resources to their most productive use and forego the income expected from the second best use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. For example, suppose that a person has a sum of Rs. 1,00,000 for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. If he is a profit maximizing investor, he would invest his money in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is the expected income from the lathe, i.e., Rs. 15,000.
On the other hand, actual costs are those which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs.
2. Business Costs and Full Costs: Business costs include all the expenses which are incurred to carry our business. The concept of business costs is similar to the actual or real costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment”. These cost concepts are used for calculating business profits and losses and for filling returns for income-tax and also for other legal purposes.
Full costs, on the contrary, include business costs, opportunity cost and normal profit. The opportunity cost includes the expected earnings from the second best use of the resources, or the market rate of interest on the total money capital, and also the value of entrepreneur’s own services which are not charged for in the current business. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs: Explicit costs refer to those which fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs involve cash payments and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the form of cash outlays, nor do they appear in the accounting system. Such costs are known as implicit or imputed costs. Implicit costs may be defined as the earning expected from the second best alternative use of resources. For instance, suppose an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is the opportunity costs of income from his own business. This is an implicit cost of his own business; implicit, because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. Thus, implicit wages, rent and interest are the highest wages, rents and interest which owner’s labour, building and capital can respectively earn from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business, but they form an important consideration in whether or not a factor would remain in its present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs: Out-of-pocket costs means costs that involve current cash payments to outsiders while book costs such as depreciation do not require current cash payments. In concept, this distinction is quite different from traceability and also from variability with output. Not all out-of- pocket costs are variable, e.g., salaries paid to the administrative staff.
Neither are they all direct, e.g., the electric power bill. Book costs are in some cases variable and in some cases readily traceable, and hence become a part of direct costs. The distinction primarily shows how cost affects the cash position. Book costs can be converted into out-of-pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest.
B. Some Analytical Cost Concepts:
5. Fixed and Variable Costs: Fixed costs are those costs which are fixed in volume for a certain given output. Fixed cost does not vary with variation in the output between zero and certain level of output. The costs that do not vary for a certain level of output are known as fixed cost. Fixed costs are costs which do not change per unit of output. Even if no crops are grown on a piece of land, the bank will insist on a mortgage payment from the farmer; even if no output is produced by a corporation, its bondholders will legally insist on payments of interest. The only way to avoid these payments is to go out of business; they are accordingly NOT considered in making a short-run operating decision, but ARE considered in making long-run, entry or exit decisions.
The fixed costs include:
(i) Cost of managerial and administrative staff.
(ii) Depreciation of machinery, building and other Axed assets, and
(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.
Variable costs are those which vary with the variation in the total output. They are a function of output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output, and the costs of all other inputs that vary with output. Variable cost is also known as operating cost.
6. Total, Average and Marginal Costs:
Total cost represents the value of the total resource requirement for the production of goods and services. It refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by the cost function.
Average cost:
Average cost (AC) is of statistical nature, it is not actual cost. Average cost is total cost per unit of output, or it is obtained by dividing the total cost (TC) by the total output (Q), i.e. AC = TC/Q
Average cost plays a major role in long-run, entry and exit decisions. The basic decision rules are parallel to those for marginal cost:
1. If AC < P, the industry is profitable. (Enter)
2. If AC > P, the industry is unprofitable. (Exit)
3. If AC = P, the industry yields zero profit.
Marginal cost:
Marginal, as always in economics, should be read as extra. Here, it is the extra cost of one more item of output; or the change in total cost divided by change in output. Marginal cost is the addition to the total cost on account of producing an additional unit of the product. Or, marginal cost is the cost of marginal unit produced. Given the cost function, it may be defined as MC = TC/ Q. Marginal cost is the type of cost to consider in short-run output decisions.
The rules to apply are:
1. If MC < P, increase output.
2. If MC > P, decrease output.
3. If MC = P, leave output unchanged. The firm is in short-run equilibrium.
Relation Between Marginal Cost (MC) and Average Cost (AC): The relationship between MC and AC may be explained as follows:
1. When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies below the AC curve, the AC curve is falling.
2. When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve lies above AC curve, the AC curve is rising.
3. MC intersects AC at its minimum. That is, MC = AC at its minimum.
 7. Short-Run and Long-Run Costs:
Short-run and long-run cost concepts are related to variable and fixed costs respectively, and often marked in economic analysis interchangeably. Short-run costs are the costs which vary with the variation in output, the size of the firm remaining the same. In other words, short-run costs are the same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the single batch of production. In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases.
8. Incremental Costs and Sunk Costs:
Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit of output, incremental cost refers to the total additional cost associated with the marginal batch of output. Incremental costs arise also owing to the change in product lines, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of old technique of production with a new one, etc.
The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk costs since they accord to the prior commitment and cannot be revised or reversed or recovered when there is change in market conditions or change in business decisions.
9. Historical and Replacement Costs:
Historical costs are those costs of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made for replacing an old asset. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm.
10. Private and Social Costs:
There are not certain other costs which arise due to functioning of the firm but are not normally marked in the business decisions. The costs of this category are borne by the society.
Thus, the total cost generated by a firm’s working may be divided into two categories:
(i) Those paid out or provided for by the firms, and
(ii) Those not paid or borne by the firms- it includes use of resource freely available plus the disutility created in the process of production.
The costs of the former category are known as private costs and of the latter category are known as external or social costs. The example of social cost are: Mathura Oil Refinery discharging its wastage in the Yamuna river causes water pollution; Mills and factories located in a city cause air pollution by emitting smoke.
Similarly, plying cars, buses, trucks, etc., cause both air and noise pollution. Such pollutions cause tremendous health hazards which involve health cost to the society as a whole. Such costs are termed external costs from the firm’s point of view and social cost from society’s point of view..
Private costs are those which are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total cost of production. Social costs on the other hand, refer to the total cost to the society on account of production of a commodity. Social costs include both private cost and the external cost.
C. Other Costs Concepts:
11. Urgent and Postponable Cost:
Urgent costs are those costs which must be incurred in order to continue operations of the firm. For example, the costs of materials and labour which must be incurred if production is to take place.
Postponable costs refer to those costs which can be postponed at least for some time e.g., maintenance relating to building and machinery. Railways usually make use of this distinction. They know that the maintenance of rolling stock and permanent way can be postponed for some time.
12. Escapable and Unavoidable Costs:
Escapable costs refer to costs which can be reduced due to a contraction in the activities of a business enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the contraction. For Example:
1. Closing apparently unprofitable branch house-storage costs of other branches and transportation charges would increase.
2. Reducing credit sales-costs estimated may be less than the benefits otherwise available.
Escapable costs are different from controllable and discretionary costs. The latter are like chopping off the additional fat and are not directly associated with a special curtailment decision.
13. Controllable and Non-Controllable Costs:
The controllability of a cost depends upon the levels of responsibility under consideration. A controllable cost may refer to one which is reasonably subject to regulation by the executive with whose responsibility that cost is being identified. Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable at some other, usually higher level.
Direct material and direct labour costs are usually controllable. Regarding so for, overhead costs, some costs are controllable and others are not. Indirect labour, supplies and electricity are usually controllable. An allocated cost is not controllable. It varies with the formula adopted for allocation and is independent of the actions of the supervisor.
14. Direct and Indirect Costs (Traceable and Common Costs):
A direct or traceable cost is that which can be identified easily and indisputably with a unit of operation (costing unit/cost centre). Common or indirect costs are those that are not traceable to any plant, department or operation, or to any individual final product. To take an example, the salary of a divisional manager, when division is a costing unit, will be a Direct Cost.
The monthly salary of the general manager, when one of the divisions is a costing unit, would be an Indirect Cost. The salary of the manager of the other division is neither a direct nor an indirect cost. Thus, whether a specific cost is direct or indirect depends upon the costing unit under consideration. The concepts of direct and indirect costs are meaning-less without identification of the relevant costing unit.
Question18. Explain the different concepts of revenue?
Ans. Meaning of Revenue:
The amount of money that a producer receives in exchange for the sale proceeds is known as revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs. 16,000 is known as revenue. Revenue refers to the amount received by a firm from the sale of a given quantity of a commodity in the market. Revenue is a very important concept in economic analysis. It is directly influenced by sales level, i.e., as sales increases, revenue also increases. The concept of revenue consists of three important terms; Total Revenue, Average Revenue and Marginal Revenue.

Total Revenue (TR):
Total Revenue refers to total receipts from the sale of a given quantity of a commodity. It is the total income of a firm. Total revenue is obtained by multiplying the quantity of the commodity sold with the price of the commodity.
 
Average Revenue (AR):
Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total revenue by the number of units sold. “The average revenue curve shows that the price of the firm’s product is the same at each level of output.” Stonier and Hague

AR Curve and Demand Curve are the same:
A buyer’s demand curve graphically represents the quantities demanded by a buyer at various prices. In other words, it shows the various levels of average revenue at which different quantities of the good are sold by the seller. Therefore, in economics, it is customary to refer AR curve as the Demand Curve of a firm.
Marginal Revenue (MR):
 Marginal revenue is the additional revenue generated from the sale of an additional unit of output. It is the change in TR from sale of one more unit of a commodity. In algebraic terms, marginal revenue is the net addition to the total revenue by selling n units of a commodity instead of n – 1.
Therefore,

MR in mathematical terms is the ratio of change in total revenue to change in output
MR = ∆TR/∆q or dR/dq = MR
Total Revenue, Average Revenue and Marginal Revenue:
The relation of total revenue, average revenue and marginal revenue can be explained with the help of table and fig.


From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the output sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at 6th unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is clear that when AR falls, MR also falls more than that of AR: TR increases initially at a diminishing rate, it reaches maximum and then starts falling.
In fig. 1 three concepts of revenue have been explained. The units of output have been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue, average revenue and marginal revenue curves respectively.
In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. From point K to K’ total revenue is constant. But at point K’ total revenue is maximum and begins to fall. It means even by selling more units total revenue is falling. In such a situation, marginal revenue becomes negative. Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means average revenue falls as more and more units are sold.
In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the fact that MR with the sale of every additional unit tends to diminish. Moreover, it is also clear from the fig. that when both AR and MR are falling, MR is less than AR. MR can be zero, positive or negative but AR is always positive.


Question19. What are the internal and external economies of large scale production?
Ans. Economies of scale are defined as the cost advantages that an organization can achieve by expanding its production in the long run. In other words, these are the advantages of large scale production of the organization. The cost advantages are achieved in the form of lower average costs per unit. It is a long term concept. Economies of scale are achieved when there is an increase in the sales of an organization. As a result, the savings of the organization increases, which further enables the organization to obtain raw materials in bulk. This helps the organization to enjoy discounts. These benefits are called as economies of scale.
The economies of scale are divided into internal economies and external economies discussed as follows:
I]. INTERNAL ECONOMIES: It refers to real economies which arise from the expansion of the plant size of the organization. These economies arise from the growth of the organization itself.
The examples of internal economies of scale are as follows:
a. Technical economies of scale:
It occurs when organizations invest in the expensive and advanced technology. This helps in lowering and controlling the costs of production of organizations. These economies are enjoyed because of the technical efficiency gained by the organizations. The advanced technology enables an organization to produce a large number of goods in short time. Thus, production costs per unit falls leading to economies of scale.
b. Marketing economies of scale:
It occurs when large organizations spread their marketing budget over the large output. The marketing economies of scale are achieved in case of bulk buying, branding, and advertising. For instance, large organizations enjoy benefits on advertising costs as they cover larger audience. On the other hand, small organizations pay equal advertising expenses as large organizations, but do not enjoy such benefits on advertising costs.
c. Financial economies of scale:
It takes place when large organizations borrow money at lower rate of interest. These organizations have good credibility in the market. Generally, banks prefer to grant loans to those organizations that have strong foothold in the market and have good repaying capacity.
d. Managerial economies of scale:
It occurs when large organizations employ specialized workers for performing different tasks. These workers are experts in their fields and use their knowledge and experience to maximize the profits of the organization. For instance, in an organization, accounts and research department are created and managed by experienced individuals, SO that all costs and profits of the organization can be estimated properly.
e. Commercial economies:
It refers to economies in which organizations enjoy benefits of buying raw materials and selling of finished goods at lower cost. Large organizations buy raw materials in bulk; therefore, enjoy benefits in transportation charges, easy credit from banks, and prompt delivery of products to customers.
II]. EXTERNAL ECONOMIES:
Occur outside the organization. These economies occur within the industries which benefit organizations. When an industry expands, organizations may benefit from better transportation network, infrastructure, and other facilities. This helps in decreasing the cost of an organization.
Some of the examples of external economies of scale are discussed as follows:
a. Economies of Concentration: Refer to economies that arise from the availability of skilled labour, better credit, and transportation facilities.
b. Economies of Information: Imply advantages that are derived from publication related to trade and business. The central research institutions are the source of information for organizations.
c. Economies of Disintegration: Refer to the economies that arise when organizations split their processes into different processes.

Diseconomies of scale occur when the long run average costs of the organization increases. It may happen when an organization grows excessively large. In other words, the diseconomies of scale cause larger organizations to produce goods and services at increased costs.
There are two types of diseconomies of scale, namely, internal diseconomies and external diseconomies, discussed as follows:
I]. INTERNAL DISECONOMIES OF SCALE:
It refers to diseconomies that raise the cost of production of an organization. The main factors that influence the cost of production of an organization include the lack of decision, supervision, and technical difficulties.
II]. EXTERNAL DISECONOMIES OF SCALE:
It refers to diseconomies that limit the expansion of an organization or industry. The factors that act as restraint to expansion include increased cost of production, scarcity of raw materials, and low supply of skilled labourer.
Some of the causes which lead to diseconomies of scale are as follows:
i. Poor Communication:
It acts as a major reason for diseconomies of scale. If production goals and objectives of an organization are not properly communicated to employees within the organization, it may lead to overproduction or production. This may lead to diseconomies of scale. Apart from this, if the communication process of the organization is not strong then the employees would not get adequate feedback. As a result, there would be less face-to-face interaction among employees- thus the production process would be affected.
ii. Lack of Motivation:
It leads to fall in productivity levels. In case of a large organization, workers may feel isolated and are less appreciated for their work, thus their motivation diminishes. Due to poor communication network, it is harder for employers to interact with the employees and build a sense of belongingness. This leads to fall in the productivity levels of output owing to lack of motivation. This further leads to increase in costs of the organization.
iii. Loss of Control:
It acts as the main problem of large organizations. Monitoring and controlling the work of every employee in a large organization becomes impossible and costly. It is harder to make out that all the employees of an organization are working towards the same goal. It becomes difficult for managers to supervise the sub-ordinates in large organizations.
iv. Cannibalization:
It implies a situation when an organization faces competition from its own product. A small organization faces competition from products of other organizations, whereas sometimes large organizations find that their own products are competing with each other.


Unit IV
Question20. What do you mean by perfect competition? Discuss its characteristics. Explain how price and output is determined under perfect competition?
Ans. Perfect Competition is a market structure where there is a perfect degree of competition and single price prevails. Under this condition, no individual firm will be in the position to influence the market price of the product.
According to Bilas, “The perfect competition is characterized by the presence of many firms; they all sell the same product which is identical. The seller is the price- taker”. In this market a uniform price prevail during a particular period of time. It is a rare phenomenon which does not exist in reality. Ex. Street food vendors
Main Features of Perfect Competition
1. Many Sellers: In this market, there are many sellers who form total of market supply. Individually, seller is a firm and collectively, it is an industry. In perfect competition, price of commodity is decided by market forces of demand and supply i.e. by buyers and sellers collectively. Here, no individual seller is in a position to change the price by controlling supply. Because individual seller's individual supply is a very small part of total supply. So, if the seller alone raises the price, his product will become costlier than other and automatically, he will be out of market. Hence, that seller has to accept the price which is decided by market forces of demand and supply. This ensures single price in the market and in this way, seller becomes price taker and not price maker.
2. Many Buyers: Individual buyer cannot control the price by changing or controlling the demand. Because individual buyer's individual demand is a very small part of total demand or market demand. Every buyer has to accept the price decided by market forces of demand and supply. In this way, all buyers are price takers and not price makers. This also ensures existence of single price in market.
3. Homogenous Product: In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are perfectly same in terms of size, shape, taste, colour, ingredients, quality, trade marks etc. This ensures the existence of single price in the market.
4. Zero Advertisement Cost: Since all products are identical in features like quality, taste, design etc., there is no scope for product differentiation. So advertisement cost is nil.
5. Free Entry and Exit: There are no restrictions on entry and exit of firms. This feature ensures existence of normal profit in perfect competition. When profit is more, new firms enter the market and this leads to competition. Entry of new firms competing with each other results into increase in supply and fall in price. So, this reduces profit from abnormal to normal level. When profit is low (below normal level), some firms may exit the market. This leads to fall in supply. So remaining firms raise their prices and their profits go up. So again this ensures normal level of profit.
6. Perfect Knowledge: On the front of both, buyers and sellers, perfect knowledge regarding market and pricing conditions is expected. So, no buyer will pay price higher than market price and no seller will charge lower price than market price.
7. Perfect Mobility of Factors: This feature is essential to keep supply at par with demand. If all factors are easily mobile (moveable) from one line of production to another, then it becomes easy to adjust supply as per demand. Whenever demand is more additional factors should be moved into industry to increase supply and vice versa. In this way, with the help of stable demand and supply, we can maintain single price in the Market.
8. No Government Intervention: Since market has been controlled by the forces of demand and supply, there is no government intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw materials, etc.
9. No Transport Cost: It is assumed that buyers and sellers are close to market, so there is no transport cost. This ensures existence of single price in market.
10. Determination of price: In a perfect competition market, price is determined by the market force of demand and supply. Every firm will charge the price determine by the equality of demand and supply force.
Price determination under perfect competition
Equilibrium of the Industry: An industry in economic terminology consists of a large number of independent firms, each having a number of factories, farms or mines under its control. Each such unit in the industry produces a homogeneous product so that there is competition amongst goods produced by different units called firms. When the total output of the industry is equal to the total demand, we say that the industry is in equilibrium; the price then prevailing is equilibrium price, whereas a firm is said to be in equilibrium when it has no incentive to expand or contract production.
As stated above, under competitive conditions, the equilibrium price for a given product is determined by the interaction of the forces of demand and supply for it as is shown in figure.














               PRICE





         Fig.: Equilibrium of a competitive industry

In Fig., OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at that price. The equilibrium price is the price at which both demand and supply are equal and therefore, no buyer who wanted to buy at that price goes dissatisfied and none of the sellers is dissatisfied that they could not sell their goods at that price. It may be noticed that if the price were to be fixed at any other level, higher or lower, demand remaining the same, there would not be an equilibrium in the market. Likewise, if the quantities of goods were greater or smaller than the demand, there would not be an equilibrium.
Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The output which gives maximum profit to the firm is called equilibrium output. In the equilibrium state, the firm has no incentive either to increase or decrease its output. Since it is the maximum profit giving output which only gives no incentive to the firm to increase or decrease it, so it is in equilibrium when it gets maximum profit.
Firms in a competitive market are price takers. This is because there are a large number of firms in the market who are producing identical or homogeneous products. As such these firms cannot influence the price in their individual capacities. They have to accept the price fixed (through interaction of total demand and total supply) by the industry as a whole.





             PRICE

Industry price OP is fixed through the interaction of total demand and total supply of the industry. Firms have to accept this price as given and as such they are price-takers rather than price makers. They cannot increase the price OP individually because of the fear of losing customers to other firms. They do not try to sell the product below OP because they do not have any incentive for lowering it. They will try to sell as much as they can at price OP.
As such, P line acts as demand curve for the firm. Thus the demand curve facing an individual firm in a perfectly competitive market is a horizontal one at the level of market price set by the industry and firms have to choose that level of output which yields maximum profit.
Trends of Revenue for the Firm

Price (`) Quantity Sold Total Revenue Average Revenue Marginal Revenue
2 8 16 2 2
2 10 20 2 2
2 12 24 2 2
2 14 28 2 2
2 16 32 2 2

Firm X’s price, average revenue and marginal revenue are equal to `2. Thus, we see that in a perfectly competitive market a firm’s AR= MR= price.
Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain the equilibrium position, has to satisfy two conditions:
(i) The marginal revenue should be equal to the marginal cost. i.e. MR= MC. If MR is greater than MC, there is always an incentive for the firm to expand its production further and gain by sale of additional units. If MR is less than MC, the firm will have to reduce output since an additional unit adds more to cost than to revenue. Profits are maximum only at the point where MR= MC.
(ii) The MC curve should cut MR curve from below. In other words, MC should have a positive slope.







In figure, DD and SS are the industry demand and supply curves which equilibrate at E to set the market price as OP. The firms of perfectly competitive industry adopt OP price as given and considers P- Line as demand (average revenue) curve which is perfectly elastic at P. As all the units are priced at the same level, MR is a horizontal line equal to AR line. Note that MC curve cuts MR curve at two places T and R respectively. But at T, the MC curve is cutting MR curve from above. T is not the point of equilibrium as the second condition is not satisfied. The firm will benefit if it goes beyond T as the additional cost of producing an additional unit is falling. At R, the MC curve is cutting MR curve from below. Hence, R is the point of equilibrium and OQ2 is the equilibrium level of output.
Supply curve of the firm in a competitive market: One interesting thing about the MC curve of a firm in a perfectly competitive industry is that it depicts the firm’s supply curve. This can be shown with the help of the following example.

Can a competitive firm earn profits? In the short run, a firm will attain equilibrium position and at the same time, it may earn supernormal profits, normal profits or losses depending upon its cost conditions.
Supernormal Profits: There is a difference between normal profits and supernormal profits. When the average revenue of a firm is just equal to its average total cost, it earns normal profits. It is to be noted that here a normal percentage of profits for the entrepreneur for his managerial services is already included in the cost of production. When a firm earns supernormal profits, its average revenues are more than its average total cost. Thus, in addition to normal rate of profit, the firm earns some additional profits.




                                     PRICE




Fig.: Short run equilibrium: Supernormal profits of a competitive firm
The diagram shows that in order to attain equilibrium, the firm tries to equate marginal revenue with marginal cost. MR (marginal revenue) curve is a horizontal line and MC (marginal cost) curve is a U-shaped curve which cuts the MR curve at E. At E, MR=MC. OQ is the equilibrium output for the firm. The firm’s profit per unit is EB (AR-ATC), AR is EQ and ATC is BQ. Total profits are ABEP.
Normal profits: When a firm just meets its average total cost, it earns normal profits. Here AR=ATC.


                            PRICE






The figure shows that MR=MC at E. The equilibrium output is OQ. Since AR=ATC or OP=EQ, the firm is just earning normal profits.
Losses: The firm can be in an equilibrium position and still makes losses. This is the position when the firm is minimizing losses. When the firm is able to meet its variable cost and a part of fixed cost it will try to continue production in the short run. If it recovers a part of the fixed costs, it will be beneficial for it to continue production because fixed costs (such as costs towards plant and machinery, building etc.) are already incurred and in such case it will be able to recover a part of them. But, if a firm is unable to meet its average variable cost, it will be better for it to shut down.


In figure .the equilibrium point and at this point AR= EQ and ATC= BQ since BQ>EQ, the firm is earning BE per unit loss and the total loss is ABEP.
Long Run Equilibrium of the Firm: In the long run, firms are in equilibrium when they have adjusted their plant so as to produce at the minimum point of their long run AC curve, which is tangent to the demand curve defined by the market price. In the long run, the firms will be earning just normal profits, which are included in the ATC. If they are making supernormal profits in the short run, new firms will be attracted into the industry; this will lead to a fall in price (a downward shift in the individual demand curves) and an upward shift of the cost curves due to increase in the prices of factors as the industry expands. These changes will continue until the ATC is tangent to the demand curve. If the firms make losses in the short run, they will leave the industry in the long run. This will raise the price and costs may fall as the industry contracts, until the remaining firms in the industry cover their total costs inclusive of the normal rate of profit.
In Fig., we show how firms adjust to their long run equilibrium position. If the price is OP, the firm is making super-normal profits working with the plant whose cost is denoted by SAC1. It will, therefore, have an incentive to build new capacity and it will move along its LAC. At the same time, new firms will be entering the industry attracted by the excess profits. As the quantity supplied in the market increases, the supply curve in the market will shift to the right and price will fall until it reaches the level of OP1 at which the firms and the industry are in long run equilibrium.







(a) (b)
Fig.: Long run equilibrium of the firm in a perfectly competitive market
The condition for the long run equilibrium of the firm is that the marginal cost should be equal to the price and the long run average cost i.e. LMC = LAC = P. The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum possible. At equilibrium the short run marginal cost is equal to the long run marginal cost and the short run average cost is equal to the long run average cost. Thus, in the long run we have,
SMC=LMC=SAC=LAC=P=MR
This implies that at the minimum point of the LAC, the corresponding (shortrun) plant is worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus, at the minimum point of the LAC the above equality is achieved.
Long run equilibrium of the industry: A perfectly competitive industry is in long run equilibrium when (i) all the firms are earning normal profits only i.e. all the firms are in equilibrium (ii) there is no further entry or exit from the market.


S



S



D
    INDUSTRY


PRICE                                                                                       COST/REVENUE



Fig.: Long run equilibrium of a competitive industry and its firms
Figure shows that in the long-run AR=MR=LAC=LMC at E1. Since E1 is the minimum point of LAC curve, the firm produces equilibrium output OM at the minimum (optimum) cost. A firm producing output at optimum cost is called an optimum firm. All the firms under perfect competition, in long run, are optimum firms having optimum size and these firms charge minimum possible price which just covers their marginal cost.
Thus, in the long run, in perfect competition, the market mechanism leads to an optimal allocation of resources. The optimality is shown by the following conditions associated with the long run equilibrium of the industry:
a. The output is produced at the minimum feasible cost.
b. Consumers pay the minimum possible price which just covers the marginal cost i.e. MC=AR.
c. Plants are used at full capacity in the long run, so that there is no wastage of resources i.e. MC=AC.
d. Firms earn only normal profits i.e. AC=AR.
e. Firms maximize profits (i.e.MC=MR), but the level of profits will be just normal. In other words, in the long run, LAR= LMR= P= LMC= LAC and there will be optimum allocation of resources.
But it should be remembered that the perfectly competitive market system is a myth. This is because the assumptions on which this system is based are never found in the real world market conditions.

Question21. What do you mean by monopoly? Discuss its characteristics. Explain how price and output is determined under monopoly?
Ans. Monopoly is that market form in which a single producer controls the entire supply of a single commodity which has no close substitutes. There must be only one seller or producer. The commodity produced by the producer must have no close substitutes. Monopoly can exist only when there are strong barriers to entry. The barriers which prevent the entry may be economic, institutional or artificial in nature.

Features
1. There is a single producer or seller of the product.
2. There are no close substitutes for the product. If there is a substitute, then the monopoly power is lost.
3. No freedom to enter as there exists strong barriers to entry.
4. The monopolist may use his monopolistic power in any manner to get maximum revenue. He may also adopt price discrimination.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY
The aim of the monopolist is to maximise profits. Therefore, he will produce that level of output and charge a price which gives him the maximum profits. He will be in equilibrium at that price and output at which his profits are maximum. In order words, he will be in equilibrium position at that level of output at which marginal revenue equals marginal cost. The monopolist, to be in equilibrium should satisfy two conditions :
1. Marginal cost should be equal to marginal revenue and
2. The marginal cost curve should cut marginal revenue curve from below.
The short run equilibrium of the monopolist is shown in figure below.

AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost curve and MC is the marginal cost curve. Upto OQ level of output marginal revenue is greater than marginal cost but beyond OQ the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium where MC = MR. Thus a monopolist is in equilibrium at OQ level of output and at OP price. He earns abnormal profit equal to PRST.
But it is not always possible for a monopolist to earn super- normal profits. If the demand and cost situations are not favourable, the monopolist may realise short run losses.


Though the monopolist is a price maker, due to weak demand and high costs, he suffers a loss equal to PABC.
Long run equilibrium
In the long run the firm has the time to adjust his plant size or to use the existing plant so as to maximise profits. The long run equilibrium of the monopolist is shown in figure below.

The monopolist is in equilibrium at OL output where LMC cuts MR curve. He will charge OP price and earn an abnormal profit equal to TPQH.

In order to show the difference between the short run equilibrium and long run equilibrium under monopoly, both can be shown in a single figure.

The monopolist is in the s h o r t r u n equilibrium at E producing OS level of output. In the long run he can change the plant and will be in equilibrium at F where MR curve cuts LMC curve. The monopolist has increased his output from OS to OL and price has fallen from OP to OJ. Profits have also increased in the long run from TPQR to GHKJ.

Question22. What do you mean by monopolistic competition? Discuss its characteristics. Explain how price and output is determined under monopolistic competition?
Ans. Perfect competition and monopoly are rarely found in the real world. Therefore, professor Edward. H. Chamberlin of Harvard University brought about a synthesis of the two theories and put forth, "Theory of Monopolistic Competition" in 1933. Monopolistic competition is more realistic than either pure competition or monopoly. It is a blending of competition and monopoly. "There is competition which is keen though not perfect, between many firms making very similar products". Thus monopolistic competition refers to competition among a large number of sellers producing close but not perfect substitutes.
FEATURES
1. Large number of sellers
In monopolistic competition the number of sellers is large. No one controls a major portion of the total output. Hence each firm has a very limited control over the price of the product. Each firm decides its own price-output policy without considering the reactions of rival firms. Thus there is no interdependence between firms and each seller pursues an independent course of action.



2. Product differentiation
One of the most important features of monopolistic competition is product differentiation. Product differentiation implies that products are different in some ways from each other. They are heterogeneous rather than homogeneous. Products are close substitutes but not perfect substitutes. Product differentiation may be due to differences in the quality of the product. Product may be differentiated in order to suit the tastes and preferences of the consumers. The products are differentiated on the basis of materials used, workmanship, durability, size, shape, design, colour, fragrance, packing etc.
3. Free entry and exit of firms
Another feature of monopolistic competition is the freedom of entry and exit of firms. Firms under monopolistic competition are small in size and they are capable of producing close substitutes. Hence they are free to enter or leave the industry in the long run. Product differentiation increases entry of new firms in the group because each firm produces a different product from the others.
4. Selling cost
It is an important feature of monopolistic competition. As there is keen competition among the firms, they advertise their products in order to attract the customers and sell more. Thus selling cost has a bearing on price determination under monopolistic competition.
5. Group equilibrium
Chamberlin introduced the concept of group in the place of industry. Industry refers to a number of firms producing homogeneous products. But, firms under monopolistic competition produce similar but not identical products. Therefore, chamberlin uses, the concept of group to include firms producing goods which are close substitutes.
6. Nature of demand curve
Under monopolistic competition, a single firm can control only a small portion of the total output. Though there is product differentiation, as products are close substitutes, a reduction in price leads to increase in sales and vice-versa. But it will have little effect on the price-output conditions of other firms. Hence each will loose only few customers, due to an increase in price. Similarly a reduction in price will increase sales. Therefore the demand curve of a firm under monopolistic competition slopes downwards to the right. It is highly elastic but not perfectly elastic. In other words, under monopolistic competition, the demand curve faced by the firm is highly elastic. It means that it has some control over price due to product differentiation and there are price differentials between the firms.
Price-Output Determination under Monopolistic Competition
Since, under monopolistic competition, different firms produce different varieties of products, prices will be determined on the basis of demand and cost conditions. The firms aim at profit maximisation by making adjustments in price and output, product adjustment and adjustment of selling costs.
Equilibrium of a firm under monopolistic competition is based upon the following assumptions:
1. The number of sellers is large and they act independently of each other.
2. The product is differentiated.
3. The firm has a demand curve which is elastic.
4. The supply of factor services is perfectly elastic.
5. The short run cost curves of each firm differ from each other.
6. No new firms enter the industry.
Individual Equilibrium and Price Variation
Based on these assumptions, each firm fixes such price and output which maximises its profit. Product is held constant. The only variable is price. The equilibrium price and output is determined at a point where the short run marginal cost equals marginal revenue. The equilibrium of a firm under monopolistic competition is shown in figure 25. DD is the demand curve of the firm. It is also the average revenue curve of the firm. MC is the marginal cost of the firm. The firm will maximise profits by equating marginal cost with marginal revenue. The firm maximises its profit by producing OM level of output and selling it at Fig. 25 a price of OP. The profit earned by the firm is PQRS. Thus in the short run, a firm under monopolistic competition earns supernormal profits.



In the short run, the firm may incur losses also. This is shown in figure 26.


The firm is in equilibrium by producing an output of OQ. It fixes the price at OP. As price is less than cost, it incurs losses equal to pabc. Thus a firm in equilibrium under monopolistic competition may be making supernormal profits or losses depending upon the position of the demand curve and average cost curve.
Group Equilibrium and Price Variation
Group equilibrium refers to price-output determination in a number of firms whose products are close substitutes. The product of each firm has special characteristics. The difference in the quality of the products of the firms under monopolistic competition results in large variation in elasticity and position of the demand curves of the various firms. Similarly the shape and position of cost curves too differ. As a result there exist differences in prices, output and profits of the various firms in the group. For the sake of simplicity in the analysis of group equilibrium, Chamberlin ignores these differences by adopting infirmity assumption. He assumes that the cost and demand curves of all the products in the group are uniform. Chamberlin introduces another assumption known as 'symmetry assumption'. It means that the number of firms under monopolistic competition is large and hence the action of an individual firm regarding price and output will have a negligible effect upon his rivals.
Based on these assumptions, short run equilibrium of a firm under monopolistic competition can be shown in Figure. 27.






Figure (A) represents short run equilibrium and figures (B) the long run equilibrium. In the short run, the price is OP and average cost is only MR. Hence there is supernormal profit equal to PQRS. But in the long run, as shown in figure 27 (B), the excess profit is competed away. MC = MR at OM level of output. LAR is tangent to LAC. Price is equal to average cost and there is no extra profit. Only normal profit is earned.


Question23. What do you mean by oligopoly? Discuss its characteristics. Explain how price and output is determined under oligopoly?
Ans. Oligopoly is a situation in which few large firms compete against each other and there is an element of interdependence in the decision making of these firms. A policy change on the part of one firm will have immediate effects on competitors, who react with their counter policies.
Features
Following are the features of oligopoly which distinguish it from other market structures:
1. Small number of large sellers.
The number of sellers dealing in a homogeneous or differentiated product is small. The policy of one seller will have a noticeable impact on market, mainly on price and output.
2. Interdependence.
Unlike perfect competition and monopoly, the oligopolist is not independent to take decisions. The oligopolist has to take into account the actions and reactions of his rivals while deciding his price and output policies. As the products of the oligopolist are close substitutes, the cross elasticity of demand is very high.
3. Price rigidity.
Any change in price by one oligopolist invites retaliation and counter- action from others, the oligopolist normally sticks to one price. If an oligopolist reduces his price, his rivals will also do so and therefore, it is not advantageous for the oligopolist to reduce the price. On the other hand, if an oligopolist tries to raise the price, others will not do so. As a result they capture the customers of this firm. Hence the oligopolist would never try to either reduce or raise the price. This results in price rigidity.
4. Monopoly element.
As products are differentiated the firms enjoy some monopoly power. Further, when firms collude with each other, they can work together to raise the price and earn some monopoly income.
5. Advertising.
The only way open to the oligopolists to raise his sales is either by advertising or improving the quality of the product. Advertisement expenditure is used as an effective tool to shift the demand in favour of the product. Quality improvement will also shift the demand favorably. Usually, both advertisements as well as variations in designs and quality are used simultaneously to maintain and increase the market share of an oligopolist.
6. Group behaviour.
The firms under oligopoly recognise their interdependence and realise the importance of mutual cooperation. Therefore, there is a tendency among them for collusion. Collusion as well as competition prevail in the oligopolistic market leading to uncertainty and indeterminateness.
7. Indeterminate demand curve.
It is not possible for an oligopolist to forecast the nature and position of the demand curve with certainty. The firm cannot estimate the sales when it decides to reduce the price. Hence the demand curve under oligopoly is indeterminate.

TYPES OF OLIGOPOLY
Oligopoly may be classified in the following ways:
a. Perfect and imperfect oligopoly.
On the basis of the nature of product, oligopoly may be classified into perfect (pure) and imperfect (differentiated) oligopoly. If the products are homogeneous, then oligopoly is called as perfect or pure oligopoly. If the products are differentiated and are close substitutes, then it is called as imperfect or differentiated oligopoly.
b. Open or closed oligopoly.
On the basis of possibility of entry of new firms, oligopoly may be classified into open or closed oligopoly. When new firms are free to enter, it is open oligopoly. When few firms dominate the market and new firms do not have a free entry into the industry, it is called closed oligopoly.
c. Partial and full oligopoly.
Partial oligopoly refers to a situation where one firm acts as the leader and others follow it. On the other hand, full oligopoly exists where no firm is dominating as the price leader.
d. Collusive and non- collusive oligopoly.
Instead of competition with each other, if the firms follow a common price policy, it is called collusive oligopoly. If the collusion is in the form of an agreement, it is called open collusion. If it is an understanding between the firms, then it is a secret collusion. On the other hand, if there is no agreement or understanding between oligopoly firms, it is known as non-collusive oligopoly.
e. Syndicated and organised oligopoly.
Syndicated oligopoly is one in which the firms sell their products through a centralised syndicate. Organised oligopoly refers to the situation where the firms organise themselves into a central association for fixing prices, output, quota etc.

P. Sweezy introduced the kinked demand curve to explain the determination of equilibrium in' oligopolistic market. The demand curve facing an oligopolist has a kink at the prevailing price. This is because each oligopolist believes that if he lowers the price below the prevailing level increases his price above the prevailing level his competitors will not follow his increase in price. Due to this behavioural pattern of the oligopolists, the upper segment of the demand curve is relatively elastic and the lower portion is relatively inelastic.
If the oligopolist reduces its price below the prevailing price level MP, the competitors will fear that their customers would go away from them. Therefore, they will also reduce the price. Since all the competitors are reducing their price, the oligopolist will gain only very little sales. Hence the demand curve which lies below the prevailing price is inelastic. If the oligopolist raises his price above the prevailing price level his sales Fig. 38 will be reduced. As a result of a rise in price, his customers will go to his competitors.
Thus an increase in price will lead to a large reduction in sales. This shows that the demand curve which lies above the current price level is elastic. Since the oligopolist will not gain a larger share of the market by reducing his price below the prevailing level and will loose a large share of the market by increasing his price he will not change the price.





For determining profit maximising price-output, combination, marginal revenue curve has to be drawn. The marginal revenue curve corresponding to the kinked demand curve has a gap or discontinuity between G and H. This gap in MR curve occurs due to the kink in the demand curve and lies right below the kink. The length of the gap depends on the relative elasticities of the two portions of the demand curve. The greater the difference in the two elasticities the greater the length of the discontinuity. If the marginal of the oligopolist passes through the discontinuous portion of the MR curve the oligopolist will be maximising his profit at the prevailing price level OP. As he is maximising profits at the prevailing price level he will have no incentive to change the price.
Even if cost conditions change the price will remain stable.


When the marginal cost curve shifts upward from MC to MC1 , the price remains unchanged as MC1 passes through the gap GH.
Similarly, the price will remain stable even when the demand conditions change. When the demand for the oligopolist increases from D to D1, the given marginal cost curve MC cuts the new marginal revenue curve MR within the gap. This means that the same price continues to prevail in the market.
The major drawback of the kinked demand curve is that it does not explain the determination of price. It explains only price rigidity. Further it is not applicable to price leadership and cartels. Kinked demand curve is also not applicable to oligopoly with product differentiation. Due to these deficiencies, a general theory of pricing is impossible under oligopoly.